International Banking - Essay Example

ASB4411 – International Banking – Supplementary work THESIS: The geographical expansion of the financial services industry is desirable only ifforeign bank entry leads to an increase in the efficiency of domestic financial systems. Introduction The entry of foreign banks in an economy is variably regarded; for most once-closed, newly deregulated financial systems, foreign banks are regarded with suspicion, being viewed as conduits of financial contagion and harbingers of unfair competition. For many emerging economies, foreign banks are seen as agents of development that would attract foreign direct investments, foster greater efficiency in the banking system, and thereby speed up economic progress. In this brief survey, these different effects shall be examined and the contexts within which they are encountered. General effects of foreign bank entry The entry of foreign banks has the potential of substantially benefiting host countries insofar as the development of their financial systems and economies are concerned. Cardenas, Graf and O’Dogherty (2004) underscore these benefits which they attribute to: (1) New technologies – foreign banks bring with them innovative products and advanced management techniques (2) Increased efficiency – domestic banks are pressured into exploring and adapting more efficient operations because of increase in competition. (3) Access to resources – foreign banks have greater access to resources from abroad, as well as stable funding and lending patterns, compared to domestic banks. These added resources are seen to make their way into the home country’s economy to further spur development. (4) Stability – foreign banks hold a more diversified portfolio, and are thus relatively immune to periods of economic and political stress in the host country. Also, they are seen as being external and resistant to domestic practices such as connected lending among related parties in domestic banks that fosters wealth concentration among the country’s board members, stockholders, and large borrowers. The same study likewise outlines concerns about the role played by foreign banks in an emerging economy. (1) Fears of contagion and spillover effects is a major concern, as the presence of foreign institutions in the host country exposes the latter to economic shocks that may be taking place abroad to which the foreign institution is vulnerable. (2) Foreign institutions have access to their markets and investment alternatives abroad, As such, they find it easier to unload their investments and exit the country (“cut and run”) during periods of political and economic instability, thereby contributing to its exacerbation. Local banks are attributed a greater dependability during times of national crisis. (3) International banks tend to foster regulatory arbitrage, seizing upon differences in banking regulations worldwide in order to circumvent effective local regulation. The complexities of exotic or novel products and operations in other countries applied locally would tend to overwhelm local regulators, or at least create confusion in the applicability of domestic regulations. (4) Conflicts of interest between parent companies and host-country subsidiaries introduces moral hazards, and when faced with a misalignment of host-country public policy and the interests of foreign stakeholders, the foreign bank will tend to choose the latter. (5) Foreign banks may negatively affect the depth, liquidity and information availability in the local market at such time as they de-list shares of their acquired institutions from the local exchange (Cardenas, Graf & O’Dogherty, 2004). The effect of foreign bank entry has often been associated with spillover effects on local banks, and a tendency to heighten competition among the players in the banking industry. Mounting competition is attributed to the increasing number of firms and increasing product substitutability, which pressure banks to invest significantly in innovations directed at cost reduction (Raith 2003). The increase in competition among banks was thought to necessarily result in a more efficient banking industry. However, spillovers and heightened competition work to reinforce one another insofar as their negative impact on domestic banks is concerned. (Lehner & Schnitzer, 2008). Foreign bank entry in the wake of financial liberalization There have been different effects of foreign bank entry, depending upon the circumstances in the host economy. These effects are particularly pronounced when the financial system of the country being entered into have just emerged from a closed system to a liberalized one. Since the 1920s, the Nordic countries (Finland, Norway, Sweden and Denmark) prohibited the opening of branches of foreign banks in their respective jurisdictions. By 1985, Norway liberalized its banking sector and welcomed the opening of foreign banks’ branches. Several factors have been identified that affect the foreign bank’s success, among which are the following: the foreign banks’ prior experiences in Norway, the pre-existence relationship of the foreign banks with Norwegian forms, prior experience in Norway, the size of the entrant-bank at start-up, and parent size (Tschoegl, 2002). In China’s case, after foreign bank entry, firms with a record of profitability were able to avail of more long-term bank loans, while firms with a higher value of potential collateral did not. Private (non-state-owned) firms have been able to substitute the more costly trade credit, for long-term bank loans. The study finds that non-state-owned firms and companies with more transparent policies and operations are the more significant beneficiaries of the entry of foreign banks. Also, when a creditor’s rights are not well-protected in a host country, collateral plays a not-so-significant role in addressing information asymmetry. The paper concludes that the