Foreign Banks Development in the UAE - Term Paper Example

Foreign Banks in UAE Name Institution Date Table of Contents Running Head: FOREIGN BANKS IN UAE 1 1 Foreign Banks in UAE 1 Table of Contents 2 FOREIGN BANKS IN UAE 15 2 Abstract 3 Introduction 4 Foreign ownership 4 Impact of foreign bank entry 7 Competition and Efficiency 9 Stability, diversification and contagion 10 Conclusion 12 References 14 Abstract Foreign banks penetrating into numerous developing countries have been the trend conspicuously observable in the last two decades. This penetration comes with a number of implications to the host country economy and the banking sector industry. As many countries grapple with the challenge of staying in course as far economic development are concerned, they are also faced with the issue of having to content with the foreign banks getting involved in their banking sector. In this paper there is a critical look of the impact of foreign bank entry into host nations and the evaluation of the aftermath of having to integrate the foreign banks into the banking system of that particular host country. The topics that are covered in this paper include: Foreign ownership; Impact of foreign bank entry; Competition and efficiency; Stability, diversification and contagion. Introduction A theoretical model indicate that when foreign banks are more efficient at monitoring high-end customer as compared to domestic banks, their entry is an advantage to those customers and may worsen off welfare and hurt other customers. Moreover, the model also portray that credit extended to the private sector should be at low rate in countries foreign bank penetration is more. Philosophers Morten and Lierman (2004) argue that in poor countries, a foreign bank’s presence that is stronger is hugely associated with reduced credit to the private sector. Countries with enormous foreign bank penetration, credit growth is slow and access to credit is less. In the last ten years emerging market economies have removed restrictions on foreign direct investment in their financial system. Owing to this, domestic institutions foreign ownership has been increasing at a rapid rate. Foreign ownership Presently, in Eastern and Central Europe countries as well as in Latin America foreign banks have a dominant share ownership of more that fifty percent of the assets in the banking sector. This trend has various implications to the host and parent country of the foreign bank. Foreign bank entry into the local market is an issue that raises a mixture of reaction amongst the policymakers and academics. Foreign banks proponents suggests that the banks are able to attain better risk diversification and economies of scale as compared to domestic banks, bring up technology that is advanced (particularly risk management), import better regulation and supervision, and lead to increased competition. According to accountants Mathieson and Schinasi (2000), owing to the fact that foreign banks are supported by their parent banks, foreign affiliates attached to international banks tend to be perceived as being safe as opposed to the domestic banks, particularly during the time the economy is facing difficulties. Scientist Naaborg (2007) notes that more importantly and to a large extend, foreign banks face less political pressures and may be to a small extend forced to lend to parties who are connected. Finlay (2011) who is a renown scientist, argues that regardless of these positive sides, critics show a vital part of business of a bank, namely lending to firms that are information wise opaque, is local in nature inherently, and it is not carried out easily by huge organizations which are managed from far away. Facts from consolidation of bank in countries which are advanced point out those large banks are less prone as compared to small banks to lend firms which are information wise difficult, for example small firms, due to the fact that there is a huge distance between the management and loan officers. In an incident of foreign bank carrying out its activity in countries that are poor, the distance (both cultural and geographical) between local subsidiaries and headquarter is expected to be exceptionally large. Besides, if not most, prospective borrowers may lack collateral that should be used and accounting information that is reliable and are consequently difficult information wise. According to Naaborg (2007), problems highlighted in countries that are advanced may be compounded when foreign banks carry their activities in countries that are poor. Several studies establish that foreign banks in countries of lower-income lend hugely to more transparent and safer customers, like large domestic firms, the government and multinational corporations (Morten & Lierman, 2004). Even in the case when foreign banks make their entry through the purchase of local banks, knowledge on local market and customer relationships may be lost, as attributed to distant managers’ essence of imposing formal accountability to closely monitor local loan officers. Evidence from countries which are advanced shows that bank-firm relationships of the target bank are disrupted when a bank is acquired by another bank. From the perspective of a public policy it is not definite that focus of foreign on high-end customers should something of a great concern. According to Philosopher Finlay (2011), as long as domestic banks persist on lending to more opaque but customers who are profitable, welfare losses should not exist, and entry by foreign bank may incidentally occasion improving of welfare segmentation of the market. On the other perspective, if entry by foreign banks forces domestic banks out of the market, then many firms that are opaque may become constrained in credit terms, opportunities for credit investment may be lost, aggregate credit will decline (Naaborg, 2007). In monitoring ‘hard’ information like collateral values and accounting information, foreign banks are better than domestic banks, but not at monitoring ‘soft’ information like trustworthiness and entrepreneurial ability of the borrower. In some configuration parameter setup entry by foreign bank increases welfare and cost-efficiency, while in some cases it leads to a reduction in cost efficiency, welfare and overall lending. ‘cream-skimming’ is as a result of foreign bank entry in such a way that hard information borrowers are not placed in the same categories as other borrowers. This has two effects: in the first place, soft-information borrowers find themselves in a pool that is worse, and are compelled to pay interest rates that are high to the extent that