The Role of Foreign Banks in Post-Crisis Asia: The Importance of Method of Entry

Montgomery, Heather Working Paper The Role of Foreign Banks in Post-Crisis Asia: The Importance of Method of Entry ADBI Research Paper Series, No. 51 Provided in Cooperation with: Asian Development Bank Institute (ADBI), Tokyo Suggested Citation: Montgomery, Heather (2003) : The Role of Foreign Banks in Post-Crisis Asia: The Importance of Method of Entry, ADBI Research Paper Series, No. 51, Asian Development Bank Institute (ADBI), Tokyo, https://hdl.handle.net/11540/4156 This Version is available at: https://hdl.handle.net/10419/111148 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/3.0/igo/ ADB Institute Research Paper Series No. 51 January 2003 The Role of Foreign Banks in Post-Crisis Asia: The Importance of Method of Entry Heather Montgomery II Additional copies of the paper are available free from the Asian Development Bank Institute, 8t h Floor, Kasumigaseki Building, 3-2-5 Kasumigaseki, Chiyoda-ku, Tokyo 100-6008, Japan. Attention: Publications. Also online at www.adbi.org The Research Paper Series primarily disseminates selected work in progress to facilitate an exchange of ideas within the Institute’s constituencies and the wider academic and policy communities. The findings, interpretations, and conclusions are the author’s own and are not necessarily endorsed by the Asian D evelopment Bank Institute. They should not be attributed to the Asian Development Bank, its Boards, or any of its member countries. They are published under the responsibility of the Dean of the ADB Institute. The I nstitute does not guarantee the accuracy or reasonableness of the contents herein and accepts no responsibility whatsoever for any consequences of its use. The term “country”, as used in the context of the ADB, refers to a member of the ADB and does not imply any view on the part of the Institute as to sovereignty or independent status. Names of countries or economies mentioned in this series are chosen by the authors, in the exercise of their academic freedom, and the Institute is in no way responsible for such usage. Cop y ri g ht © 2003 Asian Development Bank Institute. All ri g hts reserved. Produced b y ADB Publishin g . ABOUT THE AUTHO R H eather Montgomery is a research fellow at the ADB Institute. Prior to joining ADB I nstitute, she held visiting positions at various institutions, including the United States F ederal Reserve Board of Governors, Japan’s Ministry of Finance, the Bank of Japan an d J apan’s Ministry of International Trade and Industry, while completing her Ph.D. dissertation research in economics at the University of Michigan. ADB INSTITUTE RESEARCH PAPER 51 III PREFACE The ADB Institute aims to explore the most appropriate development paradigms for Asia composed of well-balanced combinations of the roles of markets, institutions, and governments in the post-crisis period. Under this broad research project on development paradigms, the ADB Institute Research Paper Series will contribute to disseminating works-in-progress as a building block of the project and will invite comments and questions. I trust that this series will provoke constructive discussions among policymakers as well as researchers about where Asian economies should go from the last crisis and recovery. Masaru Yoshitomi Dean ADB Institute IV ABSTRACT This study examines the role of foreign banks in post-crisis Asia, focusing particularly on the four countries most affected by the Asian Crisis of 1997Indonesia, Korea, Malaysia and Thailand. First, using data on the presence of foreign banks via branching as well as subsidiaries, the study shows that the presence of foreign banks in the four crisis-hit countries is actually much larger than has been previously reported once the presence of foreign branches is accounted for in the data. However, the percentage of assets controlled by foreign banks in Asia is still lower than that of other emerging economies, despite great increases in the post-crisis period. The author reviews regulations on foreign bank entry that may have limited the presence of foreign banks or influenced the method of entry (branching versus subsidiary). Given recent regulatory changes and the need for bank recapitalization in the region, the presence of foreign banks is expected to increase in the near future, so this study next takes up the policy implications of this trend. To date, foreign banks in most Asian countries appear to perform relatively worse than their domestic counterparts as measured by return on equity, cost to income ratios, and the ratio of problem loans to total loans. This finding contradicts previous research in other emerging economies, and may be due to the fact that foreign bank entry in Asia is still a very recent phenomenon, and has occurred mostly through the takeover of troubled banks in the region. The second policy issue examined here is the stability of lending by foreign banks relative to domestic banks. Macroeconomic data suggests that foreign bank lending may in some cases be more stable than domestic bank lending, particularly during crisis, but that the stability of foreign bank lending varies greatly by method of entry. Cross border claims of foreign banks are the most volatile, followed by foreign bank branch lending. Lending