Geographic expansion by banks and funding costs: New evidence

Ross Levine, Chen Lin, Wensi Xie 07 October 2016

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Should policymakers limit the geographic expansion of banks? Around the world, many regulations, laws, taxes, and other policies constrain the expansion of banks across economic borders. Some policymakers argue that as banks grow in size and geographic scope, they become more difficult to monitor. As suggested by a substantial body of research (e.g. Jensen and Meckling 1976, Scharfstein and Stein 2000, Brickley et al. 2003, and Berger et al. 2005), a worsening of corporate governance can increase bank fragility and the costs to banks of raising funds. Another potential concern is that as banks expand geographically, they become too big and interconnected to fail, distorting the allocation of capital. There are countervailing views, too. If geographic expansion adds assets to a bank’s portfolio that are imperfectly correlated with existing assets, this can reduce bank risk and lower its funding costs, as suggested by the research of Diamond (1984), Boyd and Prescott (1986), Houston, et al. (1997), and Gatev, et al. (2009).

In a recent paper, we contribute to policy deliberations and scholarly debates concerning the geographic expansion of banks by evaluating the impact of geographic expansion on the cost of a bank’s interest-bearing liabilities (Levine et al. 2016). Although existing empirical work provides valuable insights into the impact of geographic expansion on bank risk and bank valuations (e.g. Goetz et al. 2013, 2016, Calomiris 2000, Cortes and Strahan 2016), we are unaware of previous research on how geographic expansion influences overall funding costs. This is surprising since interest-bearing liabilities represent the bulk of bank liabilities.

We estimate the effect of the geographic expansion of bank holding company (BHC) assets across US states on the cost of interest-bearing liabilities. There are several advantages to examining cross-state expansion, rather than cross-country expansion. First, by studying expansion across one country, we do not have to control for differences in legal regimes and other country-specific factors that might shape bank expansion and funding costs. Second, by combining the process of interstate bank deregulation across US states with the gravity model of investment, we develop an instrumental variable for the impact of expansion on bank funding costs. It has proven difficult to develop such an identification strategy in an international setting.

Specifically, we implement Goetz et al.’s (2013, 2016) two-step procedure for constructing an instrumental variable for BHCs’ geographic expansion. First, we exploit the dynamic process of interstate bank deregulation across the US states from 1982 to 1995. Starting in 1982, individual states removed restrictions on BHCs headquartered in ‘foreign’ states from establishing subsidiaries within the deregulating state’s borders. Not only did states start the process of interstate bank deregulation in different years, they also followed very different dynamic paths as states signed bilateral and multilateral reciprocal agreements in a fairly chaotic process over many years. This first step yields year-by-year information on whether BHCs headquartered in one state can establish subsidiaries in each foreign state. This first step, however, does not differentiate among BHCs headquartered within the same state –  i.e. it does not provide information on why some BHCs in a state expand into foreign states and others do not. The second step uses the gravity model to distinguish among BHCs within the same state. The gravity model predicts that the costs of conducting economic transactions, including the costs of establishing bank subsidiaries, vary positively with distance. Thus, the gravity model predicts that when state j allows BHCs from state i to establish subsidiaries within j’s borders, BHCs headquartered in state i that are closer to state j will face lower costs of expanding into j. We exploit this as an exogenous source of variation in how interstate bank deregulation differentially affects BHCs in a state.

The integration of interstate bank deregulation with the gravity model yields a time-varying, BHC-specific instrumental variable of the cross-state dispersion of each BHC’s assets. Specifically, we (1) project the share of each BHC’s holdings of assets in subsidiaries in each foreign state j using the gravity model; (2) impose a value of zero when interstate bank regulations prohibit a BHC from establishing a subsidiary in state j; and (3) compute the projected Herfindahl index of cross-state asset holdings. We use this as the instrument for a BHC’s actual dispersion of assets.

A critical advantage of this identification strategy is that the instrumental variable differentiates among BHCs within each state and time period. Thus, we include state-time fixed effects to control for all time-varying state influences on funding costs. In this way, identification comes from comparing the differential impact of interstate bank deregulation on BHCs in the same state. Furthermore, we address concerns that other BHC-specific factors simultaneously account for both their cross-state dispersion of assets and their funding costs by (1) including BHC-fixed effects to control for all time-invariant BHC traits; and (2) controlling for time-varying BHC characteristics such as the competitiveness of the banking market in which a BHC is headquartered, as well as BHC size, capital-asset ratio, and profitability.

