Foreign Banks in Poor Countries: Theory and Evidence

WP/06/18


Foreign Banks in Poor Countries:
Theory and Evidence

Enrica Detragiache, Thierry Tressel, and
Poonam Gupta

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© 2006 International Monetary Fund
WP/06/18

IMF Working Paper

Research Department

Foreign Banks in Poor Countries: Theory and Evidence

Prepared by Enrica Detragiache, Thierry Tressel, and Poonam Gupta1

Authorized for distribution by Eswar Prasad

January 2006

Abstract

This Working Paper should not be reported as representing the views of the IMF.
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent
those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are
published to elicit comments and to further debate.

We study how foreign bank penetration affects financial sector development in poor
countries. A theoretical model shows that when foreign banks are better at monitoring high-
end customers than domestic banks, their entry benefits those customers but may hurt other
customers and worsen welfare. The model also predicts that credit to the private sector
should be lower in countries with more foreign bank penetration. In the empirical section, we
show that, in poor countries, a stronger foreign bank presence is robustly associated with less
credit to the private sector both in cross-sectional and panel tests. In addition, in countries
with more foreign bank penetration, credit growth is slower and there is less access to credit.
We find no adverse effects of foreign bank presence in more advanced countries.

JEL Classification Numbers: G21, O16

Keywords: Financial development; low-income countries; foreign banks

Author(s) E-Mail Address: Edetragiache@imf.org; PGupta@imf.org; Ttressel@imf.org



1 The authors would like to thank Thorsten Beck, Simon Johnson, Sole Martinez Peria,
Raghu Rajan, Arvind Subramanian, and participants to the joint World Bank/IMF Seminar for
very helpful comments on an earlier draft. We are also greatly indebted to Ugo Panizza and
Monica Yañez for sharing their data on bank ownership.

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Contents Page

I. Introduction.................................................................................................................. 4

II.
Empirical Evidence on Foreign Banks in Poor Countries ........................................... 6

III.
Cream-Skimming Effects of Foreign Bank Entry: Theory.......................................... 7

A. The Model with Only Domestic Banks................................................................... 8

B. The Model with Both Domestic and Foreign Banks............................................. 10

C. Welfare Effects of Foreign Bank Entry................................................................. 11

D. Foreign Banks and Cost Efficiency ...................................................................... 12

E. Relationship with the Theoretical Literature......................................................... 13

IV.
The Empirical Test: Methodology and Data.............................................................. 14
A.
Sample................................................................................................................... 14

B. Dependent Variables ............................................................................................. 14

C. Measuring Foreign Bank Presence........................................................................ 15

D. The Control Variables........................................................................................... 15

E. The Empirical Model............................................................................................. 17

F. An Overview of the Data....................................................................................... 18

V.
Results from the Empirical Tests............................................................................... 19

A. Private Credit—OLS Regressions ........................................................................ 19

B. Foreign Bank Presence and Credit Growth........................................................... 21

C. Panel Regressions.................................................................................................. 21

D. Private Credit—Instrumental Variable Regressions ............................................. 22

E. Overhead Costs...................................................................................................... 24

F. Foreign Banks and Access to Banking Services.................................................... 25

G. Extending the Sample to Higher-Income Countries ............................................. 25

VI. Conclusions................................................................................................................ 26

Appendices
I.
Welfare Comparison under Alternative Equilibria .................................................... 42
II.
Data Definitions, Sources, and Summary Statistics for Lower-Income Countries.... 43

References.............................................................................................................................. 44

Tables
1.
Sample Summary Statistics ....................................................................................... 27
2.
Financial Depth and Foreign Bank Presence in Poor Countries: OLS Regressions.. 28
3.
Financial Depth and Foreign Banks in Poor Countries: Robustness Tests................ 29
4.
Foreign Bank Presence and Changes in Financial Depth in Poor Countries............. 30
5.
Financial Depth and Foreign Bank Presence in Poor Countries: Panel Estimation .. 31
6.
Financial Depth and Foreign Bank Presence in Poor Countries: Instrumental

Variables Estimation............................................................................................... 32

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7.
Bank Cost Efficiency and Foreign Bank Presence in Poor Countries ....................... 33
8.
Access to Financial Services and Foreign Bank Presence in Poor Countries:

Bivariate Correlations ............................................................................................. 34
9.
Access to Financial Services and Foreign Bank Presence in Poor Countries:

Cross-Sectional OLS Regressions .......................................................................... 35
10.
Financial Depth, Cost Efficiency, and Foreign Bank Presence: OLS Regressions

