In defense of foreign banks

By: Ralph De Haas Deputy Director of Research

‘Banker’ has recently become somewhat of a dirty word and ‘foreign banker’ a most reviled sub-species. Over the last months foreign banks have, amongst other things, been accused of abandoning some of the emerging markets that have contributed so much to their profitability over the last decade. When the going gets tough, so the story goes, foreign banks quickly cut back their lending abroad and refocus on domestic clients. Indeed, a recent blog entry by my colleagues at the EBRD Piroska Nagy and Stephan Knobloch nicely illustrates how fast international lending to emerging markets shrank in recent months. Is foreign bank lending really inherently instable? If so, large-scale foreign bank entry, as seen in Central and Eastern Europe and to a lesser extent Latin America, may seriously undermine the stability of emerging banking systems. In answering this question, two issues should be kept in mind.

First, one needs to make a clear distinction between cross-border foreign bank lending and local lending. In the former case, multinational banks lend from their headquarters to a company abroad. In the latter case, they use a local network of branches and subsidiaries. The latter form of foreign bank lending is much more stable than the former (García Herrero and Martinez Peria, 2007). Peek and Rosengren (2000) find for Latin America that cross-border lending did in some cases diminish during economic slowdowns, whereas local lending by foreign banks was much more stable. For Central and Eastern Europe, De Haas and Van Lelyveld (2004) find that reductions in cross-border credit were generally met by increases in lending by foreign bank subsidiaries, either because new subsidiaries were established or because the lending of existing affiliates increased.

Emerging markets that allow cross-border bank lending, but put up (in)formal barriers to brick-and-mortar foreign bank entry thus do themselves a disservice. Of course, such countries could choose to not allow any form of foreign bank lending, neither cross-border nor through local affiliates. This brings me to a second important issue.

Discussions about the supposed fickleness of foreign banks often ignore the question of what is an adequate comparison group or counterfactual. Since all bank lending tends to be procyclical, in particular during crisis periods, an important question is whether foreign bank lending is less (or more) stable compared to lending by domestic banks. It may be less stable, because parent banks reallocate capital to other countries when an emerging market goes through a business cycle downturn. Parent banks redistribute group capital across various subsidiaries on the basis of expected investment opportunities (De Haas and Naaborg, 2006). It may be more stable, because parent banks usually can support subsidiaries that somehow get into financial difficulties (domestic banks lack such parents with deep pockets). This latter argument has often been used to argue why foreign bank entry in transition countries has contributed to more stable financial systems in this region.

In a forthcoming article, Iman van Lelyveld and myself analyse a large bank-level dataset of foreign bank subsidiaries across the world, to compare lending by foreign bank subsidiaries with lending by domestic banks. The dataset includes 45 multinational banks from 18 home countries with 194 subsidiaries across 46 countries (see figure 1). For each host country, we also collect data for a benchmark group of up to five of the largest domestic banks. In the empirical analysis, we look at how yearly credit growth is affected by a number of bank-specific financial variables, macroeconomic determinants, as well as an indicator of whether the host country is experiencing a banking crisis.

We find that subsidiaries of stronger parent banks – with high net interest margins or low loan loss provisioning – grow faster and that parent banks trade off lending across countries. Importantly, as a result of parental support, foreign bank subsidiaries do not typically rein in their lending during a financial crisis. In sharp contrast, we find that domestic bank lending decreases substantially during local banking crises. Apparently, subsidiaries can rely on parental support during a financial crisis, a form of support that is not available to domestic banks. This finding confirms similar results reported by De Haas and Van Lelyveld (2006) for a sample of transition countries.

These findings imply that across the board, openness to multinational bank subsidiaries may actually benefit host countries. Multinational banks provide a stabilizing factor during local financial turmoil in particular. Our results also show, however, that the health of parent banks matters a lot: weak parent banks can provide less support and their subsidiaries grow more slowly. Lending by foreign subsidiaries may even be scaled back in order to free up capital for the parent bank, leading to contagion from home to host countries. Of course, this caveat has become quite acute during the current global financial crisis, which has clearly been testing the resilience of the support effects that we document in our research.

So far, however, the anecdotal evidence suggests that multinational banks and their foreign subsidiaries have been behaving more or less as can be expected on the basis of historical patterns. That is, cross-border lending – in particular syndicated lending – has decreased significantly, but many multinational banks have so far continued to support foreign subsidiaries. Given the extreme circumstances of the current crisis, in some cases this parental support has been complemented by coordinated efforts of a number of International Financial Institutions. And, as in earlier crises, lending by domestic banks seems to have been hit equally hard, if not harder. Across many transition countries – from Latvia, to Hungary, Ukraine, and Kazakhstan – the domestic shareholders of some of the largest domestic financial institutions have been unable to come up with the additional capital support that these systemic banks needed. As a result, bank lending by these banks has contracted severely, some of them (almost) defaulted, and local governments needed to step in. While foreign bank entry is not a panacea to all banking problems emerging markets struggle with, the empirical evidence seems to suggest that the presence of foreign bank subsidiaries may add to financial stability rather than reduce it.

References

De Haas, Ralph and Iman van Lelyveld (2004), Foreign bank penetration and private sector credit in Central and Eastern Europe, Journal of Emerging Market Finance, 3(2), 125-151.

De Haas, Ralph and Iman van Lelyveld (2006), Foreign banks and credit stability in Central and Eastern Europe. A panel data analysis, Journal of Banking and Finance, 30, 1927-1952.

De Haas, Ralph and Iman van Lelyveld (2009), Internal capital markets and lending by multinational bank subsidiaries, Journal of Financial Intermediation, forthcoming.

De Haas, Ralph and Ilko Naaborg (2006), Foreign banks in transition countries: To whom do they lend and how are they financed?, Financial Markets, Institutions and Instruments, 15(4), 159-199.

García Herrero, Alicia and Maria Soledad Martínez Pería (2007), The mix of international banks’ foreign claims: determinants and implications, Journal of Banking and Finance, 31(6), 1613-1631.

Peek, Joe and Eric Rosengren (2000), Implications of the globalization of the banking sector: The Latin American experience, New England Economic Review, September/October, 45-63.

 

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