Internationalization of Banking: The Economic Benefits and Risks

Driven by telecommunication advances, easing of regulatory barriers, and global economic integration, foreign banks have dramatically increased their cross-border lending to, and investment in, developing countries. The presence of foreign banks today constitutes an important structural feature of the banking industry in many developing countries. Foreign ownership varies considerably. For instance, in Latin America, large economies such as Peru and Mexico have a foreign presence accounting for 95 and 82%, respectively, of the banking system. However, foreign ownership of the banking sector is substantially higher in Europe and Central Asia, Sub-Saharan Africa, and Latin America than in East and South Asia. As Table 9 [ PDF 8.8KB | 1 page ] indicates, the participation of foreign banks in East Asia is extensive only in Indonesia.

As the recent crisis has demonstrated, foreign participation can bring benefits as well as risks. Developing countries have reaped substantial gains through the increased availability of finance to credit-constrained firms and households, the provision of sophisticated financial services, and incentives for improved efficiency as domestic banks have had to compete with foreign entrants. However, international banks can also transmit adverse financial shocks around the globe: major banks can sharply reduce credit to developing countries due to illiquid interbank markets, tightening credit standards, or pressure on the capital base. In addition, the ability of foreign-owned banks to raise funding from their parent banks abroad can fuel a domestic credit boom, potentially offsetting efforts by central banks to contain inflationary pressures or restrict capital inflows.

There is evidence that banking flows are increasing (Table 10 [ PDF 10.8KB | 1 page ]). Again, cross-border capital flows can bring capital to countries, but also can exacerbate liquidity risks. Cross-border banking flows have several implications for financial stability. The banking systems in several emerging markets have become more dependent on foreign banks and wholesale foreign funding. This has sometimes involved borrowing by affiliates of foreign banks from their parents (for example, in Korea). In other cases, borrowing in wholesale markets in the major financial centers has financed foreign currency lending to residents (for example, in Eastern Europe).

The liquidity risks of such dependence were demonstrated when the markets became dysfunctional in September and October 2008. It is too early to assess the impact on Asia, although countries particularly active in international interbank markets, such as PRC, India, Kazakhstan, and Korea, need to be concerned about the possibility that their domestic banks will face funding difficulties in international markets, should liquidity pressures in interbank markets remain at elevated levels. Equally, the current weakness in the balance sheets of international banks will adversely affect major borrowers in developing countries. It is beyond the scope of this article to recommend policy measures for addressing the presence of foreign banks, but the changes in the nature and character of international credit intermediation are likely to endure, and emerging markets need to explore policies to address the presence of foreign banks in domestic markets. The process, however, needs to be managed carefully because the presence of international banks also presents potential risks. Efforts to reap the benefits of foreign bank presence while controlling risks could focus on vetting the soundness of entering banks as well as "ring fencing" them.

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