Corporate Finance - The Role of Domestic and Foreign Banks - Essay Example

Corporate finance .  Contents Introduction 3 Discussion 4 Recommendations 10 Conclusion 11 References 13 Introduction The role of domestic and foreign banks has become profound in the developing and transitional economies. The fast globalizations and integration of the international trading and banking environments have created several opportunities as well as threat as for both the locally and internationally operating banking and other financial institutions. There have been a number of benefits and disadvantages for the banking institutions caused by an excessive level of financial globalization. Financial globalization was expected to bring about major positive changes in the way the financial markets across the globe operate. However, the phenomenon of financial and trade globalization is also a prime driver of diverse contagions and risks for the banks and other financial institutions which are in lesser advantageous positions in the global financial domain. This includes the domestic banks in the developing countries that often face hurdles in functioning due to the increasing scale of competitiveness posed by the entrance of the multinational giant banks into the local economies and financial markets. The net impact of the financial globalization aspects is expected to be optimistic and positive in the long term scenarios with the risks and contagions becoming more influential when the economies are liberalized or opened up and tend to lose the intensity with time. This report is aimed at discussing the different issues and challenges that have been faced by the domestic banks in the developing countries due to the entrance of foreign multinational banks entering into these nations and competing with the domestic banks. For evaluating the issues faced by the local banks in the emerging nations, the challenges faced by the in the global trading and financial environments are identified and discussed. The report also includes an identification and analysis of the capabilities of the domestic banks of developing countries as compared to that of the foreign banks. Suitable recommendations are provided as to how these banks can negate or mitigate the challenges and issues that are currently being faced by them and that have to be faced by them in the future years of functioning. The report is concluded by summarizing the discussions and highlighting the main findings from the discussion. Discussion As the financial systems across different nations integrate to form a global financial system, the governments of various nations have started experiencing lesser direct control over the regulatory policies that govern their respective domestic financial markets. The local regulatory policies are fast overshadowed by the international financial rules, regulations and policies that are formulated by the international organizations like the International Monetary Fund (IMF), the World Bank etc. (Sornarajah, 2003). This creates lesser scope for the governments of the developing nations to support the domestic banks of the countries, thereby making it easy for the foreign banks to gain higher market share and profitability. The international financial policy co ordinations seem to have huge benefits for the banks and financial market entities of the emerging and developing nations and at the same time seem to act as barriers for the growth of the domestic banks due to the higher level of requirements and standards that are too fulfilled for competing on an efficient basis (Martínez and Mody, 2004). The entry of foreign banks in an economy is seen as a way through which the financial infrastructure and market conditions of the developing countries can be enhanced. Some scholars are of the view that foreign banks can improve the financial development of a developing economy through three main aspects. Firstly, the foreign banks have higher levels of resources and capabilities to improve the competitive factors and efficiency factors of a financial market. Secondly, these banks have access to sources of finances and funds from different corners of the globe which makes them possess diversified portfolios that can be used to hedge a number for risks associated with financial and capital markets like the issues of currency fluctuations, foreign exchange rate fluctuations as well as credit level changes. The functioning of foreign banks within a developing economy goes a long way in safeguarding the economy from the financial shocks in the global trade and finance domains. Additionally, the entry of foreign banks can lead to the banking industry of a developing country taking up the best practices approach, especially in management and risk management techniques which ultimately results in the creation of a more effective and efficient banking and financial sector in the country. Lastly, if the foreign banks enter into a developing country and start dominating the banking sector in the nation, then the governments of these countries are less obliged to bail out the banks which are facing liquidity and solvency issues. This seems to be a positive and optimistic factor for the economy of the country but often acts as a major threat to the domestic banks in the country. However, this also means that the lesser likelihood of bailouts and supports provided by the governments makes the domestic banks more conscious towards maintaining their efficiency and credit rating and thereby encourages a more prudent and responsible behavior among the banking institutions (Ugarteche and Ortiz, 2009). Also, this kind of internal situation enforces the need for reduction of moral and ethical hazards, increases discipline in the sector and reinforces ethical, compliant and responsible behavior among the banking institutions. The global trade and financial environment is a complex, multilayered and dynamic sector. As such, the presence of high levels of competency and resources is necessary to function on this platform. The extensive integrations and collaborations are already acting as threats to the banks which are operating within national or regional boundaries. Apart from the complexity of the financial and capital markets, there many other challenges are being