Chapter

IV Foreign Ownership of Banks and EU Integration

Author(s):
Niamh Sheridan, Alfred Schipke, Susan George, and Christian Beddies
Published Date:
January 2004
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Foreign Ownership of Banks

As previously mentioned, one of the characteristics of the current structure of the Baltic states’ financial systems is that they are dominated by bank financing. Over the course of the last several years, the percentage of foreign ownership has increased dramatically. This is especially true of Estonia and Lithuania, while somewhat less so in Latvia. Although the degree of foreign bank ownership is relatively high, other small open economies (such as New Zealand and Malta) are also notable for the dominance of foreign bank ownership. The increase in foreign ownership in the Baltics reflects to some degree a conscious decision by the authorities to attract strategic foreign investors in the aftermath of the banking crises of the 1990s.

Foreign bank ownership in the Baltics has contributed to a number of positive developments. Among them is a higher degree of diversification; the lower cost of financing due to high credit ratings of parent banks; improved efficiency as a result of economies-of-scale; improved risk management through better technical and management expertise; more rapid integration with international capital markets; and access to capital for the recapitalization of existing banks. Foreign bank ownership has also increased the overall level of confidence in the quality of the banking system, and reduced the probability of a bank panic and the danger of capital flight. In addition, especially in Estonia and Lithuania where the banking system is highly concentrated, foreign ownership is likely to reduce the risk of a government bailout in case of a crisis. For all of these reasons, foreign ownership is usually associated with an improvement in the stability of the banking system.

Foreign ownership may come at a price, however. One potential disadvantage of a banking system that is primarily owned by a few large foreign banks is that it effectively creates barriers to entry because of the perception that the parent company can provide an almost unlimited amount of funds.41 This argument becomes especially relevant in countries such as the Baltic states, where the potential profits of new entrants are limited by the small size of the domestic markets. Notably, the high cost of establishing a retail banking system, combined with relatively limited profit opportunities and the deep pockets of incumbent foreign banks, would deter even other large players from entering the market. The potential adverse implications of barriers to entry are even more pronounced in countries such as the Baltic states that lack an alternative to bank financing in the form of developed capital markets.

An even more important potential downside to foreign ownership is related to the transmission of external shocks. In all three Baltic states, foreign bank ownership is likely to be beneficial if a recession is limited to the Baltic region or any one of the Baltic countries. Under these circumstances, foreign bank ownership would foster stability by providing a lending buffer and allowing for both consumption and investment smoothing. Foreign ownership may prove to be a liability, however, in the case of a recession outside the Baltic region. In particular, how would the banking sector react if a shock were to occur in the country or region in which the parent banks are registered and do the majority of their business?

A number of studies (Goldberg, Dages, and Kinney, 2000, as well as Garcia-Herrero, 1997) show that in less-developed countries faced with a crisis, foreign ownership contributes to stability. Peek and Rosengren (1997), however, demonstrate how an adverse shock in Japan—reflected in falling share prices—led to a decline in bank lending by Japanese financial institutions in the United States. Given that equity investments in companies qualify as tier-two capital in banks’ capital adequacy ratios according to the Basel Accord, a fall in share prices in Japan forced Japanese parent banks to reduce lending. This reduction was accomplished, however, by having branches and subsidiaries of Japanese parent banks reduce lending in the United States, while maintaining lending levels in Japan. Such behavior by foreign-owned banks in the Baltics would cause a severe crisis due to their dependence on foreign banks. Whether the risks of such behavior exist in the case of the Baltics also depends on how committed banks are to the region and on the size of lending in the Baltics relative to the total lending volume of the parent bank.

