Foreign Bank Operations in Developing Economies

INTRODUCTION

Banks over the years has developed into an important aspect of an economy. With the very last episode depression the position of banks has become all the more in the way of working of the money and therefore economy of the nation. The banking sector forming a portion of the financial sector primarily facilitates as a fiscal mediator generating money supply. From the uncommon macroeconomic models banks has been found to be a part of the supply segment of the nation. However ended the period banks have been transformed from money generating organizations to multitasking entity.

Inside the capitalist economies, banks participates the role of the intermediaries linking Lenders and borrowers. Two of the mainly valuable reasons representing their efficiency are that banks diversify risks due to the great digit of projects they confront and with the intention of their experienced increasing returns to extent in search and monitoring activities with the desired to determine potentially profitable projects.

Financial sector foreign direct investment in emerging economies has surged ended the earlier period decade. While the reimbursement of delicate financial sector efficiency and better risk management are widely acknowledged, foreign ownership poses challenges pro host countries due to the migration of decision-making and the incongruence of the organizational structures of foreign-owned banks and host country officially authorized and regulatory systems. Many of these challenges will be finest met by comprehensive coordination on the part of supervisors and central banks.

Pakistan is one of the key emerging markets of South Asia with a entire population of more than 170 million. Macroeconomic stability and financial sectors reform are under fire to hold a affirmative, significant effect on real economy. The banking sector in Pakistan consists of Commercial Banks and Specialized Banking Institutions.

At current there are 55 scheduled banks, 8 DFIs, and 7 MFBs working in Pakistan whose activities are regulated under the supervision of State Bank of Pakistan. The commercial banks made up of 4 nationalized banks, 20 private sector banks, 7 foreign banks, 5 Islamic Banks, and 4 specialized banks.

Liberalization in financial sector is intended to provide equal opportunity in favor of fiscal institutions to access international market or reduce restriction from the native regulatory authority. Banking industry liberalization is one of the generally valuable agendas in fiscal sector liberalization in the preceding few years. This research will assess the role of foreign banks in Pakistani economy in order to provide an apparent picture of the impacts on Pakistani economy and responses from local market authorities to international operation of foreign banks.

Foreign banks could adopt a comprehensive management strategy in order to achieve competitive advantages against native banks and to increase profits. The comprehensive strategy of foreign banks deploys their resources together with funds, public, contemporary products and technologies to their overseas branches and subsidiaries. However, this international surgical procedure pays a little attention to stability and sustainability of community and regional economies. This research is intended to discuss the strategy of foreign banks operation in local markets and the responses of local banks towards increasing competition. The foremost argument will be focused on the impacts of foreign banks on local economy and the policies of the Pakistani government to increase contribution of foreign banks.

RATIONALE

The arguments in favor to foreign bank operations in emerging economies, generally based on assumption that the foreign banks are more efficient, more innovative and better managed than their domestic banks. There is furthermore argued that foreign banks can put in to the stability of domestic financial market and balance of payment in support of domestic government. Furthermore argues that foreign banks can boost operational efficiency of domestic financial system and enrich market discipline on government policies.

However, (Weller, 2000 and 2001) moreover argues that foreign layer presence increases competition, which could furthermore impair the development of domestic banks. Foreign banks are more competitive in nature due to their abilities to provide more competitive products with cheaper prices.

Letting them fully access to the less develop market will squeeze the domestic players in the banking industry from competition. This impair competition could furthermore advantage to focus of domestic banks in superior risk lending as good borrowers pick lesser price with more variety services. In the event of economic turmoil, here is a risk for foreign banks to transmit their function to other countries in order to reduce their highest losses.

Foreign banks could chase their customers by opening their operation in other countries in order to perform multinational companies, which have been served in the home countries. The companies feel comfortable and pay lesser cost to deal with the same banks for their international operations. Majority of foreign banks in emerging economies normally concentrate in financing for corporations originated from the same home countries. Foreign banks have a little probability to provide financing for SME as the operation of foreign banks normally is in the financial highlight. Serving SME will need more labors, which is too expensive for the foreign banks as the salaries of their personnel are relatively more than domestic banks. It is the justification in emerging economies where communication infrastructure in the rural area is unable to support the consolidation; therefore, the rural administrative operation requires more labors.