by foreign bank subsidiaries capitalized in the host country appear to be more stable than domestic lending, perhaps providing much needed capital during times of crisis. Therefore, foreign banks play an important role in Asia, not only in the traditional ways by providing new services and stimulating competition and efficiency, but also by contributing to stability of the banking sector in the face of macroeconomic fluctuations. However, the mode of foreign entry seems to have important implications for the contributions of foreign banks. Since lending by off-shore banks and foreign bank branches seems to be more volatile than locally capitalized foreign subsidiaries, policy makers in Asia should encourage foreign players to enter via fully-owned subsidiaries or joint ventures and move away from the previous pattern of branch-based entry. V TABLE OF CONTENTS About the Author II Preface III Abstract IV Table of Contents V 1. Introduction 1 2. Penetration of Foreign Banks in Asia 2 3. Method of Entry 3 4. Regulations on Foreign Bank Entry in Asia 5 4.1. Indonesia 6 4.2. Korea 7 4.3. Malaysia 7 4.4. Thailand 7 5. Effects of Foreign Bank Entry 8 5.1. Competition and Efficiency 9 5.2. Stability 13 6. Conclusions 18 Appendix: List of Financial Institutions Used in the Analysis 20 References 25 Tables (in body of text) Table 1. Penetration of Foreign Banks in Emerging Economies 2 Table 2. Penetration of Foreign Banks in AsiaIncluding Entry Via Branching 5 Table 3. Performance of Foreign and Domestic Banks in Emerging Economies 10 Table 4. Foreign Assets and Liabilities of Foreign and Domestic Banks in Asia 13 Table 5. Loan Growth of Domestic and Foreign Banks in Preand Post-Crisis Asia 15 Table 6. Average Loan Growth Rates of Foreign Banks in Indonesia and Thailand 15 Table 7. Outstanding Loans in Preand Post-Crisis Asia 17 1 The Role of Foreign Banks in Post-Crisis Asia: The Importance of Method of Entry Heather Montgomery 1. Introduction Although the Asian Crisis has brought consensus on the necessity of strong domestic financial systems, there is less consensus on the role of foreign banks in achieving the goals of economic growth and stabilization. Foreign banks are one obvious source for the capital so badly needed in the region, and proponents of their entry argue that foreign participation is a vital part of creating a vibrant financial system with a wide range of financial services and industries (Liu (2002b)). But policy makers in the region worry about the potential negative effects of opening up their financial markets to foreign participation. Recent research showing a pattern in which financial crises tend to be preceded by financial liberalization has increased concern about the effects of opening up the banking system. In particular, there are concerns that foreign bank entry will expedite “de facto KAO (capital account opening)” (Liu (2002a)), perhaps contributing to the instability of financial markets and the banking sector. This study on the role of foreign banks in post-crisis Asia begins, in section 2, by providing some quantitative estimates of how far foreign banks have penetrated the banking sector in Asia and other emerging markets. Previous studies have underestimated the presence of foreign banks in Asia due to their failure to account for entry via branching, the mode of entry most common in Asian countries. Section 3 discusses this point, as well as the advantages and disadvantages of entry via branching versus merger and acquisition. However, even after accounting for entry via branching, the level of participation of foreign institutions in Asia is still much lower than that in other emerging market economies in Latin America and Central and Eastern Europe. Section 4 discusses the regulations on foreign entry in Asian countries, which have contributed to this state of affairs, and how these regulations have changed in the aftermath of the Asian Crisis. As a result of these regulatory changes, the participation of foreign banks in Asia is expected to increase in coming years. Section 5 discusses the expected effects of increased foreign participation on domestic institutions in Asia and on the banking sector as a whole. It reviews the theoretical arguments for and against foreign bank participation in emerging markets and surveys the empirical evidence available on the issues of efficiency, competition and stability. Finally, section 6 concludes. 2 2. Penetration of Foreign Banks in Asia Table 1. Penetration of Foreign Banks in Emerging Economies Total Assets (in billions USD) 1994 Assets Under Foreign Control: (%) 1994 Total Assets (in billions USD) 1999 Assets Under Foreign Control: (%) 1999 Central Europe Czech Republic 46.6 5.8% 63.4 49.3% Hungary 26.8 19.8% 32.6 56.6% Poland 39.4 2.1% 91.1 52.8% Total 112.8 7.8% 187.1 52.3% Latin America Argentina 73.2 17.9% 157 48.6% Brazil 487 8.4% 732.3 16.8% Chile 41.4 16.3% 112.3 53.6% Colombia 28.3 6.2% 45.3 17.8% Mexico 210.2 1.0% 204.5 18.8% Peru 12.3 6.7% 26.3 33.4% Venezuela 16.3 0.3% 24.7 41.9% Total 868.6 7.5% 1302.4 25.0% Total excluding Brazil and Mexico 171.4 13.1% 365.6 44.8% Asia Indonesia n.a. n.a. 43.6 6.7% Korea 638 0.8% 642.4 4.3% Malaysia 149.7 6.8% 220.6 11.5% Thailand 192.8 0.5% 198.8 5.6% Total 1091 2.8% 2004.2 6.3% * In billions of U.S. dollars. As of December The