Given this strategy, we evaluate the impact of geographic expansion on bank funding costs. To measure funding costs, we use the implicit interest rate on a bank’s interest-bearing liabilities, i.e. total interest expenses divided by interest-bearing liabilities. To measure the geographic expansion of a BHC’s assets, we use the cross-state distribution of its subsidiaries and weight each subsidiary by its share of assets in the BHC.

We discover that geographic diversification materially lowered BHC funding costs. Geographic diversification enters the funding cost regression negatively and statistically significantly at the 1% level, and this result holds when using different measures of the cost of interest-bearing liabilities as the dependent variable and different control variables. Moreover, the estimated impact is economically large. For example, the estimates imply that a one standard deviation increase in the cross-state dispersion of a BHC’s assets will reduce the total interest expense ratio by 13.6% in our sample.

We next push things further and ask whether expansion reduces risk through a particular mechanism suggested by economic theory. We test whether geographic expansion reduces funding costs by allowing banks to hold a more diversified portfolio of assets and to manage local economic shocks more effectively. Specifically, we evaluate whether the cost-reducing effects of geographic diversification are greater when BHCs are located in states with economies that have lower correlations with the US economy and hence have greater opportunities to lower risk through geographic expansion.

The results indicate that geographic expansion reduces BHC funding costs more when the BHC is headquartered in a state that has an economy with a lower correlation with the overall US economy. This is consistent with the risk-reducing view of how geographic diversification lowers funding costs. Furthermore, the estimated impact is large. The estimates suggest that the cost-reducing effect of a BHC that expands from a home state that is perfectly negatively correlated with the US economy into an average state is more than twice as large as that of a similar BHC headquartered in a state that is perfectly correlated with the US economy that expands into the same state. The results in this paper highlight a material cost of restricting banks from using geographic expansion to diversify their risks.

References

Berger, A N, N H Miller, M A Petersen, R G Rajan, and J C Stein (2005), “Does function follow organizational form? Evidence from the lending practices of large and small banks”, Journal of Financial Economics 76, 237-269.

Boyd, J H, and E C Prescott (1986), “Financial intermediary-coalitions”, Journal of Economic Theory 38, 211-232.

Brickley, J A, J S Linck, and C W Smith (2003), “Boundaries of the firm: evidence from the banking industry”, Journal of Financial Economics 70, 351-383.

Calomiris, C (2000), US Bank Deregulation in Historical Perspective, Cambridge University Press, New York.

Cortes, K R, and P E Strahan (2016), “Tracing out capital flows: how financially integrated banks respond to natural disasters”, Journal of Financial Economics, forthcoming.

Diamond, D W (1984), “Financial intermediation and delegated monitoring”, Review of Economic Studies 51, 393-414.

Gatev, E, T Schuermann, and P E  Strahan (2009), “Managing bank liquidity risk: how deposit-Loan synergies vary with market conditions”, Review of Financial Studies 22, 995-1020.

Goetz, M R, L Laeven, and R Levine (2013), “Identifying the valuation effects and agency costs of corporate diversification: evidence from the geographic diversification of US banks”, Review of Financial Studies 26, 1787-1823.

Goetz, M R, l Laeven, and R Levine (2016), “Does the geographic expansion of banks reduce risk?”, Journal of Financial Economics 120, 346-362.

Houston, J, C James, and D Marcus (1997), “Capital market frictions and the role of internal capital markets in banking”, Journal of Financial Economics 46, 135-164.

Jensen, M C, and W H Meckling (1976), “Theory of the firm: managerial behavior, agency costs and ownership structure”, Journal of Financial Economics 3, 305-360.

Levine, R, C Lin, and W Xie (2016), “Geographic diversification and banks’ funding costs” NBER Working Paper No. 22544.

Scharfstein, D S, and J C Stein (2000), “The dark side of internal capital markets: divisional rent-seeking and inefficient investment”, Journal of Finance 55, 2537-2564.

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Topics:  Financial regulation and banking

Tags:  corporate governance, banks, banking, regulation, Too big to fail, TBTF, risk

Willis H. Booth Chair in Banking and Finance, Haas School of Business, University of California, Berkeley

Professor in Finance at Department of Finance, Chinese University of Hong Kong

Assistant Professor of Finance at the Business School, Chinese University of Hong Kong

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