Including All Countries........................................................................................... 36

Figures
1.
Impact of Foreign Bank Entry on Welfare and Aggregate Lending.......................... 37
2.
Bank Credit to the Private Sector Overhead Costs in Lower-Income Countries

by Region (Percent of GDP) .................................................................................. 38
3.
Foreign Bank Presence by Region in Selected Lower-Income Countries................. 39
4.
Private Credit to GDP and Foreign Bank Presence ................................................... 40
5.
Change in Private Credit to GDP and Change in Foreign Bank Presence

(1995-2002)............................................................................................................. 41

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I. INTRODUCTION
A large theoretical and empirical literature argues that finance is good for growth (Levine,
1997; and Beck and Levine, 2003). An implication of this work is that fostering the
development of financial markets should help less developed countries lift themselves out of
poverty. Indeed, estimates by Bekaert, Campbell and Lundblad (forthcoming) indicate that
financial liberalization, identified as opening up the stock market to foreign investors, can
increase the growth rate by as much as 1 percent per year. Recent work also suggests that
financial development reduces inequality and poverty by disproportionately boosting the
income of the poor (Beck, Demirgüç-Kunt, and Levine, 2004).

Perhaps heeding the advice of economists, in recent years many poor countries have been a
laboratory of financial sector reform. A rigorous evaluation of these efforts is still a work in
progress, but available accounts suggest that key deficiencies have been difficult to remove.2
This paper studies how one aspect of financial sector reform, the entry of foreign banks,
affects financial sector development in poor countries.

Whether foreign bank entry is a help or a hindrance is the object of some contention among
policymakers and academics.3 Proponents of foreign banks claim that these banks can
achieve better economies of scale and risk diversification than domestic banks, introduce
more advanced technology (especially risk management), import better supervision and
regulation, and increase competition. Because they are backed by their parent banks, foreign
affiliates of international banks may also be perceived as safer than private domestic banks,
especially in times of economic difficulties. Last but not least, foreign banks may be less
susceptible to political pressures and less inclined to lend to connected parties. These forces
imply a positive relationship between foreign bank presence and indicators of financial sector
performance.

Despite these advantages, critics point out that an important part of a bank’s business, namely
lending to informationally opaque firms, is inherently local in nature, and is not easily carried
out by large organizations managed from far away. In fact, evidence from bank consolidation
in advanced countries suggests that large banks are less prone than small banks to lend to
informationally difficult firms, such as small firms, because there is a greater distance
between loan officers and management (Berger and others, 2005). In the case of foreign
banks operating in poor countries, the distance (both geographic and cultural) between
headquarters and local subsidiaries is likely to be especially large. In addition, many, if not
most, potential borrowers lack usable collateral and reliable accounting information and are

2 Comprehensive descriptions of financial sector structure, performance, and soundness for
several poor countries are provided in the Financial Sector Stability Assessments (FSSAs),
jointly carried out by the World Bank and the IMF. Most of these reports are available at
www.imf.org.
3 For a summary of the issues, see, among others, International Monetary Fund (2000) and
Agénor (2001). A more detailed literature review is in Section II of this paper.

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therefore informationally difficult. Thus, the problems highlighted by studies of bank
consolidation in advanced countries may be compounded when foreign banks operate in poor
countries. Consistent with this view, several studies find that foreign banks in lower-income
countries (LICs) lend predominantly to the safer and more transparent customers, such as
multinational corporations, large domestic firms, or the government.4

Even when foreign banks enter by purchasing local banks, local market knowledge and
relationships with customers may be lost, as distant managers need to impose formal
accountability to monitor local loan officers. In fact, evidence from advanced countries
indicates that, when a bank is acquired by another bank, the bank-firm relationships of the
target bank are disrupted (Sapienza, 2002; Carow, Kane and Narayanan, 2004; Karceski,
Ongena, and Smith, 2004; Degryse, Masschelein, and Mitchell, 2004).

From a public policy perspective, however, it is not clear that foreign banks’ focus on high-
end customers should be a concern. As long as domestic banks continue to lend to more
opaque but profitable customers, there should be no welfare loss, and foreign bank entry may
simply result in a welfare-improving segmentation of the market. On the other hand, if
foreign bank entry forces domestic banks out of the market, then more opaque firms may
become credit constrained, aggregate credit may decline, and profitable investment
opportunities may be lost. In this paper, we explore these questions both theoretically and
empirically.

