## _wp16109 - 2009.  The  last  two  studies,  in  particular,  find  that  foreign  bank  affiliates  whose  parents’  relied

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### Contribution and research focus
- Introduces a previously unexamined transmission mechanism: the correlation in default risks between a global bank (parent) and its subsidiaries.
- Argues default risk is the “ultimate risk” for banking stability with direct implications for depositors, borrowers, and governments that may pay insured depositors or recapitalize large banks.
- Uses daily stock market data to measure default risk, enabling high frequency and forward-looking analysis of shock transmission as an advantage over lower frequency loan data.

### Data
- Original database of stock market prices and balance sheet characteristics for publicly traded parent banks and their publicly traded subsidiaries in developing countries.
- Final sample: 93 publicly listed foreign subsidiaries, operating in 36 host developing countries, owned by 41 parent bank groups, headquartered in 24 home countries.
- Period of analysis: from September 2008 to December 2009.
- Median ownership stake in the sample: about 61 percent.
- Initial identification found about 167 listed banks in about 44 host countries; final sample reduced due to low trading frequency and high parent ownership in many subsidiaries.
- Data sources:
  - Daily stock market information from Compustat Global for international banks and firms.
  - Stock market information from CRSP for U.S. banks and firms.
  - Bank balance sheet variables from Bankscope.
  - Host country regulatory variables from the World Bank 2007 Bank Regulation and Supervision survey.
  - VIX data from the Chicago Board Options Exchange (CBOE).
  - ∆DEF (default spread) from Federal Reserve Board interest rate releases (difference in Baa-Aaa yields).
- Bank-level variables measured as of December 2006 and winsorized at the 1st and 99th percentile:
  - relative bank size (bank assets to total system assets)
  - capital ratio (regulatory capital to risk weighted assets)
  - equity ratio (equity to total assets)
  - provisions (loan loss provisions divided by total loans)
  - deposit funding (deposits divided by total funding)
  - profitability (net income divided by total assets)
  - liquidity (liquid assets divided by total assets)
- Notes:
  - Assets and equity in mentioned ratios are book values.
  - The 2007 survey covers the 2005-2006 period.

### Empirical methodology
- Main default-risk measure: Merton (1974) distance to default (dd), computed as the difference between market asset value and face value of debt, scaled by standard deviation of asset value.
- Key elements of computation:
  - Market value of equity (V_E) used; total liabilities proxy for face value of debt X.
  - s_E is standard deviation of daily equity returns over past 3 months; require at least 45 non-missing daily returns over previous three months.
  - T set to one year; r is one year US treasury yield (risk-free rate).
  - Interpolate annual accounting items linearly over dates to avoid jumps.
  - Solve simultaneously for V_A and s_A using Newton method with starting values V_A = V_E + X and s_A = s_E V_E/(V_E + X).
  - Winsorize s_E and V_E/(V_E + X) at 1st and 99th percentiles.
  - Assign asset return m equal to equity premium of 6% following Campbell, Hilscher and Szilagyi (2008).
  - Default probability PD = F(–dd) where F is the CDF of standard normal.
- Robustness checks:
  - Alternative equity premium of 12% yields 96% correlation in levels of dd and 99% correlation in changes of dd with baseline.
  - Simplified Byström (2006) formula also computed: log (X/(V_E+X)) / (X/(V_E+X)-1) × s_E.
- Estimation approach to measure correlation:
  - Weekly change in subsidiary dd regressed on weekly change in parent dd, controlling for average dd changes of all publicly traded banks and companies in host and home countries (excluding the focal parent and subsidiary), changes in corporate credit spreads (Bbb–Aaa), weekly change in VIX, subsidiary fixed effects, and sometimes time dummies.
  - Equation (5) captures baseline correlation; equation (6) adds interactions of parent dd changes with subsidiary characteristics (size, liquidity, funding structure, capital, etc.) measured as of December 2006, and host country regulations measured as of 2006.
  - Errors clustered at host country level.
- Subsidiary characteristics considered (pre-crisis):
  - Total assets (size)
  - Provisions (asset quality proxy)
  - Return on assets (profitability proxy)
  - Local deposit funding (funding liquidity proxy)
  - Liquid assets as percentage of total assets (asset liquidity proxy)
  - Tangible equity and regulatory capital over risk-weighted assets (capital measures)
- Distance/proximity measures between parent and subsidiary:
  - Geographical distance: log of distance (kilometers) between parent/home country and host country.
  - Cultural proximity: common official language indicator.
- Host country regulatory variables examined (measured prior to crisis):
  - Capital regulation index (0 to 10; higher = greater stringency)
  - Activity restrictions index (values 3 to 12; higher = more prohibited activities)
  - Disclosure requirements index (0 to 3; higher = greater disclosure)
  - Diversification requirements index (0 to 2; higher = more diversification)
  - Loan classification stringency (minimum days for arrears classification)
  - Provisioning stringency (minimum provisions as % of loans)
  - Supervisory powers index (0 to 14; higher = greater powers)
  - Prompt corrective powers index (0 to 6; higher = more promptness)
  - Reserve requirements (average reserves required relative to deposits and other short-term liabilities)
  - Financial outflow restrictions (average of three binary variables from IMF Annual Report on Exchange Arrangements and Restrictions)

