Early this month, 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.”

The RBI 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 result ,“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. 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 for new premium customers for a year.

Deeper problem

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 structural shift. During the first two and a half decades starting in the 1960s, 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.

Emerging trends

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. Finally, there is other evidence that the activity of financial capital had acquired a degree of independence with a weakening of its relationship 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. 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 reportedly traversed from a relative flat trajectory to a steeply rising one.

Associated with this growing exposure 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 stabilised in 2003.

Shift in ownership

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 Republic 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.

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. 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.

Retail focus

Not surprisingly, with this increase in presence, the share of foreign banks in lending to non-bank residents has been rising. Since the mid-1990s (and by 2009) the share of foreign banks in credit 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 is that the international banks involved are predominantly European. Around three fourths of foreign claims in developing countries are on account of European Banks (Chart 2). 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. 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.

Supply-side push

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 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.

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