The latest edition of the New York Fed’s Current Issues in Economics and Finance, Has Foreign Bank Entry Led to Sounder Banks in Latin America? is available.

A comparison of the 1995-2000 performance of foreign and domestic banks in select Latin American countries, this study concludes that foreign banks showed higher loan growth, a more aggressive response to asset quality deterioration, and a greater ability to absorb losses than their domestic counterparts. Although foreign and private domestic banks differed little in their overall financial condition, foreign banks’ higher and more sustained credit flows offer evidence that foreign participation can strengthen the banking sectors of emerging market countries.

As authors Jennifer Crystal, B. Gerard Dages, and Linda Goldberg explain, the latter half of the 1990s saw a sharp increase in foreign ownership of emerging market banks. Local banking sectors’ need to recapitalize in the wake of severe financial crises contributed to this increase, as did the broader industry trends of consolidation, liberalization, and privatization. At present, foreign banks control majority shares in most of the larger Latin American financial systems.

To judge the soundness of foreign and domestic banks in Latin America, the authors used two forms of assessment: ratings of bank financial strength assigned by Moody’s Investors Service for banks in seven countries, and a more detailed review of the financial statements of banks in Argentina, Chile, and Colombia. The financial statement review followed the CAMEL-style approach used by regulators to evaluate bank capital adequacy, asset quality, management, earnings, and liquidity. Once the authors completed their assessment of individual banks, they sorted the results by type of bank ownership to compare the average performance of foreign, private domestic, and state-owned banks.

The ratings analysis shows that foreign and private domestic banks were closely matched in overall financial health during the period between 1995 and the end of 2000, and that both outperformed state-owned banks. The CAMEL analysis, however, reveals some important behavioral differences. Foreign banks showed more robust loan growth than private domestic banks, even when economic conditions in the host country weakened. This finding mainly reflects the strong contribution of those foreign banks with longer- established local operations. Foreign banks also appeared to adhere to stricter credit review practices, provisioning more heavily against bad loans.

In addition, foreign banks showed weaker profitability than private domestic banks, but maintained higher risk-based capital ratios. The authors comment, "Foreign banks seemed more willing to tolerate, or could better afford, lower returns in the near term for the sake of building longer-term institutional strength." This approach, the authors suggest, "signals a strong commitment to local markets."

While the authors call for more research on these issues, they contend that their results "support the potential for foreign ownership . . . to contribute to sounder and more stable banking systems in emerging markets."

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