liberalization of the banking industry contributes to the easing of constraints among firms, in particular firms that are less subject to government intervention. The entry of foreign banks helps reduce inefficiency in resource allocation that results from discrimination by state-owned banks against non-state-owned firms in extending credit (Lin, 2010). The entry of foreign banks contributes to making China’s banking industry more competitive and efficient. This finding has important bearing on determining which of two opposing views is accurate and, therefore, should be made the basis of policy formulation. The first of these views, termed the positive stream, argues that the entry of foreign banks enhances the efficiency of the domestic banking sector. The pessimistic view states that an already inefficient domestic banking sector will succumb to the strength of foreign competition and become vulnerable to takeover by the foreign entrants. The findings of the study tended to support the positive view (Xu, 2010). The study likewise makes the distinction between banking regulation and financial liberalization. The fact that the banking sector has been opened up to new players does not imply the relaxation of banking regulation. Confirmation of the positive view is made on the condition that the activities of foreign banks are strictly monitored and regulated, to ensure that the new entrants contribute to economic development and social welfare (Xu, 2010). In Australia’s post-deregulation period (from 1988), empirical data tended to suggest that while foreign bank entrants tended to be more efficient than domestic banks, this does not necessarily translate to higher profits. The major domestic banks have effectively used size to create an entry barrier to foreign banks. The effect of foreign entry has been for competition to increase in the banking sector, due to increased diversity in bank types, forcing domestic banks to aim for efficiency improvements (Sturm & Williams, 2004). Foreign bank entry into developing economies Despite the global financial crisis of 2008, foreign banks have continued to expand into emerging markets. Economic factors, both in the home and host countries, contribute to the decision of foreign banks to expand into host countries. These economic factors also influence the choice of entry mode and the organizational structure of banks that open up in the target destinations. While foreign bank entry into developed markets are motivated to do so by the high level of financial and economic development, entry into emerging markets find initiative to do so in the potential offered by such markets, although they lag behind in their economic development. The profit potential found in such markets entice efficient foreign banks to expand, contrary to earlier studies that the profit incentive pertained to already advanced economies. Neither is it true that foreign banks enter into emerging markets to follow key clients. On the contrary, data points to the opposite, that foreign banks’ presence in a developing economy tends to encourage non-financial firms to enter into non-traditional markets. Another important determinant of foreign bank entry is the similarity of legal, cultural and geographical proximity of the home country to the host country (Hryckiewicz & Kowalewski, 2010). Other determinants influence the success of foreign bank entry, such as geographical and cultural difference between the home and the host country, the lowering of regulatory barriers, and the relative profitability of banking activity in the host country. Considered important is the lowering of regulatory constraints, which enable foreign banks to redirect banking activities to the sectors perceived to have greater value added (Magri, Mori & Rossi, 2005). Conclusion The foregoing discussion was by no means an exhaustive discussion, but it provides a bird’s eye view of the various issues surrounding bank entry into an economy. Greater competition and vulnerability to contagion are to be expected, but the advantages far outweigh the disadvantages. What is necessary is to strengthen the local banking industry to withstand the competition, through consolidation and reform. The more competitive environment, managed correctly, will foster a more efficient banking system and thereby a more progressive economy. Wordcount = 1,500 excluding title and thesis statement References Cardenas, J; Graf, J P; & O’Dogherty, P 2004 Foreign banks entry in emerging market economies: a host country perspective. CGFS Working Group paper. Accessed 15 November 2010 from http://www.bis.org/publ/cgfs22mexico.pdf Hryckiewicz, A & Kowalewski, O 2010 Economic determinates, financial crisis and entry modes of foreign banks into emerging markets. Emerging Markets Review, vol. 11, pp. 205-228. Lehner, M & Schnitzer, M 2008 Entry of foreign banks and their impact on host countries. Journal of Comparative Economics, vol. 36, pp. 430-452 Lin, H 2010 Foreign bank entry and firms’ access to bank credit: Evidence from China. Journal of Banking and Finance. doi:10.1016/j.jbankfin.2010.09.015 Magri, S; Mori, A; & Rossi, P 2005 The entry and the activity level of foreign banks in Italy: An analysis of the determinants. Journal of Banking & Finance, vol. 20, pp. 1295-1310. Raith, M 2003 Competition, risk, and managerial incentives. American Economic Review, vol. 93 issue no. 4, pp. 1425–1436. Sturm, J-E & Williams, B 2004 Foreign bank entry, deregulation and bank efficiency: Lessons from the Australian experience. Journal of Banking & Finance, vol. 28, pp. 1775-1799. Tschoegl, A E 2002 Entry and survival: the case of foreign banks in Norway. Scandinavian Journal of Management, vol. 18, pp. 131-153 Xu, Y 2010 Towards a more accurate measure of foreign bank entry and its impact on domestic banking performance: The case of China. Journal of Banking and Finance, doi:10.1016/j.jbankfin.2010.10.011 Read More