Ebook The Real Effect of Foreign Banks
Access to finance and, by extension, a well functioning financial sector are of central importance for economic growth and development. Starting with King and Levine (1993) and, more recently, Rajan and Zingales (1998) a growing body of literature has shown that a country’s level of financial development has a direct bearing on its economic prospects (see, e.g., Beck et al., 2000). In particular, inefficient domestic banking systems often constrain growth because firms with external financing needs lack access to credit, especially in developing countries. In this context, the role of foreign banks in mitigating financial inefficiencies is ambiguous.
On the one hand, foreign lenders can act as catalysts for financial development through superior expertise (Claessens et al., 2001), provide new sources of financing (BIS, 2001 and 2006), and might induce consolidation in fragmented banking systems (Gelos and Roldos, 2004), which all can improve the efficiency of local intermediation and availability of credit (Beck et al., 2004). On the other hand, foreign entry might exert competitive pressures on domestic banks which, in response, cut back their own lending activities (Giannetti and Ongena, 2007) to such a degree that the overall availability of credit decreases (Gormley, 2008). Hence, the effect of foreign banks on domestic economic activity is both an important empirical and policy question all the more that existing work offers conflicting predictions and contradictory empirical evidence.
We propose to fill this gap in the literature by investigating the incidence of foreign banks on firm growth and by identifying the economic channels through which their presence affects real economic activity. By supplying additional funds and increasing competition, foreign banks might remedy inefficiencies in domestic banking systems, thereby lowering borrowing costs and increasing the access to credit for local firms. However, in the presence of informational asymmetries entry by outsiders with superior lending expertise might lead to market segmentation through “cream-skimming” so that local banks cut back their own lending (see Dell’Ariccia and Marquez, 2006, Detragiache et al., 2008, or Sengupta, 2007). Hence, greater competition can also reduce access to credit (Petersen and Rajan, 1995).
To assess the net real effect of foreign banks on their host economies we examine how outside entry affects the link between financial dependence and industrial growth, which we measure as the growth in real value added by industry and country, in a panel of 81 developed and developing countries. Our primary variable of interest is an interaction term between an index of financial dependence and the share of total domestic banking assets held by foreign lenders, which we take from World Bank data described in Claessens et al. (2008). Assuming that US financial markets are relatively frictionless we measure the former as the fraction of investment not funded by retained earnings for US firms from 1980 to 1989, which we also update to the period from 1980 to 1999 as a robustness test. By interacting country attributes (presence of foreign banks) and an exogenous industry benchmark (external financial dependence) in a difference-in-difference framework we isolate the impact of foreign banks on real economic activity while avoiding simultaneity and reverse-causality concerns. A plethora of time, country, and industry fixed effects address potential omitted-variable biases.
We find that foreign banks consistently and significantly mitigate the adverse consequences of financial constraints for firm performance. The greater an industry’s dependence on external finance in a given country the more their presence increases real growth. To put this effect into perspective, an industry in the 75th percentile of financial dependence in a country in the 75th percentile of foreign-bank presence would grow 1.17 percentage points faster than those located at the corresponding 25th percentiles. The impact is even more pronounced for firms in developing countries, who often have access to alternative sources of funds. By contrast, foreign banks do not significantly affect firm performance by relaxing external financing constraints in low-income countries as opposed to mid and high income ones.
In a similar vein, bank entry be it de novo or incremental unambiguously and immediately lessens the negative effects of financial dependence on real economic activity. However, the first foreign bank has a much greater impact on real economic activity than further entry, especially in developing countries. The mode of entry also matters. Only banks entering through acquisitions significantly and consistently improve the performance of more financially dependent firms. Since entering banks face considerable informational and legal obstacles acquisitions provide access to local lending expertise which helps in overcoming asymmetric-information problems and in establishing lending relationships. By contrast, greenfield investments do not offer any informational advantages to the entering bank or its borrowers, which might explain their lack of statistical significance.
The fact that this acquisition-entry effect is significantly larger in developing countries, where informational and legal problems in credit markets loom larger than in advanced economies, offers further support for our interpretation. Indeed, the inclusion of variables measuring the existence of credit bureaus and registries or of well-defined creditor rights and their enforcement does not affect the relation between foreign banks and firm performance and is only statistically significant on their own for advanced economies, where such mechanisms function well enough to facilitate financial intermediation.
We also relate the impact of foreign banks on growth to the occurrence of banking crises, financial development, and the quality of legal and political institutions in host countries. We find that foreign banks mitigate the adverse consequences of (local) banking crises on growth (see Kroszner et al., 2007 or Dell’Ariccia et al., 2008) to the point of insignificance. In the presence of foreign entry, banking crises only affect growth negatively in African countries, which have dysfunctional financial systems and very low foreign-bank penetration, whereas their impact is statistically insignificant in all other developing and advanced economies.
Our results are robust to the inclusion of a host of interaction terms between financial dependence and measures of financial, legal, and political development. Decomposing such institutional effects by level of economic development we find the following symmetry: foreign banks continue to relax the financing constraints and improve firm performance in developing but not advanced countries whereas independent financial and legal development only contributes to real economic activity in advanced but not developing economies.
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