The foreign bank entrance in the Central and Eastern Europe has various reason, which is very much correlated to the privatization in transition time in the ex- communist countries from centralized economy to market-based economy as one of the efforts to be acknowledged as the EU member. Historically, foreign bank entrance through branching is the largely favorable for foreign banks as the head quarters have more flexibility to control the operations and branching is officially dependence from the home country jurisdiction. (Pigott, 1986) mentions that foreign bank entrance in Asia mostly conducted through branching or representative.

SIGNIFICANCE

Foreign banks play very important role in the development of the economy. Their first impact on the economy is that they bring FDI in the home nation. As we know that foreign banks from developed economies bring more sophisticated corporate culture and new product and services which enhance the market competition in the domestic banks.

Another argument pro foreign bank presence in other countries is to explore competitive advantages in the less efficient banking practice with the hope to increase their operation by competing with local banks. Restructuring of domestic banks in Latin America, Asia and Central Europe must include the opening of these markets to foreign banks. As evident, foreign bank markets boost significantly in Latin America and Europe. The market share of foreign banks in Asia is still very low even though foreign banks entry is fully opened for foreign investors.

The performance of foreign banks in host countries is one of parameters to evaluate the contribution to the stability of domestic financial sectors. Most of those studies conclude that foreign banks in developed countries are fewer efficient that those in emerging countries as a consequence of dense competition against domestic banks in developed countries. Foreign banks reports higher returns on equity and lesser cost-to-income and credit ratios than do domestic not more banks.

LITERATURE REVIEW

Consistent with traditional arguments in hold of capital account liberalization, foreign bank existence is argued to increase the amount of funding available to domestic projects by facilitating capital inflows. Foreign bank existence may also increase the stability of accessible lending, by diversifying the capital and funding bases supporting the supply of domestic credit, an argument that appears especially persuasive for small and/or volatile economies.

Foreign banks are argued to improve the excellence, pricing, and accessibility of financial services, both directly as providers of such improved services and indirectly through competition with domestic financial institutions (Levine, 1996). Foreign bank existence is argued to improve financial system infrastructure, including accounting and transparency, financial regulation, and through stimulating the increased presence of such supporting agents as rating agencies, auditors, and credit bureaus (Glaessner and Oks, 1994).

A foreign presence may also improve the ability of financial institutions to successfully measure and manage risk. Foreign bank presence may import financial system regulation and supervisory skills from home country regulators. While many of these goals may ultimately be achievable without foreign financial institutions, increased foreign presence may meaningfully speed up the process. The efficiency of foreign banks in Australian economy within the contexts presented by comparative advantage theory and new trade theory.

(Claessens, Demirguc-Kunt, and Huizinga, 1998) examine the effects of foreign bank entry on the domestic banking sector. They show that in developing countries foreign banks tend to have greater profits, higher interest margins, and higher tax payments compared to domestic banks. But the reverse is true in developed countries. Another interesting conclusion is that both

Profitability and overhead expenses of domestic banks fall with foreign bank entry. (Demirguc-Kunt and Huizinga, 1999) present similar results, they show that foreign banks have generally higher profits and margins compared to domestic banks in developing countries, while the opposite is true in industrial countries. (Demirguc-Kunt, Levine, and Min, 1998) find that foreign bank participation lowers the possibility that a country will experience a banking crisis. They point to that the presence of foreign banks lowers overhead costs and profits of domestic banks. Foreign banks also increase overall economic growth by raising the efficiency of domestic banks. (Demirguc-Kunt and Huizinga, 1999) present similar results, they illustrate that foreign banks have generally higher profits and margins compared to domestic banks in developing countries, while the opposite is true in industrial countries. (Demirguc-Kunt, Levine, and Min, 1998) demonstrate that foreign bank participation lowers the possibility that a country will experience a banking crisis, they indicate that the presence of foreign banks lowers overhead costs and profits of domestic banks. Foreign banks also increase overall economic growth by raising the efficiency of domestic banks.

