Michael Hsu was a financial sector expert at the International Monetary Fund when the first version of this paper was written. The authors are grateful to Jose Vinals, Christopher Towe, Rina Bhattacharya, Julian Chow, Luis Cortavarria, Michaela Erbenova, Alessandro Giustiniani, Daniel Hardy, David Hoelscher, Elias Kazarian, Michael Moore, and other IMF colleagues for helpful comments and input. The paper also benefited from comments and suggestions by a number of home and host supervisory authorities and key private sector representatives of the financial industry. The views expressed in this paper are those of the authors.
Some host countries (e.g., Brazil, Mexico, and New Zealand) encourage, or require, subsidiarization of local business units. Differences in corporate tax rates across home and host countries, or differential treatment of overseas profits from branches and subsidiaries (e.g., the United Kingdom), are also known to influence banks’ choice of legal mode of incorporation into a host country.
In some cases, such constraints may be two-sided, while in others may operate in only one direction. For example, Brazil has ring-fencing regulations to prevent Brazilian subsidiaries from moving funds to their parents but has no barriers on parent funding of the subsidiaries using various instruments (e.g., equity or debt).
For example, in Argentina, Bolivia, Brazil, Chile, Ecuador, India, and Korea, branches face local capital and liquidity charges identical to those applied to subsidiaries and require local representation on their boards.
Note, for example, that within the European Union, interbank and intra-group exposures with a duration of less than one year have been exempt from large exposure rules.
For example, the Swedish Support Act 2008/09:61 explicitly states that the liquidity situation in a Swedish bank’s foreign subsidiaries can be expected to improve through the Swedish guarantee program.
The European Commission’s Study on the feasibility of reducing obstacles to the transfer of assets within a cross-border banking group during a financial crisis, Final Report, April 2010 (http://ec.europa.eu/internal market/bank/windingup/index en.htm.), provides recommendations on lifting restrictions on intra-group transfers of assets if such transfers can potentially limit the extent of a crisis.
In the words of one large, global, cross-border banking group, the branch structure “enables banks to offer clients access to the parent company balance sheet and leverage the full balance sheet to provide support to clients, offering the potential for lower lending costs and enhanced credit availability in host countries.”
By centralizing trades and cash management activities, the group is able to net its customer obligations and rights and deliver only the net amount to third parties, which would reduce the total liquidity needed by the group.
Appendix I describes the Spanish cross-border banking model as an example of a decentralized approach toward risk management in a global retail bank; it draws, in part, on Asociacion Espanola de Banca (2010).
See Appendix II for a summary of views from a sample of major global banking groups regarding subsidiarization and the drivers of preference for legal corporate structure.
Figures 1 and 2 provide the geographical distribution of branches and subsidiaries of foreign banks. The number of branches is generally larger than the number of subsidiaries in Asia, the Middle East, North America, and western Europe, while subsidiaries outnumber branches in Latin America and central and eastern European countries. For most advanced economies (with the exceptions of France and Switzerland), the number of branches of foreign banks is larger than the number of subsidiaries. In contrast, subsidiaries appear to dominate (both in terms of number and total assets) in most emerging market economies, where the frequency of macroeconomic and financial dislocations tend to be higher than in advanced economies.
Staff analysis (available upon request) presents some limited evidence that the stability and resilience of intra-group capital flows are related more to idiosyncratic factors in a country than to the legal structure of foreign banks in host countries.
See Box 2 for further information on home/host supervisory responsibilities regarding foreign bank affiliates.
A good example of such cooperation is the two-tier supervision practice of the operations of the two large Spanish banks’ overseas subsidiaries, where close cooperation exists between home and host supervisors.
If the organizational structure of the banking group is too complex, it may be difficult for senior management of the group to monitor and stay on top of what risks are being assumed within the organization. The crisis produced examples of CEOs and other senior management acknowledging that they were unaware of the risks and exposures assumed by their institution. The experience of some European banks and of Lehman during the recent crisis suggests that an affiliate can take on excessive risks and incur losses that could create significant financial stability risks, threatening the stability of the entire group regardless of its structure.
An extreme variant of such self-sufficiency, the “stand-alone subsidiarization” (SAS) model, was explored by the U.K. Financial Services Authority (2009) as a way to reduce the likelihood of costly banking group failures by requiring group affiliates to be organized independently of each other and the parent, with complete firewalls between different parts of the group. While offering some potential benefits (e.g., by isolating the failure to the parent and/or specific affiliates), the adverse implications of SAS may be significant (e.g., hampering the ability of a banking group to manage liquidity and capital on a group-wide basis, given the strict constraints on intercompany flows and transfer of capital and liquidity to individual affiliates—factors that may in turn affect the stability of the group as a whole).
A counter-argument to this may be that a subsidiary structure may complicate, rather than facilitate, resolution. Recently, an informal group of 10 creditors proposed treating the many subsidiaries of Lehman Brothers as one entity in an effort to boost the payouts to bondholders and reduce those to subsidiary creditors. Creditors have argued that their payouts would be boosted if the various subsidiaries (18) are combined as opposed to carrying out the resolution with a subsidiary-by-subsidiary approach (see Financial Times, December 16, 2010, http://www.ft.com/cms/s/0/0eb247d6-08aa-11e0-b981-00144feabdc0.html#axzz19dMw9XHG).
The idea of a living will—proposed by the United Kingdom’s FSA—is a prominent example of a set of proposals targeted to preserve a firm as a going concern (without public support), to promote resilience of key functions, and facilitate rapid resolution or wind-down in a scenario of severe financial distress. The overall objective of all such proposals is similar to that of the idea discussed in this paper, that is, to resolve TITF institutions without systemic disruption and without putting public finances at risk.
See Appendix III which illustrates the point that under stricter forms of ring-fencing, banking groups have substantially larger needs for capital buffers at the parent and/or subsidiary level than under less strict (or in the absence of any) ring-fencing.
These exclude costs that banking groups organized largely as branch-based structures may have to incur if they are transformed into subsidiaries. In discussions on this issue, many bankers say that the subsidiary approach may be more costly in terms of capital, liquidity, operating flexibility (e.g., lending limits, or requirements to conduct certain businesses) and administrative expense than a branch system. The impact on the parent bank’s desired return from its operations in host countries may in some cases induce the bank to simply exit the market or refocus its activities. Empirical information to support these arguments, however, was not available.
For more details, see Cerutti et al. (2010).