Financial integration and the role of foreign banks in domestic financial systems

Countries that are signatories to financial integration arrangements allow for some form of penetration into their markets by foreign financial institutions. The presence of the foreign banks may help make their domestic counterparts very competitive.

In the 1990s, there were massive flows of FDI worldwide. In that decade, FDI flows to emerging markets grew from $19.3 billion to $142.6 billion, with FDI in finan-cial services from OECD countries accounting for nearly 25 per cent of total FDI flows. At the same time, Latin America and Central Europe were the major recipi-ents of international capital flows to the banking sector.

The participation of foreign banks in Africa is very low. Recent data show that Europe has the highest degree of intraregional financial integration, with around 16 per cent, followed by Africa and the Middle East (7.7 per cent), while Latin America has the lowest (0.6 per cent). Between regions, the major recipient of foreign partici-pation has been Latin America, where OECD countries, Europe, the United States and Canada own 46.5 per cent, 28.2 per cent and 18 per cent, respectively, of total assets of the regional banking system, while European banks account for the greatest share of foreign banks in Africa.

The theoretical 4.5.1 What determines foreign bank location in

domestic markets?

The location of foreign banks across the world is influenced by many factors, includ-ing the profitability of the investment, the development of the financial system of the country they seek to penetrate, and the need to follow similar strategies as their competitors and maintain their market share. Galindo, Micco and Serra (2002) argue that foreign bank participation in domestic markets is enhanced by trade inte-gration, the flow of foreign direct investment and the strength of the legal system prevailing in the domestic countries.

The theoretical underpinning for the relationship between economic integration and foreign banking penetrations is that international banks follow their custom-ers (multinational firms) around the world, in order to provide them with financial services and exploit informational advantages derived from long-term bank-client relationships. With regards to trade, firms can also rely on international banks to minimize the costs of international transactions by using the same bank for any type of bilateral payments. Galindo, Micco and Serra (2002), using a gravity model and bilateral data from 176 countries, find that a 1-per-cent increase in trade raises foreign bank participation by 0.7 per cent, implying that trade integration is a sig-nificant determinant for the expansion of banks abroad.

Large multinational firms established abroad as a result of the flow of FDI prefer to deal with known banks. International banks following these firms can also derive informational benefits from such associations. Banks also locate abroad because the multinational firms need to have access to capital denominated in local currency, to avoid a currency misalignment between revenues and costs. In such a case, the foreign bank may decide to locate in the foreign country and move intermediate funds from the local market towards international firms. For reasons of portfolio risk diversification, foreign local banks also have incentives to operate in other retail banking activities. Galindo, Micco and Serra (2002) find that a 1-per-cent increase in FDI flow increases foreign bank participation by 1.3 per cent.

The sound legal environment of the host country also increases foreign bank partici-pation. Strong legal codes and the safeguarding of property rights tend to minimize learning costs in the investment process, and can also reduce operational costs, given that certain economies of scale can be exploited at the international level. La Porta, Lopez-de-Silanes and Shleifer (1997, 1998) argue that banks are more willing to locate in foreign countries with which they share similar legal codes, because the rights of creditors and shareholders would be protected and the regulatory environ-ment would be similar to that of the bank’s country of origin. Similarities in regula-tions also reduce costly adaptation to new environments.

The fragmented

Galindo, Micco and Serra (2002) demonstrate the strong relationship between shar-ing of legal origin and cross-border bankshar-ing. They report that countries receive an average of $17 billion from countries with whom they share legal codes, and only

$12 billion from countries with different legal origins. The results imply that foreign participation in country pairs that share legal codes is 26 per cent greater than when codes differ.

The same studies by Galindo, Micco and Serra (2002) indicate that if the host coun-tries have prudential regulation and supervision practices similar to those of source countries, there is greater investment in banking. They observe that, on average, host countries worldwide receive nearly $21 billion from source countries with similar prudential regulations, versus less than $10 billion from countries with different standards. The results suggest that when supervisory practices are similar, foreign participation is increased by nearly 19 per cent. This finding also suggests that har-monizing regulations across countries can increase financial market integration even at the regional level by increasing the participation of external and national players in several markets simultaneously.

4.5.2 Impact of foreign banks in domestic markets Financial liberalization makes a financial system function better, in turn fostering growth by improving system efficiency and, under certain conditions, increasing the availability of funds. In particular, the financial liberalization process in recent dec-ades has allowed foreign banks to freely participate in local markets (figure 5.3).

Overall empirical evidence on the impact of foreign banks on domestic markets is scant. However, the fragmented evidence available suggests that the effects of inter-nationalizing the banking system are positive, since banking systems increase their competitiveness and efficiency, in particular when foreign banks come from a more developed country. However, there is some controversy as to whether credit volatil-ity is reduced by foreign banks. On the one hand, some authors claim that foreign banks are able to stabilize credit because they have access to external funds and, due to their reputation (brand name), they are able to stabilize local deposits.