presence of foreign banks in emerging markets has increased dramatically in the 1990s, but this increase has not been as rapid in Asia as it has in the emerging markets of Central and Eastern Europe or Latin America. Figure 1, from Mathieson and Roldos (2001), shows the percent of assets under foreign control1 in several emerging 1 Mathieson and Roldos (2001) use three different measures of foreign bank participation in emerging markets: “Foreign Participation” is measured as the ratio of the sum across all banks of the assets of each bank multiplied by the percentage of equity held by foreigners to total bank assets. However, since corporate control may not be directly and exclusively related to the proportion of a bank’s equity held by a particular owner, “Foreign Control” measures the ratio of the sum of the total assets of those banks where foreigners own more than either 40 or 50 percent (Although holding more than 50% of total equity 3 markets. By this measure, participation in Asia is well below that of emerging markets in Central Europe and Latin America. Central Europe displays the largest growth in foreign participation, with the share of foreign control increasing from less than 10 percent to over 50 percent between 1994 and 1999. Foreign participation in the banking sector there was prompted by the privatization of the previously state-owned banking system. Hungary was the first to embark on an aggressive privatization plan, and by the end of 1999 foreign participation in the banking sector reached about 60% of total assets. Poland’s privatization drive has accelerated in the past two years and the share of foreign control of bank assets is now above 50%. The Czech Republic began to privatize its state-owned banks in 1998, and by the end of 1999 foreign institutions controlled almost 50% of total bank assets. That percentage is expected to reach more than 90% with the privatization of the last remaining large state-owned bank in 2001 (Mathieson and Roldos (2001)). Likewise, in Latin America, where foreign banks have had a presence for decades, foreign control of total bank assets increased from under 10% in 1994 to over a quarter of the banking sectors total assets in 1999. The presence of foreign banks is especially strong in Argentina, Chile and Mexico. They already had a substantial participation rate in Argentina and Chile in 1994, and by 1999, the percentage of bank assets under their control had increased to roughly half. The increase in foreign control in Mexico, from less than 1% in 1994 to 19% in 1999 is even more striking. The sale of the third largest Mexican bank in May 2000 and the second largest one in June 2000 will bring foreign control to about 40% (Mathieson and Roldos (2001)). According to them, Brazil is the only market in Latin America where foreign banks are unlikely to dominate, due to the large share of bank assets under government control and the presence of three well-capitalized, well-managed private banks. Among the emerging economies, Asia stands out in terms of the lack of a foreign presence in its banking sector. Although foreign participation in the sector has increased dramatically since the Asian crisis of 1997, according to Mathieson and Roldos (2001), the percentage of assets under majority foreign control in Asia still remained only 6% in 1999. 3. Method of Entry Most studies of foreign participation in the banking sector in Asia underestimate the presence of foreign banks, since they focus on the percentage of assets controlled by fully-owned, locally-capitalized foreign bank subsidiaries or joint ventures in which a foreign partner owns a majority share, and ignore the more significant presence of foreign banks via branching. Until very recently, foreign commercial bank operations in Asia were conducted almost entirely through branches or representative offices rather than wholly-owned subsidiaries or joint ventures2 (Pigott (1986)). typically ensures effective control of a bank, according to Mathieson and Roldos (2001), a number of analysts have argued that hostile takeovers are unlikely to occur when the existing owners hold more than 40% of bank equity). The data reported in figure 1 correspond to the 50% foreign control measure. Total Assets are measured in billions of US dollars. 2 This generalization does not apply to all Asian countries. In Malaysia, for example, almost all foreign bank participation occurs through majority foreign-owned joint ventures or fully foreign-owned subsidiaries. 10 Table 3. Performance of Foreign and Domestic Banks in Emerging Economies Return on Equity Cost-to-Income ratio Problem loans/ total loans (units: %) Foreign Banks Domestic Banks Foreign Banks Domestic Banks Foreign Banks Domestic Banks Central Europe Czech Republic 14.4 −1.6 70.9 40.5 18.8 28.5 Hungary 16.1 −26 62.4 113 10.6 15.1 Poland 24.1 −0.1 50.9 59.9 11.1 9.2 Total 19.3 −5 59.9 62.1 13.7 17.1 Turkey 68.3 29.8 39 48.2 6.1 4.1 Latin America Argentina 5.8 −0.7 73.4 76.9 5.7 17.3 Brazil 10.4 5.2 73.3 68.8 7.5 7.6 Chile 10.9 14.9 59.8 64.4 1.9 1.5 Colombia 2.7 1.7 70.6 69.1 5.4 6.8 Mexico −14.3 −2.1 112.3 78.5 4.1 8.7 Peru 14.9 10.8 64.8 80.5 6 13.2 Venezuela 40.6 38.2 56.3 64.6 3.9 4.1 Total 6.3 4.7 77.9 71.2 6.1 8.5 Total excluding Brazil and Mexico 9.9 7.5 67.5 71.9 4.5 10.4 Asia Korea −44.2 −20 53.7 