Corporate Finance - Issues to Be Addressed by Domestic Banks - Literature review Example

Issues to be addressed by Domestic Banks Identify and critically examine the issues that need to be addressed by domestic banks in developing countries to meet the challenges posed by multinational banks and the ever evolving global market in trade and finance. Introduction Global financial market in trade and finance has caused significant effects on domestic banking sector and the domestic economies of developing countries. As the world goes towards economic integration, financial development has become an important aspect of globalization. It has resulted in profound socioeconomic challenges and benefits to domestic banking sector of developing countries (Detragiache et al, 2006). Liberalization of the international financial system has led to entry of foreign banks into developing countries, causing increased competition and efficiency effects in domestic markets (Barros and Caporale, 2012). This causes effective flow of capital in developing countries and boosts development agenda and economic growth. However, domestic banks face competition because foreign financial firms have a lot of resources and economies of scale that give them competitive advantage over domestic banks. Foreign banks also lead to the transfer of financial problems from the developed to developing countries as it was experienced through the 2008/2009 financial crisis when financial problems in United States’ financial sector spread throughout the world and caused domestic banks to become bankrupt and run out of credit. Domestic banks in developing countries respond to economic liberalisation and financial integration and entry of foreign firms in several ways. This paper critically examines the issues that domestic firms need to address in order to meet the challenges posed by multinational banks and the ever-evolving global trade and financial markets. It uses literature from past researches and commentaries. A case study of Indonesia is also used to enhance a practical understanding of underlying issues in globalization of trade and finance. Literature Review Several pieces of literature show that foreign banks in developing countries cause significant challenges to the domestic banking system. In order to meet these challenges, domestic banks need to understand and address the underlying issues of international banking. Most of the literatures argue that foreign firms cause increased competition in the domestic financial system, which can be solved using bank-specific control mechanisms and other competitive strategies that meet the challenges of international banking and global financial integration. Issues and Challenges that Should be Addressed by Domestic Banks Ernst and Young (2013) suggest that for local firms to achieve their growth targets, they should focus on three fundamental issues that threaten profitability as a result of entry of foreign markets in developing countries. The three threats are: margin compression, High competition and increased cost of conducting business, and impact of changes in domestic and international financial regulations. Increased Competition and Higher Costs of Conducting Business High level of competition caused by foreign banks in developing countries creates pressure for domestic banks to lower their costs in order to remain competitive in the market (Bashir et al, 2014). Competition from foreign banks also leads to reduced profitability for the domestic banks. These issues need to be addressed by the domestic banks in order to meet the challenge of remaining relevant and surviving in the increasingly competitive global financial market (Cho, 1990). Foreign banks are associated with innovative products and new unique financial services that attract customers (Barros and Caporale, 2012). For domestic banks to survive under this situation they have no other choice than to imitate the foreign banks or improve their efficiency in order to survive in the globalized market; this comes with increased costs. Ernst and Young (2013) support this view by suggesting that developing countries are facing intense competition from foreign banks which have more global reach and larger economies of scale. As the challenge for profitability becomes imminent, domestic banks should address the issue of maintaining good returns on equity. Foreign banks causing competition in developing countries are not necessarily from developed countries. For instance, banks from neighboring countries offer significant competition to domestic firms in Indonesia. Cho (1990) observes that the presence of foreign banks in Indonesia have led to increased competition in the country’s banking market. It also causes increased expenses and reduces profitability of the local banks. Competition results in efficiency as a result of reduced intermediation spread (Eichengreen & Hausmann, 2005). However, loan quality for domestic banks may decline as a result of the presence of foreign banks. Furthermore, foreign banks in developing countries cause higher administrative costs. According to Ernst and Young (2013), globalized financial markets has caused global, regional and domestic banks to struggle for survival and compete for customers in profitable segments. This competition has necessitated the increased use of technology to meet customer needs. Domestic firms in developing countries are at a greater disadvantage because they lack sufficient technology to compete with foreign firms with enough resources to develop these technologies (Zukauskas & Neverauskas, 2008). Domestic firms therefore incur a lot of costs if they have to keep up with the dynamics of competition in globalized financial and trade markets. Improved technology enables domestic companies to compete more efficiently for customers in profitable segments who require high quality and customized products and services. Profitability Issues On the issue of margin compression, Ernst and Young support the suggestion that increased competition drives down profit margins. Increased price competition resulting from the entry of foreign firms cause domestic firms to lower their interest on loans and increase their interest on deposits, leading to a reduction of the spread and profit margins. Were and Wambua (2014) suggest that the financial liberation and entry of foreign firms in developing countries leads to increased competition and efficiency which drives own profit margins. Stability Issues of stability in the financial sector also arise from the entry of foreign banks and increased globalization of financial and trade markets. According to Powell (2008), foreign banks act as stabilizing forces in financial markets of developing countries. In a speech delivered in the proceedings of G20 workshop on competition