Does the Geographic Expansion of Banks Reduce Risk?

Does the Geographic Expansion of Banks Reduce Risk?

Economic theory provides conflicting views on a basic question in banking: does the geographic expansion of a bank’s activities reduce risk? Textbook portfolio theory suggests that geographic expansion will lower a bank’s risk if it involves adding assets whose returns are imperfectly correlated with existing assets. In addition, diversified banks might enjoy cost-efficiencies that can enhance stability. And, if diversification makes a bank too big or too interconnected to fail, implicit or explicit government guarantees can lower the risk of investing in the bank.
Other theories, however, stress that expansion can increase bank risk. Models of corporate expansion in which owners cannot easily control their managers suggest that bankers might expand geographically to extract the private benefits of managing a larger “empire,” even if this lowers loan quality and increases bank fragility. Alternatively, distance can hinder the ability of a bank’s headquarters to monitor its subsidiaries, with potentially adverse effects on asset quality. And, to the extent that diversification increases complexity, it could hinder the ability of banks to monitor loans and manage risk.
Empirical assessments of these views have yielded mixed results. This ambiguity might reflect the challenges of identifying an exogenous source of variation in geographic expansion and of accounting for where bank holding companies (BHCs) choose to expand. First, if BHCs increase the riskiness of their assets when they expand geographically, then the simple correlation between expansion and risk might overstate the causal impact of geographic expansion on risk. Second, BHCs not only choose whether to expand, but where. Textbook portfolio theory suggests that geographic expansion will appreciably lower risk only if the BHCs expands into “dissimilar” economies — those whose asset returns have low correlation with the BHC’s existing investments — and failure to account for this could bias the estimated impact of geographic expansion on risk.

Martin Goetz, Luc Laeven, and Ross Levine

The Cato Institute

August 31, 2016

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