69.2 15.1 8.6 Malaysia 16.4 7.8 34.7 42.6 6.8 8.4 Thailand −66.1 −20.2 128.9 72 46.2 36.5 Total −35.7 −14.3 63.8 64.2 19.2 13.8 In Asian economies, because the entry of foreign banks is still a relatively new phenomenon, there are only limited empirical studies of the relative performance of foreign and domestic banks. Table 3 from Mathieson and Roldos (2001) shows that in the emerging economies of Central and Eastern Europe and Latin America, foreign banks generally report higher returns on equity and lower cost-to-income and problem loan ratios than do domestic banks. However, in some Asian countries, the performance indicators of locally-capitalized foreign banks are worse than those of domesticallyowned banks. This may be due to the fact that it was only recently that many foreign 11 banks entered Asia via mergers and acquisitions. These few takeovers and mergers were often allowed only in order to provide much needed capital to troubled banks in the aftermath of the Asian crisis. In time, these newly acquired banks may regain their asset quality and performance. Note that in Malaysia, where foreign owned subsidiaries pre-date the Asian crisis of 1997, foreign banks outperform domestic banks on aggregate. Studies which look at measures of openness to foreign entry rather than actual entry by foreign banks suggest that the limited openness of Asian economies to date has been costly. Cross-country studies find that tighter restrictions on entry into the banking sector tend to increase overhead costs and reduce the efficiency of the banking sector (Barth, Caprio and Levine (2001)). A related study of eight Asian economies in particular reveals that “the costs of financial services and the fragility of the financial systems are negatively related to the degree of openness of the domestic market to foreign financial firms” (Claessens and Glaessner (1999)). Even if foreign banks prove to be more efficient than domestic banks in Asia, as they have been in other emerging markets, fears that they will take over the entire banking sector and completely dominate domestic banks are probably unrealistic, since they enter countries by targeting specific market niches (Levine (1996)). A study of the effect of foreign bank entry on domestic banks in Argentina shows that they tend to enter specific areas where they have a comparative advantage. Although domestic banks with a concentration in areas that were aggressively targeted by foreign banks experienced falling net margins and increasing overheads, domestic banks specializing in other markets showed higher net margins and higher before tax profits (Clarke et. al. (1999)). Thus, even if Asia opens to foreign bank entry, domestic banks will be able to retain competitive advantages that come from “superior knowledge of local circumstances and relationships within the local community” (Meltzer (1998)). The degree of competition felt by domestic banks upon foreign entry depends to some extent upon the reason for the entry into the host market. Many studies examing the determinants of foreign bank activity find that the expansion is determined by foreign direct investment in other sectors of the economy, suggesting a “follow the customer” strategy9 (Aliber (1984), Buch and Lapp (1998), Buch (2000), Goldberg and Saunders (1981), Goldberg and Johnson (1990), Gross and Goldberg (1991), Miller and Parkhe (1998), Sabi (1988), Sagari (1992)). However, most of these studies focus on U.S. banks, and the motivation behind their entry into foreign markets, varies by region. In Latin America, the first wave of foreign bank entry came as a result of regulatory liberalization, and accelerated in the wake of the Tequila Crisis. In Central and Eastern Europe, foreign bank entry came after government-owned banks were privatized. In Asia, it seems to follow foreign direct investment in other sectors. 9 Clarke et al. (2001) point out that in most studies it is unclear whether FDI in the non-financial sector is the causal influence on the FDI of banks. Causation may run the other way, or some omitted factor may explain both. Although most studies attempt to control for omitted factors such as market size (proxied for by GDP or population) or foreign trade, these controls may not be sufficient. Even if a convincing link is found between non-financial FDI and FDI by banks, this positive association does not necessarily mean that foreign banks are providing services exclusively or even primarily to the affiliates of clients from their home countries. 12 Research into the expansion of Japanese banks, which may have the strongest presence in Asia, indicates that although they often may enter foreign markets on the heels of foreign direct investment by clients in the manufacturing sector, they eventually begin to serve local clients as wellissuing trade credits for related suppliers for example. Pomerleano and Vojta (2001) find that in the Philippines, Japanese banks tend to focus on servicing large Japanese corporations seeking to finance their foreign direct investment rather than multinational corporations or local customers. Thus they have little effect on the domestic banks in the Philippines. Other studies (Seth and Quijano (1991), Nolle and Seth (1996)) have found that Japanese banks initially enter in pursuit of their customers