they may not need to borrow any longer. Welfare may decrease or increase determined by the parameters, but soft-information borrowers are not better off and in other circumstances they are worse off. Countries that have a huge presence of foreign banks should make the private sector less accessible to credit. Impact of foreign bank entry According to Welfens and Cillian (2009), foreign bank entry brings with it many benefits to the financial systems of the host nations and the economies as a whole. The benefits come from gains in efficiency occasioned by new products, management techniques and technologies as well as competition that is accelerated encouraged by the new entrants. Further more, as foreign banks may possess greater resource accessibility from abroad, they have funding that is stable and patterns of lending visa-avis the domestic banks. According to European Publication Limited(EPL) (2003), they also possess a credit portfolio that is more diversified geographically and consequently would not be greatly hit during episodes of stress in the country that is hosting them. Another important aspect in Emerging Market Economies (EME) is concerned with effects on connected lending practices by banks. In emerging market economies where wealth is greatly concentrated it is likely that stockholders, large borrowers, and the board members of the bank are related closely. Banks that are foreign do not get entangled in lending that is connected both due to the reason of absence of parties that are related and their equity structure that is widely held does not condone that kind of behavior. It is important to point out that foreign banks introduced new capital to many emerging market economies which went through hard economic times and moreover they bring supervision from authorities of their home country (Mathieson & Schinasi, 2000). In equal measure, financial sector foreign investment raises some issues to worry about. More participation of foreign institutions may expose economies of host countries economies to events that are happening in other countries where their foreign banks carry their activities. In the other incident, international bank have access to many investment alternatives and therefore are more prone to “cut and run” as compared to banks that are domestically owned when their respective investments are not performing as projected. Notable accountants such as Jonung et al (2008) observe that local stockholders in emerging market economies are faced with increased transactions costs and many times have vested interest that hinder them from unloading their financial investments (Mathieson & Schinasi 2000). More concerns are triggered by modern technologies applied by large foreign banks depend largely on hard data that is not usually available in emerging market economies particularly for medium and small enterprises; subsequently banks may end up rationing credit to this kinds of firms or accelerating risk borne by domestic institutions trying to serve more opaque customers attributed to increased competition. International banks are likely to take part in differences of regulatory arbitrage seizing in regulation allover the world. Mathieson and Schinasi (2000) note that regulators of the host country may be overwhelmed by the complexities characterized by supervision of complex and large financial institutions, understanding new operations and products and by difficulties to attain coordination that is effective with their counterparts situated in other host countries or at home. Conflicting interests in the parent companies and their respective subsidiaries may emanate from actions of the management-on the host country-looking to solely pursue the interest of the former. Foreign banks may negatively affect the liquidity, the depth and information accessible by participants in the market when they de-list shares of institutions that are acquired (EPL, 2003). Competition and Efficiency In emerging market economies, foreign bank subsidiaries enjoy profitability and interest rate margins that are high as compared to banks that are domestically owned, on the other hand, in economies that are industrialized the reverse happens. The same studies found out that presence of foreign bank that is significant is characterized with a plummeting margin, overall expenses and profitability in banks that are domestically owned. Moreover, the efficiency impact of entry of foreign bank on banking systems seem to happen as soon as entry occurs and are not dependable on the share of the market. Studies of the experiences of Turkey, Colombia, Argentina, United States, United Kingdom, Spain, Germany, France and Australia strongly support the conclusions (Mathieson & Schinasi, 2000). The impact on markets may come from both the actual entry of new competitor, as well as an effect on the increased likelihood of new entries into the industry in pursue of huge profits. These results that are contrasting could be explained by the different origin of acquisition and mergers which occur in industrialized countries and emerging market economies. In contrary with countries that are industrialized, in emerging market economies, cross-border acquisitions and mergers have occasioned concentration indexes increase. Scientist Brown (2002) argues that it has been demonstrated that in spite of the increase in concentration after entry of foreign bank during 1994-1997 in countries such as Turkey and Mexico, the competition intensity did not go down. More research in the banking system of Mexico showed that during the 1997-2002 periods there was competitive pressure decline. Regardless of this the Mexican case it may be too early to monitor effects in competition emanating from the bank mergers which also occurred during those years. Presence of foreign bank may also foster development and efficiency of markets of domestic financial by increasing the number of financial products that are available to local customers via technologies that are imported and the know-how. An illustration of this is the role played in derivatives markets in Mexico by foreign banks. Whereas their total assets participation is 82%, their portion in operations of derivatives is 94%. Foreign banks that are small play a major role in corporate sector lending, and in the money markets, government securities and the derivatives. Many of these affiliates carry out their activities from a single office which is located in Mexico City and provide a variety of products for big corporate customers. Despite the fact that they hold 4% only of banking system assets, their derivatives market share