Foreign bank ownership could transmit a shock from the parent bank to the subsidiary even in the absence of trade links to the parent bank’s home country.42 Most of the foreign banks in the Baltics are owned by two Swedish groups, SEB and Swedbank. The likelihood of a recession-induced crisis on the parent bank—and therefore potentially on the subsidiary—would depend on the former’s level of diversification of assets, in particular with respect to its lending operations. Table 4.1 shows that one of the two largest parent banks (Swedbank) tends to be highly exposed to Sweden, while the other Swedish parent bank (SEB) is diversified outside of the region.43 Therefore, a business cycle-induced down-turn in Sweden could reasonably be expected to affect more negatively the income position and balance sheet of Swedbank. Given their levels of exposure to this bank, Estonia and Lithuania would be especially vulnerable to such a turn of events.44

Table 4.1.Diversification of Swedish Parent Banks and Baltic Subsidiaries(In percent of total assets)
Baltic Subsidiaries
Parent BanksEstoniaLatviaLithuania1
SwedbankHansabankHansabankHansabanka
Sweden90Estonia54Lithuania1100Latvia1100
Estonia4Lithuania28
Other (Norway, Denmark)6Other (Latvia)18
SEBEesti UhispankVilniaus BankasLatvijas Unibanka
Sweden42Estonia1100Lithuania1100Latvia1100
Germany37
Baltics3
Other18
Source: Information from respective banks.

No major assets held abroad.

Source: Information from respective banks.

No major assets held abroad.

Furthermore, the Baltic states are vulnerable to exogenous real shocks due to their relative openness, as reflected in their share of exports to GDP (Table 4.2). To what degree the Baltics would ultimately be affected by such an exogenous shock depends on the regional diversification of their exports. None of the Baltic states depends exclusively on the export market of any single country. A sharp economic downturn in Sweden or Finland, however, is likely to have substantial implications for Estonia, while a recession in Germany or the United Kingdom is likely to have adverse implications for Latvia and Lithuania, respectively. Under such a scenario, foreign bank ownership could compound the transmission of the recession if the country of the parent bank is in recession.

Table 4.2.Export Dependence and Diversification, 2002
Estonia
Total exports in percent of GDP66.6
In percent of total exports
Finland20.4
Sweden(2)112.4
United Kingdom4.3
Latvia
Total exports in percent of GDP27.5
In percent of total exports
Germany15.3
United Kingdom14.4
Sweden(3)110.4
Lithuania
Total exports in percent of GDP39.6
In percent of total exports
United Kingdom13.4
Latvia9.7
Sweden(9)14.2
Sources: IMF, Direction of Trade Statistics and World Economic Outlook.

Ranking of trading partner.

Sources: IMF, Direction of Trade Statistics and World Economic Outlook.

Ranking of trading partner.

Because it relies heavily on Sweden in both the banking and export sectors, Estonia would be the most vulnerable of the Baltic states to adverse developments in Sweden, because a real shock could be compounded by a financial shock originating in the latter country. Although two of the three largest banks in Lithuania are owned by the same Swedish group, Lithuania’s export dependence on Sweden is marginal. Therefore, the possibility of a dual shock is less likely. The same applies to Latvia, which has less foreign bank ownership in the first place.

The Baltic states have profited in a number of respects from foreign bank ownership. The greatest risk that remains as a result of the ownership structure is that of an adverse shock in the country of the parent bank that could be transmitted to the Baltics. What matters most, however, is not so much ownership but rather the level of diversification of the parent bank. The more diversified the lending portfolio of the parent bank, the less likely an economic downturn would affect the performance of the parent and therefore that of the subsidiary. Because Swedbank’s lending is more highly concentrated in Sweden, and given that Estonia’s export market is also strongly dependent on Sweden, Estonia would be the most vulnerable country among the Baltic states.

The analysis suggests that, overall, foreign ownership has contributed to the stability of the Baltic banking system. Some of the risks that remain, especially as they are related to the possibility of the transmission of shocks from parent banks to subsidiaries, are likely to diminish in the process of further EU integration. As a result, the loan portfolios of the parent banks are likely to become more diversified and therefore less dependent on the performance of the parents’ home countries.