In our theoretical model, foreign banks are better than domestic banks at monitoring “hard”
information, such as accounting information or collateral values, but not at monitoring “soft”
information, such as the borrower’s entrepreneurial ability or trustworthiness. In this setup, in
some parameter configurations foreign bank entry increases cost-efficiency and welfare,
while in others it leads to a reduction in overall lending, cost efficiency, and welfare. The
intuition for the latter—more surprising—result is that foreign bank entry causes “cream-
skimming,” whereby hard-information borrowers are no longer pooled with other borrowers.
This has two consequences: first, soft-information borrowers find themselves in a worse pool
(because the “cream” has been “skimmed”), and have to pay such high interest rates that they
may no longer want to borrow. Second, monitoring costs are paid in equilibrium, which
increases operating costs. Welfare may increase or decrease depending on the parameters, but
soft-information borrowers are never better off and sometimes they are worse off. The model
also implies that countries with a larger foreign bank presence should make less credit
available to the private sector.

In the second part of the paper, we turn to the data and find that a larger foreign bank
presence is associated with shallower credit markets in poor countries, consistent with the
model. This effect is large, robust to the choice of specification, and holds both in a cross-
sectional and dynamic panel specification. In addition, credit growth is slower in countries

4 See Bonin and Wachtel (2003) on Eastern Europe, Brownbridge and Harvey (1998) on
Anglophone Africa, Mian (forthcoming) for Pakistan, Haber and Musacchio (2005) for
Mexico, Clarke and others (2005) for Latin America, and Gormley (2005) for India.

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with a larger initial foreign bank presence. The relationship also holds when we instrument
the foreign share to control for endogeneity (using population size and religious affiliation—
a measure of cultural proximity—as instruments). Finally, foreign bank presence is
negatively associated with indicators of access to financial services, such as branch
penetration and number of deposits per capita. We interpret these results as supporting the
view that the entry of foreign banks in poor countries leads to “cream skimming” and a
decline in credit to opaque firms.

The empirical relationship between foreign bank presence and financial performance
becomes statistically insignificant when we include higher-income countries in the sample.
This is consistent with the theoretical model, because differences in monitoring abilities
between foreign and domestic banks are likely to be less marked and opaque firms less
important in these countries. This finding underscores the need to allow for heterogeneity
among groups of countries of different income level when studying the effects of financial
reforms.

The paper is organized as follows: The next section reviews the empirical literature on
foreign banks in poor countries. Section III presents the theoretical model. Section IV
discusses the empirical methodology and data. Section V presents the results of the empirical
tests. Section VI concludes.

II. EMPIRICAL EVIDENCE ON FOREIGN BANKS IN POOR COUNTRIES
A number of empirical studies have investigated various implications of the increased
globalization of banking in general, and of growing foreign bank presence in developing
countries in particular. The evidence is drawn both from cross-country samples and
individual country studies.

Based on cross-country studies, foreign-owned banks have been found to have lower
operating costs and higher profitability than private domestic banks, while state-owned banks
have higher costs and lower profitability than the other two categories (Mian, 2003; Micco,
Panizza, and Yañez, 2004). Foreign bank entry in developing countries also appears to lower
interest margins and profitability, suggesting an increase in competition (Claessens,
Demirgüç-Kunt, and Huizinga, 2001; Gelos and Roldós, 2004; Micco, Panizza and Yañez,
2004; Martinez Peria and Mody, 2004). A recent study of eight Latin American countries,
however, finds the opposite to be true (Levy-Yeyati and Micco, 2003).

Turning to the effects of foreign bank entry on access to credit, surveys of entrepreneurs
indicate that firms are less credit-constrained in countries with more foreign bank
participation (Clarke and others, 2004). On the other hand, a study of lending behavior in
four Latin American countries concludes that foreign banks lend less to SMEs than domestic
banks on average, although this is not true for foreign banks that have a large presence in the
country (Clarke and others, 2005). In Eastern Europe, Giannetti and Ongena (2005) find that
foreign bank presence benefits all firms, though the effects are more pronounced for large
firms and firms less likely to be involved in connected lending.

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Additional evidence on foreign and domestic bank behavior in LICs comes from individual
country studies. Haber and Musacchio (2005) analyze Mexico’s experience in the 1990s.
After a mismanaged bank privatization led to a financial crisis in 1994-95, the Mexican
government introduced several reforms, including liberalization of foreign bank entry. As the
presence of foreign banks grew, bank capitalization improved and non-performing
loans (NPLs) and operational expenses declined, but lending, particularly to the private
sector, declined. The fall in private lending was more pronounced in foreign than in domestic
banks. Thus, while the Mexican banking system has become more stable and profitable, it
seems to have retreated from the business of lending to the private sector. Haber and
Musacchio’s view is that deep reforms to improve the enforcement of property rights are
necessary to enable financial intermediation, and especially lending by foreign banks, to
reach risky borrowers in Mexico.

