Geographic expansion reduces banks’ risk: New evidence

Martin Götz, Luc Laeven, Ross Levine

Economists differ on whether the geographic expansion of a bank’s activities reduces risk. A key challenge when attempting to answer this question is identification – does diversification cause lower risk, or are safer banks just also more diversified? This column uses a new identification strategy to demonstrate that geographic diversification materially reduces bank holding company risk.

Economists offer strikingly different answers to a basic question: 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. Diamond (1984) and Boyd and Prescott (1986) emphasise that diversified banks enjoy cost-efficiencies that can enhance stability. And, if diversification makes a bank too big or interconnected to fail, implicit or explicit government guarantees can lower the risk of investing in that bank (Gropp et al. 2011).

In contrast, other theories stress that bank expansion will increase risk. For example, research by Jensen (1986), Denis et al. (1997), and others suggests that bankers will expand geographically to extract the private benefits of managing a larger ‘empire’, even if this lowers loan quality and increases bank fragility. Others stress that distance can hinder the ability of a bank’s headquarters to monitor its subsidiaries, with potentially adverse effects on asset quality (e.g. Brickley et al. 2003, Berger et al. 2005).

Empirical assessments of these conflicting views have yielded mixed results. Demsetz and Strahan (1997) and Chong (1991) find that geographically diversified bank holding companies (BHCs) in the US hold less capital and choose riskier loans. Acharya et al. (2006) find that as BHCs expand geographically, their loans become riskier. In contrast, Akhigbe and Whyte (2003) and Deng and Elyasiani (2008) present evidence that risk falls as BHCs expand geographically.

A new identification strategy

A key challenge facing all of these studies is identification: Does diversification cause lower risk or are safer banks just also more diversified? If BHCs increase the riskiness of their assets when they expand geographically, then an ordinary least squares (OLS) regression of risk on geographic diversity will yield an upwardly biased estimate of the impact of geographic expansion on risk. That is, OLS estimates will understate any risk-reducing effects of geographic expansion due to attenuation bias.

In a new paper, we develop and implement a new identification strategy to better address the potentially confounding effects of endogeneity and assess the causal impact of geographic diversification on BHC risk (Goetz et al. 2016). Our identification strategy has two building blocks and is based on regulatory changes across the states of the US. First, we exploit the cross-state, cross-time variation in the removal of prohibitions on BHCs headquartered within a state to enter other states. From the 1970s through the 1990s, individual states of the US removed restrictions on the entry of out-of-state banks at different points in time. Not only did states start deregulating in different years, states often signed bilateral and multilateral reciprocal interstate banking agreements in a somewhat chaotic manner and exhibits enormous cross-state variation. This process of interstate banking deregulation took place over almost 20 years and culminated in the Riegle-Neal Interstate Banking Act of 1994, which removed all remaining barriers to entry for out-of-state banks at the federal level. This first building block yields state-time information on the legal ability of BHCs headquartered in one state to enter metropolitan statistical area (MSA) in other states, but it alone does not differentiate among BHCs headquartered within the same MSA. The second building block exploits geography. Using information on the exact street address of each BHC’s headquarters, we calculate the distance from each BHC to all MSAs outside of the BHC’s home MSA. Because of their physical location, BHCs within the same MSA have different distances to MSAs in other states. Building on the gravity theory of international trade (Frankel and Romer 1999), we hypothesise that distance differentiates among the investment behaviour of BHCs headquartered within the same MSA. We then combine the gravity model of BHC investment with the dynamic process of interstate bank deregulation to construct an instrumental variable for the diversification of each BHC across MSAs.

This gravity-deregulation methodology yields a time-varying, BHC-specific instrumental variable of cross-MSA expansion. The instrument explains actual bank expansion well and satisfies a battery of validity tests. Even when comparing BHCs headquartered within the same MSA and controlling for MSA-pair-time fixed effects, BHCs within the same MSA that are physically closer to a foreign MSA expand more into that market than BHCs headquartered in the same MSA that are further away from that foreign MSA.

Geographic diversity reduces risk

Using instrumental variables, we discover that geographic diversity reduces risk. To measure risk, we primarily use the standard deviation of a BHC’s stock returns, and confirm the results using the (inverse) Z-score and other risk measures. Across an array of specifications and robustness tests, and when examining the reduced form relationship between BHC risk and the instrument, we find a statistically significant and economically large effect. Holding other things constant, the instrumental variable estimates suggest that the expected reduction in risk from a one-standard deviation increase in the exogenous component of geographic diversification of BHC activity across MSAs is about 23% of the average value of risk, or about 52% of its sample standard deviation.

These analyses hold even when including BHC and MSA-time fixed effects. Because our gravity-deregulation methodology yields a time-varying, BHC-specific instrument of geographic diversification, we include BHC fixed effects to account for time-invariant BHC effects. Moreover, since differences in the location of BHCs headquartered within the same MSA help account for their differential expansion into foreign MSAs, we also include MSA-time fixed effects to condition out all time-varying, unobservable MSA traits, such as changes in competition or general risk at the MSA-level.

Conclusion

It is important to emphasise the boundaries of our analyses. We do not assess each of the potential mechanisms linking geographic expansion and risk. Rather, we develop a new identification strategy that allows us to assess the net impact of geographic diversity on BHC risk more precisely than past studies and gauge whether the effects of geographic diversification on risk are driven by changes in loan quality. The findings indicate that geographic expansion materially reduces BHC risk.

Authors’ note: These are the views of the authors and not those of the ECB or the Eurosystem.

References

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