abroad, but there is evidence that they then expand their customer base to include domestic companies. For example, Yamori (1998) investigates the locational choice of Japanese banks and finds that FDI, particularly from the manufacturing industry, is an important determinant of the location choice of Japanese financial institutions, suggesting that Japanese banks follow their customersthe Japanese manufacturing industry. However, unlike U.S. banks expansion patterns abroad, the expansion patterns of Japanese banks seem to also be affected by the size of local banking opportunities in the host countries as measured by the log of per capita GNP in the host country. Looking at the expansion of Japanese banks into the United States, Peek and Rosengren (1998) find that their customer base in the 1980s included “numerous domestic U.S. companies.” Of course, foreign bank activity is determined not just by nationality, but also by the particular strategy of the bank in question. Deutsche Bank and other money center banks such as Chase-JP Morgan, have withdrawn somewhat from emerging markets, limiting their credit exposure in order to focus on investment banking and private banking activities. These banks may offer some trade finance, but mostly provide advanced treasury and capital market products, cross-border underwriting and M&A services-niche markets that offer little direct competition for domestic markets. Following a completely different strategy, at least three foreign banks operating in emerging economies-local subsidiaries of Citibank, HSBC and Standard Chartered-have done well in the retail banking10 market by targeting high-end consumer and commercial business and offering innovative and high-quality retail services, credit cards, and mortgage and personal lending. There is also some evidence that in the mid-1990s, Japanese banks shifted their emphasis in Asia away from wholesale toward retail banking (McCauley and Yeaple (1994)). Overall, research to date suggests that greater openness to foreign financial institutions will benefit emerging markets in Asia. Although the activities of some foreign entrants may provide competition for domestic banks, this will spur efficiency in the banking sector for both foreign and domestic players. Moreover, the role of domestic financial institutions will not be eliminated by the entry of foreign banks. By capitalizing on their local knowledge and relationships in the retail and small and medium enterprise loan markets, domestic banks will continue to play a crucial role in the financial system. Very few foreign banks are likely to penetrate these markets to a meaningful degree. Rather, foreign banks are likely to focus on areas where they have demonstrated a comparative advantage: foreign exchange and derivatives trading, global underwriting of bonds and equities, cross-border M&As, trade finance and investment 10 As noted above, it is difficult to categorize banks as solely “wholesale” or solely “retail” banks. 13 management services. Thus, rather than substituting for domestic bank services, they will complement the range of wholesale and retail products offered by domestic banks. 5.2. Stability Because of the enormous economic damage caused by the Asian crisis of 1997, the main concern of policymakers in Asia is often not the efficiency of or even competition from foreign banks, but stability. Foreign banks tend to be more specialized in foreign currency lending (Pigott (1986)), and as shown in Table 4 below, hold a higher percentage of both assets and liabilities in foreign currency. Note that the spread between the percentage of foreign liabilities and foreign assets is much higher for foreign banks than for domestic ones, indicating that foreign banks have higher net external positions. Table 4. Foreign Assets and Liabilities of Foreign and Domestic Banks in Asia Domestic Banks Foreign Banks Foreign Assets Foreign Liabilities* Foreign Assets Foreign Liabilities* Indonesia 5.42% 5.11% (18.10%) 8.26% 43.01% (69.05%) Korea 7.76% 7.17% (13.17%) 9.33% 65.1% (65.29%) Malaysia 2.91% 4.09% 1.43% 11.63% * Foreign liabilities including foreign currency deposits are in parentheses. These issues have brought concerns that foreign banks may withdraw more rapidly than domestic banks in the event of crisis (Park (2002)), or even that the very presence of foreign banks may increase the likelihood of a crisis. However, because foreign banks can rely upon an internationally-diversified funding base-in particular advances from the parent (Terrell (1979), (1986))-proponents of foreign bank access point out that they are likely to be less vulnerable to business cycles in the host country, and thus may provide a more stable source of credit than domestic banks. By diversifying the host country’s overall banking system, international banks may actually stabilize it (Meltzer (1998)), making it less vulnerable to crisis. Empirical evidence suggests that foreign banks remain sensitive to economic conditions in their home countries. Lending by Japanese banks operating branches in the United States has been shown to be sensitive to the financial condition of the parent bank (Peek and Rosengren (1997), (2000a)), and U.S. bank claims on Latin American and Asian emerging markets and industrialized countries have been shown to be sensitive