Foreign Banks and The International Provision of Credit Linda Goldberg Federal 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.

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. No. 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.

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 Mismeasurement of difficulties in downturns and strengths in boom periods --- ex. Borio et al. BIS 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.

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