faced by the domestic banks in the present day scenario. The entry of the foreign banks into the developing economies often exacerbate the complexities of the financial and trading environment, thus making it more difficult for the limited resourced local entities to function in a sustainable and competitive manner (McCauley, McGuire, and Von Peter, 2010). There are four main entities included in the phenomenon of financial globalization which are the governments, investors, financial institutions and borrowers (Slaughter, 2009). Each of these entities helps the countries to drive higher financial integration and co operation. However, on an international platform, the impact of all these entities becomes effective only when the domestic banks have the means and resources to compete and influence on a global scale (Ocampo, 2003). The absence of such kind of power and resources among the domestic banks in the developing economies pose as a major threat for the competiveness and sustainability of these banks in the global financial markets. The governments of respective nations are one of the primary agents in the area of globalization. The governments of different countries support globalization by adopting liberalization and other reforms that aim at adding value to the economy of the nation but often impose several restrictions and high operating standards on the local financial sectors (Mishkin, 2000). The governments use a number of financial instruments for restructuring extensive capital accounts, foreign exchange transactions, borrowing and lending activities by banking institutions, derivative transactions and the participation of the foreign banks and investors in the domestic financial sectors. However, the liberalization of the financial markets in different developing countries have lowered the entry barriers for the foreign banks into these economies which has resulted in these banks function as powerful entities in the domestic markets (Herrmann and Mihaljek, 2009). The excessive control and dominance of the foreign banks and local economies create major challenges for the domestic banks because the position of the domestic banks becomes weaker. The presence of foreign banks in the financial markets also raises the functioning level of the banking institutions and financial institutions in the market. Consequently, the domestic banks start losing market share because their resources and capabilities for competing with the foreign banks are much limited as compared to the internationally operating banking institutions (Houston, Itzkowitz and Naranjo, 2007). These kinds of issues were the main reasons as to why the gradual lifting of the regulatory restructurings in the emerging and developing countries over the last 30 years have included periods of reversals in which the regulatory restrictions were re imposed (Herrero and Peria, 2007). One of the most prominent reversals that occurred in the banking industry was after the global debt crisis experienced in the year 1982 and the Argentine banking crisis that took place in Latin America in the year 1996 (Mundell, 2000). While the benefits of the foreign markets entering into an economy were perceived to be many, more than often it is observed that the major chunks of the profits and revenue are taken by the banks themselves which leaves very little scope for the developing nations to gain from the process of allowing the foreign banks to operate in their economies. (Ffrench-Davis and Griffith-Jones, 2009) Additionally, the high level of competition faced by the domestic banks in the developing countries make it difficult for them to bring in proper revenues and economic contributions for the nation and as such, the presence of foreign banks in a developing country function as a derogatory factor in the medium to long terms scenarios (Mussa, 2000). As identified by the International Monetary Fund (IMF), the shifts in the developed and developing countries related to the financial and capital markets can explain the role of the banking and financial institutions as a main force of globalization. At the global level, the entrance of foreign banks in the developing economies creates the scopes for internationalization of trading economy (Dornbusch, Park and Claessens, 2000). However, when viewed from the perspective of the developing and emerging nations, the foreign banks functioning in these economies often act as highly powerful entities in the financial markets that tend to exploit the knowledge of the local banks regarding the market environment of the country. However, in the developing countries, the increased level of competition in the banking industry creates a vulnerable position for local banks because of their limited resources and capabilities and position of operations. The position of the local banks is weaker as compared to the foreign banks when evaluated in terms of the global trading and financing environment. The fright banks in the developed countries aim at expanding their businesses in new markets and regions so as to increase their market shares, profitability and customer base and to diversify the risk factors associated with their respective businesses. This aim of the foreign banks is supported by the intensely liberalized and globalized macroeconomic environment which allows the international corporations to conduct their businesses in different geographical locations. Though these activities help to create higher economic integration, they also create a difficult situation for the local players in which their hold on the industry declarers and the often have a tough time competing with the vast resources and knowledge of the internationally operating players in the banking sector. The foreign banks are likely to have both positive and negative effects on the economic systems of a country, especially in that of an emerging economy. The functioning of the foreign banks may exert extensive pressure on the existing supervisory and regulatory frameworks in the country and thus enforce several changes and modifications in the regulatory policies. These regulatory policies may thus, be more biased towards supporting the functions and policies of the foreign banks and neglect the requirements of the domestic banks in the country. In