Drawing on an exceptionally rich dataset of 80,000 business loans in Pakistan, Mian
(forthcoming) finds that private domestic banks lend more to informationally opaque
businesses than foreign banks, and that they are more successful at recovering defaulted debt.
The interpretation of these results is that distance constraints (both cultural and geographic)
between top management and loan officers force foreign banks to curtail discretion in
lending decisions, resulting in less lending to informationally opaque smaller businesses, as
in the theoretical model of Stein (2002). Distance also appears to impair the recovery of
defaulted loans.

In a third country study on India, Gormley (2005) compares borrowing behavior of firms
located in districts with and without foreign bank entry. He concludes that the top 10 percent
of most profitable firms benefited from foreign bank entry through an increase in loan size,
while other firms experienced a 7.6 percent drop in their likelihood of having a loan. This
result is driven by a decrease in domestic bank loans to group-affiliated firms. The result
holds after instrumentation of foreign bank location.5

In the next section, we develop a simple theoretical model to explore how entry by banks
more skilled at lending to high-quality, less opaque customers may affect the credit market
equilibrium and welfare.

III. CREAM-SKIMMING EFFECTS OF FOREIGN BANK ENTRY: THEORY
In a world of perfectly competitive markets and full information, foreign bank entry in poor
countries should undoubtedly be welfare improving. With access to better technology, more
opportunities to diversify risk, and, possibly, better corporate governance, these banks should
be able to offer more attractive interest rates and increase the volume of credit. When
information about borrower quality is imperfect, on the other hand, banks have to screen and

5 Gormley (2005) also presents a theoretical model in which foreign banks have higher
monitoring costs but lower funding costs than domestic banks. In this model, foreign bank
entry can result in less credit being made available to creditworthy but lower-quality
borrowers.

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monitor perspective borrowers. If foreign banks have an advantage only in lending to the less
opaque customers, the effects of foreign bank entry on credit availability, efficiency, and
welfare are not clear-cut. In this section, we develop a theoretical model to shed light on this
issue. The model is a simple variant of the standard credit market model with adverse
selection.

A. The Model with Only Domestic Banks
There are two categories of agents, banks and entrepreneurs, and two time periods. Banks are
perfectly competitive. They have access to a perfectly elastic supply of funds, and their cost
of funds is normalized to one. Entrepreneurs are risk-neutral and are one of three types
θ ∈{H, S, }
B randomly assigned in the first period. The proportion of each type of
entrepreneurs is given by µ ∈{µ , µ , µ , where µ + µ + µ = 1. Each entrepreneur
H
S
B }
H
S
B
knows his type, but other market participants do not; he has no private resources and must
obtain financing from a bank.6 Banks can raise unlimited funds. Individuals of type B (the
bad borrowers) have access to a risky project which requires an initial investment of one unit
and returns R > 1 units with probability p in period two. The project is assumed to have
negative net present value, i.e. pR < 1, but limited liability makes it an attractive “gamble,”
so if B types receive financing they invest. Entrepreneurs of type H and S have access to an
identical, safe, socially efficient project requiring an initial investment of size I = 1 and
returning R > 1 in period two with probability one.

Two monitoring technologies allow banks to identify the type of an agent ex ante. Through
the first technology, which costs c per project, banks monitor hard information, such as
H
balance sheets prepared according to transparent accounting standards or assets that can be
used as collateral. Based on this information, banks can perfectly identify agents of type H ,
but cannot separate out type S entrepreneurs from types B . To identify type S entrepreneurs,
banks must monitor soft information, such as the person’s entrepreneurial skills and honesty.
The soft information technology costs c per project. We assume that monitoring soft
S
information is more costly than monitoring hard information ( c > c ).
S
H

At the beginning of the first period, banks offer potential customers a menu of contracts
consisting of one or more interest rate/monitoring strategy combination. For instance, a bank
may offer an interest rate with no monitoring, another interest rate with monitoring of the
applicant’s hard information, and a third interest rate with monitoring of the applicant’s soft
information. Perspective borrowers choose one of the contracts on offer or decline to borrow.

In this setup, there are four possible equilibrium outcomes. Consider first the pooling
outcome (equilibrium A), in which banks offer a contract involving no monitoring and all

6 The model could easily be enriched by adding moral hazard and collateral constraints. The
main conclusions would hold or even be reinforced.

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