Foreign Ownership Of An Emerging Country’s Banks

We have just seen how in small emerging market economies especially the value of the government guarantee to the banking industry is highly negatively correlated with the value of the banks’ loan assets. When the bank's assets decrease because of a macroeconomic shock, there is an increase in the government's liability from the guarantee because the expected risk exposure is now higher, unless the bank raises adequate additional capital. This requires prompt action by the government or by the shareholder.  Unfortunately, when a serious crisis erupts, a statement by the government that it will stand by its guarantee has less credibility, while shareholders lack the incentive to provide additional capital. Incidentally, the same shareholders of the bank may have less new investment capacity, having invested in other sectors of the same economy.  The "cultural proximity" between the two countries resulted in direct investments being cumulated. When the country’s economy collapsed the value of those firms also collapsed. Spanish banks had anticipated this event by creating, on their balance sheet, loss reserves to be used to write off their investments both in the banks and in the industrial and service companies they owned—which in the event they did. Following these large write-offs they were either unwilling or unable to infuse additional equity capital in the Argentinean banks they owned, thus accelerating their demise and shifting upon the government the responsibility for guaranteeing the bank’s liabilities.  It has rightly been suggested that especially governments in emerging markets perform risk audits of their assets and liabilities using VAR-like methods in their assessments. We recommend that they should also periodically reassess the value of the guarantee they are implicitly and explicitly giving to the banking system and measure the expected risk exposure.  There would arise a strong case for prudential regulation requiring the banks operating in these countries to sell or to diversify their loans portfolios into other countries’ assets through securitizations, credit default swaps and credit derivatives. Furthermore, as Spain's example shows, the foreign shareholders of the banks should comply with similar rules especially if they are banks themselves.