Monday, January 16, 2012

Foreign Banks: Trends, Impact and Financial Stability

This paper introduces a comprehensive database on bank ownership for 137 countries over 1995-2009, and reviews foreign bank behavior and impact. It documents substantial increases in foreign bank presence, with many more home and host countries. Current market shares of foreign banks average 20 percent in OECD countries and 50 percent elsewhere. Foreign banks have higher capital and more liquidity, but lower profitability than domestic banks do. Only in developing countries is foreign bank presence negatively related with domestic credit creation. During the global crisis foreign banks reduced credit more compared to domestic banks, except when they dominated the host banking systems.

Although interrupted by the recent financial crisis, the past two decades have seen an unprecedented degree of globalization, especially in financial services. Not only have crossborder bank (and other capital) flows increased dramatically, but also many banks, from both advanced and developing countries, have ventured abroad and established presence in other countries. Although there are exceptions and regional differences, few countries have been left out from this trend of increasing financial integration. As a result, foreign banks have become important in domestic financial intermediation. For example, in terms of loans, deposits and profits, current market shares of foreign banks average 20 percent in OECD countries and close to 50 percent in emerging markets and developing countries.

Given the importance of foreign banks in many countries, understanding the motivations of foreign banks to enter a particular host country, the mode by which they do so, and the impact they have on financial sector development and lending stability has become essential. These questions have become even more prominent as a result of the financial crisis. Although much research has been conducted, many questions remain unanswered, however, partly because data availability has been limited.

This paper contributes to the literature on foreign banking in two ways. It introduces a new and comprehensive database on bank ownership, including the home country of foreign banks, covering 137 countries from 1995 to 2009. And, using this extensive database, it provides salient facts on trends in foreign ownership, compares foreign and domestic bank characteristics, and analyzes the relationship between foreign bank presence and financial development and the impact of foreign banks on lending stability during the recent crisis.

Before the crisis, the general consensus was that the benefits of foreign banks greatly outweigh costs in many dimensions. Particularly, it was generally considered that foreign banks add to domestic competition, increase access to financial services, enhance financial and economic performance of their borrowers, and bring greater financial stability (Clarke, Cull, Martinez Peria and Sanchez, 2003, Claessens, 2006, Chopra, 2007, and Cull and Martinez Peria, 2011). Generally, lower costs of financial intermediation (measured by margins, spreads, overheads) and lower profitability are documented with greater foreign bank presence (Claessens, Demirguc-Kunt, and Huizinga, 2001 and related studies, e.g., Mian, 2003, Berger, Clarke, Cull, Klapper and Udell, 2005). Also, evidence exists of better quality financial intermediation, e.g., lower loan-loss provisioning with more foreign entry (Martinez-Peria and Mody, 2004). Likely a number of factors are behind these effects of foreign banks, such as the introduction of new, more diverse products, greater use of up-todate technologies, and know-how spillovers (e.g., as people learn new skills from foreign banks, they migrate over time to domestic banks). In addition, foreign banks likely pressured governments to improve regulation and supervision, increase transparency, and more generally catalyze domestic reform (Levine 1996, Dobson, 2005, and Mishkin, 2006).

The effects of the entry of foreign banks on development and efficiency appear to depend though on some conditions. Limited general development and barriers can hinder the effectiveness of foreign banks (Garcia-Herrero and Martinez Peria, 2005; Demirguc-Kunt,Laeven and Levine, 2004). Also, the relative size of foreign banks’ presence seems to matter.

With more limited entry (as a share of the total host banking system), fewer spillovers seem to arise, suggesting some threshold effect (Claessens and Lee, 2003). In terms of individual bank characteristics, it seems that larger foreign banks are associated with greater effects on access to financial services for small and medium-sized enterprises, perhaps as they are more committed to the market, while smaller banks are more niche players (Clarke et al. 2005). Furthermore, the health of both the home and the local host bank operation seem to matter, with healthier banks showing better credit growth (Dages, Goldberg and Kinney, 2000; see also Haber and Musacchio, 2005 and De Haas and Van Lelyveld, 2006).

While the entry of foreign banks is generally thought to have favorable effects on the development of host banking systems, including through increased credit extension, some studies find more ambiguous results. Some show that foreign banks “cherry pick” borrowers (Detragiache, Gupta, and Tressel, 2008; Beck and Martinez Peria, 2007). This can undermine overall access to financial services, since cherry picking worsens the remaining credit pool, and lower financial development, especially in low-income countries where relationship lending is important. Indeed, Detragiache, Tressel and Gupta (2008) show the presence of foreign banks in low-income countries to be associated with less credit being extended. At the same time, a number of studies show that (funding) shocks to parent banks can be transmitted to their foreign subsidiaries with negative consequences for their lending (Peek and Rosengren (1999, 2000); Acharya and Schnabl (2010), Chava and Purnandam (2011); Cetorelli and Goldberg, 2011). Since the onset of the global financial crisis, more studies have also pointed out the risks of foreign banking for financial stability. De Haas, Korniyenko, Loukoianova and Pivovarsk (2011) and Popov and Udell (2010) find for emerging European countries that foreign subsidiaries reduced their lending more compared to domestic banks. De Haas and Van Lelyveld (2011), comparing loan growth of foreign subsidiaries of large multinational banking groups with large domestic banks, find similar results.