to U.S. macroeconomic conditions (Goldberg and Kinney (2001)). However, the operations of foreign banks appear to be insensitive to macroeconomic conditions in the host country, at least for emerging markets (Goldberg and Kinney (2001)). This suggests that foreign banks can play an important role in providing credit during economic downturns. As long as the business cycle of the host country and the home country are not perfectly synchronized, this situation can actually be a stabilizing force. Indeed, it has been shown empirically that foreign bank penetration rose in the wake of crisis in Latin America (Peek and Rosengrean (2002b)), and we are currently seeing the same trend in post-crisis Asia. Thus, foreign banks seem to play an important role in 14 supplying credit when domestic institutions are unable to do so and in recapitalizing the banking sector in crisis-hit economies. There is also the question of whether the lending of existing foreign banks is more volatile than that of domestic banks, and whether existing foreign banks are more likely than domestic banks to withdraw in the face of crisis. Overall, there seems to be little evidence to support this. On the contrary, studies on the behavior of foreign banks in Latin America during the Tequila crisis of 1994-1995 provide evidence that foreign banks may actually increase stability in crisis hit countries (Goldberg and Kinney (2000), Crystal and Goldberg (2001), Peek and Rosengren (2000b)). Goldberg and Kinney (2000) investigate the behavior of foreign and domestic banks in Argentina and Mexico for the period 1994-1999 and fail to find any support for the argument that foreign banks contribute to instability or are excessively volatile in their responses to market signals. In fact, the authors find that foreign banks exhibited stronger loan growth and lower volatility of lending in the period surrounding the 1994-1995 Tequila crisis. Crystal, Dages and Goldberg (2001) report similar results in their study of foreign bank activity in Chile, Columbia and Argentina: foreign banks showed higher and more stable average loan growth, higher average provisioning expense, comparable or weaker profitability, and higher risk-based capital ratios than domestic banks. These data echo the findings of Peek and Rosengren (2000b) for Argentina, Brazil and Mexico. They found that despite economic problems in the host countries, foreign bank subsidiaries there have continued to grow. Contrary to the concerns of policymakers in developing countries, “foreign bank subsidiaries did not pull back in response to economic problems in the host country; rather, they viewed the economic problems as providing opportunities to expand, either by acquisition or by internal growth of existing subsidiaries.” These findings suggest that foreign ownership may provide an important stabilizing influence in emerging market financial systems. Table 5 presents average loan growth rates11 for domestic banks and foreign bank branches and subsidiaries operating in Indonesia, Korea and Malaysia both before and after the crisis of 1997. As in Latin America, there appears to be no statistically significant difference between loan growth rates for domestic and foreign financial institutions. Although there has been little rigorous research into the influence of foreign banks on Asian emerging markets, there is some evidence that those that were already operating in Asia prior to the 1997 crisis contributed to stability in the region. In Indonesia, foreign banks were spared the bank runs that forced domestic banks to rebuild liquidity and curtail lending. In addition, exchange rate and interest rate shocks to the Indonesian economy had a much more adverse effect on domestic bank capital than on foreign bank capital, meaning that the supply of bank loans from foreign banks was less affected (Aziz et. al. (2002)). Although foreign banks could not supply enough credit to completely offset the decrease in supply by domestic banks, they clearly played a stabilizing influence during the crisis. 11 Due to data limitations, Table 5 does not include cross-border lending by off-shore financial centers, which may be more volatile. 15 Table 5. Loan Growth of Domestic and Foreign Banks in Preand Post-Crisis Asia Pre-Crisis (-Dec 1996) Post-Crisis (Jan 2000 - Mar 2002) Domestic 28.26 (1.00) 18.56 (4.04) Indonesia Foreign 22.19 (2.03) 11.50 (5.34) Domestic 17.16 (6.52) 19.40 (1.78) Korea Foreign 6.52 (1.64) 13.79 (4.97) Domestic n.a. 5.23 (0.73) Malaysia Foreign n.a. 8.30 (1.39) * Standard deviations are in parentheses. However, the stability of foreign bank lending during banking crises may depend upon the mode of entry of the institutions. Recent studies indicate that subsidiaries allow foreign banks to provide a wider range of activities and bring greater stability in lending to host countries than do branches, although empirical research in this area is limited (Clarke and Sanches (2001)). Table 6 shows the average loan growth rates for foreign-owned branches and foreign-owned subsidiaries operating in Indonesia and Thailand. In both countries, foreign bank branches have statistically significantly higher loan growth rates than do foreign bank subsidiaries, but this higher growth is accompanied by higher volatility in lending as well. Table 6. Average Loan Growth Rates of Foreign Banks in Indonesia and Thailand Branches 17.75 (6.45) Indonesia Subsidiaries 3.04 (4.19) Branches 40.06 (17.80) Thailand Subsidiaries 5.37 (2.64) * Standard deviations are in parentheses. 