Global Deleveraging and Foreign Banks’ Lending to Latin American Countries

Lending by foreign banks to emerging markets is a defining feature of financial globalization. In the years preceding the recent global crisis, foreign bank lending to emerging economies expanded rapidly—whether directly from parent banks’ headquarters in advanced economies (cross-border flows) or through their affiliates operating in host countries. In the case of Latin America, lending by foreign banks became a significant source of funding for households and firms over the last decade. Although there is no consensus on the benefits of foreign banks’ activity, on balance the presence of foreign-owned banks is generally believed to have enhanced competition and aided overall financial stability.¹

After the onset of the global credit crunch in 2008–09, however, foreign banks became a potential conduit through which financial stress in advanced economies could spread to emerging markets. Funding shortages in interbank markets and the need to deleverage bank balance sheets raised concerns that foreign banks would pull back from international lending activities, potentially disrupting macroeconomic and financial stability in emerging market economies.²

In Latin America, the growth rate of total foreign banks’ credit slowed significantly after the collapse of Lehman Brothers in the third quarter of 2008. Yet crucially, the lending behavior of parent banks vis-à-vis their local affiliates in Latin American economies was starkly different. Cross-border lending, which is mostly denominated in foreign currencies, followed a boom-bust pattern, reversing sharply after the fourth quarter of 2008. In contrast, lending by their affiliates operating locally (a large share of which is denominated in host countries’ domestic currencies) proved much more resilient and continued to expand, even amid the financial turmoil.

This paper explores how the global financial shocks were transmitted to Latin American countries through the foreign bank lending channel. For this purpose, we undertake an econometric analysis of the determinants of foreign banks’ lending to Latin American and Caribbean countries using data from the Bank for International Settlements (BIS). The sample covers twelve Latin American countries and spans 1999 (the first year for which data are available on a quarterly basis) to the first quarter of 2009, at the height of the global credit crunch. We assess the effects of three factors that characterized the recent global financial turmoil: the freezing of international money markets, the deterioration of the financial health of parent banks in advanced economies, and more restrictive lending standards in developed countries’ banking systems. The sample period used in the paper thus provides an event study of the transmission of the global crisis to foreign banks’ lending, rather than a systematic description of foreign banks’ reaction to crises.

To identify the channels of transmission and the possible mitigating factors, we exploit differences in the geographic structure (cross-border versus local affiliates) and currency mix (foreign versus domestic) of foreign banks’ lending to Latin American countries at the bilateral level (that is, between each Latin American recipient country and a BIS-reporting creditor country in a given quarter). For this purpose, we rely on publicly available data from the BIS on the currency structure of foreign banks’ claims, together with confidential BIS data on the share of foreign banks’ total lending extended through local affiliates (in both domestic and foreign currencies).

Our results indicate that international money market conditions had a significant impact on foreign banks’ lending to Latin American and Caribbean countries. In particular, an increase in the TED spread caused by liquidity shortages in the global interbank market adversely affects foreign banks’ lending growth to Latin American countries. Also, a deterioration of parent banks’ own financial soundness in advanced economies is associated with reductions in foreign banks’ financing to Latin American countries. Changes in banks’ lending standards in advanced economies also seem to have a statistically significant effect on the growth of foreign banks’ credit to Latin American countries.

However, we also find that the propagation of these global financial shocks was significantly more muted for countries where foreign banks conduct a higher share of their lending through their local affiliates in domestic currency than through cross-border...