Influence of foreign bank entry on small firm credit availability : implications of information differences in emerging economies

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Influence of Foreign Bank Entry on

Small Firm Credit Availability

Implications of information differences in emerging economies

Matthijs Kooiman 0178888

Bachelor Thesis International Economics and Finance 2nd Version: February 13, 2006

Professor Enrico C. Perotti Ph.D.

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Introduction

For many decades emerging economies have been target for foreign banks to expand their business in these markets. Since the beginning of the 1990’s the Central and Eastern European (CEE) countries have been the subject for banks to settle there, and since May 1st 2004 ten new countries entered to the European Union (EU), there are even more incentives to focus on that market.

I want to give an overview of foreign bank entry in emerging economies and the different issues this brings up for foreign banks, domestic banks, host countries and domestic firms. I especially want to look at the effect on the credit availability for small firms in emerging economies. As a motivation to study these matters are the increasing entry figures in the Central and Eastern European countries. Therefore I will begin with a descriptive chapter on the accession countries.

First I am going to establish how emerging the accession countries really are. I will do this by looking at some main economic development indicators, and establish the advantages of foreign direct investment (FDI) in emerging economies. Then I will look at the advantages for foreign banks to put up a branch or subsidiary in an emerging economy and the advantages for the host country to welcome these banks in their markets. I will focus on corporate banking rather than consumer banking.

Next I will handle the issue of information differences within different kinds of organizational structures. I will explain the difference between soft and hard information and the impact these different kinds of information can have on the available credit lines for local small and medium-sized enterprises (SME).

I would like to conclude with an explanation of what could be the developments in the financial markets of Central and Eastern Europe. What will be the role of foreign banks and of the domestic banks? Is there room for both of them, and will the SME still be able finance its operations.

This thesis will comprehend no more than a literature overview of the aspects that I want to research. In the future I plan to extend this with more empirical work to see the results of foreign bank entry on the firm’s level.

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1 Central and Eastern European Markets

The ten accession countries are all located in Central and Eastern Europe (CEE), except for Malta and Cyprus (figure 1). In general these countries are labelled as emerging economies, and several research papers have concluded that economic development matters a great deal for foreign banks to enter specific countries. And that it also has great influence on the domestic financial sector. The main arguments are that domestic banks are pressured to reduce costs, increase efficiency and increase their diversity of financial services through the increased competition. This furthermore would lead to lower interest rates and lower profit margins for the domestic banks (Lensink and Hermes, 2004, pp. 555-556).

Figure 1: 10 new member countries

In order to decide the level of development of these new member countries I have listed some tables with the main indicators for economic development of the ten new countries in comparison to the European Union.1 These indicators are the GDP per capita, the GDP growth and the inflation rates for the last ten years. The EU figures are separated in the EU as it is today with 25 countries and the EU as before May 1st without the 10 accession countries.

1_{The tables are derived from tables of 31 European countries that are available at epp.eurostat.cec.eu.int.}

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1.1 GDP development

In table 1 the GDP index figures of the ten new member states are shown, per capita in terms of purchasing power parity. The numbers are relative to the European Union with 25 countries, which is set at 100. Since the figures for 2005 are all forecasts, I will look at the 2004 figures.

Table 1: Gross Domestic Product per capita in Purchasing Power Parity

The European Union’s index as it would be without the new member states was 108 in 2004, while the average index for the new members was 59.9. That is a significantly lower index than the EU with and without the new members. However, the prospects are that all countries (apart from Malta) continue to grow in the next two years. For 2007 the average GPD index is forecasted to be 65, which is an average annual growth of 2.76%. This in contradiction to the rest of the Union (15 countries), who’s GDP figure is forecasted to decrease to 107 the coming 2 years.

In table 2 the real GDP growth figures are listed. The growth in 2004 for the EU in total was 2.4%, and for 15 countries 2.3%. This is not a very significant difference, but there are some other noticeable figures in the table. The average growth rate of the 10 accession countries for example was 5.25%. Latvia was growing at a pace of 9.8% in 2004 in will continue growing with high figures. Also Lithuania has been growing strong, 10.5% in 2003 and it is forecasted to grow 5.8% in 2007.

