Foreign direct investment in the financial sector of emerging market economies

March 2004

Executive summary

Foreign participation in the financial sectors of emerging market economies (EMEs) increased rapidly during the 1990s. It has continued to expand so far in this decade, on balance - although its pace fell somewhat following problems in Argentina in 2002 and the global slowdown in mergers and acquisitions. While banks accounted for the majority of financial sector foreign direct investment (FSFDI), they were joined during this period by securities and investment firms. In a number of countries in Latin America and central and eastern Europe (CEE), foreign banks now account for a major share of total banking assets. In Asia, the share of foreign banks is, overall, much lower, but still substantial.

FSFDI was fostered by financial liberalisation and market-based reforms in many EMEs. The liberalisation of the capital account and financial deregulation paved the way for foreign acquisitions and the integration of EME financial firms into an expanding global market for corporate control. This underlines the character of FSFDI as part of a broader trend towards consolidation and globalisation in the financial industry. In some cases, heightened competition in traditional markets increased pressure on major international banks to find new areas for growth. With financial institutions in advanced economies increasingly searching for profit opportunities at the customer and product level, FSFDI offered a means of access to EME markets with attractive strategic opportunities to expand.

The integration of EME financial firms into the global market has resulted in a wider diversity of financial institutions operating in EMEs and - given their greater emphasis on risk-adjusted profitability - a broad range of business strategies. These include expansion into local retail banking and securities markets, where elements such as client relationships and reputation are important components of the franchise value of operations. Such factors have tended to raise the costs of exiting a country and hence increased the permanence of FSFDI.

Improvements in local financial infrastructure made the risks of conducting business in EMEs easier to manage, but events such as the Russian default in 1998 and Argentine actions in 2002 also made financial institutions more sensitive to the potential consequences of low-probability, but high-cost events involving country risk. Thus, financial institutions in industrial countries now tend to evaluate country risk separately and more rigorously by applying country-focused stress testing and other techniques. Because the objective of preserving the franchise value may have narrowed the room for strategic manoeuvre, risk managers now more actively seek ways to mitigate the impacts of realisations of country risk - for example, by using more local funding and establishing in advance potential sources of funds for stress scenarios. Nonetheless, a projection of long-run profitability remains the prerequisite for staying in the host country.

An important, lasting benefit of FSFDI is its effect on financial sector efficiency that arises from local banks' exposure to global competition. Generally, host countries benefit from the technology transfers and innovations in products and processes commonly associated with foreign bank entry. Foreign banks exert competitive pressures and demonstration effects on local institutions, often inducing them to reassess business practices, including local lending practices. The result can be better risk management, more competitive pricing, and in general a more efficient allocation of credit in the financial sector as a whole.

Foreign banks' presence can also help to achieve greater financial stability in host countries. Host countries may benefit immediately from foreign entry, if the foreign bank recapitalises a struggling local institution and, in the process, also provides needed balance of payments financing. The better capitalisation and wider diversification of foreign banks, along with the access of local operations to parent funding, may reduce the sensitivity of the host country banking system to local business cycles and changing financial market conditions. Their use of risk-based credit evaluation (and spillovers to local banks' practices) tends to reduce concentration in lending and, in times of financial distress, fosters prompter recognition of losses and more timely resolution of problems. In stress situations, foreign-owned institutions can also provide an alternative location for deposits that does not involve capital outflows.

Notwithstanding these benefits, the growing involvement of foreign firms in the financial systems of EMEs has given rise to concerns, especially where a majority of EME banking assets have become foreign-owned. One set of issues arises when integration transforms a domestic institution such that key decision-making and control functions - including strategic planning and risk management - are shifted to the parent. This shift may reduce the information available to host country supervisors and monetary authorities, and it may interfere with the access of authorities to key firm decision-makers. The reduction in information could become an issue, especially when parent institutions make subsequent strategic changes that significantly affect host country financial markets. If the integrated firms' equities are delisted, the resulting loss of information and market signals may not be fully offset by financial disclosures by the global institution. Another concern is that the financial sector of a globally integrated host country may have greater exposures to shocks that arise from external economic, financial, and strategic developments. The relevance of these issues very much depends on bank and host country-specific factors, such as the business strategy and management approach of individual banks, the legal form of operations or the composition of the host country financial system.

Adjustments in the supervisory framework can help offset the attendant information loss and resulting risks to financial stability. Host country regulators have the capacity to impose information and disclosure requirements on subsidiaries and, in principle, also on branches. In addition to ensuring adequate information from the local operation, supervisors should make fuller use of existing frameworks for cross-border supervisory information sharing. More generally, the mutual benefits of increasing the extent of cooperation among home and host country supervisors are compelling because of the additional complexity introduced by the expansion of banks' operations into EMEs, the intensifying competitive dynamic in global markets, and the potential relevance of EME operations for the risk assessment of the equity holders and creditors of the parent.

Information sharing among authorities responsible for financial stability is especially important in periods of market stress. In such situations, information sharing frameworks often emphasise the flow of information from host to home country. At the same time, however, home country supervisors and financial institutions should recognise the need in the host country for information when the parent bank has problems, especially when the bank's subsidiary is a large presence in an EME's financial markets. Similarly, central banks need to be in close contact when a parent bank's problems appear likely to affect a local EME subsidiary or branch.

Although new strategies by acquired banks may present challenges to supervisors, they can also be a catalyst for developing supervisory skills. Accordingly, developing pertinent technical skills should be an important area of cooperation between authorities in advanced and EME countries. In some markets, foreign-owned banks have been prominent in the rapid expansion of consumer lending and foreign currency lending to both households and businesses. Supervisors need appropriate tools to assess how such credit is managed by banks, and authorities in charge of financial stability may need additional information and techniques to monitor for financial vulnerabilities. Cross-border information sharing, training programmes and other forms of technical assistance may help meet this need. The EME financial reforms that triggered the 1990s expansion of FSFDI did not come without some costs of adjustment (including having to weather difficult periods) in moving towards a more marketdriven system, but they also generated demonstrable and substantial long-term benefits. Accordingly, public policy should be focused on maximising these benefits by continuing to encourage diversity and competition in financial systems - not only between foreign and domestic banks, but also between banks and other financial institutions.

Given the prominence of country risk in investing firms' strategic decision-making, measures aimed at reducing country risk should be especially beneficial. One essential component of host country policy in this direction is a commitment to growth and stability. Another is the protection of property rights and equal treatment of banks, irrespective of ownership. From this viewpoint, a more extensive implementation of the internationally recognised set of financial standards and codes can help to reduce country risk. Another related policy element to reduce country risk is strengthening of legal frameworks. The smooth functioning of the market for corporate control would be assisted by greater international compatibility of accounting standards, takeover rules, and insolvency codes. As highlighted in this report, the availability and quality of local information may be of particular relevance in this context.

Regional integration of EME financial systems, often within a framework for broader economic integration in the region, is another complementary approach to this objective. There is substantial anecdotal evidence of major benefits from regional compacts such as those of the European Union and NAFTA. In the case of very poor countries where some special support for FSFDI may be merited, public sector provided political risk insurance, if properly designed, could be useful.

See also the related publications: Central bank papers submitted by Working Group members