in the financial sector, Powell argued that foreign banks have easier access to global pools of liquidity than domestic banks. This allows them to smooth the shocks of liquidity in developing countries. However, foreign banks may also bring financial shocks from their home countries into the developing countries where they operate their business. In order to overcome the effects of liquidity shock, domestic markets encourage the entry of several foreign banks as a way of diversifying risks. Regulation Changes As globalization of financial markets increases, managing regulatory change is becoming particular challenging for domestic and foreign banks in developing countries. For instance, domestic banks in developing countries start to move towards the adoption of IFRS accounting standards. As foreign banks increase in Indonesia, regulators have become more selective on foreign ownership (Vallikappen, S. and Moestafa, 2013). Globalization of financial markets has led to the development of a standard financial transaction tax system which affects foreign banks. Indonesia has its own taxes on securities transactions rather than adopting international standard. This enables domestic firms to take advantage of their domestic knowledge and capabilities to minimize taxation expenses. As international regulations change, foreign firms get higher advantage to manage them because they are more accustomed to global factors and have more experience in the global market. International regulatory changes place regulatory burden on domestic banks, causing profitability to decline (Committee on the Global Financial System, 2010). New capital standards cause increased costs of funding among domestic firms, and lead to decreased profits. How Domestic Banks Address Challenges Posed by Foreign Banks in Developing Countries In order to respond to the problem of reduced profit margins in developing countries, domestic banks adopt firm-specific strategies to address the margin pressure. According to Ernst and Young (2013), firms need to increase fee-based product offerings and focus on products that offer high yields such as vehicle finance, micro-lending and infrastructure finance. However, achieving positive outcomes from these steps is difficult because significant investments are required in order to understand customers and mitigate risks (Cho, 1990). Therefore, domestic firms may use advanced risk management capabilities to enhance differentiation from foreign firms and win customers in the market (Giannetti and Ongena, 2008). Differentiation enables domestic firms to price their products appropriately in order to achieve higher profit margins despite the high competition from foreign firms. Ernst and young (2013) have suggested three ways that domestic banks in developing countries may develop to manage profit margin compression: growing non-interest income, rebalancing portfolios, and re-pricing loans. In our case study, Indonesia is one of the developing countries with a special focus on rebalancing of portfolios. Firms need to rebalance their portfolios in terms of high- lending and micro-retail credit. Powell (2008) suggests that large international banks focus on large corporations in their product pricing and market positioning. Therefore, as suggested by Ernst and Young (2013) domestic banks need to re-balance their banking portfolio and increase their micro-lending to serve the underserved SMEs and increase their profit margins. Fee-based products and fee income can also be used as non-interest income alternatives to increase profit margins (Ernst and Young, 2013). Rather than focusing on interests to earn profits, domestic firms may use charge non-interest fees on previously free services in order to boost their profits. Domestic banks may charge new fees on their services or improve their collection rate on existing fees. Employees may be given incentives to improve fee collection. Some banks may also form strategic alliances with foreign banks in order to build their product offerings and increase their profit margins (Hermes and Lensink, 2004). Domestic banks may address the reduction of profit margins by increasing their prices. Re-pricing of loans involves increase of prices of loans in order to meet the rising financing costs associated with increased competition as a result of entry of foreign banks into developing countries. Bank-specific control mechanisms can also be used to overcome the challenges faced by domestic banks in developing countries as a result of foreign firms’ entry into their countries. The size of domestic banks in developing countries determines their ability to compete with foreign banks (Bashir et al, 2014). Big-sized domestic banks have bigger asset base, so they can absorb bad debts and meet increased costs as a result of competition more easily than small banks. Were and Wambua (2014) suggest that bank-specific factors such as bank size, credit risk, liquidity risk, and operating costs affect the performance of domestic banks. The research of Were and Wambua shows that large banks in Kenya have higher interest spread and higher profitability margin. Such banks enjoy higher reputation which attracts more customers even with low interest in deposits and high interest on loans. Therefore, domestic banks in developing countries should increase their size by marshalling their resources and investing in growth and expansion to rural areas where foreign banks do not prefer. Case Study – Indonesia Indonesia’s banking sector has undergone significant changes over the past years. In 1998, Indonesia’s deregulation allowed foreigners to own up to 99% of stake in banks in the country (The Straits Times, 2014). Indonesia opened its banking sector to foreign banks following the 1997/1998 financial crisis (Cho, 2007). Until 2011, the country was one of the most welcoming countries for foreign banks in the world. Some of the foreign banks that entered the country include Bangkok Bank, JPMorgan Chase, Bank of America, Royal Bank of Scotland, Deutsche Bank, Standard Chartered, City Bank and Bank of China. Apart from Korea, Indonesia is the leading home for foreign banks in Asia. Indonesia’s high presence of foreign banks was intended to increase operating efficiency in the banking industry and help the financial market to achieve liquidity in times of financial crisis. Powell (2008) suggests that by 2008 foreign banks owned 40.9% of total banking assets in Indonesia. As of July 2014, several banks were still operating as branches of foreign banks including Citibank, JPMorgan Chase, Standard Chartered, Deutsche Bank and HSBC. This period before the banking bill indicates that Indonesian domestic banks are facing significant challenges caused by foreign banks. Cho (2007) suggests that foreign banks have led to increased competition