Banks leaning on foreign affiliates

Shereel Patel
In a preview of its soon-to-be released Global Financial Stability Report, the IMF says cross-border lending may compound domestic and global shocks to a country's economy and financial system.

Unsurprisingly, the report's analysis lends support to policies that foster international cooperation to limit the risks associated with the failure of international banks.

The report points out that banks operating in multiple jurisdictions generally have two ways to conduct their international lending business: directly across borders or through their foreign affiliates.

The effects on the "host economy" are likely to be very different, according to the structure the lending bank adopts, the IMF analysis suggests, leading it to conclude that cross-border loans can act as a "double-edged sword".

On one hand, if loans are made directly from a bank's home headquarters to firms or other banks in another country, the foreign bank is likely to transmit global shocks to the host countries it services through a sharp reduction in credit, in association with a pull-back to core financial centres and regional markets.

This retreat has been well observed in the wake of the global financial crisis, primarily among "euro area" banks, courtesy of tighter regulations and a need to clean up bank balance sheets.

"The retrenchment of European banks from cross-border lending to Asia provided room for the expansion of other, more regionally-focused banks; Chinese and Japanese banks, for example, have partially filled the gap," the IMF said.

On the other hand, local lending by a foreign bank through a subsidiary can play a stabilising role during domestic crises.

"Around domestic crises, foreign-owned affiliates tend to reduce their credit less than domestic banks and this is particularly true if the parent bank of the subsidiary is well-capitalised and has stable funding sources," said Gaston Gelos, chief of the IMF's global financial stability analysis division.

The relative shift towards more subsidiary-based lending since the crisis is therefore likely to have positive implications for the financial stability of the host country.

Nonetheless, other benefits may accrue from cross-border lending, even if activity is at reduced levels.

For example, direct cross-border lending by global banks contributes to the allocation of global savings across countries, and helps borrowers diversify their funding sources - albeit at the risk of sharper credit declines.

Policymakers should therefore act to make international banking safer, the IMF notes, adding that governments have a part to play in building resilience to financial shocks by encouraging the subsidiaries of global banks to rely more on local funding sources.