The process of financial globalization that accelerated in the 1990s has brought many changes to the financial sectors of developing countries.* Countries have opened up their stock markets to foreign investors, allowed domestic firms to cross-list and issue debt overseas, and welcomed foreign direct investment into their local financial sectors. When it comes to the banking sector, arguably no change has been as transformative as the increase in foreign bank participation in developing countries. On average, across developing countries, the share of bank assets held by foreign banks has risen from 22 percent in 1996 to 39 in 2005. At the same time, foreign bank claims on developing countries, which together with the loans extended by foreign bank branches and subsidiaries include cross-border loans, increased from 10 percent of GDP in 1996 to 26 percent in 2008 (see Figure 1).
There is significant debate surrounding the implications of foreign bank participation for developing countries. Supporters of this process (e.g., Mishkin, 2006 and Goldberg, 2009) argue that foreign banks can bring much needed capital and liquidity, as well as technical skills, product innovation and needed regulatory reforms to developing countries. Also, they highlight the potential gains in terms of increased competition and improvements in the efficiency of the banking sector. On the other hand, the critics of foreign bank entry and of financial globalization (e.g., Stiglitz, 2005 and Rodrik and Subramanian, 2009) argue that foreign banks can destabilize the local banking sector for a number of reasons. First, foreign banks can “import” shocks from their home countries and/or spread shocks from other developing countries in which they operate. Second, fierce competition with foreign banks can threaten the survival of local banks. Finally, foreign banks may fail to increase access to finance for a majority of domestic firms and consumers if they only concentrate on a top and selected segment of the market.
So what does the existing empirical evidence tell us about the impact of foreign bank participation? With few exceptions, the overwhelming evidence from cross-country research and from a significant number of case studies suggests that foreign banks are more efficient than domestic banks and, consequently, can exert competitive pressure. In contrast, the evidence on the effects of foreign bank participation on access to finance is mixed, with many cross-country studies suggesting that foreign banks enhance access, but some case studies (mostly from countries where foreign bank participation is still low and/or where the contractual and institutional environment is underdeveloped) providing evidence to the contrary. Clearly more research is required on this topic.
Research on the impact of foreign bank participation on banking stability suggests that for the most part foreign banks have played a stabilizing role in developing countries, bringing capital and liquidity during crises and lending more than domestic banks. However, most of the studies on this issue have concentrated on the behavior of foreign banks during financial crises that started in developing countries. New research on the recent crisis, which originated in the US, suggests that global banks played a significant role in the transmission of the crisis to emerging market economies. However, the contraction in lending supply was especially severe when originating in banks that prior to the crisis had developed greater vulnerability to a US dollar shortage. Hence, it was not openness to international banking flows per se that caused the propagation of the financial crisis, but rather concentrated exposures to foreign banking flows from specific countries (see Cetorelli and Goldberg, 2009).
As countries emerge from the 2007-2008 crisis and more research gets done, it will be interesting to see what the bulk of the evidence reveals regarding the role of foreign banks in the international transmission of this past crisis and what measures are taken by developing countries regarding the presence of foreign banks in their economies.
* Editor's Note: This blog post is based on Cull, Robert and Maria S. Martinez Peria, “Foreign bank participation in developing countries: What do we know about the drivers and consequences of this phenomenon?" The Encyclopedia of Financial Globalization. Forthcoming.