in Indonesia’s local market. Due to high level of presence of foreign banks, Indonesia has been experience rapid growth of the financial sector and an increasing rate of credit expansion (Juoro, 1992). In terms of profitability, Powell (2008) suggests that foreign banks in Indonesia have larger profit margins than domestic private and state-owned banks due to their aggressive operations, sophisticated risk management, and higher economies of scale. Efficiency is seen to be similar in foreign and domestic banks. In order to resolve the problems of foreign bank presence in the country and protect the domestic financial market from foreign banks’ competition, BI has recently reduced the ownership of domestic banks by foreigners from 99% to 40% in order to restrain foreigners from becoming controlling shareholders. Furthermore, Indonesia’s Banking bill 2014 was introduced to restrict operations of foreign banks in order to prevent inflow of financial crisis into the country. Rather than operating as branches of their parent companies, foreign banks in Indonesia are required to become Perseroan Terbatas (PT). This system protects the local banking sector from financial crisis originating from the foreign bank’s home country (The Straits Times, 2014). When the law comes into effects, foreign companies will not operate as branches of parent companies, but as an independent company so that the parent company does not withdraw money from it whenever crisis set into the home country. Another step taken in Indonesia was the consolidation of domestic banks to strengthen local bank ownership and increase their efficiency and reduce costs. Regulation of foreign banks has increased in Indonesia to avoid problems brought by foreign banks. For instance, the country monitors speculative foreign exchange of foreign banks in order to ensure financial stability for domestic banks (The Straits Times, 2014). Another regulation is that foreign ownership of local banks is limited through a single presence policy for foreign banks. Exit policies are also applied to foreign banks in the domestic market. Individually, Indonesian domestic banks have started to diversify into micro and higher-margin tiers of the economy as their target markets for financial services. Vallikappen and Moestafa (2013) argue that domestic banks in Indonesia recorded up to 23% returns on equity compared to the average equity return of 21%, 20%, and 9% in China, Canada, and United States respectively (Vallikappen and Moestafa, 2013). These high returns are caused by the investment of Indonesian banks on micro lending which increases their interest margins. Discussion and Conclusion The case study of Indonesia’s banking market reflects the findings of literatures on the issues and challenges of foreign banks in developing countries. It has been noted from the case study that Indonesia has one of the leading open banking markets. As a result, the local banks have led to several problems to the domestic banks. Cho (2007) have led to high competition and inefficiencies in the local banks. This resonates with the findings of literature review. Several authors and commentators of international banking agree that foreign banks increase competition for the domestic banks and cause high efficiencies and high costs. Competition has necessitated the increased use of technology to meet customer needs, and domestic banks are forced to struggle with new approaches and differentiated strategies which require a lot of costs to be incurred (Ernst and Young, 2013). As domestic banks attempt to keep up competition from foreign companies, they need to invest in sophisticated technologies and customer-focused differentiation strategies. Since Indonesia has a lot of foreign banks, the competition faced by domestic banks is very high. According to Ernst and Young (2013), competition offered by foreign banks cause an increase in costs of domestic banks including administrative and operation costs. An issue of stability has also been raised by some researchers and observers. For instance, Powell (2008) suggests that foreign firms stabilize the host country’s financial market. This is indicated by the shift of Indonesia’s financial markets from a closed to an open system following the 1997/1998 financial crisis. In this case, entry of foreign firms brought stability to the domestic financial system because banks from several countries diversify risks and reduce the chances of failure in the financial market. However, The Strait Times (2014) has suggested that foreign firms may cause more financial crisis against the expectation of Powell (2008). In fact, the House Assembly of Indonesia introduced a bill to limit the operational presence and ownership of foreign banks in Indonesia as a way of avoiding crisis. The argument of the bill supporters is that when foreign banks face crisis in their countries, they withdraw money from their branches in Indonesia. Therefore, Indonesia is attempting to prevent this by limiting ownership of banks by foreigners to only 40% while at the same time requiring foreign banks to establish independent banks in the country rather than branches. Another issue that domestic banks need to consider in order to meet challenges of multinational banks is regulation. In this case, Ernst and Young (2013) argue that managing regulation is an essential element in international banking. Indonesia is now planning to start regulations of foreign banks, and domestic banks should know how to manage these regulatory changes. New standards on capital for Indonesian banks are being regulated. Limiting ownership of banks by foreigners to 40% may limit investment opportunities in the country as Indonesian domestic banks fail to meet the equity capital needs of their business. Literature also suggests that profit margin is a key issue for domestic banks to consider. Foreign banks offer competition which leads to decreased interest margins and low profitability (Berger, 2005). However, this can be addressed by banks through investment portfolio of micro and high-margin lending. Micro lending has been experienced in Indonesia where domestic banks are experiencing high profits for lending to small scale businesses and individuals. This confirms the relevance of Powell (2008) who suggested that foreign banks do not invest in SMEs, and domestic firms can make profits by filling that gap. The problem of high competition that limits profits can also be reduced by re-pricing of loans. In this case, prices of loans may be raised in order to reduce costs associated with competition from foreign banks and increase interest and profit margins. Furthermore, profits may be increased through the growth of non-interest income such as fees on non-interest activities. 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