Financial sector FDI (FSFDI) surged in the latter half of the 1990s. Using cross-border M&As targeting banks in emerging market economies (EMEs) as a proxy, the value of FSFDI rose from about $6bn from 1990-1996 to almost $50bn in the following four years (see graph 1). Along with total FDI, FSFDI peaked in 2001 with a value of about $20bn. FSFDI declined sharply in 2002, but stabilised in 2003 well above the levels seen in the first half of the 1990s. FSFDI in EMEs also gained importance relative to cross-border mergers within developed countries. The share of M&A cross-border deals involving financial institutions from EMEs as targets increased from 18% in 1990-1996 to 30% in 1997-2000.

Regional differences

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FSFDI inflows displayed considerable regional differences (see graph 1). Between 1990 and 2003, the majority of flows entered Latin America. Overall, transactions targeting banks in the region accounted for $46bn or 56% of total cross-border M&A. FSFDI progressed steadily from 1995 onwards (following the Mexican crisis) with the exception of 1999 (Brazilian crisis) and 2002 (Argentine and Brazilian crises). Mexico accounted for about 50% of the cumulative investment in the region from 1990 to 2003.

Countries in central and eastern Europe (CEE) became major recipients of FSFDI when the privatisation of their banking system and preparations for EU membership took place in the second half of the 1990s. Cross-border M&A deals involving CEE financial firms were about $20bn or 24% of all cross-border deals. Poland and the Czech Republic experienced the highest inflows.

The proportion of cross-border M&As in East Asia’s financial sector has been small compared with other regions. The value of cross-border M&As targeting non-Japan Asian countries was $14bn or 17% of the total during 1990-2003. Asia, however, has been one of the fastest growing target regions for M&A, with a sizeable jump in cross-border M&A activity occurring in Korea and Thailand. In addition, there has been a large number of small-value cross-border M&A transactions in the finance sector between East Asian economies. In 2003, Asia received the largest share of FSFDI inflows.

The national sources of FSFDI also vary considerably across the target regions (see graph 2). In Latin America, Spanish and US banks accounted for about 80% of cumulative investments. Spanish banks, in contrast to US firms, have a clear regional focus on Latin America and play virtually no role in the other areas. The same is true for many of the western European banks that have invested in CEE. Five euro area countries account for about 70% of the cumulative investment in this region. In Asia globally active banks from the US, the UK and the Netherlands, but also foreign private equity funds, are among the largest sources of FSFDI.

Banks transformed

FSFDI transforms the acquired financial firm into a part of an international (or global) financial organisation. The provision of new capital is one element of this transformation. The characteristic feature of FSFDI is, however, the transfer of ownership and managerial control. From this viewpoint, the medium and long-term effects of FSFDI are primarily the consequence of the ongoing transfer of know-how, the integration into the processes of the parent organisation and the global market for corporate control.

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The actual degree of integration depends on bank-specific factors such as the legal form and the business model.

Foreign ownership usually involves the transfer of human capital on both the managerial and the operational level. Examples include the assignment of staff as well as the training of local management and staff. Complementary to this is the transfer of “soft” infrastructure such as back office routines or credit control systems. Such transfer has gained importance as banks seek to integrate their EME operations into the overall strategic framework and management of the firm and to reap economies of scale through standardisation of processes.

FSFDI can also involve the “transfer” of reputation. Reputation effects may begin with the announcement of an acquisition by a foreign financial institution. More is put at risk when the acquired bank operates under the parent’s brand name. While reputation can be an important asset – in particular when trying to establish and deepen client relationships in retail markets – it exposes the foreign parents (and their shareholders) to the risk of changes in perceptions of its commitment to and performance in EMEs.

Access to parental resources is of particular relevance in crisis periods. In the case of a subsidiary (as a separate legal entity), the parent’s liability and obligation to support the local operation is limited to the invested capital, while for branches the parent’s capital may be the more relevant measure of resources. However, experience suggests that the decision to support an EME operation ultimately depends on an assessment of the costs and benefits for the group, including factors such as reputation risks or the potential loss of franchise value.

