Were Multinational Bank Taking Excessive Risks Before the Recent Financial Crisis?

Abstract

The recent financial crisis has clearly shown that the relationship between bank internationalization and risk is complex. Previous scholars have argued that multinational banks benefit from portfolio diversification because it reduces their overall riskiness. However, researchers have radically questioned this argument on the grounds that these banks face perverse incentives, which lead them to take excessive risks. Because both theses are grounded on solid theoretical arguments, the true risks level of bank internationalization is an empirical issue. In this paper, we study the relationship between bank internationalization and risk in the period prior to the recent financial crisis. We consider market-based, forward-looking indicators (i.e., expected default frequency (EDF), credit default swaps (CDS), the Sharpe ratio, and the implied volatility of option prices on bank stock) and balance-sheet-based backward-looking measures (i.e., Z-score and earnings volatility) of excess risk for a sample of 384 listed banks from 56 countries from 2001 to 2007 and relate them to the degree of internationalization of the banks’ activities. We find robust evidence that international diversification increases bank risk.

Keywords: Banks, Risk, Multinational banking, Economic integration, Market structure

JEL Classification: G21, G32, F23, F36, L22