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Table 2: Real GDP growth rate %

The only country that doesn’t show strong growth is Malta, which shows slow growth figures since 2001 and even showed negative growth in 2003. The reason for the deviating figures of Malta is that its economy isn’t comparable with the rest of the accession countries. Malta has been relatively developed for ages, since it has been a part of the United Kingdom since the 19th century until 1974. Thereby Malta’s economy relies for a great deal on tourism, but following the September 11th attacks, the tourist industry fell back worldwide, and Malta suffered too (U.S. Department of State, 2006). However, forecast is that growth for Malta is going to develop again, but it stays well under the EU average the coming years.

On average the growth rates of the accession countries outperformed the EU in the last ten years and will remain to do so the coming years. Yet looking at the difference of the two EU growth figures, they contribute little to the EU as a whole.

1.2 Inflation

The average inflation rate of the accession countries in 2005 was near 3.1%, which is 1% higher than the former 15 EU countries. But even though this is still a higher figure than the EU, the real high inflation rates are observed in the mid 1990’s, until the beginning of the millennium. Looking at 1996, inflation in Estonia, Lithuania and Hungary reached figures around and more than 20%. For the other countries inflation also reached heights well above the European level. This peak slowly decreased towards the beginning of the millennium and in 2003 there was even a little deflation in the Czech Republic and Hungary.

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Table 3: Inflation figures

The rapid slowdown of the inflation rates is due to the conditionality of the Maastricht criteria, which the accession countries had to satisfy. The Maastricht inflation criterion states that the inflation rate should not exceed by more than 1.5 percentage points of the three best performing member countries of the EU.

It is not entirely possible to keep the inflation rates that low for these countries, which is explained by the Balassa-Samuelson effect. This theory states that higher productivity in the tradable sector leads to higher prices in the non-tradable sector and thus a higher domestic price level. This is often the case in emerging economies and causes high inflation rates. However, in a BIS working paper Mihaljek and Klau provide extensive econometric evidence that the Balassa-Samuelson effect can’t be accounted for the whole inflation differential of accession countries vis-à-vis the Euro Area. They calculate that it can only be accounted for 0.2 to 2.0 percentage points (Mihaljek and Klau, 2003, p.1). But even then the only country that may have other factors that influence their high inflation rate is Latvia.

Looking at the indicators above the accession countries in general have the characteristics of emerging economies. Gross Domestic Product figures that fall way behind the GDP level of Europe, while the GDP growth figures outperform the growth figures of the European Union. While the inflation rates of the mid 1990’s look like those of underdeveloped countries, the current levels look more like under control. But altogether they differ among each other and have a volatile character, and stay relatively high compared to the European Union average.

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The knowledge that these are economies with have high growth and relatively low inflation figures, makes it clear these markets serve foreign banks well. There is obviously a need to finance this growth and they have large investment opportunities. However, banks where already present in these markets before the 10 countries accessed the European Union. So even though economies can be less open towards foreign presence of large corporations or financial institutions, they already attract FDI. In the next chapter I will explain the reasons for banks to go abroad and for host countries to welcome foreign banks.

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2 Foreign Bank Entry

Foreign bank entry (FBE) is a form of FDI that has been exercised for long, but since more countries open up their capital accounts for FDI, foreign bank entry is an increasing process in emerging economies. A research conducted by the IMF in Europe, Latin America and Asia shows that the degree of foreign bank entry increased dramatically in these economies since the second half of the 1990s, and the increase in European emerging economies where by far the largest (International Monetary Fund, 2000, p. 153). The amount of bank assets in foreign hands countries as the Czech Republic, Poland and Hungary has increased from 8 percent in 1994 to more than 50 percent in 1999 (Table 4).

Table 4: Foreign bank ownership in selected emerging economies1

Source: International Monetary Funds

A FBE can be done by either setting up a branch (a store, a bank, or another organization that is part of a larger group and is located in a different part of a geographical area from the parent organization) or a subsidiary (a company controlled or owned by a larger one). Other forms of participating in a foreign country are a joint-venture or a minorities share in a domestic bank. The last two are especially interesting in counties with severe asymmetric information problems, in which case the domestic bank can provide the necessary inside information.

For a foreign bank and a host country it has several advantages to either set up a branch in another country or welcome the banks. It has however more advantages for less developed countries than developed counties. The rest of this chapter provides the main reasons for banks to

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go abroad and for host countries to welcome them, to see whether a win-win situation can be achieved.

