Early in May this year, India's central bank, the
Reserve Bank of India, issued an unusual set of guidelines
for foreign banks operating in the country. The notification
stated: ''It has been decided that for all foreign
banks operating in India, the CEO (chief executive
officer) will be responsible for effective oversight
of regulatory and statutory compliance as also the
audit process and the compliance thereof in respect
of all operations in India.''
For those accustomed to normal principles of corporate
governance, this official notification must come as
a surprise. Who other than the CEO of a company would
be finally responsible for compliance? The RBI, however,
had a reason to state the obvious, based on allegations
of fraud in branches of banks such as Citibank and
Standard Chartered Bank. ''It is observed,'' it noted,
''that Indian operators of foreign banks functioning
in India as branches of the parent banks generally
do not have a separate audit committee vested with
the responsibility of examining and reviewing inspection/audit
reports for their compliance.'' As a result in its
view, ''In the recent past there have been concerns
about the adequacy of regulatory compliance by foreign
banks in India and it is felt that this is on account
of business heads and units reporting directly to
their ‘functional heads' located overseas and not
to the CEO of Indian operations.''
To deal with this, the RBI is also contemplating institutional
requirements that would improve regulatory oversight.
As opposed to allowing foreign banks to function through
''branches'' of units registered abroad, it is expected
to soon require foreign banks to operate in India
through wholly owned subsidiaries registered in the
country. This would make the bank's Indian operation
an Indian entity and facilitate regulation.
The problem is not restricted to India. Indonesia
has experienced a recent instance of fraud in which
a relationship manger allegedly spirited $2 million
from the accounts of customers. In response, the Indonesian
central bank has banned Citibank from canvassing new
premium customers for a year.
These instances point to a much deeper problem that
emerging markets face when dealing with foreign banks,
whose presence in their economies is increasing. During
what is considered the ''second wave'' of global financial
integration since the 1960s (with the first dated
between 1890 and 1930), the relationship between international
banks and developing countries took two forms. The
first was the acquisition of international claims
by the banking system in emerging markets, involving
cross-border flows of capital to both public and private
sector targets. The second was an expansion of the
host country presence of international banks in emerging
markets, increasing deposit mobilisation and lending
by local subsidiaries in local currencies.
However, as the Committee on the Global financial
System (CGFS) noted in a 2010 report, the history
of international banking even in the period after
the 1960s has seen some kind of a sructural shift.
During the first two and a half decades starting in
the 1960s, international banking transactions were
largely between the developed countries. In the period
from the mid-1980s to the present, however, there
has been an increasing emphasis on the creation of
branches and subsidiaries in developing countries,
with focus on the retail business.
There are a number of noteworthy features of this
recent period. The first was an initial increase and
subsequent acceleration of international bank lending
in developing countries. Taking the cross-border claims
and local claims of foreign banks in both foreign
and local currencies together, the ratio of international
bank lending to developing countries rose gradually
at around 4 per cent per annum between the 1980s and
the early 2000s, and then accelerated to touch almost
double its 2002 value by the time of the financial
crisis of 2008. Second, while there was a close relation
between the ratio of international trade to GDP and
the international claims of banks relative to GDP
till the end of the last century, subsequently there
has been a sharp divergence with bank claims racing
ahead of trade. If trade had led or, at least, significantly
influenced financial flows earlier, that seems to
be much less true more recently. Finally, there is
other evidence that the activity of financial capital
had acquired a degree of independence with a weakening
of its reationship with trends in the real economy.
Principal among these was the emergence and growth
of securities and derivatives markets, leading to
a substantial lengthening of intermediation chains
and the emergence of new institutions and instruments.
Overall, even though the exposure of international
banks in developing countries is only a fifth of that
in the developed, that exposure has in recent years
reportely traversed from a relative flat trajectory
to a steeply rising one.
Associated with this growing exposure of foreign banks
in developing countries has been a significant increase
in their physical presence. According to an earlier
(2004) study by the CGFS, there has been a surge in
foreign direct investment in the financial sectors
of developing countries. The study, by examining cross-border
M&As targeting banks in emerging market economies
(EMEs), found that cross-border deals involving financial
institutions from EMEs as targets, which accounted
for 18 per cent of such M&A deals worldwide during
1990-96, rose to 30 per cent during 1997-2000. The
value of financial sector FDI rose from about $6 billion
during 1990-96 to $50 billion during the next four
years. Such FDI peaked at $20 billion in 2001, declined
sharply in 2002, but stabilized in 2003. The net result
is a clear shift in the ownership of the financial
sector. More recent evidence indicates that this figure
has risen sharply since.
