Bank organization structure affects international shock transmission

In recent decades, global have expanded internationally by establishing foreign subsidiaries and branches in many countries. Our paper shows that such increased cross-border linkages among global banks provides a channel for transmission of liquidity shocks across countries.

Increased cross-border connections among global banks can improve risk sharing if they allow global banks to easily reallocate capital via cross-border, internal capital markets on the basis of relative needs (Karolyi, Sedunov, and Taboada (2018)) or they can be harmful if they allow liquidity shocks to easily propagate across countries (Cetorelli and Goldberg (2012)).

In this paper, we examine if the organization structure of global banks affects how they respond to liquidity shocks and whether it plays a role in transmission of such shocks across countries. The answer to these questions has important implications for future regulation of global banks.

Liquidity shocks induce fire sales of liquid securities by international branches of global banks that are dependent on their parent banks for capital and funding. Thus, response of global banks to liquidity shocks can result in an increased correlation between the performance of financial markets in times of financial distress.

Our paper contributes to the current debate regarding optimal regulation of global banks in the aftermath of the global financial crisis. Regulators, concerned that global banks can transmit shocks across countries, have proposed a slew of new regulations that require global banks to establish independently capitalized subsidiaries (from their parent banks). For example, the Dodd-Frank Act ‘Intermediate Holding Company’ rule in the U.S. requires all global banks in the U.S. to be organized as independently capitalized subsidiaries. Similarly, the European ‘Capital Requirements Directive and Capital Requirements Regulation’ requires all non-EU banks to be independently capitalized from their parent bank.

Global banks resist such regulations arguing that holding multiple, fragmented pools of capital around the world, is inefficient as compared to operating a centrally managed capital pot, and that it increases the cost of bank credit. By documenting that independently capitalized subsidiaries of global banks are less prone to transmit shocks across borders, and by quantifying the magnitude of the effect, our study helps regulators and bankers to better understand the costs and benefits of new capital regulations imposed on global banks.