The importance of foreign banks during downturns

Jayant Krishna, Group CEO of the UK-India Business Council (UKIBC), recently appealed to Finance Minister Nirmala Sitharaman to eliminate the disparity in taxes paid by foreign banks compared to domestic banks suggesting that it will incentivise foreign banks to open more branches. Although India abolished the Dividend Distribution Tax last year that benefitted foreign banks, the marginal tax rate is still higher at 43.68% compared to 25.17% for domestic banks. A policy to equalise tax will have to weigh the reduction in tax revenue against the additional benefits generated by foreign banks to the domestic markets. That determination requires an answer to the following question—how much do foreign banks contribute to the domestic economy?

Foreign banks from developed and developing countries have been expanding steadily since financial deregulation swept the globe in the 1990s. In India, the number of foreign banks increased from 23 in 1991 to 46 in 2020. Indian banks also expanded their overseas branches from 110 in 1991 to 190 in 2018. Academic studies on the benefits of foreign banks have shown mixed results. Several studies conclude that foreign banks play a positive economic role, especially in emerging markets, by increasing local banks' efficiency and lowering financial intermediation costs. However, some studies have questioned foreign banks' contribution since they generally cater to the elite firms of the country with little impact on the smaller and rural markets.

A narrower focus on foreign banks' contribution is their lending behavior during a recession. They can play a positive role by engaging in countercyclical lending to offset reductions in lending by domestic banks during downturns when defaults deplete their capital. Since foreign banks have access to their parent banks' internal capital markets, they can respond differently during business cycles in the host countries by increasing lending during downturns. Studies before the 2008 recession show mixed results on foreign banks' responses during domestic crises. Some show countercyclical lending while others show procyclical lending. Studies examining the 2007–2009 financial crisis show that foreign banks reduced their lending in most countries, because the recession was global and affected parent banks worldwide.

Our recent research focused on foreign banks' role in the United States during recent recessions, 1990-1991, 2002, and 2007-09. We believed a longitudinal study is warranted because foreign bank behavior may be different when they enter the country for the first time. In particular, they may use recessions as an opportunity to establish their presence. Research by one of the authors (Seth) found that foreign banks engaged in countercyclical lending during the 1990-91 recession in the U.S. and offset the reduction in lending by U.S. banks.

Our paper extends this research to determine whether such countercyclical lending continued in subsequent recessions. We adopt a unique methodology to measure countercyclical lending. A downturn can have differential effects in an economy, with some regions less affected than others, especially in large countries like the U.S., India, and China. Measuring foreign bank lending in the aggregate, as many past studies have done, would be faulty as it would not capture lending behavior at the local level. We examined lending at the local level and compared them to those of matching domestic banks. Finally, we also separated the foreign banks into foreign branches and subsidiaries. Foreign subsidiaries can establish offices to attract local deposits that are insured by the Federal Deposit Insurance Corporation (FDIC), but foreign branches cannot benefit from this insurance.

Our results show that both foreign and domestic banks showed countercyclical lending at the local level for the first two recessions. In the 1990-91 recession, foreign branches and their domestic counterparts increased lending in areas where GDP declined and unemployment increased. In the 2001 recession, foreign subsidiaries and their domestic counterparts increased lending in similar conditions. During the 2008 recession, foreign branches exhibited procyclical lending. The overall conclusion is that foreign banks and their domestic counterparts exhibit similar behavior during recessions, whether for countercyclical or procyclical lending.

How should the results be interpreted for India’s policy towards expanding the role of foreign banks? Our study and others indicate that expansion of foreign banks in the last three decades has resulted in converging lending behavior. Central banks should not expect foreign banks to behave differently from domestic banks.

Views are personal. Seth is Professor of Finance Department, IIM Calcutta and Visiting Professor, CBS, Denmark; Rai is Professor, Hofstra University, U.S.