### Theoretical priors and expectations
- Expect positive correlation between parent and subsidiary dd due to:
  - Internal capital markets reallocating resources away from subsidiaries.
  - Perceptions that weaker parents are less able to support subsidiaries.
  - Shared business models leading to common exposure to shocks.
- Expected dampeners of correlation:
  - Subsidiary profitability and high quality assets (higher return on assets, lower provisions).
  - Greater subsidiary size (total assets) — may benefit from too-big-to-fail guarantees and more stringent local oversight.
  - Higher local deposit funding and higher liquid assets.
  - Higher capital (tangible equity and regulatory capital).
  - Greater geographical distance may reduce correlation by limiting parent control.
  - Cultural proximity ambiguous: could reduce correlation via greater decentralization or increase correlation via closer ties.
  - Stronger host country regulatory/supervisory frameworks (capital stringency, provisioning, classification, supervisory powers, prompt corrective powers, disclosure) expected to reduce parent–subsidiary dd correlation.

### Key empirical results
- Visual evidence: median weekly changes in Merton’s dd for parents and subsidiaries from September 2008 to December 2009 show very high correlation.
- Regression evidence (Table 3 columns (2.1)-(2.4)):
  - Foreign subsidiary dd is significantly correlated with parent dd after controlling for average dd of firms in home and host countries and global factors like VIX and corporate credit spread.
  - Correlation magnitude:
    - Maximum of 0.45 when only subsidiary fixed effects are added.
    - Minimum of 0.27 when time and subsidiary dummies are included.
  - Correlation is statistically and economically significant and is almost twice as large as the correlation between subsidiary dd and all companies in home and host countries.
- Using the Byström (2006) simplified dd measure:
  - Correlation between foreign subsidiaries and their parents remains highly significant, ranging between 0.2 and 0.3.
- Sensitivity to parents with multiple subsidiaries:
  - Excluding parent banks owning multiple subsidiaries (e.g., Barclays, BNP Paribas, Citibank, HSBC, ING, Société Générale, Standard Chartered) does not materially change estimates.
  - Correlation varies between 0.26 and 0.29 when such parents are excluded.

### 4.2 The factors that affect the correlation between the parent and subsidiary distance to default — Overview
- Subsidiary characteristics examined: size, capitalization, funding structure, liquidity, profitability, provisioning, and distance from the parent (both geographical and cultural).
- Purpose: to explore whether the association between the Merton distance to default of foreign bank subsidiaries and that of their parents changes with these subsidiary characteristics.

### 4.2 Key empirical findings
- Parent banks’ distance to default is less correlated with subsidiaries’ distance to default when subsidiaries have higher deposit funding ratios.
  - Numerical effect reported: a one standard deviation increase in the deposit funding ratio lowers the association between the distance to default of the parents and the subsidiaries from 0.28 (0.32) to 0.21 (0.27).
- Geographical distance matters:
  - The association between parents’ and subsidiaries’ distance to default is lower for countries that are physically distant.
  - The same numerical change for geographical distance is reported alongside deposit funding ratio: from 0.28 (0.32) to 0.21 (0.27).
- Cultural proximity matters:
  - For subsidiaries that are culturally close to the parents the correlation between the parents and the subsidiaries is 0.33.

