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Foreign Bank Entry and Access to Credit

Evidence from case studies and

cross-country analysis

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Background papers

Bank Lending to Small Businesses in Latin America: Does Bank Origin Matter?

By George Clarke, Robert Cull, Sole Martinez Peria,

and Susana Sanchez

Does Foreign Bank Penetration Reduce Access to Credit in Developing Countries? Evidence from Asking Borrowers

By George Clarke, Robert Cull, and Sole Martinez Peria

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Motivation

Foreign bank entry refers to a process by which foreign banks set up operations in a host country mainly by either opening up a branch or a subsidiary.

In recent years, foreign bank participation has increased tremendously in several developing countries. For example, in Argentina, Chile, Czech Republic, Hungary, and

Poland, over 50% of total banking assets are now in foreign-controlled banks.

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Foreign bank participation in developing countries

0 10 20 30 40 50 60

Hungary

Chile

Poland

Czech Republic

Argentina

Veneuzuela

Peru

Mexico

Colombia

Brazil

Malaysia

Thailand

Korea

1994

1999

Source: IMF(2000)

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What is the impact of foreign bank entry?

Recent cross-country studies find that entry by foreign banks increases competition, efficiency, and banking sector stability, factors that should benefit all borrowers. See Barth et al. (2001c), Claessens et al.(2000), Dages et al. (2000),

Demirguc-Kunt et al. (1999), Goldberg (2001)

However, opponents of foreign bank entry argue that this process might still harm small and medium-sized enterprises.“[foreign bank entry in Argentina] created a banking system apparently

more stable but this system failed in terms of providing adequate financing for small and medium-sized enterprises” – Joseph Stiglitz, El Pais, January 10, 2002. [Translated from Spanish].

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Why should we care about credit to SMEs?

Given that SMEs account for more than 50 percent of employment in many countries, reduced access to credit for these firms could hurt overall economic performance.

Country Year % of employment generated by SMEs

Argentina 1999 80.6 Brunei 1991 59.2 Canada 1995 60 Germany 1995 65.7 Korea 1991 78.5 México 1993 50.8 Philippines 1993 50 Spain 1995 63.7 Thailand 1991 73.8 United States 1995 53.7 IERAL (1999) and Escude et al. (2001)

Economic Importance of SMEs

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Foreign bank entry and access to credit: Literature review

Not much research on this topic. Evidence provided is mixed.

U.S. studies U.S. based studies indicate that large and organizationally complex

institutions find it difficult to lend to informationally opaque small and medium-sized enterprises.

See, for example, Berger and Udell (1995), Berger et al. (1995), Keeton (1995), Levonian and Soller (1995), Berger and Udell (1996), Peek and Rosengren (1996), and Strahan and Weston (1996).

The U.S. evidence is relevant since Focarelli and Pozzolo (2000) have found that foreign banks tend to be large.

However, Mester (1997) argues that advances in credit scoring methodologies, enhanced computer power, and increased data availability could help large banks to overcome some of the diseconomies and obstacles in lending to small borrowers.

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Foreign bank entry and access to credit: Literature review

Direct evidence on the impact of foreign bank penetration on small business lending in Latin America is mixed.

Evidence for Argentina: Berger et al. (2000) find that in 1998 small businesses in Argentina

were less likely than larger ones to receive any credit from large banks or from foreign banks.

Escudé et al. (2001) find that while foreign banks allocated a smaller share of their lending portfolio to SMEs, they granted almost half of the total credit to this sector in the year 2000.

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How do we study the impact of foreign bank entry on access to credit?

Examine banks’ behavior - Case study approach Controlling for a number of bank characteristics, we investigate whether bank origin affected the share and growth rate of bank lending to small businesses in Argentina, Chile, Colombia, and Peru during the mid-1990s.

Analyze borrowers’ perceptions - Cross-country analysis

We use responses from a survey of about 3,000 enterprises in 36 developing and transition economies conducted in 1999, to study whether, controlling for firm level and country characteristics, borrowers’ perceptions regarding interest rates and access to long-term credit are positively associated with the presence of foreign banks.

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Case studies on foreign bank entry and SME lending in Latin America

Using bank-level data for Argentina, Chile, Colombia, and Peru for the mid-1990s, we regress

(1) The share of bank lending to SMEs and(2) The growth rate of real bank lending to SMEs on: Bank level characteristics (e.g., ROA, expense averages) Bank origin dummy (foreign if 50% of assets owned by foreigners) Bank size and size squared Interaction between bank size and bank origin to test whether the impact of

size on bank lending to SMEs might depend on bank origin.

Definition of lending to SMEs differs by country. Argentina – bank loans < 1 million dollars. Chile – loans to firms with debts < 1.5 million dollars. Colombia – firms with assets < 1.7 million dollars. Peru – firms with loans <500,000 dollars.

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Findings on foreign bank entry and SME lending in Latin America

(1) Foreign banks in Argentina, Chile, Colombia, and Peru generally lent a smaller fraction of their funds to SMEs than similar domestic banks in the late 1990s.

(2) However, differences between foreign and domestic banks were far less pronounced for large banks than they were for small banks in all four countries.

In Chile and Colombia, large foreign banks might actually have lent relatively more to SMEs than large domestic banks.

(3) The growth rate of real lending to SMEs was higher for foreign banks than for domestic banks in Peru, and was also higher for large foreign banks than large domestic banks in Argentina and Chile.