various developing countries, the foreign banks tend to act as catalysts that drive and support significant reform processes which in the long term help in enhancing the overall efficiency and growth potential of the financial sector and the economy. Also, the foreign banks helps to foster allocative efficiency which is beneficial for the financial sector of the country but which performs the role of a major constraint for the functioning of the domestic banks of the country (De la Torre, Yeyati and Schmukler, 2002). Foreign banks often also help to remove the imbalances and distortions within the economies of such nations which lead to a concentrated financial system (Toporowski, 2009). This is a primary challenge for the domestic banks because; the domestic banks are used to perform within local boundaries along with the existing distortions in the economy. Substantial shifts in the way the industry functions because the domestic banks to be unable to introduce quick transformations and as such reduce their competiveness, thereby creating scope for the foreign banks to capture greater market shares in the industry (Levine, 2002). The foreign banks also set in motion the intensity of competitive forces in the economy. One of the main consequences of a fast moving competitive force is that the local banks are highly pressurized to make more efficient and optimal use of the available resources and capabilities. As has been observed in case of Korean banking industry, the foreign banks entering into a developing economy cut down the level of lending to a great extent as compared to the domestic banks in terms of financial downturns (Calvo and Reinhart, 2002). Due to this, the foreign banks are more equipped to meet the financial downturn issues and in cases of economic and financial crisis, the local banks are highly affected while the foreign banks are able to maintain their success factor through the international banking strategies. The threats for forced mergers and acquisitions also have emerged as a major concern for the domestic banks. Often, the large scale foreign banks aim at taking over the domestic banks in order to extract benefits from the knowledge and experience of these banks regarding the local banking and financial sector. Especially in the cases, when the local banks are unable to compete with the foreign markets and tend to losses their market shares, the threats of takeovers and acquisitions become prominent. In many scenarios, the small domestic banking institutions are forced to enter into acquisitions with the foreign banks in order to deal with the problem of insolvency or bankruptcy (De Vincenzo, Doria and Salleo, 2005). In other cases, even if a bank which is in a weak financial position wants to turnaround the financial position and performance of the business, the threat of hostile takeovers by the foreign multinational banks prevents them from being able to function towards achieving their objective and these banks are forced into hostile takeovers by the foreign banks. The fact that the foreign multinational banks are able to gain more influence and power on the markets of a developing country, limits the control and contribution of the domestic banks in the economy and the financial market as well (DeYoung, Evanoff and Molyneux, 2009). Recommendations The developing countries generally display a lower level of integration into the global trading and financing environment. As such, the financial globalizations and integrations which lead to the foreign banks entering into their economies and acting as a competitive threat to the local banks create major threats for the domestic banks. Thus, it is more crucial for these economies and regulatory forces in these economies to take careful steps to support and promote the interests of the domestic banks so that these banks do not face illiquidity and solvency problems because of the lack of adequate resources and capabilities to compete with the foreign banks. Also, the governments of these developing or emerging economies should take adequate steps to provide the domestic banks with the right incentives, risk management scopes and capabilities, sufficient capitals and reserves and capital outflows and inflows that can enable these banks to function efficiently and compete with the foreign banks operating in the same markets. In developing economies, the need for more comprehensive regulations and policies for risk management are necessary. The governments of these countries should focus on negating the imperfections and imbalances present in the capital and financial markets and also avoid the vulnerabilities within the industry. Therefore, building up solid and consistent financial systems is a pre requisite that would enable the domestic banks to compete effectively with the foreign banks in the developing nations. Conclusion In the last decade, nations across the globe have become highly integrated in terms of financial entities and functioning, especially with the aim of taking the advantages of financial globalization to develop the financial sectors of the countries. While the functioning of foreign banks provides economic incentives for a nation, the challenges posed by them for the domestic banks cannot be overlooked upon. This is because, in order to create an effective financial and economic environment, the success and sustainability of both the large scale foreign banks and the limited scale domestic banks are necessary. Also, the scopes of the foreign banks from developed countries taking advantages of the weaker situations of the domestic banks in the developing countries become high in this kind of external environment. As such, the international policymaking institutions as well as the governments of the developing countries should carefully evaluate their regulatory policies and the environment of the financial sector and provide suitable support system and mechanisms for the domestic banks to survive and sustain in the challenging and adverse conditions. References Calvo, G. & Reinhart, C., 2002. Fear of Floating. Quarterly Journal of Economics, 117(2), pp. 379- 408. De la Torre, A., Yeyati, E. & Schmukler, S., 2002. Financial Globalization: Unequal Blessings. 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