### Interpretation of geographical distance and cultural proximity
- Geographical distance and cultural proximity are interpreted as proxies for more independent management of subsidiaries from their parents.
- Evidence for this interpretation is suggestive but not conclusive.
- For a subset of 47 subsidiaries, a proxy for subsidiary management independence was constructed: the share of declared independent board members (defined as members owning no or a small number of shares in the bank, not clients or suppliers of the bank, and without family members working in the bank).
- The share of independent board members interacted with the parent distance to default is positively and significantly correlated with the interaction of parent distance to default with:
  - geographical distance: correlation = 0.92
  - cultural proximity: correlation = 0.65
- The negative interaction of geographical distance and cultural proximity measures with the parent distance to default is interpreted as suggestive that more independently managed subsidiaries exhibit a lower correlation between subsidiaries’ and parents’ distance to default.

### Subsidiary characteristics that affect parent–subsidiary default correlation
- Even when controlling for host country dummies–parent distance to default interactions, subsidiary characteristics matter.
- Subsidiary features associated with a lower correlation between subsidiaries’ and parents’ distance to default:
  - higher retail deposit funding ratios
  - greater cultural proximity to the parent (i.e., cultural closeness)
  - greater management independence (as proxied by share of independent board members)
- Empirical example cited: for subsidiaries that have higher retail deposit funding ratios and that are culturally closer to the parent, the correlation between subsidiaries’ and parents’ distance to default is lower.
- Additional numeric note in source: "0.13 for those that are not culturally similar."

### Host-country banking regulations and their effects
- Host-country regulatory characteristics are associated with lower parent–subsidiary distance-to-default correlations when regulators impose:
  - greater disclosure requirements
  - higher capital requirements
  - higher reserve requirements
  - stronger provisioning requirements
  - tighter restrictions on the range of activities banks can undertake
- Quantified example: a one standard deviation increase in the index of capital regulation lowers the correlation of the distance to defaults from 0.29 to 0.18.
- The economic impact for other statistically significant regulatory variables is described as roughly of the same magnitude.

### Main conclusions and policy tradeoffs
- There is a statistically and economically significant positive correlation between parents’ and subsidiaries’ distance to default; this result is robust to alternative distance-to-default measures and bank samples.
- The correlation varies with subsidiary characteristics: it is lower for subsidiaries with higher deposit funding ratios and for subsidiaries more independently managed from the parent.
- The host-country regulatory framework influences the extent to which shocks to parents’ distance to default affect subsidiaries: stricter capital, reserve, provisioning, and disclosure requirements and tougher restrictions on bank activities are associated with lower correlations.
- Policy tradeoffs:
  - Tighter host banking regulations can help insulate foreign subsidiaries from changes in parent default risk during crises.
  - However, minimizing correlations via tighter host regulation may raise costs for the host country and may not be globally optimal.
  - Ring-fencing measures by one country could increase stress on the banking group’s legal entities in other jurisdictions or the group as a whole and may create inefficiencies in internal allocation of capital and liquidity.
  - The Basel Committee’s Report and Recommendations of the Cross-Border Bank Resolution Group (CBBRG) highlighted these downsides and called for a credible framework for cooperation across national supervisors and uniform mechanisms for resolution of cross-border banking groups to avoid unilateral and costlier solutions.

### Key statistics and illustrative figures (as presented in the text)
- Subset used for board-independence proxy: 47 subsidiaries
- Correlation between share of independent board members interacted with parent distance and:
  - geographical distance interaction: 0.92
  - cultural proximity interaction: 0.65
- Example regulatory impact: one standard deviation increase in capital regulation index lowers correlation from 0.29 to 0.18

*Source: Excerpt from the IMF working paper content unit _wp16109 - 2009.  The  last  two  studies,  in  particular,  find  that  foreign  bank  affiliates  whose  parents’  relied*

### 2009.  The  last  two  studies,  in  particular,  find  that  foreign  bank  affiliates  whose  parents’  relied

### _wp16109 - 2009.  The  last  two  studies,  in  particular,  find  that  foreign  bank  affiliates  whose  parents’  relied

### Contribution and research focus
- Introduces a previously unexamined transmission mechanism: the correlation in default risks between a global bank (parent) and its subsidiaries.
- Argues default risk is the “ultimate risk” for banking stability with direct implications for depositors, borrowers, and governments that may pay insured depositors or recapitalize large banks.
- Uses daily stock market data to measure default risk, enabling high frequency and forward-looking analysis of shock transmission as an advantage over lower frequency loan data.

