Risk and the Corporate Structure of Banks

by R. Christopher Small, for The Harvard Law School Forum at Harvard Law School, February 1, 2010.

In our paper Risk and the Corporate Structure of Banks, which was recently accepted for publication in the Journal of Finance, we analyze how risk affects the organizational structure of banks’ foreign operations. Our primary focus is on a bank’s decision to set up affiliates as either subsidiaries or as branches. Subsidiaries are locally incorporated stand-alone entities endowed with their own capital and protected by limited liability at the affiliate level. In other words, they are foreign-owned local banks for which the parent bank’s legal obligation is limited to the capital invested. By contrast, branches are merely offices of the parent bank without an independent legal personality. As such, the liabilities of branch affiliates represent real claims on the parent bank. Therefore, the decision to enter as either a subsidiary or a branch has important implications for the parent bank’s risk exposure.

We focus on two different, albeit related, sources of risk. First, banks are subject to credit or economic risk in the host market. Some of this risk can arise as a result of changes in macroeconomic conditions as shocks to economic activity and interest rates affect the credit worthiness of borrowers and may lead them to default on their loans, making the affiliate’s revenue uncertain. Second, host governments may engage in policies that infringe on the bank’s property rights and expropriate either fully or partially the bank’s revenue and capital. Such actions may entail direct expropriation, but extend to other policies including discretionary taxation, capital controls on repatriated profits, the redirecting of business toward state-owned or favored institutions, or forcing banks to hold government debt…(continue reading)

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