2.1 Reasons for Banks

Reasons to go abroad for a bank depend on a few location-specific factors. Three main reasons can be distinguished; the degree of economic integration of the home and host country, the opportunities in the host country and host country regulation.

“Follow the costumer”

The first directs to the “following the costumer” argument. Multiple studies have proven a significant and positive relation between the amount of a bank's FDI and the degree of integration between the home and the host country. However, these studies mostly apply on developed countries and not on developing, since most research is done in the United States. In developing countries it could be the other way around, which is referred to as the “lead the costumer” argument. Foreign banks face little competition in developing countries, so they have lots of opportunities to develop financial services, and this could attract FDI of other non-financial firms. However, according to this theory the actual ‘following the costumer’ argument is of less value in developing countries (Clark,Cull, Martinez Peria and Sánchez, 2001, pp. 4-10).

Host country opportunities

In a study on cross-border shareholding in the banking industry Focarelli and Pozzolo (2000) find that one reason is the opportunities in the host country. They conclude after extensive research that foreign banks are more likely to enter when the host countries show goods growth prospects and the banking system is less efficient. They find that GDP per capita and inflation correlate negatively with foreign bank presence. Also foreign banks are more eager to enter when local banks have higher average costs, lower interest margins and higher cash flows. These are typically signs of inefficient use of capital.

Degree of regulation

The third argument is the degree of regulation in the host country. Focarelli and Pozzolo (2000) find that banks rather invest in countries with lower degrees of regulation. Barth et al. show that countries with higher restrictions on banking activities come with higher net interest margins and overhead costs (Barth, Caprio and Levine, 2001 b). Also an important aspect of regulation is the

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legal environment. If banks face a lot of legal procedures before they can set up operations in the host country, they will be less more likely to enter. Thus heavy regulation will work more as a disincentive probably than lower regulation works as an incentive to invest in a country.

A lot of research on this topic is based on the United States in the early 1980s when the regulations in the different states of the US favoured foreign banks above domestic ones. The result was that foreign banking increased rapidly because regulations across states were not set homogenous. When the regulations became more homogenous by several acts the degree of entry decreased (Goldberg, 2001). But due to the individual state regulations it is an interesting case, and it has had great influence on the nature and pattern of foreign banking participation (Clark, Cull, Martinez Peria and Sánchez, 2001, p.9).

2.2 Reasons for the Host Country

There are a number of reasons for the host country to welcome foreign banks to establish a branch or subsidiary in their country. Especially in the case of an emerging economy the presence of foreign banks could have a positive influence on the domestic banking sector.

Efficiency

According to Corsetti, Pesenti and Roubini (2001), who did a study on the influence of foreign banks during the Asian Crisis of 1997-1998, a closed financial market could lead to suboptimal behaviour of domestic agents. With foreign competition the domestic banks are forced to act more efficiently. Phrased differently, allowing foreign banks to own domestic financial institutions leads to the ‘import’ of the strict international standards. In an article on short term effects of foreign bank entry on the domestic financial sector, Lensink and Hermes also come up with the efficiency argument, which should lead to lower interest rate margins and profit. They also point at the increased competition and the improvement of the quality of the banking system (Lensink and Hermes, 2004, p.555).

Involvement

Moreover Corsetti et al. argue that when foreign banks directly operate on the domestic market, they also own stakes in domestic firms which makes them more concerned with the domestic corporate sector. So they will not withdraw quickly of the market when things are not going that well (Corsetti, Pesenti and Roubini, 2001, p.34).

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Government influence

Another argument presented by Corsetti et al. is that the need for the monetary authorities to act as a lender of last resort will be reduced. This is because the foreign branches are often part of larger international groups, which secures their liquidity by intervention of the parent organization (Corsetti, Pesenti and Roubine, 2001, p.35). Lensink and Hermes also argue that foreign bank entry may contribute to a reduction of government influence in the domestic banking sector, which could lead to a reduction in the importance of directed credit policies (Lensink and Hermes, 2004, p.556).

Spill-over effects

Lensink and Hermes also emphasise the positive spill-over effects. They argue that foreign banks may introduce new financial services and banking techniques that may be copied by the domestic banking sector. In the case of a joint-venture of a take-over, foreign banks may improve the management of the banks, and due to improvements in regulation and supervision the quality of banking operations of domestic banks may improve.