### Data
- Original database of stock market prices and balance sheet characteristics for publicly traded parent banks and their publicly traded subsidiaries in developing countries.
- Final sample: 93 publicly listed foreign subsidiaries, operating in 36 host developing countries, owned by 41 parent bank groups, headquartered in 24 home countries.
- Period of analysis: from September 2008 to December 2009.
- Median ownership stake in the sample: about 61 percent.
- Initial identification found about 167 listed banks in about 44 host countries; final sample reduced due to low trading frequency and high parent ownership in many subsidiaries.
- Data sources:
  - Daily stock market information from Compustat Global for international banks and firms.
  - Stock market information from CRSP for U.S. banks and firms.
  - Bank balance sheet variables from Bankscope.
  - Host country regulatory variables from the World Bank 2007 Bank Regulation and Supervision survey.
  - VIX data from the Chicago Board Options Exchange (CBOE).
  - ∆DEF (default spread) from Federal Reserve Board interest rate releases (difference in Baa-Aaa yields).
- Bank-level variables measured as of December 2006 and winsorized at the 1st and 99th percentile:
  - relative bank size (bank assets to total system assets)
  - capital ratio (regulatory capital to risk weighted assets)
  - equity ratio (equity to total assets)
  - provisions (loan loss provisions divided by total loans)
  - deposit funding (deposits divided by total funding)
  - profitability (net income divided by total assets)
  - liquidity (liquid assets divided by total assets)
- Notes:
  - Assets and equity in mentioned ratios are book values.
  - The 2007 survey covers the 2005-2006 period.

### Empirical methodology
- Main default-risk measure: Merton (1974) distance to default (dd), computed as the difference between market asset value and face value of debt, scaled by standard deviation of asset value.
- Key elements of computation:
  - Market value of equity (V_E) used; total liabilities proxy for face value of debt X.
  - s_E is standard deviation of daily equity returns over past 3 months; require at least 45 non-missing daily returns over previous three months.
  - T set to one year; r is one year US treasury yield (risk-free rate).
  - Interpolate annual accounting items linearly over dates to avoid jumps.
  - Solve simultaneously for V_A and s_A using Newton method with starting values V_A = V_E + X and s_A = s_E V_E/(V_E + X).
  - Winsorize s_E and V_E/(V_E + X) at 1st and 99th percentiles.
  - Assign asset return m equal to equity premium of 6% following Campbell, Hilscher and Szilagyi (2008).
  - Default probability PD = F(–dd) where F is the CDF of standard normal.
- Robustness checks:
  - Alternative equity premium of 12% yields 96% correlation in levels of dd and 99% correlation in changes of dd with baseline.
  - Simplified Byström (2006) formula also computed: log (X/(V_E+X)) / (X/(V_E+X)-1) × s_E.
- Estimation approach to measure correlation:
  - Weekly change in subsidiary dd regressed on weekly change in parent dd, controlling for average dd changes of all publicly traded banks and companies in host and home countries (excluding the focal parent and subsidiary), changes in corporate credit spreads (Bbb–Aaa), weekly change in VIX, subsidiary fixed effects, and sometimes time dummies.
  - Equation (5) captures baseline correlation; equation (6) adds interactions of parent dd changes with subsidiary characteristics (size, liquidity, funding structure, capital, etc.) measured as of December 2006, and host country regulations measured as of 2006.
  - Errors clustered at host country level.
- Subsidiary characteristics considered (pre-crisis):
  - Total assets (size)
  - Provisions (asset quality proxy)
  - Return on assets (profitability proxy)
  - Local deposit funding (funding liquidity proxy)
  - Liquid assets as percentage of total assets (asset liquidity proxy)
  - Tangible equity and regulatory capital over risk-weighted assets (capital measures)
- Distance/proximity measures between parent and subsidiary:
  - Geographical distance: log of distance (kilometers) between parent/home country and host country.
  - Cultural proximity: common official language indicator.
- Host country regulatory variables examined (measured prior to crisis):
  - Capital regulation index (0 to 10; higher = greater stringency)
  - Activity restrictions index (values 3 to 12; higher = more prohibited activities)
  - Disclosure requirements index (0 to 3; higher = greater disclosure)
  - Diversification requirements index (0 to 2; higher = more diversification)
  - Loan classification stringency (minimum days for arrears classification)
  - Provisioning stringency (minimum provisions as % of loans)
  - Supervisory powers index (0 to 14; higher = greater powers)
  - Prompt corrective powers index (0 to 6; higher = more promptness)
  - Reserve requirements (average reserves required relative to deposits and other short-term liabilities)
  - Financial outflow restrictions (average of three binary variables from IMF Annual Report on Exchange Arrangements and Restrictions)