It is indeed true that the M&A drive, involving
the acquisition of banks in emerging markets by financial
firms from the developed countries has been concentrated
in two regions: Eastern Europe and Latin America,
with some countries such as Slovak Republic1
and Mexico being the focus. However, there is evidence
that even Asia, where thus far the absolute share
in banking assets of foreign firms is low, has been
experiencing an increase in foreign presence especially
after the 1997 crisis.
With respect to Asia, the CGFS found that: ''The proportion
of cross-border M&As in East Asia's financial
sector initially was small compared with other regions.
The value of cross-border M&As targeting non-Japan
Asian countries was $14 billion or 17 per cent of
the total during 1990-2003. Asia, however, has been
one of the fastest growing target regions for M&A,
with a sizeable jump in cross-border M&A activity
occurring in Korea and Thailand. In addition, there
has been a large number of small-value cross-border
M&A transactions in the finance sector between
East Asian economies. In 2003, Asia received the largest
share of FSFDI inflows.''
Among the many reasons cited as explaining the desire
of banks to establish a physical presence in emerging
markets to expand their business, three are of particular
relevance. These are: (i) a combination of increased
competition and saturating business opportunities
at home; (ii) increased access to enhanced liquidity
at low interest rates as a result of monetary easing;
and (iii) greater liberalisation, better profit conditions
and improved security in EMEs. These are important
because they point to the role of supply side decisions
in driving foreign bank expansion and presence in
emerging markets.
As a result of these processes, an IMF study found,
between 1995 and 2005, the share of foreign banks
in total bank assets rose from 25 to 58 per cent in
Eastern Europe and from 18 to 38 per cent in Latin
America, though even by that date the increase in
East Asia and Oceania was much less (from 5 to 6 per
cent) (Chart 1). However, as noted above, it is likely
that the trend would have been visible in Asia as
well more recently.
Chart
1 >> Click
to Enlarge
Not surprisingly, with this increase in presence,
the share of foreign banks in lending to non-bank
residents has been rising. From the mid-1990s (and
by 2009) the share of foreign banks in credit to non-bank
residents rose from 30 to 50 per cent in Latin America,
to nearly 90 per cent in emerging Europe, but is still
at about 20 per cent in emerging Asia.
A second feature of the recent focus on emerging markets
is that the international banks involved are predominantly
European. Around three fourths of foreign claims in
developing countries is on account of European Banks
(Chart 2). Part of the reason is that mid-sized European
banks faced with increased competition at home are
now seeking out developing countries to expand business
and sustain profitability.
A third feature is that in their lending banks are
no more targeting either governments or international
corporations investing in developing countries. Rather
their focus is increasingly on retail lending, in
the form of housing-related and other personal lending.
As a result, the share of non-bank private sector
borrowers in the portfolio of foreign banks has grown
from about 25 per cent to more than 60 per cent of
claims over the 1985-2009 period. Public sector borrowers
now account for only 15 per cent of total international
claims on developing countries, ac compared with more
than 40 per cent two decades ago.
Finally, the increased presence of these foreign banks
has been accompanied by a substantial increase in
their activity in wholesale markets, including securities
and derivatives markets.
Chart
2 >> Click
to Enlarge
Thus, financial integration results in a supply-side
push of international banks into developing countries
in two senses. It involves, as in the past, an increase
in capital flows into developing countries, which
is determined by liquidity and structural conditions
in the developed countries. It also involves the creation
of branches and subsidiaries of foreign firms in developing
countries, to expand business beyond what can be undertaken
only with capital from the home country. One implication
of these developments is that the presence of these
institutions imports into the ''emerging markets''
the practices and instruments associated with the
process of financial innovation in developed countries
since the mid-1980s. Local institutions too begin
to adopt these practices and stay with them even when
events such as the recent financial crisis suggest
that they render the system fragile and crisis-prone.
This obviously means that the regulation in developing
countries must either be geared to limiting foreign
presence in their banking sectors or dealing with
new institutions, instruments and practices. The recent
moves of the Indian government indicate that while
it has chosen to relax restraints to foreign entry,
it is yet to devise an adequate regulatory frame to
deal with the resulting brave new world.
1
Between
1995 and 2002, the Slovak Republic witnessed an increase
in the share of assets held by foreign banks from
9 to almost 82 percent. In Mexico, the share of assets
held by foreign banks increased from 2.31 percent
in 1995 to 61.9 per cent in 2002 (Cull and Peria 2007).
*
This article was originally published in The Business
Line, 31st May 2011.
