Banking revolution can be good news for developing countries

Developing countries can benefit enormously from the growth of international banking, but only if they put in place the right institutional, legal and regulatory structures.

These would include better cross-frontier co-operation among banking supervisors and legal rights to property and to the enforcement of contracts.

This is the view of a World Bank report. The pre-eminent global development institution has called this major piece of work “bankers without borders”.

Taking the place, in part, of the credit they previously supplied has been an increase in activity involving banks in the developing world, so-called South-South lending.

“The full causes and implications of these changes are not yet completely understood,” says the report, adding: “International bankingcan have important benefits for development by improving efficiency and risk sharing, but benefits do not accrue unless the institutional environment is developed and the right policies are adopted.”

In a foreword to this important addition to World Bank publications, the bank’s President Jim Yong Kim summed up the changes brought about by the credit crunch and subsequent Great Recession. “During the decade prior to the 2007-2009 global financial crisis, banking activities across national borders increased dramatically. In many cases, the trend brought benefits, including additional capital, liquidity, and technological improvements.”

The bank’s position, said Dr Kim, was that developing countries ought to be supported “in reaping the benefits of international banking while also minimising the risks to financial stability”.

Opportunities and costs

The report opens by commenting that the key to rapid economic growth, shared prosperity and reduced poverty was a mixture of three factors: international economic and financial integration, sound policies at the national level and effective international co-operation.

Cross-border banking, it says, can contribute to faster growth and greater economic welfare in two ways. First, as noted by Dr Kim, by bringing capital and expertise that will lead to a more competitive banking system in the host country and, second, by allowing for risk sharing and diversification, smoothing out the effects of domestic shocks.

However, the bank adds: “International banking may also lead to costs. Risk sharing will inevitably expose host countries to systemic risks from time to time.” Underlining the point, the report says: “Risk sharing also has a downside. International banks that export risks will also import them.

“Perhaps no sector than banking better illustrates the both the potential benefits and perils of deeper international integration.”

Now, that very integration has stalled and been partly reversed. “Multi-national banks from developed countries – ‘the North’ – have scaled back their international operations, coinciding with a general backlash against globalisation.”

In part, this cutting back on credit to developing countries reflects tougher regulation in the banks’ home nations, with increased capital requirements meaning there is less available to lend. This, in turn, has raised the question of the extent to which developing countries “should trust international banks with the local provision of their financial services, given that they may retrench and lead to a significant erosion of skills and services?”

Rise of “South-South” banking

During the immediate aftermath of the crisis, one response to the cutbacks in developed-country bank lending was for borrowers to go direct to the capital markets. “The importance of well-functioning domestic capital markets as a ‘spare tyre’ was confirmed during the global financial crisis, when in many countries they substituted at least partly for the decline in bank funding.”

A longer-term trend was the replacement, in part, of developed-country bank lending with substitutes closer to home. In the new climate, says the report, “’South-South’ transactions – from developing countries to other developing countries – started growing, starting to replace the leading role of ‘North-South’ transactions in the aftermath of the global financial crisis”.

The bank takes a mixed view of the growth of “South-South” lending. On the upside, it is likely to increase local competition and spur financial development. Being more familiar with developing-country culture, they tend also to be better than developed-world banks at serving small and medium-sized enterprises (SMEs) and households.

Furthermore: “They are also likely to be more committed to host countries and less likely to exit during downturns.”

But on the downside, it is probable they will face similar economic shocks in their own countries as in the host country, meaning that “greater regionalisation will limit risk sharing”.

Institutional environment is key

Looking to the future, the report assesses the likely impact of financial technology – Fintech – on developing countries.

Large developed-world banks that are able to devote resources to developing fintech products and services will play an important role here, but the report warns that they may be tempted to cherry-pick the best clients.

Overall, the report warns that while international banking can deliver important benefits, these “do not accrue unless the institutional environment is developed and the right policies are adopted”.

It expands on this point: “Research suggests that institutionally better developed countries tend to reap both more of the development and risk-sharing benefits of international banking.

“Specifically, good information-sharing, property rights, contract enforcement, and strong regulation and supervision are key. Of particular importance, these improvements prevent foreign banks from just displacing domestic banks and exploiting regulatory weaknesses. And with strong institutions, both the foreign banks and the domestic banks that are now exposed to greater competition can…improve access and inclusion for SMEs and households that were previously excluded.”

Concluding, Dr Kim says of the report: “International banking is no panacea for guaranteeing financial development and stability, and…the right policies are central to generating benefits while avoiding negative repercussions associated with cross-border banking.”