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0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

0 500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500

(billions of pesos)

Domestic Foreign

Chile: Estimated share and growth of lending to SMEs by bank size and origin

-15%

-10%

-5%

0%

5%

10%

15%

20%

0 500 1000 1500 2000 2500 3000 3500 4000 4500 5000 5500

(billions of pesos)

Domestic Foreign

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Foreign bank entry and SME lending in Latin America

Conclusions: Despite their potential size advantages, small foreign banks do not seem to

be interested in SME lending, relative to small domestic banks.

On the other hand, large foreign banks appear to behave similarly to large domestic banks and in some cases surpass them in terms of either shares or growth rates of SME lending.

Limitations of this study Only a small group of countries included.

Potential external effects of foreign bank entry not considered.

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Cross-country analysis on foreign bank entry and SME lending in developing countries

Regress responses from a survey of about 3,000 enterprises in 36 developing and transition economies regarding interest rates and access to long-term credit on:

Firm characteristics (size, sales growth, export growth, etc.) Country level macro variables (inflation, growth rate, financial

development, etc.) Institutional and regulatory variables (legal origin, rule of law, protection of

property rights, quality of supervision, limits on bank entry). Extent of foreign bank ownership in the country. Interaction of foreign bank ownership with firm size to determine whether

benefits of foreign ownership accrue only to large firms.

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Cross-country analysis on foreign bank entry and SME lending in developing countries

Results strongly support the assertion that foreign bank penetration improves firms’ access to credit. Enterprises in countries with high levels of foreign bank penetration tended

to rate interest rates and access to long-term loans as lesser constraints on enterprise operations and growth than enterprises in countries with less foreign penetration.

The benefits of high levels of foreign bank penetration do not appear to accrue only to large enterprises.

Although some evidence suggests that entry by foreign banks benefits large enterprises more than small ones, there is strong evidence that small enterprises experience net gains and there is no evidence that they are harmed by foreign bank entry.

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Assets in Foreign Banks Set At 20th Percentile Median 80th Percentile Change between

20th and 80th Percentiles

Ave. Estimated Probability that Enterprise Will Rate High Interest Rates as a Major Problem All Enterprises 66.8% 63.0% 53.0% -13.8% Small 66.1% 62.7% 53.7% -12.4% Medium 68.4% 64.6% 54.5% -13.9% Large 64.3% 59.7% 47.8% -16.5% Ave. Estimated Probability that Enterprise Will Rate Access to Long -Term Loans as a Major Problem All Enterprises 51.3% 44.4% 28.2% -23.1% Small 56.0% 49.4% 33.2% -22.9% Medium 47.2% 40.3% 24.5% -22.6% Large 50.5% 42.9% 25.5% -25.0%

Quantifying the impact of foreign bank penetration

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Summary of results

Empirical evidence on the impact of foreign bank entry on access to credit is in general encouraging.

In Latin America, SME lending has declined in the 1990s, but large foreign banks seem to lend as much if not more to SMEs than their domestic counterparts.

Cross-country firm-level survey evidence indicates that SMEs report high interest rates and access to long-term credit to be less of an obstacle in countries with significant levels of foreign bank penetration.

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Other interesting questions regarding foreign bank entry

(1) What draws foreign banks to a country?

(2) Which banks expand abroad?

(3) What do foreign banks do once they arrive?

(4) How do mode of entry and organizational form affect foreign

bank behavior?

(5) For a detailed discussion of these issues see Clarke, Cull,(6) Sanchez and Martinez Peria, “Foreign Bank Entry: Experience,(7) Implications for Developing Countries, and Agenda for Further(8) Research,” Working Paper No.:2698, October, 2001

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What draws foreign banks to a country?

Foreign bank entry is guided not only by foreign banks’ desire to follow their domestic clients abroad, but also by a pursuit of market opportunities in the host developing countries.

In general, foreign banks are attracted to countries with fewer restrictions on entry and bank activity.

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Which banks expand abroad?

A number of studies have found a positive correlation between bank size and the degree of internationalization. One plausible reason for this is that larger banks might be more likely

to have clients (e.g., multinational companies) that demand banking services abroad.

Further, large banks might be better able to exploit the economies of scale associated with expanding overseas.

Banks that are more innovative and efficient are also more likely to expand abroad.

Finally, restrictions on outward foreign direct investment reduce the likelihood that local banks will enter other countries.

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What do foreign banks do? It appears that foreign entry exerts competitive pressure on domestic banks. Overwhelmingly, the evidence indicates that domestic banks are

forced to become more efficient (by lowering their costs) following the entry of foreign banks.

Regarding the type of lending that foreign banks undertake, recent evidence seems to discredit the notion that foreign entry might reduce access to SMEs.

At the same time, existing empirical studies suggest that in general foreign banks do not seem to threaten financial stability.

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How Do Mode of Entry and Organizational Form Affect Foreign Bank Activity?

This is perhaps the area where research on developing countries is most limited.

However, the literature on developed countries suggests a number of preliminary conclusions.

First, due to efficiency differences between domestic and foreign banks in developing countries, cross-border mergers and acquisitions and de novo entry might both be appealing.

Second, recent technological changes mean that both the foreign banks and consumers in developing countries might benefit from economies of scale arising from cross-border mergers and acquisitions.

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How Do Mode of Entry and Organizational Form Affect Foreign Bank Activity? (continued)

Third, subsidiaries appear to be the preferred organizational form for developing countries to promote since they allow foreign banks to provide a wider range of activities and appear to be a more stable source of financing relative to cross-border lending.

On the other hand, whether subsidiaries are preferable to branches is an issue that requires further investigation. While existing evidence suggest that branches engage in a more

narrow set of activities, branches’ access to the parent bank capital is more direct than is the case for subsidiaries, as recently illustrated by the decision of two foreign banks not to recapitalize their subsidiaries in Argentina.