FINANCIAL STRUCTURE, GROWTH AND STABILITY: The Role of Foreign Banks Arturo Galindo Inter-American Development Bank XX Meeting of the Latin American Network of Central Banks and Finance Ministries Washington DC; October 25, 2004

Outline Motivation Evidence on the Role of Foreign Banks –Efficiency –Stability/Volatility –Market segmentation Conclusions

Motivation Ownership structure of banks has changed Worldwide. Foreign banks (FBs) are major players especially in developing countries By 2003, FBs headquartered in developed countries were lending US$1.45 trillion to developing countries. –60% was cross-border lending or domestic lending in foreign currency –40% loans by local branches and subsidiaries in domestic currency This source of lending is particularly important in Latin America

Motivation Cross border lending is more than 20% in developing countries Loans in local currency are near to 15% In LAC these are 60% and 65% respectively

Motivation

The role of FB Pros and Cons –Pros: FBs play a useful role in promoting capital inflows and competition and hence modernization and improvement in efficiency of banks and of quality of the regulatory framework (Levine 1996) Modernization of the payments system and of risk management and monitoring techniques, improving the mobilization of savings and the allocation of resources Increase stability: Large, internationally diversified banks are safer, have a lower probability of failure, leading to less flighty depositors.

The role of FB Pros and Cons: –Cons: Increase volatility: Import shocks from home (or other foreign) countries; reduce exposure when the going gets tough in the host; in the limit, simply pack up and leave! Large presence of FBs may crowd out domestic banks that may not be able to compete for deposits with FBs (Stiglitz 1994). This could reduce lending to SMEs and marginal sectors and reduce the effectiveness of monetary policy.

Efficiency Efficiency claims can be broken into two components: –FBs are more efficient than domestic counterparts –Greater efficiency is transfered to the whole banking system through competition and/or imitation Evidence for developed countries does not support that FBs are more efficient than their domestic counterparts (Hasan and Hunter (1996), Vander Vennet (1996)) For developing countries, Claessens, Demirguc- Kunt and Huizinga (2001) find that FBs have higher profits and lower interest rate margins than domestic counterparts

Efficiency In LAC, FBs opperate with lower overhead costs that allow them to have lower net interest income mantaining a similar return on assets than domestic counterparts.

Efficiency FBs appear to be more efficient. Evidence on the role of FBs in increasing competition is mixed –According to Claessens et al (2001) the presence of FBs is also associated with a higher level of competition, reducing the profitability and margins of domestic banks in the average developing country. –Levy-Yeyati and Micco (2003) find the opposite in a bank level panel study of 8 LAC countries: Increasing FB presence is correlated with decreasing levels of competition and higher returns on equity

Volatility / Stability Loyal Lenders or Fickle Financiers ? –A lively debate has ensued as to whether foreign banks bring stability or instability to credit. –Stability: Large, internationally diversified, safer, lower probability of failure, depositors less flighty. –Instability Import shocks from home (or other foreign) countries Reduce exposure when the going gets tough in the host In the limit, simply pack up and leave!

Evidence finds mixed results Peek and Rosengren (2000a) – Effect of Japanese banks in the US. Van Ricjkeghem and Weder (2000) – Transmission of shocks due to presence in many countries Crystal et al (2002), Dages et al (2000), Goldberg (2001), Peek and Rosengren (2000b) - US banks in several countries or international banks in two or three countries Martinez Peria, Powell and Vladkover (2003) –consider “international claims” of BIS Morgan and Strahan ( ) – consider role of US banks during “business cycle” Volatility / Stability

Galindo, Micco and Powell (2004) use a simple portfolio model to show that an internationally diversified bank (FB) can be safer than a domestic one because the former can take advantage of the LLN. Additionally they can be more stable if depositors perceive that the FB has alternative funding sources in case of liquidity shocks. However they can also be more fickle when the host country faces a shock to expected returns and they may cut back on local operations faster than domestic banks. In short, there is a trade-off. FBs are more stable when liquidity shocks hit FBs are more volatile when facing opportunity shocks Volatility / Stability

In order to identify shocks Galindo, Micco and Powell (2004) adopt the following strategy:

ijtjtij jt ijijt DFor I loans      54 (arg) * * : = “Liquidity Shock” (Positive) : = “Opportunity Shock” (Positive) )0d-l & 0>l(  jt I )0d-l & 0>l(  I : = Indicator Function taking value of one if arg is true and –1 otherwise e.g. (arg) jt I And estimate: In a panel of banks for 11 LAC countries Volatility / Stability

Results suggest that –FBs tend to stabilize credit during deposits crunches –But amplify the credit cycles driven by changes in business opportunities in the economy. Consistent with anecdotal evidence. Case of Chile after 1998 Deposits did not fall, the system increased holding of foreign assets, but FBs increased much more.

Volatility / Stability Another example is Colombia ( ). Deposits fell nearly 10%, credit collapsed in nearly 30%, but the drop was smaller in FBs.

Market Segmentation A concern is that FB presence can reduce access to credit from some segments of the market (SMEs, for ex.) –FBs have less knowledge of informationally opaque SMEs –SMEs are usually related with a single bank Evidence for Argentina shows that FBs headquartered in LAC lend more to SMEs than FBs with headquarters outside the region (Berger et al (2001)). However FBs can also bring technological innovations that make lending to SMEs easier (Mester(1997) suggests a U-shaped relationship between bank size and SME lending)

Market Segmentation Emprical evidence is scare and inconclusive. –Clarke et al (2000) find that: Small FBs in Argentina, Chile, Colombia and Peru lend less to SMEs than domestic banks. But medium and large FBs lend more to SMEs in Chile and Colombia but not in Argentina and Peru. In Argentina and Chile, loans from FBs grew more than these types of loans from private domestic banks during the 1990s. –IDB(2004) looks at a wider sample of developing countries (70) and asks whether FBs affect overall credit to SMEs. Compared with medium and large firms, small firms are able to finance 8% less of their investment with bank credit. In countries with large FB participation the gap increases. It could be however that FBs increase total credit but increase it more to large firms as suggested by Martinez Peria et al (2002)

Market Segmentation

Conclusions Apparently benefits outweigh costs FB entry is associated with greater efficiency and less instability after deposits shocks (except in major crisis episodes where all banks have lost) but with more instability after idiosyncratic opportunity shocks. Evidence on the impact of SMEs is still inconclusive