Decision-making

The second, related set of changes associated with the acquisition by a foreign firm is the integration of decision-making and risk management of the local operation into that of the parent. In theory, strategic decisions, including those on broad risk management parameters such as overall country risk exposure, are centralised at headquarters while day-to-day responsibilities remain at the local level. In practice, however, the degree of integration varies considerably and depends on institution-specific factors such as the business focus and the firm’s internal culture governing delegation of decision-making of the bank.

The strategic adjustments after an acquisition often include specialising the foreign operation in the host country market. Frequently, acquired institutions become more focused and reliant on the domestic market than they were before their acquisition. The parent institution may at times prefer to book all international assets in the home country or in a regional centre, and will thereby remove international assets from the local balance sheet. Similarly, the parent may seek funding efficiencies by encouraging local funding and consolidating overseas funding in relevant foreign offices. While the group as a whole may become more diversified, the acquired institution may lose international diversification of assets, liabilities and income sources.

The acquisition by a global financial institution shifts corporate control to a parent institution that is owned by a large number of individual and institutional shareholders. This might affect the calculus behind strategic decisions in the same way as globalisation does in other areas. Operations in EMEs are increasingly assessed and managed by comparing the risk-adjusted returns with those of a global portfolio of other investments. However, the policy framework for the financial system is often seen as an important instrument to influence and promote economic development and internal equity. Thus, possible differences in the objectives of shareholders and domestic policies can arise as FSFDI increases.

Efficiency drive

Ongoing improvements in efficiency and price formation in host country financial markets are the most persistent benefits arising from the integration of domestic financial firms into internationally active institutions. The transfer of human capital and new technology as well as the integration into the parent’s decision processes result in modifications of risk management and business (in particular lending) practices and product innovation. The evaluation of business success through global equity markets increases the incentives to adjust business according to its expected profitability on an ongoing basis.

Heightened competition spreads the efficiency-enhancing effects of foreign bank entry across the financial system. Declining costs or increasing productivity is a documented pattern in banking markets after foreign bank entry. At the same time, profits do not rise. One interpretation is that foreign banks apparently often reserve more aggressively against bad loans, reflecting a risk-based assessment of loan quality and a more disciplined credit culture. Another interpretation is that clients benefit through lower prices and greater access to credit. The two explanations are consistent with enhanced efficiency of the domestic financial system.

Enhanced efficiency in the host country financial system should lead to better allocation of credit. One aspect is the reduction of related-party lending. Foreign-owned financial institutions replace other considerations in the credit decision with the application of formal credit standards and risk-adjusted pricing. This reduces (or eliminates) subsidisation of activities that might not be viable on market terms, reduces moral hazard and avoids the build-up of implicit contingent liabilities on the balance sheet.

 

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Credit concerns

There is no firm empirical support for an often expressed concern that the credit standards employed by foreign-owned banks reduce credit to specific sectors, namely small and medium-sized enterprises (SMEs) – sometimes known as “cherry-picking”. Some studies find that large banks tend to assign a smaller share of their portfolio to SMEs and that smaller firms are less likely to borrow from foreign banks. There is also evidence that foreign banks do not discriminate against SMEs. Moreover, a number of studies have documented the benefits for the host country economy as a whole stemming from the presence of foreign banks.

Country-specific factors seem to play an important role in determining foreign bank lending to specific sectors. Differences in the access to relationship-related credit information is one explanation. On the one hand, foreign banks may have advantages in transactions lending because of better access to information technologies for collecting and assessing hard information. The use of standard credit scoring has probably facilitated expansion of foreign banks into household lending. On the other hand, foreign banks may be disadvantaged in relationship lending to informationally opaque SMEs because of difficulties in using soft information.

From this viewpoint, the behaviour of foreign banks would be indicative of shortcomings in the legal or accounting infrastructure and should be of concern to both foreign and domestic banks.

In any case, changes in lending policies by foreign-owned banks cannot be viewed in isolation when assessing their effect on credit availability for SMEs. Even if foreign banks focus on specific market segments, increased competition in these markets appears to induce other domestic banks to channel resources to other parts of the economy while they begin to look for new creditworthy clients. Foreign banks also induce improved credit availability by enhancing the stability of the banking sector.

