How does the geographic spread of a bank’s subsidiaries affect its value?

Our new research show that the values of banks in emerging countries are highly responsive to their internationalisation strategies

Georgios EfthyvoulouFrom the mid-1990s and up until the onset of the global financial crisis, the internationalisation of financial institutions increased dramatically. The main contributing factors to this phenomenon were the liberalisation and deregulation of financial markets, the higher demand for international financial services arising from increased economic and financial integration, and the mitigation of geographic distance effects on bank efficiency through technological improvements.

In recent years, though, the global banking sector has undergone a major transformation, which accelerated in the wake of the global financial crisis. Banks from the Eurozone and other developed economies retrenched from several foreign markets due to lower margins on foreign business in countries where they lacked scale and expertise. A substantial regulatory overhaul subsequent to the crisis also created disincentives for multinational banks from advanced economies to maintain large and complex foreign operations. Banks from emerging economies, on the other hand, continued to expand abroad – following the increasing dominance of their countries in the world economy in recent years – and became more regionally integrated. As a result, the current landscape of global banking encompasses a larger variety of players, with banks from emerging markets having an increasingly important role, and is characterised by a rising trend towards greater regional activity.

In a recently published study in the Journal of Financial Stability, Canan Yildirim and I use recent data from the 150 largest banks across the world – originating from both developed and emerging economies – to examine how the performance of these banks (as measured by their valuations) are affected by changes in their geographic diversification (the cross-country distribution of their subsidiaries).

Our study explicitly factors in the conditionality of the bank diversification-performance relationship upon the locus of destination of the diversification efforts: regional versus global. The key insight here is that a region, defined in geographic terms, consists of countries with lower physical, economic, cultural and institutional distance from each other than at the global level. The regional focus of banks’ international activity can thus be explained by what is referred to as ‘compounded distance’; that is, the need to manage various dimensions of distance simultaneously (Rugman et al., 2011). This clearly suggest that, in order to gain a better understanding of the performance implications of banks’ geographic diversification, it is imperative to account for the existence of regional boundaries. To this end, our study employs internationalisation measures that have never been used in the banking literature, and makes a distinction between two types of geographic diversification: intra-regional, referring to diversification within a single region where the bank is already present, and inter-regional, referring to diversification across different regions.

Our empirical analysis produces two main results. First, higher levels of geographic diversification are associated with changes in valuations for emerging country banks (EC banks), but not for developed country banks (DC banks). Second, the direction of effects depends on the locus of destination of the diversification efforts: while higher levels of intra-regional diversification lead to value enhancement, higher levels of inter-regional diversification seem to induce a negative (but statistically unstable) effect on the valuation of EC banks. Specifically, the results suggest that the long-run value of Tobin’s Q ratio (a company – or bank’s – market value divided by the replacement value of its assets)  for EC banks increases by 0.8 standard deviations when their intra-regional diversification increases by 1 standard deviation, and decreases by 0.3 standard deviations when their inter-regional diversification increases by 1 standard deviation.

Our study also sheds light on potential explanations for the aforementioned findings. When EC banks diversify across different regions, they face extensive challenges and high risks (especially in periods of heightened financial distress), which can eliminate or even outweigh the high profitability gains that can be drawn from having access to an expanded multi-regional network. On the other hand, when they engage in a more regionally-concentrated strategy, they achieve an increase in profitability without being penalised as much in terms of risk. Through intra-regional diversification, it is indeed possible to access different markets and resources embedded in different countries in the region, while, due to geographic proximities and institutional and cultural similarities, adaptation costs and risks remain relatively low. As suggested by Arregle et al. (2009), although countries continue to matter, national markets in the same region share similarities that decrease the newness of the problems and the liability of foreignness.

Given that a regional focus is becoming increasingly important in global banking, the absence of value gains for DC banks can be attributed, to some extent, to dismal growth prospects and costly regulations in the banking markets of these countries, especially since the onset of the global financial crisis. Furthermore, DC banks do not only operate in more financially and institutionally developed countries, but are also larger, more mature and earlier-comers to the internationalisation stage compared to EC banks. Consequently, the marginal benefits and costs of pursuing further geographic diversification (either regionally or globally) are much weaker for these banks.

The expansion of international financial institutions has been particularly strong since the mid-1990s, reflecting the sharp increase in financial globalisation. Given the concerns about global banks serving as a risk transmission channel, the extent of international diversification gains in banking is critically important for investors, bankers and policy-makers. The design of regulatory policies and geographic expansion strategies should take into account that aggregate or total international diversification is not a sufficient indicator of bank multinationality, and that the value gains from international expansion depend on the banks’ home country set-ups and the locus of international diversification, as indicated by the results of this paper. In particular, our finding that EC banks’ valuations are highly responsive to their internationalization strategies may be of help to policy-makers in ECs, with regards to implementing policies aiming at encouraging the diversification of banking, especially within the same region.