Looking Forward: The Implication of EU Accession

Joining the European Union implies that accession countries will profit from the free movement of goods and services. Theoretically, this should reduce barriers to entry into the banking sector in the Baltics even further and ensure that national regulators do not discriminate against foreign banks. Free movement of services implies that a bank licensed to operate in one country of the European Union does not need additional approval to set up branches and subsidiaries in another EU country. Since this should lead to more competition, smaller countries such as the Baltics are likely to profit because foreign banks could set up branches or subsidiaries, or even simply threaten entry, without incurring high regulatory costs. This in turn should reduce financing costs, especially for small and medium-sized enterprises.45

The Creation of an EU Passport for Capital Markets and the Implications for the Baltics

The principle of the European financial market has been one of regulatory competition with minimal harmonization and mutual recognition of rules. Especially with respect to capital markets, EU regulation is still developing, which is one of the reasons why capital markets remain segmented. Raising capital across borders is still subject to regulatory barriers. The lack of a common legal framework and enforcement rules have particular implications for accession countries such as the Baltic states. Within the European Union, there are some 40 public entities that deal with securities market regulation and supervision. The number will increase substantially once the next wave of accession countries has joined the European Union. The largest benefit for accession countries, especially those with underdeveloped domestic capital markets, would come from simply being able to adopt a common European framework. Given the small size of the Baltics, the costs for investors of obtaining information about the regulatory framework and enforcement rules of these countries are relatively high. Under these circumstances, the adoption of a unified framework would be associated with scale efficiencies and therefore lower information costs. This would contribute to the creation of markets based on ratings and default risk, and eliminate the premium for institutional differences.

The latest proposal by the EU Commission is designed to create a single European market for securities. While no final decision has been made concerning the specifics and the exact timing, there seems to be general agreement about the principle. A single European market for securities would have significant implications for the Baltics. According to the current proposal, small and medium-sized enterprises would be able to use a simplified prospectus that could be updated by attaching financial statements. This would reduce otherwise prohibitively high standards and costs, allowing these enterprises to access capital markets. The same simplification would apply to the prospectus for bond issues worth more than €50,000 and sold via private placements. Another feature of the proposal would also benefit the Baltic states: for bond issues in excess of €50,000, the issuer can choose the country in which the prospectus will be approved, and this prospectus can then be used in all EU countries. Given the small size of the Baltics and the scarcity of knowledge available on financial market instruments, this aspect of the proposal should be beneficial.

Settlements and Payments Systems

The greatest benefits for the Baltics, in terms of both efficiency gains and risk reduction, would occur if the countries adopted a common European platform for payments and settlements. Analogous to the segmentation of capital markets, however, such a common platform does not exist, given that the backbone of the EU settlements and payments system comprises the individual systems of EU countries.46 Consequently, the Baltic states had to adopt and improve their own national systems first in order to participate in the Trans-European Gross Settlement System (TARGET). In this vein, all three countries have embarked on the development of a new interbank transfer system, which will entail a real-time gross settlement for large and urgent transactions and a designated-time net settlement for retail transactions.

Changes in Operating Procedures in Preparation for EMU Membership

Policy decisions by central banks in the run-up to EMU membership, like pension reforms and government debt-management strategies, potentially can foster capital market integration. Most accession countries, including the Baltic states, still have mandatory reserve requirements for banks that are in excess of those in the European Union. Reserve requirements continue to play a particularly important role in Estonia and Lithuania, the two states that chose a currency board arrangement as their exchange rate regime.47 One of the requirements for EMU membership is the reduction of reserve requirements to 2 percent of deposit liabilities. Reserve requirements in excess of the EU average would put the banking systems of the Baltic states at a competitive disadvantage. A reduction of cash reserves, however, is often associated with an increase in liquidity. The increase in liquidity could, of course, be sterilized through open market operations. The Bank of Estonia opted instead to allow banks to hold 50 percent of the required reserve in the form of high-quality, euro-denominated foreign assets. In addition to minimizing adverse liquidity implications, this action has accelerated the integration of capital markets because banks are encouraged to invest a percentage of their assets in Europe.48

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