Local incentives

Entry by foreign financial institutions may also support the development of financial markets in host countries. Foreign financial firms have both the incentives and the expertise to develop certain segments of local markets, such as funding, derivatives and securities markets. The foreign firms often try to create markets or gain market share through product innovation, especially by offering a variety of new financial services to corporate clients, including over-the-counter (OTC) derivatives or structured products. Foreign financial institutions frequently offer asset management services which, perhaps accompanied by rising national income and pension reform, add to the demand for financial assets, in particular tradable securities.

Foreign financial firms also seek to develop domestic financial markets that can assist them in managing their local exposures. Hedging markets in EMEs tend to be underdeveloped, perhaps with the exception of hedging markets for currency risk. However, interviews revealed a preference on the part of foreign banks to hedge local risks in domestic markets when possible. Incentives to promote financial market development exist in particular with respect to local funding markets (eg, the interbank market or the market for bank debt securities) and the management of interest rate and currency risks.

Foreign financial firms often provide technical advice in creating new markets or modernising existing ones. Finally, foreign institutions may contribute to improvements in the legal framework and the financial infrastructure, including accounting standards and auditing practices.

 

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Financial stability

The injection of foreign capital via FSFDI into the financial system of EMEs has been most important in the aftermath of financial crises in Latin America and the privatisation of financial systems in CEE.

FSFDI also contributes to financial stability in the host country in the medium and long term by improving the management of risks and by enhancing the capacity of the system to absorb shocks.

Empirical results are consistent with the view that foreign banks contribute to the resilience of the host country’s financial system.

The introduction of the risk management practices of the foreign parent enhances the overall soundness of the local financial system. More aggressive measures by foreign banks to address asset quality deterioration point to tighter credit review policies and practices that may help to limit the build-up of non-performing assets in the financial system. To the extent that foreign entry encourages the adoption of risk-based practices in lending and the management of loan portfolios, it contributes to the reduction of concentration of exposures and prompter resolution of problems.

In addition, foreign institutions possess incentives to work actively to make the financial system sounder and more secure in order to mitigate their own risk. One example is the introduction of new products, such as OTC derivatives, that can be used to hedge risks and assistance in developing the legal, accounting and regulatory infrastructure to support a new market. Another is the promotion of innovation in clearing and settlement systems that reduce operational risks.

Foreign institutions can also be a catalyst for regulatory changes in the EME’s financial system. The responsibility for the supervision of foreign-owned financial institutions can provide incentives for upgrading supervisory knowledge, especially when the foreign-owned institutions undertake innovative activities.

Credit cycles

The ability to manage credit risk together with stronger capitalisation, access to market or parent funding and diversification of the parent’s risks tends to make foreign banks less sensitive to both home and host country business cycles.

Consequently, lending to local residents in the local market is likely to be more stable in times of stress than either cross-border lending or the lending of indigenous banks in the markets. Research also supports the notion that foreign bank presence smoothes the host country’s credit cycle.

Foreign-owned institutions may also exert a stabilising influence in times of financial distress. Stronger capitalisation, and the possibility of an injection of additional funds by the parent, if needed, reduce the probability of failure. The existence of banks that continue operating in a crisis increases the probability of the system as a whole remaining functional.

The local presence of foreign-owned banks that are perceived as “safe” can further reduce financial fragility by absorbing the domestic capital flight within the local financial market, thereby moderating capital outflows and larger financial pressures often observed in episodes of market distress.

Traditionally, a “flight to quality” in an EME translated into capital flight, in the absence of trusted institutions in the domestic financial system. When such trusted institutions operate in the host country, a flight to quality may still occur as capital flows to those institutions, but without the balance of payments effects that add to exchange rate and interest rate pressures.

The possibility that foreign-owned financial institutions will limit “flight to quality” episodes is not certain, however. Government action can vitiate this benefit, as in Argentina, where initially foreign-owned banks received deposit inflows, but then experienced massive withdrawals once depositors became concerned that foreign banks could be discriminated against. Moreover, if foreign banks become increasingly concerned about political risk (or country risk more generally), they may reduce domestic assets and liabilities, putting pressure on domestic markets and possibly exerting pressure on the capital account.