Human Capital

The last argument they use is the increase in quality of human capital. This is possible because foreign banks import high-skilled managers to work at their branches, who can teach their practices to the local employees. Moreover, the foreign banks can invest more in the training of local employees (Lensink and Hermes, 2001, pp.555-556).

Important to emphasise is that according to Lensink and Hermes most of these effects may happen on the long run in less developed markets, but on the short term the cost of domestic banks rise due to investments they have to make to implement the changes. And due to the amount of market power domestic banks still have in the short run they are still able to raise the interest rate margins.

2.3 Examples of Foreign Presence

Since I already mentioned that foreign bank entry is not a new development, but emerged dramatically since the beginning of the 1990’s, I want to put some examples next to that. I will give three short examples of banks that have presence in CEE countries.

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The HSBC Bank is one of the largest globally operating financial institutions of the world. In CEE they have offices in Cyprus (124), the Czech Republic (9), Hungary (12), Malta (61), Poland (10), and Slovakia (2). And in Turkey (although not a member of the EU yet but still a candidate) HSBC has 165 offices already. The operations of HSBC range from consumer finance to corporate banking services (HSBC Group, 2006).

Citibank’s first CEE regional office opened in 1985 in Hungary, and they have presence in the Czech Republic since 1991. Around the same time Citibank established in Poland where they merged with Bank Handlowy w Warszawie SA in 2001. Furthermore they have presence in Slovakia, Romania, Russia and the Ukraine. They also own a subsidiary and 24 branches in Turkey since 1975. Citibank’s operations ranges from retail banking to wholesale banking (Citibank, 2006).

ABN AMRO owns two branches in the Czech Republic and two subsidiaries in Poland. And although they are not a part of the EU, they have 15 branches in Romania. All operations where set up in the early and mid 1990’s. In Turkey they are the oldest foreign bank, since 1921, and rank among the top 3 banks at this moment. All operations differ among the countries but involves investment banking and corporate clients. They do however aim at developing strong relations with local companies as well as their multinational clients (ABN-AMRO, 2006).

These are three concise examples of foreign bank presence in CEE countries and there operations in that in those countries. Next thing I want to take a look at are the differences in information that these banks have to assess once they are faced with foreign SME’s.

Above described are all examples of foreign bank entry and the positive effects for host countries and foreign banks that can occur when foreign banks enter an emerging economy. But these are not the only effects that take place. There will be a huge change in credit supply since foreign banks and domestic banks pursue different goals and operate in different ways. There is a large possibility that small and medium-sized enterprises will have less credit availability due to the fact that they are not an interesting target for foreign banks. A factor that plays a major role in that is the difference in information produced by SME’s and the different ways of credit approval by the foreign and domestic banking sector. In the next chapters I will go deeper into this subject of information differences and the impact it will have on the local SME’s.

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3 Information Differences

Now that we know that the Central and Eastern European countries are interesting markets for foreign banks to set up operations and we also have established the advantages for the foreign bank and for the host country, we want to take a look at what take place once foreign banks set up operations in an emerging economy. The focus will be on the information differences that exist between the foreign banks and the local SME’s.

The foreign banks have to operate in an environment they are not completely familiar with and have to deal with firms that they do not know. The foreign bank has to assess credit applications of all sort of firms, and not only the big corporations they followed the other country or new firms with a lot of growth opportunities. They also have to deal with SME’s that were a former client of the domestic bank they took over, formed a joint-venture with, or are stakeholders in another way. The problem with that is that each firm produces different kinds of information, which can be classified from soft to hard information, and each organization has a different way of gathering and assessing these kinds of information.

Soft information includes for example a character assessment of the entrepreneur and the degree of trust. Examples of hard information are financial statements and credit history (Gianetti and Ongena, 2005, p.12). An important difference between the two sorts of information is the degree in which it can be passed over to others. Soft information is often only valuable for the information producer, while hard information is understandable for anyone and can be passed on to different levels of an organisation. Soft information has more of a qualitative character whereas hard information contains more quantitative characteristics (García-Appendini, 2005, p. 2).