### Theoretical priors and expectations
- Expect positive correlation between parent and subsidiary dd due to:
  - Internal capital markets reallocating resources away from subsidiaries.
  - Perceptions that weaker parents are less able to support subsidiaries.
  - Shared business models leading to common exposure to shocks.
- Expected dampeners of correlation:
  - Subsidiary profitability and high quality assets (higher return on assets, lower provisions).
  - Greater subsidiary size (total assets) — may benefit from too-big-to-fail guarantees and more stringent local oversight.
  - Higher local deposit funding and higher liquid assets.
  - Higher capital (tangible equity and regulatory capital).
  - Greater geographical distance may reduce correlation by limiting parent control.
  - Cultural proximity ambiguous: could reduce correlation via greater decentralization or increase correlation via closer ties.
  - Stronger host country regulatory/supervisory frameworks (capital stringency, provisioning, classification, supervisory powers, prompt corrective powers, disclosure) expected to reduce parent–subsidiary dd correlation.

### Key empirical results
- Visual evidence: median weekly changes in Merton’s dd for parents and subsidiaries from September 2008 to December 2009 show very high correlation.
- Regression evidence (Table 3 columns (2.1)-(2.4)):
  - Foreign subsidiary dd is significantly correlated with parent dd after controlling for average dd of firms in home and host countries and global factors like VIX and corporate credit spread.
  - Correlation magnitude:
    - Maximum of 0.45 when only subsidiary fixed effects are added.
    - Minimum of 0.27 when time and subsidiary dummies are included.
  - Correlation is statistically and economically significant and is almost twice as large as the correlation between subsidiary dd and all companies in home and host countries.
- Using the Byström (2006) simplified dd measure:
  - Correlation between foreign subsidiaries and their parents remains highly significant, ranging between 0.2 and 0.3.
- Sensitivity to parents with multiple subsidiaries:
  - Excluding parent banks owning multiple subsidiaries (e.g., Barclays, BNP Paribas, Citibank, HSBC, ING, Société Générale, Standard Chartered) does not materially change estimates.
  - Correlation varies between 0.26 and 0.29 when such parents are excluded.

*Source: _wp16109 - 2009.  The  last  two  studies,  in  particular,  find  that  foreign  bank  affiliates  whose  parents’  relied*

### 4.2 The factors that affect the correlation between the parent and subsidiary distance to default

### 4.2 The factors that affect the correlation between the parent and subsidiary distance to default

### Overview of tested subsidiary characteristics
- Subsidiary characteristics examined: size, capitalization, funding structure, liquidity, profitability, provisioning, and distance from the parent (both geographical and cultural).
- Purpose: to explore whether the association between the Merton distance to default of foreign bank subsidiaries and that of their parents changes with these subsidiary characteristics.

### Key empirical findings
- Parent banks’ distance to default is less correlated with subsidiaries’ distance to default when subsidiaries have higher deposit funding ratios.
  - Numerical effect reported: a one standard deviation increase in the deposit funding ratio lowers the association between the distance to default of the parents and the subsidiaries from 0.28 (0.32) to 0.21 (0.27).
- Geographical distance matters:
  - The association between parents’ and subsidiaries’ distance to default is lower for countries that are physically distant.
  - The same numerical change for geographical distance is reported alongside deposit funding ratio: from 0.28 (0.32) to 0.21 (0.27).
- Cultural proximity matters:
  - For subsidiaries that are culturally close to the parents the correlation between the parents and the subsidiaries is 0.33.
- Footnote/reference indicator present for deposit funding ratio result: 22.