This concern about the potential for foreign dominance of the U.S. banking industry was primarily based on the assumption that foreign and domestic banks must compete directly, and that the presence of foreign banks must jeopardize the domestic banking industry (Bleakley, 1992). However, little empirical research has been done to verify or falsify this conventional ‘competitive exclusion’ hypothesis (i.e., that the new foreign entrants and domestic banks would find themselves in direct competition). This hypothesis, mainly based on the assumption of zero-sum competition, holds that the presence or entry of one (sub)population will negatively affect the prosperity of a related one. In the U.S. banking context, the rapid growth of foreign direct investment (FDI) during the 1980sindicated intensified competition between domestic and foreign banks, which, it was assumed, could influence foreign and domestic banks’ entry patterns (Caves, 1996). The interaction between foreign and domestic firms is an area of particular interest to strategic management scholars and practitioners. There are many strategic issues associated with intensified foreign competition and its impact on domestic firms and industry structures. For instance, researchers have been interested in examining how foreign multinational corporations (MNCs) differ from domestic competitors in terms of their competitive advantages and disadvantages (Caves, 1996; Hymer, 1960; Zaheer, 1995; Zaheer and Mosakowski, 1997), how the activities of foreign MNCs affect host country productivity and that of domestically owned firms (Aitken and Harrison, 1999; Caves, 1974; Chung, Mitchell, and Yeung, 2003), and how domestic customers and competitors shape the strategic behavior and performance of foreign MNCs in the markets they enter (Fiegenbaum, Lavie, and Shoham, 2004; Morck and Yeung, 1991; Murtha, Lenway, and Bagozzi, 1998).

Many countries experienced crises of the 1990s, attributed to a combination of unsustainable current account deficits, excessive short-term foreign debts, and weak domestic banking systems. This combination led to the so called ‘‘Twin crisis” which was the interrelationship between two phenomena: banking crisis and currency crisis. However, the experience in each crisis country was in some degree unique and one or more of these conditions were present to a different extent (Feldstein, 2002). (Lamfalussy, 2000) shows the synopses of four market crises; Latin American 1982–83, Mexico 1994–95, East Asia 1997–98 and Russia 1998, principally linked to the banking sector. In the case of Thailand, economic crisis in mid1997 can largely be related to three policy errors:

1. Liberalization of foreign capital flows while having rigidity in the exchange rate system.
2. Premature liberalization of financial institutions
3. Failure prudently to supervise financial institutions (Allison and Suwanraks, 1999).

The liberalization of financial institutions in Thailand was a controversial issue with some questioning whether they should be liberalized in the light of their lack of maturity.

The banking sectors of the European Union (EU) candidate countries have been subjected to deregulation and liberalization over the last decade. It is argued that liberalization will significantly affect the degree of cross-border competition in the integrated banking sector’s performance and efficiency (Claessens et al., 2001; Gual, 1999; De Brandt and Davis, 2000; Hasan et al., 2000; Berger et al., 2000). (Levine, 2001) analyzed the relationship between financial liberalization and banking efficiency, finding that greater presence of foreign banks enhances the efficiency of the domestic banking system by decreasing banks ‘overhead costs and profits. There is a growing body of empirical studies to suggest that the overall economic success of a country is a positive function of the development of its financial sector, and of its banking system in particular. Recent studies have shown that countries with well-developed financial institutions tend to experience more rapid rates of real GDP per capita growth (Levine, 1997; Levine and Zervos, 1998; Rajan and Zingales, 1998). More importantly, empirical studies have disclosed the existence of a positive correlation between foreign ownership of banks and stability of the banking system (Caprio and Honahan, 2000; Goldberg et al., 2000).