Evidence shows that the use of soft and hard information depends a great deal on the organizational form a corporation has. Stein (2002) refers to “organizational diseconomies”, with which he indicates that soft information is more attractive in small, decentralized and “flatter” organizations, while for large hierarchical organizations it is more attractive to work with hard information. The obvious advantage in this case is that hard information can be much more easily transferred among the multiple layers of the firm (Stein, 2002, p. 1892). He applies the information problem to the banking industry. He argues that a loan officer that works under full decentralization, i.e. he is also the CEO of the local bank, will have more research incentives to

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define the quality of a loan because it is for sure that the capital allocation stays within his operating unit.

In a hierarchical organization capital allocation over the different operating units is decided from above in the hierarchy. So the line manager is never certain of the amount of capital it is going to be able to work with. This gives him less incentive to do a lot of research on different investment projects and he would settle for harder information. Another aspect is that the line manager will be very eager to make sure the capital allocation is in favour of his unit, and thus will produce this kind of information that can be passed on easily to its superiors, to convince them that he needs the largest possible amount of the total capital budget (Stein, 2002, p.1893).

As Stein researched the information differences in a theoretical framework, by putting together a model that measures the degree of efficiency used by managers to acquire information within decentralized and hierarchical organizations, in a paper by Liberti (2005) the topic is clinically researched. Liberti explored the hierarchical decision-making approval process in a foreign bank. He used a large foreign bank in Argentina for this purpose.

Liberti studies two dimensions of the organizational structure, namely the vertical and the horizontal dimension. The vertical dimension is described by the levels of approval a loan application has to go through before a decision is being made. The horizontal dimension depends on the number of account officers that work in a team and have to report to a supervisor. In his study on the vertical dimension he comes to a number of conclusions. His first conclusion is that loan approvals that have to be judged at higher levels of the organization contain more hard than soft information. Also loans that need a large amount of signatures and obtain a longer period of time to obtain approval contain more hard information.

Next result he finds applies to geographic location. He concludes that a loan that needs the same level of approval contains relatively more soft than hard information if direct communication is possible with the final officer. That means that “inside” branch loans contain different information than “outside” branch loans. Complexity of loans doesn’t seem to have any influence on the information differential. Under his assumptions of credit complexity there is at no level of approval any suggestion of differences in information usage. In the horizontal dimension the team size matters also for the sort of information used. Easier communication and access to the

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supervisor requires less hard information and reduces the costs of transmitting soft information (Liberty, 2005, pp.4-5).

One other noticeable topic Liberti studied is the quality of information. How soft is soft information and how hard is hard information. The results of that are that some soft information behaves as hard information. If soft information has a degree of subjectivity so that it is easily to transmit or verify, it can be treated as hard information as it moves up in the hierarchy for approval. Then there is the question of the hardness of hard information. If the information doesn’t comply with the measures of reliability, the explanatory power of hard information decreases. Soft information is being used more heavily in the vertical dimension, if the hard information is unreliable (Liberty, 2005, pp.6-7).

Information differences play a major role in the credit approval process. And different organizational structures use different kinds of information. Next thing I would like to study is the influence of these information differences on the SME’s that operate in the emerging economies. To what extent will they be influenced by the presence of foreign banks?

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4 Implications of Information Differences

An important aspect of foreign bank entry which has been subject of little attention is the effect on the SME or the small entrepreneurial firm. So far empirical work has mainly focussed on the positive impacts of equity market liberalization. Studies show that it decreases the cost of capital, causes investment booms, and increases growth. Since these studies mainly include listed firms, there is little known about the benefits for non-listed firms, which are the small and medium enterprises (Gianetti and Ongena, 2005, p.5).

The reason why this would be important for the case of foreign bank entry in emerging economies is the following. It is the case in the last several years that the banking industry is consolidating enormously, resulting in larger banks, which tend to lend less to smaller firms, even if these projects might have positive NPV’s (Berger, Demsetz and Strahan, 1999). Banks that expand there business abroad are in general large financial institutions. More often these institutions are hierarchical organized, instead of decentralized. As we have established earlier hierarchical firms often rely more on hard than on soft information.

Second important thing is that in the emerging economies not very much large firms are located but instead a lot of small businesses. There is also evidence that small businesses produce little hard information, so rely on their soft information supply (Berger and Udell, 2002). This could conclude that small business lending would decrease on a large scale if foreign banks take over the market in another country, since they simply don’t rely on the type of information the local businesses produce.