In addition, foreign bank entry may generate competitive pressure that leads to measures that guarantee future stability through more aggressive provisioning stand-ards and higher capital ratios (Crystal, Dages and Goldberg, 2001). On the other hand, some economists claim that foreign banks are more sensitive to shocks in the host economy because they can substitute local assets with alternative investments abroad that are not easily available for local banks.

Foreign institutions improve the quality and availability of financial services by bringing in new and better skills, management techniques, training procedures and technology 4.5.3 Foreign banks, efficiency and regulatory

standards

Most foreign banks that seek to penetrate other markets tend to be better at resource allocation and overall efficiency. These banks are also linked with increased com-petition and the diffusion of new technologies. Furthermore, foreign institutions improve the quality and availability of financial services by bringing in new and better skills, management techniques, training procedures and technology. Levine (1996) argues that the presence of foreign banks seems to lead to the development of better rating agencies, accounting standards and credit bureaus that acquire and process information, as well as better bank supervision and a more adequate legal framework. Foreign banks tend to follow sound prudential practices adopted in their home country.

It should be noted that for foreign banks from developed countries, these practices are usually more stringent than those of developing countries. In such cases, the increased security inspired by international banks leads domestic banks as well as supervisors to adopt international standards in order to ease competitive pressures coming from depositors searching for the safest institutions. The presence of foreign institutions also boosts competition and improves the operation of the domestic market (local banks), which in turn leads to improvement in resource allocation and faster economic growth. In addition, international competition reduces interest rate margins and local banks’ profitability.

4.5.4 Foreign banks and the stability of domestic markets

Some critics wonder whether the presence of foreign banks plays a role in stabiliz-ing domestic credit and deposits. Some argue that foreign banks, due to their access to foreign liquidity, are less dependent on erratic local deposits, and therefore can stabilize credit in the host country. Moreover, the good reputation of many for-eign banks allows “depositor-flight-to-quality” to occur within the domestic market during financial turmoil, stabilizing both deposits and credit.

Others argue that foreign banks decrease their exposure to the country when domes-tic conditions deteriorate, thus increasing credit volatility. Moreover, these banks can transmit shocks from their home countries, strengthening the contagion during financial crises. Changes in a foreign bank’s claims at home or in other countries can spill over to the host country. In some regions of the world, most foreign banks come from developed countries. Hence, a contraction in those countries would affect the domestic market not only through a contraction of external demand, but

Empirical evidence about the impact of foreign banks on the amount of credit to small businesses in developing countries is scarce and inconclusive

also through a reduction in local credit, amplifying the domestic business cycle even more.

The validity of the two views is an empirical matter. Galindo, Micco and Serra (2002) studied individual bank credit behaviours after a change in deposits or in business opportunities (measured as the change in external demand), and found that all bank credit reacts to changes in deposits, but this reaction is smaller for foreign banks. However, foreign bank credit is 20 per cent less sensitive to changes in domestic deposits than domestic bank credit. With respect to bank reaction to business opportunities, after a contraction in external demand, all banks reduce their loans, but this reduction in credit is 50 per cent smaller for domestic banks.

The results suggest that foreign banks would increase credit volatility if shocks were mainly changes in business opportunities in the host country, but would reduce it if the main source of credit volatility was the domestic supply of deposits. Which view dominates remains an empirical question.

4.5.5 Foreign banks and market segmentation

As argued in previous sections, foreign bank penetration has potential benefits. How-ever, some researchers argue that increased foreign bank penetration in developing countries could reduce access to credit for some segments of the market, particularly small and medium-sized firms that depend heavily on bank financing.

In general, foreign banks are large and complex financial institutions that find it difficult to lend to small and medium-sized firms for which they have little informa-tion. Small businesses tend to have exclusive dealings with a single bank with which they have developed an “informal relationship” that reduces asymmetric informa-tion. Large foreign banks are likely to have difficulties developing these types of rela-tionships. While large foreign banks are unlikely to replicate the lending method of small domestic banks, they can introduce new technological innovations that foster credit to small and medium-sized firms.

Empirical evidence about the impact of foreign banks on the amount of credit to small businesses in developing countries is scarce and inconclusive. In an analysis of the behaviour of foreign banks in a number of countries, Clarke, Cull, Pería, and Sánchez (2002) found that foreign banks generally lend less to small businesses than domestic banks. They also found that in a country with a developed financial sector, lending to small businesses by medium-sized and large foreign banks was stronger than lending by domestic banks. They suggest that the better institutional environ-ments in countries with developed financial markets allowed large foreign banks to use scoring methodologies, enabling them to increase their lending to smaller firms.

The liberalization of