### Economic interpretation
- Higher deposit funding ratios at subsidiaries are associated with weaker transmission of parent bank default risk (as measured by Merton distance to default) to subsidiaries.
- Greater physical distance between parent and subsidiary jurisdictions is associated with a weaker correlation in distance to default.
- Cultural closeness is associated with a higher parent–subsidiary correlation in distance to default (example correlation reported: 0.33).

*Source: _wp16109 - 4.2 The factors that affect the correlation between the parent and subsidiary distance to default*

### 0.13 for those that are not culturally similar.

### _wp16109 - 0.13 for those that are not culturally similar.

### Interpretation of geographical distance and cultural proximity
- Geographical distance and cultural proximity are interpreted as proxies for more independent management of subsidiaries from their parents.
- Evidence for this interpretation is suggestive but not conclusive.
- For a subset of 47 subsidiaries, a proxy for subsidiary management independence was constructed: the share of declared independent board members (defined as members owning no or a small number of shares in the bank, not clients or suppliers of the bank, and without family members working in the bank).
- The share of independent board members interacted with the parent distance to default is positively and significantly correlated with the interaction of parent distance to default with:
  - geographical distance: correlation = 0.92
  - cultural proximity: correlation = 0.65
- The negative interaction of geographical distance and cultural proximity measures with the parent distance to default is interpreted as suggestive that more independently managed subsidiaries exhibit a lower correlation between subsidiaries’ and parents’ distance to default.

### Subsidiary characteristics that affect parent–subsidiary default correlation
- Even when controlling for host country dummies–parent distance to default interactions, subsidiary characteristics matter.
- Subsidiary features associated with a lower correlation between subsidiaries’ and parents’ distance to default:
  - higher retail deposit funding ratios
  - greater cultural proximity to the parent (i.e., cultural closeness)
  - greater management independence (as proxied by share of independent board members)
- Empirical example cited: for subsidiaries that have higher retail deposit funding ratios and that are culturally closer to the parent, the correlation between subsidiaries’ and parents’ distance to default is lower.

### Host-country banking regulations and their effects
- Host-country regulatory characteristics are associated with lower parent–subsidiary distance-to-default correlations when regulators impose:
  - greater disclosure requirements
  - higher capital requirements
  - higher reserve requirements
  - stronger provisioning requirements
  - tighter restrictions on the range of activities banks can undertake
- Quantified example: a one standard deviation increase in the index of capital regulation lowers the correlation of the distance to defaults from 0.29 to 0.18.
- The economic impact for other statistically significant regulatory variables is described as roughly of the same magnitude.

### Main conclusions
- There is a statistically and economically significant positive correlation between parents’ and subsidiaries’ distance to default; this result is robust to alternative distance-to-default measures and bank samples.
- The correlation varies with subsidiary characteristics: it is lower for subsidiaries with higher deposit funding ratios and for subsidiaries more independently managed from the parent.
- The host-country regulatory framework influences the extent to which shocks to parents’ distance to default affect subsidiaries: stricter capital, reserve, provisioning, and disclosure requirements and tougher restrictions on bank activities are associated with lower correlations.
- Policy tradeoffs:
  - Tighter host banking regulations can help insulate foreign subsidiaries from changes in parent default risk during crises.
  - However, minimizing correlations via tighter host regulation may raise costs for the host country and may not be globally optimal.
  - Ring-fencing measures by one country could increase stress on the banking group’s legal entities in other jurisdictions or the group as a whole and may create inefficiencies in internal allocation of capital and liquidity.
  - The Basel Committee’s Report and Recommendations of the Cross-Border Bank Resolution Group (CBBRG) highlighted these downsides and called for a credible framework for cooperation across national supervisors and uniform mechanisms for resolution of cross-border banking groups to avoid unilateral and costlier solutions.

### Key statistics and illustrative figures (as presented in the text)
- Subset used for board-independence proxy: 47 subsidiaries
- Correlation between share of independent board members interacted with parent distance and:
  - geographical distance interaction: 0.92
  - cultural proximity interaction: 0.65
- Example regulatory impact: one standard deviation increase in capital regulation index lowers correlation from 0.29 to 0.18

*Italic: Source — Excerpt from the IMF working paper content unit _wp16109 - 0.13 for those that are not culturally similar.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2016/_wp16109.pdf_