Banking activity is location-specific in the sense that presence in the foreign market is required for information production and signaling and to monitor domestic and local customers, reduce transaction costs and undertake portfolio optimization and asset transformation . For example, the need to monitor customers more closely than can be done from the headquarters provides an incentive to establish a direct overseas presence although these foreign offices will probably still face somewhat of a disadvantage relative to their local competitors in this area; banks with a diversified customer base will be able to reduce transaction costs by pooling customers with offsetting needs ; banks that excel in producing value-added products develop expertise in portfolio and asset transformation; banks that specialize in syndicated loans, foreign exchange, Eurobond issues and derivatives develop signaling related advantages.
The location of banks involves a comparison between exporting to the host
country (through correspondent banking) and market servicing from a production
unit sited in the host country (an office in the foreign market). Khoury (1979)
formalizes this problem and shows that firms export when demand grows at a
predictable rate as long as the marginal cost of production and transport are
less than the cost of undertaking Banks. The model developed in this paper
shows that when demand is volatile banks exercise caution not only by exporting
but also by undertaking partial Banks. The initial version of the model is
based on the assumption that the bank has a monopoly over an investment
opportunity and the product market is perfectly competitive, i.e., the impact
on prices and market structure is minimal. This assumption is relaxed in
subsequent sections. The bank produces under constant marginal costs but makes
decisions prior to the revelation of demand.