Foreign Banks or Foreign Capital?

One less emphasised lesson from the global financial crisis was that developing countries that are successful in attracting foreign financial investors take a hit when such a crisis occurs because of a reverse flow of capital. Foreign financial firms needing to cover losses or meet commitments at home withdraw their capital generating a credit crunch in emerging market economies.

It is to be expected, therefore, that the crisis-induced debate on regulating finance should revisit not just policies with regard to capital flows into these economies, but also policies with regard to the entry and operation of foreign financial firms. This is particularly important because since the 1980s and especially after the series of currency and financial crises in emerging markets starting in the late 1990s, the presence of foreign financial firms, especially foreign banks, in developing countries has increased substantially.

However, there is a strand in the literature that suggests that it is not the presence of foreign banks per se, but the nature of their presence that determines vulnerability. To quote an IMF study (Kamil Herman and Kulwant Rai (2010), “The global credit crunch and foreign banks' lending to emerging markets: Why did Latin America fare better?“) based on the experience of countries in Latin America and the Caribbean (LAC): “Following the Lehman demise in the third quarter of 2008, lending by foreign banks to the LAC region slowed rapidly, amid the freezing of global money markets and doubts about the health of banks in advanced economies. Most of this deceleration in foreign banks' total credit growth, however, reflected a sharp contraction in cross-border loans to LAC, which are largely denominated in foreign currency and funded in wholesale markets. On the other hand, lending by local affiliates of foreign banks—which is mostly denominated in local currency and funded with domestic deposits—proved much more resilient and continued to expand, even amid the global turmoil.”

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Thus, the study concludes, if foreign banks deliver a higher share of their lending through local affiliates, with funding from domestic sources, the risk of a reverse, “homeward flow” of capital in times of crisis is lower. The implication of this argument should be clear. Financial liberalisation of the kind that encourages foreign banks to establish a physical presence and mobilise and lend local currency resources is preferable to liberalisation that merely eases conditions for the cross-border movement of capital. An open door policy must be adopted with respect to institutions and not just their capital.

But by focusing on the possible withdrawal of liquidity due to extraneous reasons, which is obviously likely only when lending is cross-border and in foreign currencies, the IMF study may be missing out on more direct ways in which foreign bank strategies can influence access to credit in developing countries, especially for productive investment.

A recent paper by Hamid Rashid of the United Nations' Department of Economic and Social Affairs (“Credit to private sector, interest spread and volatility in credit flows: Do bank ownership and deposits matter?“) points to more complex ways in which foreign banks' operations can affect credit provision, especially when those banks mobilise local resources and lend in local currencies. Based on data from 81 developing countries the paper points, inter alia, to three important trends. The first is that increasingly foreign banks are displacing domestic banks in the market for deposits. Not only is the deposit share of foreign banks significantly higher than that of domestic banks, but the rate of growth of deposits with foreign banks is also higher. The second is that behaviourally foreign banks are different from domestic banks, displaying a lower average loan-to-asset ratio and an asset portfolio with a higher share of non-lending, high-return activities such as investments in securities. This means that a larger share of deposits goes to support such activities. Third, as foreign banks increase their share of deposits, domestic banks are forced to increase their reliance on non-deposit-based funding to finance their lending (and non-lending) activities. However, the higher costs and uncertainty associated with non-deposit-based funding force domestic banks to reduce their lending activities. Overall, credit availability tends to get squeezed, and inasmuch as other evidence shows that foreign banks prefer retail to productive lending, this would adversely affect lending for investment purposes in particular.

In other words, developing countries should not only consider restricting capital inflows with controls, but also the entry of foreign firms that are the carriers of that capital.