Country Characteristics in Foreign Bank Investments and Risk Taking: The Role of Shared Culture, Common Institutions and Geographic Proximity

• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/infi.12066
• Date: 01 June 2015
• Author: Judit Temesvary,Ann L. Owen

Country Characteristics in

Foreign Bank Investments and

Risk Taking: The Role of Shared

Culture, Common Institutions

and Geographic Proximity

Ann L. Owen and Judit Temesvary

Department of Economics, Hamilton College, Clinton, NY, USA.

Abstract

We examine country characteristics in foreign bilateral banking rela-

tionships and explore how shared cultural heritage, common institu-

tions and geographic proximity are related to banks’foreign

investment choices. Using a newly compiled data set on BIS-reporting

banks’activities, we find that proximity and common institutional

arrangements are the primary correlates of bilateral bank portfolio

allocations. Information flow as measured by cross-country phone calls

is also strongly correlated with foreign bank investment, though the

direction of causation is unclear. Trust between individuals in the two

countries matters only as a proxy for other cultural similarities that are

We thank Boriana Pratt for valuable research as sistance. Lewis Davi s, Grace Gu, Jarrod Hunt, Ari

Farshbaf, Peter Kondor, Ayse Sapci and seminar participants at th e 2014 Annual Summer Workshop

of the Economics Insti tute of the Hungarian Academy of Scien ces provided helpful comments.

Temesvary would also like to thank the Departm ent of Economics at Cornell University for hosti ng

her during the compl etion of this project.

International Finance 18:2, 2015: pp. 227–248

DOI: 10.1111/infi.12066

© 2015 John Wiley & Sons Ltd

embedded in historical colonial relationships. We also find that the

relationship between cross-country bank regulatory differences and

bank investments has changed in the aftermath of the financial crisis.

I. Introduction

Cultural and instit utional simila rities play an importa nt role in shaping economic

exchange between countries because they mitigate informational asymmetries

(Portes and Rey 2005; Guiso et al. 2009). In the case of financial transactions in

particula r, cultural and regulator y similarit ies reduce the costs as sociated with

evaluat ing and mon itoring bor rowers and i nvestment proj ects acro ss borders.

Geographic proximit y may also play a role in reducing the costs of monitoring

investments. However, in a computerized global finan cial system with s ophisticated

means of managing risk, are factors like shared cultu re and geographic dista nce still

relevant in investment decisions? Our research answers this question affirmatively,

at least to some extent. We find that geograph ic proximity and common institutional

arrangements are ass ociated with more foreign ban k investments and risk taki ng

between countries. In contra st, we find only mixed evi dence that indicators of

common cultural herit age predict these bilate ral banking relat ionships. Finally, we

find that the link between bi lateral bank investments a nd bank regulatory arbi trage

opportunities be tween countries has dimin ished since the financial crisis.

These results are impor tant because recent developme nts in global financial

innovation have the potentia l to change the nature of g lobal banks’investment and

risk management pra ctices. Previously, when ban ks in one country a cquired assets

in another country, both the costs of doing busin ess and the costs of monitori ng

were concentrated in the target countr y. Recently, the increasing use of financial

derivatives and third- party guarantee s have enabled banks to t ransfer a substant ial

portion of the risk a ssociated with internat ional portfolio investm ents to residents of

a third country. This allows banks to separ ate the profit implications of i nvesting in

a country with a simi lar culture or close geograph ic proximity from risk manag e-

ment concerns. In theory, banks’ability to transfer risk may then enable higher risk

countries to become more integrated i nto the global financial system. However,

despite the growing sca le of foreign banking, we find t hat proximity, shared culture,

and common history or ins titutional arr angements stil l anchor these tra nsactions.

In developing these result s, our primary contributi on is that we use a unique and

detailed d ata set on bi lateral forei gn bank cl aims volume s, risk tra nsfers and

guarantees to refine our un derstanding of t he relationship bet ween countries’shared

culture, geographic proximity and regulatory similarities and the patterns of

financial transac tions across borders. O ur approach enhances th e methods of others

who have used gravity models to predict these bil ateral transact ions because we

expand the set of the sta ndard gravity mo del variables that proxy for cultu ral and

228 Ann L. Owen and Judit Temesvary

© 2015 John Wiley & Sons Ltd