20 September 2018

Vox EU: Foreign expansion, competition, and bank risk

This column explores how banks’ decisions to enter foreign markets impacted their individual and systemic risk. Results from a sample of European banks suggest that banks’ foreign expansions decreased risk from both an individual and systemic viewpoint. The findings cast doubt on the idea that banking globalisation was one of the culprits behind the crisis.

Ten years after one of the deepest financial crises in history, economists are still searching for the deep-rooted causes that led to the unfolding of those events. One ground of consensus is that the crisis resulted from excessive build-up of risk and leverage in the banking sector. Banks had been exposing themselves to runnable short-term liabilities too heavily and had invested in risky portfolios in search of yield. What incentives brought them to such behaviour with uncontrolled, and perhaps unintended, consequences is still a matter for heated debates.

Two general explanations have emerged and both triggered intensive theoretical and empirical research. The first is lax monetary policy, while the second is banking globalisation. There is extensive and solid-grounded evidence that lax monetary policy played a significant role. A number of studies have assessed the role of banking globalisation for the dynamics of credit, but none so far has addressed the question relating bank decisions to enter foreign markets to their impacts on a battery of measures of their individual and systemic risk.

In particular, authors started by collecting foreign entries for 15 European banks classified as globally systemically important banks (GSIBs) by the Basel Committee on Banking Supervision(2014), at the end of 2015 over a 10-year time period from 2005 to 2014.

Next, they matched their entry data with several balance sheet variables and a rich set of risk metrics. They use several standard risk metrics taken from the literature. Most importantly, they consider both individual and systemic risk metrics. For individual risk they use market-based metrics as well book-based indicators founded on banks’ internal risk models. This makes sure that their results are not driven by either exuberant market conditions or biased internal risk assessment. The metrics of individual risk authors consider are credit default swap (CDS) price, loan-loss provision ratio, the standard deviation of returns, the Z-score, and the leverage ratio. As systemic risk metrics they use the conditional capital short-fall, the long-run marginal expected shortfall and the ΔCoVaR computed using either CDS prices or equity prices.

Authors found a clear negative correlation between risk and openings during the 2005–2014 period. Similar patterns can be observed for the other risk metrics.

From a theoretical standpoint, when a bank expands to a foreign market where competitive pressure differs for its home market, the implications for the bank’s riskiness are ambiguous. The impact of more competition on overall bank risk is ambiguous because not only may more competition increase or decrease the amounts of deposits raised and loans extended by the bank, but also the change in firm risk-taking on the assets side may dominate or be dominated by the opposite change in bank run-vulnerability on the liabilities side.

Despite theoretical ambiguity, their empirical analysis finds that expansion in foreign markets that are more competitive than the home one reduces individual bank risk. Results are less clear-cut for systemic risk. This is understandable. Systemic risk is likely to depend upon a number of market-based characteristics (such as the type of interconnections) and other macro externalities that go beyond competition.

In this respect, their results also suggest that the consolidation of the banking industry promoted by regulators to promote stability in the aftermath of the financial crisis may entail some unintended consequences for bank riskiness through the competition channel.

Full article

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