16 Even more volatile than the lending of foreign bank branches is that of offshore foreign banks. Although “off-shore financial activities are not inimical to global financial stability provided they are well supervised and supervisory authorities cooperate”12 (BIS (2000)), there is substantial evidence that off-shore lenders actually retreat in times of crisis. During the Tequila crisis in Latin America, off-shore lenders pulled back in response to the economic problems in the host country, unlike foreign bank subsidiaries, who took the opportunity to expand their operations (Peek and Rosengren (2000b)). During the Asian crisis, while U.S. money center banks generally maintained the operations of their offshore branches and subsidiaries, cross border lending into Asia plummeted13 (Palmer (2000)). It is difficult to empirically document the role of offshore financial centers in capital flight, since many of their activities are not included on the balance sheet. However, even aggregate data confirms that cross-border lending is more volatile than domestic lending or lending by foreign institutions that entered via branching or subsidiaries. Table 7 shows outstanding loans and credit before and after the Asian crisis of 1997 for Indonesia, Korea, Malaysia and Thailand. Cross-border claims in all these crisis hit economies fell substantially between 1996 and 1998. In most, outstanding loans by domestic banks fell or grew only slightly over the same period. Outstanding loans by foreign banks, however, grew significantly. This suggests that as in the case of Latin America during the Tequila crisis of 1994-1995, foreign bank subsidiaries and branches stepped in to provide loan demand that could not be met by domestic banks during the Asian crisis. However, cross-border lending was actually more volatile than any other types of lending, and exacerbated, if not to some extent caused, the credit crunch that accompanied the crisis. These large disparities in the lending behavior of foreign banks that are present via subsidiaries or branches, versus those that are engaged primarily in cross border lending, has led to recommendations that policymakers concerned about the stability of foreign bank lending should encourage cross-border lending through brick and mortar subsidiary operations rather than through offshore lending (Peek and Rosengren (2000b)). 12 BIS (2000) provides a grouping of offshore financial centers into categories reflecting their perceived quality of supervision and degree of co-operation. 13 For example, cross-border lending to Asia fell 36% between June 1997 and June 1999, but local claims of foreign banks declined just 6%. NB: Cross-border claims are those booked outside the foreign counterparty’s home country, usually at the U.S. bank’s head office in the United States. This type of claim is usually denominated in U.S. dollars. Local claims on foreign counterparties are those booked in the local offices of the reporting bank-offices located in the country of the counterparty. 17 Table 7. Outstanding Loans in Preand Post-Crisis Asia 1996 1998 Rate of Change: 1996-1998 Cross-Border Claims of BIS Banks (units: $ bil) Total Claims 58.7 45.0 −23.3% Foreign 12,412 32,225 159.6% Indonesia Local Lending (units: Rp bil) Domestic 71,153.4 125,110 75.8% Cross-Border Claims of BIS Banks (units: $ bil) Total Claims 104.2 67.3 −35.4% Foreign 7,361.9 8,364.4 13.6% Korea Local Lending (units: Won bil) Domestic 148,726.7 152,958.9 2.9% Cross-Border Claims of BIS Banks (units: $ bil) Total Claims 28.8 18.9 −34.4% Foreign 47.9 66.1 38.0% Malaysia Local Lending (units: RM bil) Domestic 178.5 246.6 38.2% Cross-Border Claims of BIS Banks (units: $ bil) Total Claims 69.4 39.4 −43.2% Foreign 143.8 173.4 20.6% Thailand Local Lending (units: Baht bil) Domestic 4,111.2 3,762.9 −8.5% * Cross-Border claims of BIS banks includes non-local currency claims by BIS reporting banks’ affiliates in vis-à-vis countries. Local foreign banks lending includes lending in non-local currency as well as lending in local currency. The rate of change in foreign banks’ local lending as measured in billions of USD was −22.90 % for Indonesia, −20.59 % for Korea, −8.12 % for Malaysia, and for −14.95 % for Thailand. It is important to keep in mind, however, that overall, cross-country studies on the relationship between foreign bank entry and the incidence of banking crisis suggest that the presence of foreign banks, or even just opening to foreign bank entry, reduces the likelihood of crises. Investigating the period 1988-1995, Demirguc-Kunt and Min (1998) show that foreign bank entry is associated with a decreased incidence of local banking crises. A study by Levine (1999), building upon the work of Demirguc-Kunt and Min (1998), uses the same multivariate logit model to relate the probability of a banking crisis to a series of macroeconomic and banking system health indicators, including the number of foreign banks relative to total banks. Levine’s study reports that the foreign bank share variable has a statistically significant negative coefficient, leading to the conclusion that greater foreign bank participation was a stabilizing influence after controlling for other factors. Barth and Levine (2001) find that it is not foreign bank ownership per se that is linked to the likelihood of a banking crisis, but rather limitations on foreign-bank entry and ownership. Independent of actual foreign 18 bank entry, they find that the likelihood of a major banking crisis is positively associated with greater limitations on foreign-bank participation. 