International capital flows in banking have increased over recent decades. The internationalization of banking has thereby been driven by the globalization of economic activity as well as by the deregulation of financial markets. Banks have various possibilities in order to expand their operations into foreign markets: For example, they can operate through their domestic offices (through direct cross-border lending and borrowing). Alternatively, they can set up an affiliate abroad (through FDI). On the one hand, the internationalization allows for risk-sharing possibilities and enables an improvement of the allocation of capital. On the other hand, cross-country linkages can transmit shocks from one banking system to the other. This has become obvious during the recent crisis and fuelled debates about regulatory measures. Yet appropriate regulatory actions require an understanding of the driving forces behind these capital flows. Research on the determinants of cross-border bank activities reveals that geographical or cultural distance, differences in the legal system, arbitrage possibilities or entry barriers affect banks’ international investment decisions. Moreover, growth differentials and interest rate differences may influence cross-border banking.
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