Another reason why small firms may not benefit from foreign bank entry is that foreign banks may have a lack of information of the local market. This is a major problem in countries with severe asymmetric information problems and weak legal enforcement (Acharya, Sundaram and John, 2004). If foreign banks compete domestic banks away the situation for small firms would even deteriorate. This could be altered however when a foreign bank sets up a joint-venture with a domestic bank. The domestic bank can provide the foreign bank with the inside information on the market and the players.

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All mentioned above could thus lead to a worse position of SME’s in these emerging economies. And if they do benefit from the financial integration, it will be to a lesser extent than the large established firms (Gianetti and Ongena, 2005, p.6).

However, since the strong development of the Eastern European countries came only in the early nineties, the banking sector was still an underdeveloped system and the banks lacked expertise in efficiently allocating loans. It is therefore possible that the destruction of soft information on small firms has been minimal. In countries with more developed banks and more experience in extending credit the loss would probably higher in case of an acquisition (Gianetti and Ongena, 2005, pp.33-34).

Another new insight on the implications of information differences is given by García-Appendini, who empirically investigates the use of soft information in bank lending. For that purpose she uses a separation in “transaction banking” and “relationship banking”. The term relationship banking or lending refers to financial institutions that have overcome the asymmetric information problem that exists between the banks and the firms’ managers on certain projects. They have been able to gather information about the firms through different channels, from which the most important information is trade credit (García-Appendini, 2005, p. 3).

Trade credit is given by a firms’ input suppliers. Banks can gather the trade credit information and use it to value their credit applications. García finds that transaction banks are less likely to grant a loan to firms on which they have negative information on trade credit, i.e. firms that are paying the supplier after the due date. However, with relationship banks this negative information does not affect the decision of granting the loan at all. In other words, a relation banks rather relies on its own information than on others information (García-Appendini, 2005, p 3).

The main important result with respect to soft information here is the following: relationship banks tend to rely more on their own gathered soft information supply on a SME’s. Only when there is not enough soft information available, the information on trade credit becomes an important determinant on the firms’ credit applications (García-Appendini, 2005, p. 3).

Furthermore, banks tend to use only negative information on a firms’ trade credit in their credit approvals. Positive information is not incorporated in the banks’ credit approval (García-Appendini, 2005, p. 37).

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Conclusion

In this thesis I wanted to give some insight in the developments around foreign bank entry in CEE countries and the difficulties that surround that with respect to information differences and SME’s lending. The CEE countries have offered attractive investment opportunities since in the beginning of the 1990’s the financial markets started integrating with the Western European markets and their equity markets started liberalizing. Since they had to satisfy the Maastricht criterion of low inflation figures to access the European Union in 2004, they have created even a more stable investment climate.

For the emerging host countries there are quite some advantages of the foreign bank establishing in their economy. Foreign banks can increase the efficiency level, they can reduce the need for monetary authorities to act as a lender of last resort, bring positive spill-over effects and increase the quality of human capital. Yet, these advantages only hold in less developed economies and on the long run.

However, due to information differences, soft versus hard information, some disadvantages on the level of the small and medium-sized enterprise can arise. SME’s rely more on soft information, and foreign banks act as large hierarchical organized institutions that rely more on hard information. This could mean that SME lending decreases if foreign banks take over the market.

It could be though, that foreign banks do not just take over the market, but rather take minority shares or set up a joint-venture with domestic bank. In that case the domestic bank can still have influence on the kind of information that is used to approve credit. And since there is empirical evidence that banks that built relations with small firms rely more on their own soft information supply, this could be an advantage for the local SME’s that have long relationships with domestic banks.

Another possibility is that foreign banks and domestic banks are going to specialize in different sectors. Foreign banks main business is corporate banking,, so they can provide the larger corporations with financial services. Domestic banking sector can keep serving the local SME’s, and both sectors could survive. There could be enough space for that, since the larger corporations are also mainly new entrants in the markets.

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To draw these kinds of conclusions further research has to be done, and extend to the question how for example foreign banks initially enter a country. Do they set up a branch, a subsidiary, a greenfield, a joint-venture, or do they take-over or merger with a domestic bank, or take minority shares? Once you can establish the structure of the organization, you can say something about the way they handle information, and thus about the likelihood a SME will survive in this liberalized market.

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Influence of foreign bank entry on small firm credit availability : implications of information differences in emerging economies