There is also the experience of the impact of foreign banks’ participation in different countries. (Dages et al, 2000) examined the lending patterns of domestic and foreign banks and found that foreign banks typically have stronger and less volatile lending growth than their domestic counterparts. They also found that diversity of ownership contributes to greater credit stability during times of turmoil and weakness of the financial system. (Weller, 2000) showed that the entry of a larger number of multinational banks resulted in a lower credit supply by Polish banks during the early transition phase. The benefits of increased foreign participation in the banking sector are discussed by (Gruben et al, 1999; Lardy, 2001). (Demirguc-Kunt et al, 1998) noticed that over the period 1988– 1995, and for a large sample of countries, entry by foreign banks was generally associated with a lower incidence of local banking crises.

An important issue for emerging market economies is whether the entry of foreign banks will contribute to the banking system’s stability and being a stable source of credit, especially in periods of crisis. (Mathieson and Roldos, 2001) have pointed to two related issues: whether the presence of foreign banks makes systematic banking crises more or less likely to occur, and whether there is a tendency for foreign banks to “cut and run” during a crisis. In general, it has been suggested that foreign banks can provide a more stable source of credit because the branches and subsidiaries of large international banks can draw on their parents (which typically hold more diversified portfolios) for additional funding. Large international banks are likely to have better access to global financial markets and the entry of foreign banks can improve the overall stability of the host country’s banking system (stronger prudential supervision, better disclosure, accounting and reporting practice, etc.).

The main expected benefits and drawbacks from the entry of foreign banks are clearly defined by (Bonin et al, 1998; Dages et al., 2000; Doukas et al., 1998). The main expected benefits include:

• Introduction of new banking technology and financial innovations (for foreign banks it is relatively easy to introduce new products and services to the local market).
• Possible economies of scale and scope (foreign banks can help encourage consolidation of the banking system, they have knowledge and experience of other financial activities: insurance, brokerage and portfolio management services).
• Improvement of the competitive environment (foreign banks represent potential competition to local banks).
• Development of financial markets (foreign banks entry may help deepen the inter-bank market and attract business from customers that would otherwise have gone to foreign banks in other countries).
• Improvement of the financial system’s infrastructure (transfer of good banking practice and know-how, accounting, transparency, financial regulation, supervision and supervisory skills).
• Attracting foreign direct investments (the presence of foreign banks may increase the amount of funding available to domestic projects by facilitating capital inflows, diversifying the capital and funding basis).

The main arguments against foreign banks entry, however, are (Anderson and Chantal 1998, p. 65):

• Fear of foreign control (control over the allocation of credit implies substantial economic power in any economy).
• Banking as an infant and special industry (this argument is a version of the general infant industry argument, and banks are subject to various special protections due to their central role in economy).
• Foreign banks may have different objectives (foreign banks may be interested only in promoting exports from the home country or in supporting projects undertaken by home country firms).
• Regulatory differences (supervisors of the host country lose regulatory control and if the home country has weak bank supervision, this may lead to unsound banking in the host country).

A most comprehensive empirical survey about foreign banks entry was carried out by (Claessens et al, 2001) who investigated the relationship between foreign banks entry and the performance of the domestic banking sector in 80 countries. They used panel estimations with 7,900 bank observations for 1988–1995. The main result of the study was that foreign banks tend to have higher profits than domestic banks in the developing countries, while in developed countries foreign banks are less profitable than domestic banks. Their results also indicated that higher foreign bank presence is related with lower profitability, costs and margins of domestic banks.

(Hermes and Lensink, 2003) developed further the model used by (Claessens et al, 2001). They used bank-level accounting data from 990 banks in 48 countries for the period 1990-1996. Threshold estimations were used to study how foreign banks entry effects are related, in a short term, with the economic development of the countries involved. The results indicate that at a lower level of economic development, foreign banks entry is associated with higher costs and margins for domestic banks. At a higher level of economic development, on the other hand, foreign banks entry has a less significant effect on domestic banks’ profitability. This result adds some support to the technology gap hypothesis.

(Zajc, 2002) analyzed foreign banks entry effects on domestic banks in the Czech Republic, Estonia, Hungary, Poland, Slovakia and Slovenia for the period 1995–2000. His results are somewhat different from those presented by (Claessens et al, 2001). He found that foreign banks entry is associated with lower non-interest income but increases overhead expenses.