International diversification gains and home bias in banking

December 2007

Abstract

This paper assembles a bank-level dataset covering the operations of 38 international banks from eight industrial countries and their 399 subsidiaries overseas during 1995-2004, and studies the extent of the diversification gains from their local operations in industrial and emerging economies. Linking parent banks with their foreign subsidiaries and classifying the latter by their location, the paper finds that increasing the assets allocated to their foreign subsidiaries, enhances the risk-adjusted profitability of international banks. These gains are reduced-but by no means depleted-when they concentrate their subsidiaries in specific geographical regions, which tends to be the pattern of international bank expansion. Using the mean-variance portfolio model, the paper also finds a substantial home bias in the international allocation of bank assets. Overall, the results indicate that international diversification gains in banking are substantial, albeit largely unexploited by current bank expansion strategies. The results support the notion that risk weighting in the single factor model under Basel II may be excessively penalizing because it weighs international bank exposures only on the basis of the idiosyncratic risk of the recipient countries without accounting for cross-country diversification gains.