Foreign banks contribute potentially large longer-term benefits to their host economies (see, for example, Claessens and van Horen 2012). But the experience of the recent crisis has revealed that their lending can be more cyclical than that of domestic banks (Cetorelli and Goldberg 2011, Claessens and van Horen 2012, De Haas and Lelyveld 2011). The financial stability impact of retrenchment by foreign banks has been a major concern for some economies. In 2009, in Central and Eastern Europe these risks resulted in a coordinated policy action (the so-called Vienna Initiative), which encouraged foreign banks to maintain their exposures there (De Haas et al. 2012).
But most studies of foreign bank lending during the recent crisis have a major shortcoming -- they do not distinguish between foreign branches and subsidiaries. This distinction seems to be important. New evidence suggests that foreign bank branches significantly amplified the domestic credit cycle in the UK (Figure 1) (Hoggarth, Hooley, and Korniyenko 2013). And studies of the US and Italian banking systems have also found that lending by foreign branches was particularly cyclical during the recent crisis (Goulding and Nolle 2012, Albertazzi and Bottero 2013).
Figure 1. Annual growth in bank lending to the UK private sector
Sources: Bank of England, BIS and Bank calculations.
Notes: See Hoggarth, Hooley and Korniyenko (2013).
Branches vs subsidiaries: What is the difference?
Branches differ from subsidiaries in several important respects. A branch is legally inseparable from its parent, whereas a subsidiary is a separate legal entity. This means that a branch is mainly supervised by its home authorities as part of supervision of the banking group as a whole, whereas a subsidiary is authorised and separately regulated and supervised by the authorities in the host country. And in contrast to subsidiaries, branches are not usually separately capitalised.
What determines whether a banking group operates abroad through a branch or a subsidiary structure? Attitudes of the host authorities are important, which is reflected in cross-country differences in national regulation and taxation. A bank’s business model may also favour a particular regulatory structure. Banks with significant wholesale market operations tend to prefer to operate abroad through a branch structure given the greater flexibility to move funds across the banking group. In contrast, global retail banks usually prefer a more decentralised subsidiary model, more focused on raising deposits from retail customers in the host economy. That said, although the legal distinction between a branch and subsidiary is clear, the regulatory treatment, in practice, sometimes overlaps.
Why was lending by foreign branches so cyclical?
During the recent credit boom and bust, lending growth by foreign branches to the UK private sector was extremely cyclical, reaching a peak of 23% in 2007 Q3, and falling to a trough of minus 23% in 2009 Q3 (see Figure 1, red line). The cyclicality of lending growth by UK-owned banks and foreign subsidiaries was significantly lower (Figure 1, orange and green lines, respectively).
Moreover, these large swings in branch lending materially amplified the credit crunch in the UK. Although a lot of their business activities tend to be with non-residents, foreign branches are important sources of credit for UK financial and non-financial companies. For example, foreign branches accounted for around 20% of lending to UK non-financial companies prior to the crisis.
These observations also have a wider relevance. Although foreign branches play a particularly important role in the UK – accounting for almost one-half of total banking system assets in 2007 – they also account for around 10% of total bank assets in other major economies such as US, Italy, and Ireland (Figure 2).
Figure 2. Assets of foreign branches
Sources: National central banks and Bank calculations.
Notes: See Hoggarth, Hooley and Korniyenko (2013).
Why was lending by branches so cyclical? We identify several demand and supply factors during the post-crisis period for the case of the UK, which factors are supported by empirical evidence, including regression analysis of a panel of over 100 UK resident banks – foreign branches, foreign subsidiaries, and UK-owned banks.
- A more cyclical business model.
Lending by foreign branches was more concentrated in sectors where credit demand was more sensitive to the recent domestic economic cycle, such as lending to financial companies.
- Lower loan supply standards.
Branches may have been willing – and able – to take on more credit risk. This is suggested by the fact that during the pre-crisis boom lending by foreign branches to most sectors grew more rapidly than was the case for domestic banks and foreign subsidiaries.
- More unreliable sources of external funding.
Foreign branches appeared to rely more heavily on interbank funding, especially from abroad, that turned out to be fickle during the crisis. This may have forced branches to cut back lending to the UK real economy.
- Liquidity withdrawals by the parent bank.
Foreign branches, in aggregate, up-streamed lending significantly to other parts of their banking groups abroad during the crisis -- in contrast to both UK-owned banks and subsidiaries. Figure 3 shows that in net terms, branches up-streamed over 5% of their balance sheet to their own banking group. Cetorelli and Goldberg (2012) also observed similar trends in the US.
Figure 3. Claims and liabilities of UK-resident banks with their own banking group abroad
Source: Bank of England.
Dead or alive? Some lessons for regulators
Much of the policy debate regarding foreign branches since the crisis has been on how to effectively resolve them when they are ‘dead’. The need for improved resolution regimes was highlighted by cases such as the failure of Landsbanki UK – a branch of Icelandic-owned bank whose subsequent resolution proved problematic. The FSB and G20 have made much progress on cross-border resolution agreements, although there is clearly more to be done.
But the recent experience of the UK suggests that regulators may also need to pay close attention to the risks that branches – particularly large ones – may pose to financial stability and the broader economy when they are ‘alive’. We suggest three potential lessons for prudential regulation and supervision:
- Macroprudential policymakers should monitor lending growth not just in aggregate, but also by different types of banks.
Periods of unusually rapid credit growth are often a harbinger of a subsequent sharp reversal associated with large bank losses and, in some cases, bank failure. Our study of the UK shows that different types of banks exhibited large differences in the amplitude of their lending cycles. National macroprudential policymakers should, therefore, monitor closely the growth in domestic lending not only in aggregate, but also by different types of banks, and to different sectors of the economy.
- International cooperation is essential for effective supervision of foreign branches.
Effective supervision of foreign branches is potentially more difficult than for foreign subsidiaries and domestically owned banks. Host authorities have more limited information on the strength of the banking group as a whole – of which a branch belongs to – than home authorities. Host regulators also have more limited policy tools to supervise — as well as to resolve — foreign branches, since they largely fall outside national regulatory perimeters. There is also a question whether the surveillance job could fall between the cracks of host and home national prudential policymaking bodies.
This highlights the importance for host authorities to have access to timely and comprehensive information on the parent bank as well as on its branch. It also reinforces the need for close collaboration over policy actions with the foreign banking group’s home authorities. For example, reciprocity agreements with other supervisors may be a way forward to make national macroprudential policies more effective.
- Regulatory approaches to foreign branch activity may need to be reviewed, but tighter restrictions on foreign branch activity should be balanced against the risks from regulatory fragmentation.
The relatively higher reliance of branches on unstable funding sources that turned out to be fickle suggests there could be tighter limits on borrowing and lending by existing branches within their own banking group, and more generally, of banks financing domestic credit from funding cross-border rather than domestic deposits. At one end of the spectrum, some propose full ring-fenced subsidiarisation of foreign branches (Turner 2014).
But the question of tighter regulation of foreign branches needs to be seen in the broader context of the economic and financial stabi