Literature Review

In many countries, the entry of foreign banks has been increased on a high scale during the 1990s especially in the countries which are less developed. Due to financial linearization policies, the entry of foreign banks operations increased during the early 1990s which in turn allowed foreign banks to set up their branches in host country and performing their operations (Claessens, et al. 2001).This rapid growth has led to many questions that are being raised for their presence in the domestic banking markets. The three major consequences which led to their tremendous growth are competition which will be affected by their presence, the efficiency of domestic banks and the less proof that we have about this consequences (Liebscher, et al. 2006). The only broad study was based on Claessens, et al. (2001) analysis which focused on the efficiency and competition effects of foreign banks entry. This study had various variables which measured income, profits and costs of domestic banks reflecting changes in both competition and efficiency of domestic banking markets. It was a turn-around i.e. a negative relationship between the presence of foreign banks and factors like profitability, non-interest income and extra curricular income of the domestic banking markets. The size of the banks in terms of market share was supported by Claessens, et al. (2001) study due to only presence of foreign banks due to three factors. First, it led more demands for domestic banks to give up their profits and huge income. Secondly, it forces domestic banks to prove them to be more efficient which in turn will reduce costs. And finally, domestic banks will try to portrait few of the banking techniques and practices which will reduce costs.

Though many emerging countries fear about letting foreign banks enter their host country, the liberalization of banking policies have made it clear that in an open market, they can face challenges about the entrants of foreign banks in the host country and their efficient working styles (Liebscher, et al. 2006). The entry of foreign banks will lead to two major effects. One, the domestic banks will be in the bad loans section due to attractive power of foreign banks and good practices which they follow. Two, the local banks can benefit from their better technologies that they use for learning. Though there will be competition possessed by both the domestic and foreign banks, one thing is for sure that domestic financial market will gain by lowering the interest rates for taking a loan (Mathieson, Schinasi and International Monetary Fund 2000). The authors Caprio and Honohan (2002) has discussed in more details about the factors which led to increase role of foreign banks in emerging markets. They said that the increase in ownership of foreign banks in emerging markets is one of the faces of the ongoing consolidation of banking system in both developed and emerging markets. The globalization of financial services industry, banks are facing more competition from non-bankers for credit and financial services, particularly security markets, which has put immense pressures on the interests rate margins and profits, which in turn has led to a change in the franchise value of banks (Folkerts-Landau and Chadha 1999). In the recent decades, banking has become information, communication and computation intensive industry. There is a decline seen in both domestic and across border to handle these activities (Mathieson, Schinasi and International Monetary Fund 2000).

In many less developed countries, there is an inefficiency which is seen in domestic banks and there is a lack of competition among lenders in high borrowing costs and there is a limited financial access for many firms. The entry of foreign banks may increase the supply of credit and improve efficiency, by increasing the competition. However many banking theories have found an asymmetric relationship which demonstrates reducing access to credit for some firms by greater competition (Petersen and Rajan 1995). There is a huge amount of money involved in finding information about local firms which may limit foreign banks to cream-skimming, where they lend only to that firms who are more profitable and which adversely affect both domestic banks and firms that rely on them (Gormley 2007). The general liberalization of banking policy, many emerging markets have been reducing barriers to trade in the financial service since the early 1990s. There have been many significant changes in the restrictions of entry of foreign banks which have been motivated for improving the level of competition and efficiency in the banking sector. Mainly they have been triggered just to reduce the cost of restructuring and recapitalization which in turn is building an institutional structure in the banking sector which is healthier to future domestic and external shocks (Mathieson, Schinasi and International Monetary Fund 2000).

Effects of foreign bank entry

There are many effects which have given a sharp rise in the level pf participation of foreign banks entering a host country. The host’s country in which the foreign banks enter have a clear evidence that by entering into emerging markets, there will be an overall positive effect in the banking system in terms of its efficiency and stability of the system. Allowing foreign banks to enter is typically viewed as having the most beneficial effects when such entry occurs in the context of a more general liberalization of trade and production of financial services. It has been argued that general liberalization of trade in financial services induces countries to produce and exchange financial services. This in turn allows the domestic banks to inherit few of its services that are helpful in nature. This would be especially true for foreign branches of international banks since they are supervised on a consolidated basis. For example, the local subsidiary of international banks is an entity on its own Caprio and Honohan (2002). Failure of that will be in turn monitored by the parent bank. The new products and services provided by the foreign banks will give an idea for the domestic banks to follow the same to be more efficient by upgrading the quality and size of its staff. The branches and subsidiaries of major international banks have good practice of disclosure, accounting and reporting requirements that are closely aligned with international best practices. To inculcate this into the domestic bank market, the overall quality of the information about the state of the banking system will be improved on a high scale. Also, when crisis arise, foreign banks help the domestic residents to do their capital flight at home, thus, adding stability to the system. On the other hand, many argue that the entry of foreign banks in host country can worsen the banking system. If the domestic banks have weak capital and are inefficient in nature, for example, they may respond opposite to increase foreign entry by undertaking high risks activities in an attempt to earn good returns. It has been seen during the early period of liberalization that foreign banks tend to attract or take less risky customers i.e. cherry-pick the most creditworthy domestic markets and customers, leaving behind more risky customers for the domestic market to serve. This happened during the liberalization period which hold loans with fixed interest rates and had to compete with other financial firms that were lending it on higher rates and offer high deposit interests rates. During this period, many disadvantaged institutions got worse; few of them undertook high returns with high risk activities (Mathieson, Schinasi and International Monetary Fund 2000). Apart from the impact of foreign bank entry upon the stability of domestic banks, there have been also concerns about the behavior of foreign banks. During the crisis period, it was noted that foreign banks were involved in lending money to cross border financial firms than to lend it to domestic firms who were badly affected. In this way, the behavior turned out to be opposite thus violating the international practice that was followed. Finally, the issue concerning the supervision of foreign banks is of great concern. The entry of foreign banks is a means of importing supervision for at least a portion of the banking system, simultaneously improving the quality of staff and practices of domestic supervising. They site the examples of Banks of Credit and Commerce International which has fallen between the cracks that complex cross-border financial transaction undertaken by international banks may be difficult to supervise by either the host or home country supervisors (Mathieson, Schinasi and International Monetary Fund 2000).

Despite worries that foreign firms could destabilize domestic finance, some countries have remained low on admitting the fact that foreign owned financial firms could destabilize the local financial system, thus, putting them out of business. It was seen that the prosperity of foreign banks in the host country tends to be correlated with that of the countries in which it operates; it would rather show a long-term commitment to the host countries. There is very little evidence to support these fears, despite the growing presence of foreign owned financial intermediaries, by improving the overall operating efficiency, thus, gaining improvements in both official and private elements on the financial infrastructure and long term growth (Levine, Loayza and Beck 2000).

Foreign banks become more than niche player in financial sectors. In high income and upper middle income countries, they represent more that one in five of the banks which usually account for much less than 10 percent of local banking assets. Thus, they become niche player in catering international trade business and foreign companies. Even before the expansion takes place in the host country, foreign owned financial firms have a huge share in poorer countries. Even if they have high operating costs, foreign owned banks are more profitable than local banks which imitate their investment in good quality services. They also have high interest margins and high tax payments. The smaller the country the more likely is to reply on foreign owned banks. But few big countries like India and Indonesia have good amount of share of these foreign owned banks Caprio and Honohan (2002).