Some though find that global banks support their foreign affiliates during times of financial stress through internal capital markets (De Haas and Van Lelyveld, 2006 and 2010; and Barba-Navaretti, Calzolari, Levi and Pozzolo, 2010). Ongena, Peydro Alcalde and Van Horen (2011) find that, while foreign banks reduced lending more than local domestic banks did, they did not compared to domestic banks that had financed their lending boom through borrowing from international capital markets. In addition, De Haas and Van Horen (2011) show that during the global crisis foreign banks continued to lend to those countries that were geographically close and with whom they have established long-term lending relationships, suggesting that foreign banks do differentiate between countries during times of stress.

The crisis also highlighted that, while foreign banks play important roles in the global financial system and affect domestic financial systems, access to financial services, and consequent economic performance, many aspects are not yet well understood, in part due to lack of data. Many studies to date have only used short time periods and a limited number of countries, and hardly any have investigated bilateral ownerships. These three aspects are important to consider, however. A long time period is necessary to properly disentangle effects of cyclical developments and structural changes. A broad spectrum of countries needs to be studied as the causes and effects of foreign bank presence might differ with respect to the importance of foreign banks in the host country or (home and host) development and business and institutional environments. And bilateral patterns need to be studied given the interplay between home and host countries features in entry decisions (Galindo, Micco and Serra 2003, and Claessens and Van Horen, 2010) and between (cultural and institutional) distance and performance (Claessens and Van Horen, 2011).

This paper introduces an extensive database on that contains information on the ownership of 5377 banks in 137 countries from 111 home countries. For each bank, ownership, domestic versus foreign, is determined for each year the bank was active over the period 1995 to 2009, with all changes in ownership (from domestic to foreign and foreign to domestic) and all exits recorded. Important to investigate the factors behind the spread and impact of foreign banks, the home country of the main investor of each bank is identified. Using this database, the paper illustrates salient trends in foreign bank presence over the past two decades. It shows that, albeit interrupted by the global financial crisis, foreign bank presence has increased substantially in most countries, sometimes from none to foreign banks holding 67 percent market share (in terms of numbers) in a single decade. Also many more home countries have become active as investors, with several emerging countries becoming important “exporters.” Substantial differences still exist, though, with foreign bank presence ranging from zero to 100 percent. And foreign ownership is still mostly regional, with this pattern becoming stronger over time.

Taking stock as of end 2007, i.e., just before the crisis, the paper shows that in terms of loans, deposits and profits, foreign banks capture on average about 20 percent of market shares in OECD countries and close to 50 percent in emerging markets and developing countries. Interesting, in those countries with over 50 percent foreign banks in numbers, foreign banks tend to play an important part in financial intermediation. In contrast, when less important in numbers, foreign banks tend to be niche players.

The paper then studies balance sheet and performance characteristics of domestic and foreign banks, and the relationships between foreign bank presence and financial sector development and stability. In terms of balance sheets, the paper finds that foreign banks generally have higher capital adequacy and better liquidity positions. They also engage relatively less in traditional lending businesses. In terms of performance, maybe surprising, foreign banks underperform domestic banks in emerging markets and developing countries, but do not perform differently in high-income countries. Differences reflect in part variations in business strategies between foreign and domestic banks and host country circumstances. Particularly, performance may differ because foreign banks have more conservative portfolios and operate with less ease in some countries than domestic banks do.

In terms of the relations between foreign bank presence and financial sector development, patterns differ by host country. Specifically, in middle-income and high-income countries, foreign bank presence tends to have an insignificant relationship with credit extended. In low-income countries, however, foreign bank presence is associated with less credit extended. In terms of financial stability, we find that foreign banks generally reduced their domestic credit during 2009 more than domestic banks did. Foreign banks did enhance the stability of domestic financial systems though in countries with majority foreign bank presence since their credit growth declined there less than that of domestic banks. The crisis continues to affect banks in many ways. Faced with large losses and capital shortfalls, many banks in advanced countries are undergoing major restructurings, either voluntary or as conditions of government recapitalizations. Furthermore, banks need to comply with stricter regulations, such as Basel III and other measures triggered by the crisis. And all banks are responding to changing global economic patterns, including the economic slowdown in advanced countries and the increased economic importance of emerging markets. While many advanced countries’ banks are less likely to be active investors in the near future, banks from emerging markets, being in much better financial positions, are likely to step into the void, increasing their relative importance as foreign investors, especially within their geographical regions.

The paper itself is structured as follows. Section 2 provides an extensive description of the construction of the database. Section 3 starts with an overview of the main trends in foreign banking. It then reviews the trends in regionalization in foreign bank presence. Section 4 examines the importance of foreign banks in the host country banking system, the balance sheets and performance of foreign banks relative to domestic banks and provides some evidence on the relationship between foreign bank presence and financial sector development. Section 5 studies the impact of foreign bank ownership on lending stability during the global financial crisis. Section 6 discusses the future of foreign banking, including the rising importance of emerging market foreign banks. Section 7 concludes.

IMF. Author/Editor:Claessens, Stijn; Horen, Neeltje van


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