Since the late 1990s, the importance of multinational banks has grown dramatically. Between 1999 and 2009 the average share of bank assets held by foreign banks in developing countries rose from 26 percent to 46 percent. The bulk of the pre-global crisis evidence analyzing the consequences of this significant transformation in bank ownership suggests that foreign bank participation brought many benefits to developing countries, especially in terms of bank competition and efficiency.
The recent global financial crisis, however, highlighted the role of multinational banks in the transmission of shocks across countries. Most of the research has focused on transmission through the lending channel – how foreign bank lending behaved during the crisis. A number of papers, including some before the recent global crisis, have documented that lending by foreign bank affiliates declines when parent banks’ financial conditions deteriorate.
Rather than focus on how parent banks transmit shocks to their affiliates through the lending channel, in a recent paper, Deniz Anginer, Eugenio Cerutti and I explore the association between parent banks’ and subsidiaries’ default risks during the recent crisis.* More specifically, we examine whether an increase in the default risk of a parent bank is positively correlated with a similar rise in its foreign subsidiaries’ default risk. We also examine the factors that dampen or amplify the correlation between parent banks’ and foreign subsidiaries’ default risks. In particular, we examine the role of subsidiary financial characteristics (such as capital and funding structure) and the impact of host country bank regulations (e.g., pertaining to bank capital, reserve requirements, bank activities, etc.)..
We use data for 93 publicly listed foreign bank subsidiaries, operating in 36 host developing countries and owned by 41 parent bank groups, headquartered in 24 home countries, during the period from September 2008 to December 2009. We estimate the weekly correlation between parents’ and subsidiaries’ distance to default and investigate the factors that affect this correlation. Distance to default, which is based on Merton’s (1974) structural credit risk model, is the difference between the market asset value of the bank and the face value of its debt, scaled by the standard deviation of the bank’s asset value. Hence, distance to default is inversely related to default risk. Our focus on developing countries as hosts of foreign bank subsidiaries is driven by the fact that these countries were not at the core of the global financial crisis, allowing us to better identify factors that might help insulate affiliates from their parents potentially in trouble.
Our empirical findings show that a subsidiary’s distance to default is significantly correlated with the parent bank’s distance to default, even when we account for the distance to default of other banks and firms in the home and host countries, as well as for global factors that may influence subsidiaries’ distance to default. This finding is robust to the sample of banks considered and to the way we calculate the distance to default measure. Also, we find that certain subsidiary characteristics influence the correlation in the distance to default between subsidiaries and parents. In particular, this correlation is lower for subsidiaries that have higher capital, retail deposit funding, and profitability ratios and for subsidiaries that are more independently managed from their parents. Finally, the regulatory regime in place in the host countries also affects the extent to which shocks to the parents’ distance to default influence subsidiaries. In particular, the correlation between the distance to default of the subsidiary and the parent is lower for subsidiaries operating in host countries that impose higher capital, reserve, provisioning and disclosure requirements and tougher restrictions on bank activities.
Change in the distance to default across all multinational parent banks and foreign subsidiaries
* Anginer, D., Cerutti, E., Martinez Peria, M.S. “Foreign Bank Subsidiaries' Default Risk During the Global Crisis: What Factors Help Insulate Affiliates from Their Parents?” Policy Research Working Paper 7053.