Foreign Banks and The International Provision of Credit

Linda GoldbergFederal Reserve Bank of New York

October 25, 2004

Presentation for the

IADB XX Meeting of the Latin American Network of Central Banks and Finance Ministries

These comments expressed in this presentation are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New

York or the Federal Reserve System.

Important Motivating Question

Do foreign banks play a beneficial role in

promoting financial development and

stabilizing credit, or play a less benign role

by crowding our the domestic financial sector

and accentuating international shocks?

I will discuss two types of contributions of foreign banks to emerging market financial systems (both positive)

1. Foreign banks from well-supervised countries promote emerging market financial sector development

– by enhancing local financial sector efficiency

– by reducing the magnitude of local credit cycles.

• Do foreign banks transmit foreign shocks? -- yes.

• Do foreign banks accentuate the effects of such shocks? -- no. Similar transmission across private domestic banks and foreign-owned banks

I will discuss two types of contributions of foreign banks to emerging market financial systems (both positive)

2. Foreign banks promote institutional development in emerging market hosts

First, some background on foreign bank activity in emerging markets.

We start by observing that foreign entry is often associated with tremendous regulatory changes and post-crisis needs for financial capital.

Since 1990 the extensive entry by foreign bank financial multinationals has often been supported via local bank acquisitions. The U.S. and Spain have been especially active source countries.

Chart 1: Value and Number of Acquisitions of Banks in Developing Countries

by Source Country, 1990-20037468

38

2122 23

32 34 20 16 714714 8 4

0

5,000

10,000

15,000

20,000

25,000

Unite

d Sta

tes

Spain

Unite

d King

dom

Nethe

rland

sIta

ly

Austri

a

Franc

e

Germ

any

Canad

a

Belgium

Irelan

d-Rep

Japa

n

Portu

gal

Sweden

Greec

e

Switzer

land

Val

ue

(in

US

$ M

illi

on

s)

Source: Bank of England; Thompson Financial

Banks in Latin America were frequent targets in the mid/late 1990s, as were banks in Eastern Europe and more recently in Asia. Activity continued in 2002 and 2003, but Latin American divestitures also occurred.

0

2

4

6

8

10

12

14

1995 1996 1997 1998 1999 2000 2001

Latin America Eastern Europe AsiaNo. of acquisitions

By 1999 bank assets under foreign control were dramatically higher than 5 years prior. By 2003, we saw a more nuanced pattern of developments.

Bank Assets Under Foreign Control, 1994, 1999, and 2003 (Assets of banks in which foreigners own 40% or more of bank)

0

20

40

60

80

100

120

Perc

en

t o

f B

an

kin

g S

ecto

r

1994 1999 2003

source: Mathieson & Roldos, 2001,plus calculations using Fitch IBCA Bankscope

What do foreign banks do in emerging markets?

First, a conceptual point / academic set of arguments.

In “Financial-Sector FDI and Host Countries: New and Old Lessons”, I argue that foreign bank participation is the financial sector analogue to FDI, even though FDI terminology is more common for manufacturing and extractive resource industries.

Many lessons from research on FDI apply to F-S FDI: – technology transfers, – productivity spillovers, – wage effects, – macroeconomic growth, and – fiscal and tax concerns.

One special role of FS-FDI, because of its importance to financial intermediation,is in shock transmission. Banks magnify or dampen local business cycles, and transmit foreign shocks through the lending channel.

Reasons for cyclicality in lending:

One special role of FS-FDI, because of its importance to financial intermediation,is in shock transmission. Banks magnify or dampen local business cycles, and transmit foreign shocks through the lending channel.

Reasons for cyclicality in lending: Market risk. Asset demands and supplies change

– ex. Berlin and Mester RFS 1999.

• Mismeasurement of difficulties in downturns and

strengths in boom periods --- ex. Borio et al. BIS 2001.

• Intertemporal smoothing, leading to countercyclical loan demand and procyclical loan supply.

Both foreign banks (multinationals) and domestic banks are pro-cyclical suppliers of credit. Both contribute to international business cycle integration.

• Domestic banks rely more on domestically generated sources of funds for lending activity, so domestic bank lending is highly procyclical. It is sensitive to domestic cycles, and increases the amplitude of these cycles.

Both foreign banks (multinationals) and domestic banks are pro-cyclical suppliers of credit. Both contribute to international business cycle integration.

• Foreign banks rely more on source country funds. They transmit slightly more of their own country shocks to markets in which they have a presence, but also reduce the amplitude of locally generated cycles.

– Goldberg (2002, 2003) on US-ROW, foreign banks in Latin America

– Healthy domestically-owned private banks in Latin America exhibited sensitivities to foreign shocks similar to sensitivities by foreign-owned banks.

Both foreign banks (multinationals) and domestic banks are pro-cyclical suppliers of credit. Both contribute to international business cycle integration.

• Most research, often from World Bank studies, shows that foreign banks do not worsen credit flows to small and medium sized enterprises in Latin American countries.

– Research continues on this issue.

FS-FDI can improve local efficiency.

Improved allocative efficiency. foreign investors enter into industries with high entry

barriers and reduce local monopolistic distortions.

Higher technical efficiency. the increased competitive pressure and demonstration

effects by foreign banks may spur local firms to more efficient use of existing resources.

FS-FDI can improve local efficiency.

Improved allocative efficiency. foreign investors enter into industries with high entry barriers and

reduce local monopolistic distortions.

Higher technical efficiency. the increased competitive pressure and demonstration effects by

foreign banks may spur local firms to more efficient use of existing resources.

Foreign banks operating in developing countries appear to be more efficient than their domestic counterparts, whether privately owned or government owned.

Domestic banks are forced to become more efficient after foreign entry, especially in the business lines in which foreign banks choose to compete.

FS FDI can prompt local institutional development

Bank integration with foreign head-office can lead to stronger risk-management systems / operational controls

• Product innovation and expansion of services (broader range of credit and deposit products, treasury, financial advisory services, etc)

• Anecdotal evidence of spillovers to supervision

Some recent anecdotal information based on CE-3 (Poland, Hungary, Czech Republic): foreign bank entry improved system soundness: financial strengthening and flexibility to resist shocks, increased banker training and sophistication, strengthening of risk-management processes and new product delivery. In addition, the prospect of joining the EU was a catalyst to improve the supervisory and regulatory framework (Czech Republic).

Determinants of international credit flows from U.S. reporting banks:

Data on cross border flows and local lending reinforce the point that business-cycle related variables are not the only thing to watch.

Total cross-border lending from the U.S. is expanding to Europe and Asia; total cross border claims on La.America/Caribbean on average are flat or down.

U.S. Reporting Banks Total Cross Border Claims

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2000

:Q3

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Period

To

tal C

ors

s B

ord

er

Cla

ims

(B

illio

ns

)

Total Europe Asia Latin America and Caribbean

The picture is even less rosy for U.S. net lending by local affiliates in Latin American and Caribbean.

U.S. Reporting Banks Net Local Country Claims

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Period

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Total Europe Asia Latin America and Caribbean

Continuing challenges and issues for discussion

• Even after repositioning of foreign banks, and reduced exposure to some Latin American markets, is there any evidence that the host economy is (on balance) worse off?

– Linked to the question of whether institutional improvements and efficiency gains persist.

– Is the financial system after reduced positions by foreign banks nonetheless healthier from their prior involvement, and the capital injected when it was needed most?