International Diversification in Bank Asset Portfolios

Through their transformation of assets, banks carry a considerably degree of non-diversifiable economic risks on their books, and given that banks are extremely sensitive to deadweight costs of financial distress, we ask whether international extensions of credit may improve the diversification of such risks. Using an unpublished data set on the cross-border claims of banks located in four countries (France, Germany, the U.K. and the U.S.) to determine the degree of international diversification of bank asset portfolios, we find a substantial amount of home-country claims. We use the mean variance-portfolio model hedged for exchange-rate risk to determine the optimal degree of diversification. Relative to this benchmark, we find that banks in all countries except Germany are actually underinvesting domestically. We investigate the determinants behind the difference between the optimal and actual observed portfolios through a regression of the deviation from benchmark on variables that capture country-specific risks and other potential barriers to cross-border lending. We find that less over-investment occurs between countries that are similar in legal system and language. However, conditional on over-investment, improvement in risk factors that proxy for sovereign and private sector risk, tends to increase the extent of over-investment. Hence, these capture risks, which are idiosyncratic relative to the benchmark portfolio, but affect banks’ actual portfolios.