6. Conclusions The following conclusions emerge from this overview of the role of foreign banks in Asia. In post-crisis Asia, foreign banks operate on a much more even playing field with domestic banks compared to the past. Branching restrictions, as well as special treatment for the branches of foreign banks, were largely phased out with the financial sector liberalization that was implemented in most countries in the 1980s. More recently, ceilings on the shares of foreign partners in joint ventures have been raised substantially and in most cases eliminated. However, as a legacy of the previously heavily regulated environment, the penetration of foreign banks in Asia-whether measured in terms of loans, deposits or assets-is very low, lower than in Central Europe or Latin America even in the early 1990s. This fact is observed even when taking into account the activity of foreign banks via branches, the mode of entry most used by foreign banks in Asia. Looking forward, the presence of foreign banks in Asia is expected to increase rapidly, due to both the deregulation already in place and the progress being made by the World Trade Organization on the Generalized Agreement on Trade in Services. Although many developing countries have already unilaterally liberalized trade in services and entry into the financial sector, the signing of the GATS will reinforce the trend toward financial service liberalization, and lock countries into a commitment to maintain the liberalization they have instituted thus far. Finally, foreign financial institutions are increasingly being welcomed in Asian countries as part of the recapitalization of the banking sector in the wake of the crisis. As academic research has shown, banking crises bring increased foreign participation in the banking sector. This increase in foreign participation in the banking sector should be welcomed by policymakers. The presence of foreign banks will likely improve the financial infrastructure, including accounting and transparency, by stimulating the establishment and strengthening of rating agencies, auditors, credit bureaus. Foreign banks effectively “import” financial system supervision and supervisory skills from home country regulators, and these skills may spill over to the host country. In addition, foreign banks can help improve financial services within a country both by offering services directly and through increased competition with domestic banks. Increased competition from foreign entrants stimulates the efficiency of both foreign and domestic players in the market. Fears that foreign entrants will take over and dominate the host country’s banking sector are unsubstantiated, as studies show that foreign banks tend to focus on niche markets that complement rather than substitute for services and products offered by domestic banks. Thus, domestic financial institutions will continue to play a crucial role in the financial system in Asia. In addition to the benefits of an improved financial infrastructure and increased efficiency in the banking sector, foreign banks contribute to the stability of the financial sector. They tend to be more internationally diversified than their domestic counterparts, rendering them less sensitive to macroeconomic conditions in the host country. Thus, they are able to provide credit when domestic banks cannot, helping to 19 smooth out business cycle fluctuations. The experience of Latin America in 1994-1995 shows that foreign banks can play an important role in recapitalizing the banking sector following banking crises. This trend has also been seen more recently in post-crisis Asia. More importantly, research has shown that by diversifying the host country’s banking system overall, international banks actually reduce the likelihood of crisis in the first place. One caveat, however, is that the mode of foreign entry matters. Until recently, almost all foreign entry into the banking sectors of Asian countries has been through offshore lending institutions or branching, rather than through fully-owned subsidiaries or majority-owned joint ventures. There is clear evidence that offshore lending is much more volatile than lending by “brick and mortar” foreign banks. Lending by branches, subsidiaries and joint venture banks may have supervisory advantages as well. As witnessed during the Asian crisis, offshore lending tends to be more difficult for the host country supervisor to monitor or influence (Peek and Rosengren (2000b)). Although empirical studies on the relative merits of foreign bank branches versus subsidiaries are limited, recent studies suggest that foreign bank subsidiaries are able to provide a wider range of financial services (Clarke and Sanches (2001), Miller and Parkhe (1998)), thereby contributing to stability. 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