In discussing these factors, it is important to recognise that well capitalised, managed and trusted domestic banks can be expected to exert a similarly stabilising influence as foreign banks. Hence, the broad lesson is that healthy banks are key for financial stability. Whether these are foreign-owned or domestically owned is of second-order.

Boost for EMEs

FSFDI has been instrumental in the integration of EME financial sectors into the global financial system. Important structural and regulatory changes within EMEs, in combination with expansion of the global market for corporate control, have been major driving forces behind this development.

Among other things, growth of FSFDI has reflected the efforts of investing banks to integrate EMEs into their market and client-specific strategies and to exploit economies of scale. As a result, EME financial systems now include a broader range of financial institutions with diverse strategies. The integration process has also given rise among potential investors to more rigorous evaluations of the expected profitability and risk of doing business in EMEs.

At the firm level, many of the benefits of FSFDI for host countries come from the transfers of technology and related expertise that typically occur within an integrated firm – such as extension of better risk management and risk-adjusted pricing to markets where previously they were only imperfectly applied. Similarly, host country customers benefit directly from new financial products and services that FSFDI introduces.

At the industry level, FSFDI generates widespread ongoing benefits, as foreign participation raises the efficiency of host country financial systems by exposing local operations to global competition. At the macroeconomic level, FSFDI also typically brings needed balance of payments finance. Given the stronger capitalisation and better risk management associated with FSFDI, it has most probably contributed on balance to greater financial stability in host countries as well.

Host country issues

The expansion of FSFDI has brought substantial benefits, but it has also brought to the forefront two issues for host country authorities in charge of financial stability. One is to explore whether, and in what ways, the growing global integration of the host country financial systems has changed the exposure to shocks that arise from external economic, financial and strategic developments.

A second issue is to ensure that authorities and market participants have adequate information to assess the conditions in the host country financial system. As highlighted in this report, the availability and quality of local financial information may be of particular relevance in this context. In addition, the mutual benefits of greater cooperation among home and host country supervisors are compelling in this context because of the additional complexity introduced by the expansion of banks’ operations into EMEs.

The Working Group’s research, including its interviews with market participants, revealed that investing institutions have made considerable progress in upgrading their risk management capabilities – especially in the aftermath of the recent problems in Argentina. They have also become more sensitive in their strategic planning to the consequences of country risk, as experience has involved extreme events that severely damaged the franchise value of operations in EMEs. In part because risk management tools, including specialised market instruments, provide at best only limited protection, absorption of country risk is, for the most part, internalised by investing firms.

Country risk can be difficult to hedge against, but there are some fundamental steps that can be taken by a host country to improve its risk environment. Prominent among these is a commitment to policies that foster economic growth and stability. Another is the implementation of international financial codes and standards. Likewise, strengthening domestic legal frameworks is an essential step to reduce country risk. Because many of the benefits of FSFDI depend on the effective functioning of the market for corporate control, measures aimed at achieving closer conformity of local accounting standards, takeover rules, and bankruptcy codes with international counterparts are also especially important.

There are some additional public policy steps that can speed up the process of global financial integration. Participation in compacts aimed at regional integration of financial systems, often within frameworks for broader economic integration within the region, can be an important step towards this objective, as demonstrated by countries’ experiences under the EU and the North Atlantic Free Trade Agreement.

Some poorer countries may merit special public policy support to promote capital inflows and growth; for them, political risk insurance provided by public or multilateral insurers – if properly designed – could be helpful in encouraging more FSFDI.

Future progress

How should future progress be measured? Because the ultimate yardstick is the contribution that a more efficient, globally integrated financial system makes to economic development and prosperity, such measures ought to be linked closely to the benefits of FSFDI and the factors that generate them.

Hence, measures of progress ought to focus on the strength of the institutional and regulatory framework of host country financial systems, the degree of integration of the financial system in the global market for corporate control, and the capacity of investors and authorities overseeing financial stability to assess and manage risk.

This article is an extract from “Foreign direct investment in the financial sector of emerging market economies” submitted by a working group established by the Committee on the Global Financial System of the Bank for International Settlements

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