is 33%. Recent research in the banking industry shows the presence of institutions that are foreign owned as a mitigating factor of negative effects of market concentration that is increased. Research carried out by scientist Liebscher (2006) found out that concentration was responsible of financing obstacles increase; nevertheless, the impact is dampened in countries that have a larger portion of banks that are foreign owned. Stability, diversification and contagion The upsurge in globalization of corporate links and financial markets across economies has augmented the speed at which occurrences in one market may impact others. Foreign banks subsidiaries can be a likely source of stability during which the local market go through stress, as they form part of entities that are globally diversified. On the other hand, they can be a reason of contagion from events taking place somewhere else, as they serve as mechanisms of transmission for the adopted policies by their stockholders in reaction to shocks in their country at home or in any other places that they possess investments (Lierman et al., 2004). The foreign bank lending stability has been analyzed by contrasting the behavior local lending and cross border lending by foreign banks in terms of crisis. It looks like foreign banks that have build a local presence (such as subsidiaries and branches) are less likely to bring down their exposition or to ‘cut and run’ during times of crisis, largely owing to huge fixed costs of building a branch network and market share gaining. Offshore lending it was established was more volatile as compared to onshore lending for Mexico, Argentina and Brazil, the similar pattern was found for Eastern Europe and Central Europe countries. Foreign banks showed stronger growth in loan linked with volatility compared to most banks owned domestically, and consequently contributing to stability that was greater in credit. The presence of foreign bank onshore was a reason for fostering deposit stability base by permitting domestic depositors to carry out their “flight to quality” while they are at home. All in all, it was appreciated that bank soundness as opposed to ownership per se was an element that was important in the volatility and growth of bank credit. Increased participation of foreign banks tends to bring down any eminent crisis in banking (Liebscher, 2006). Contagion empirical evidence demonstrated that financial problems in Japan during the early 90s and late 80s were transmitted to the United States through operations of Japanese banks in the mortgage market of America. It was further established the offshore and onshore exposure of United States banks to emerging market economies were greatly responsive to economic conditions in the United States as compared to emerging markets interest rates and growth. On top of that, when banking system ownership is concentrated highly in a single foreign country, a shock that is adverse to that foreign country is likely to spill-over and engulf the economy of the host country. UAE banks predicted implication, apart from the ones mentioned above, can be summed as reduced profitability in the short term due to increased completion. Banks will have to compete in order to offer higher returns to shareholders. Implications that are unforeseen comprise of escalating overhead transitional costs related with possible transformation of some local banks from being privately owned to publicly held banks, reduction in loan portfolio, and banks’ undercapitalization. In order to deal with challenges of foreign bank entry, some banks in UAE have to be encouraged to accurately prepare for mergers, either with foreign banks or local ones in an effort to diversify risk and gain entry into external new market. Many of the benefits to the UAE are the same as outlined earlier. The UAE banking sector will be involved in a race in which every contestant is trying as much as possible to offer better and faster services. The high competition from the USA banks makes it inevitable that many such banks will enter the UAE market. Conclusion Increased direct foreign investment has led to foreign banks entry as an order of the day in many industrialized countries and emerging market economies. This growing trend has resulted into different implications in both the parent country of the foreign bank and the host country. In poor country the entry of foreign banks has been hurting due to the diverse effects of their penetration and increased complexities in regulation. In this paper the various literatures concerning the impact of foreign bank entry has been explored vastly analyzing every step effect to the local market of the host country and parent branch of the bank. Efficiency, competition, contagion and diversification have all been reviewed to try and bring a clear picture of the impact of the foreign bank entry. The impact of foreign bank entry has been explored as far as United Arab Emirates is concerned. The paper has provided an insight into the impact on the banking sector following foreign bank entry. References Morten B. & Lierman F. (2004). Financial markets in Central and Eastern Europe: stability and efficiency perspectives. London: Routledge. Europe Publications Limited. (EPL) (2003). The Middle East and North Africa, Volume 50 Routledge. Finlay, B. (2011). Beyond Boundaries in the Middle East: Leveraging Non-Proliferation Assistance to Address Security/Development Needs with Resolution. Darby, Pennsylvania, DIANE Publishing. Kogan, P. (2004). Middle East Review. London, Kogan Page Publishers. Mathieson Donald & Schinasi Garry J. (2000). International capital markets: developments, prospects, and key policy issues. New York, International Monetary Fund. Naaborg, I. J, (2007). Foreign bank entry and performance: with a focus on Central and Eastern Europe. Eburon Uitgeverij B.V. Lierman F. et al. (2004). Financial markets in Central and Eastern Europe: stability and efficiency perspectives. London: Routledge. Liebscher K. (2006). Financial development, integration and stability: evidence from Central. Eastern and South-Eastern Europe. Edward Elgar Publishing. Welfens P. J. J. & Cillian R. (2009). EU - ASEAN: facing economic globalization. New York: Springer. Brown, J. R. (2002). Opening Japan's Financial Markets. London: Routledge. Jonung L ., Walkner C. & Watson M. (2008). Building the Financial Foundations of the Euro: Experiences and Challenges. Taylor & Francis. Mathieson D. J. & Schinasi G. J. (2000). International capital markets: developments, prospects, and key policy issues. New York: International Monetary Fund. Read More