Bank Lending to Small Businesses in Latin America: Does Bank Origin Matter?

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1 Bank Lending to Small Businesses in Latin America: Does Bank Origin Matter? George Clarke, Robert Cull, Maria Soledad Martinez Peria, and Susana M. Sánchez * Abstract: Recently, foreign bank participation has increased significantly in developing countries fueling concerns that foreign banks might extend credit only to certain sectors, leaving customers like small businesses unattended. Using bank level data for four Latin American countries during the mid-1990s, we investigate whether bank origin affects the share and growth of lending to small businesses. While on average foreign banks seem to lend less to small businesses, regressions results reveal significant differences between small and large foreign banks. In general, we find that the latter surpass large domestic banks in their share and growth of lending to small businesses. Keywords: foreign bank participation, small business lending JEL: G21, G3 * Authors are World Bank staff members. We are grateful to Mark Flannery and two anonymous referees for useful comments and suggestions. We would also like to thank the Central Bank of Argentina, the Argentinean Superintendency of Financial Institutions, the Chilean Superintendency of Banks and Financial Institutions, the Colombian Superintendency of Banks, and the Peruvian Superintendency of Banks for providing us data and advice. We are particularly grateful to the following individuals at these institutions: Juan Carlos Alfaro, Patricio Alvarez, Tamara Burdisso, Liliana Castineira, Jorge Cayazzo, Jaime Córdova, Patricia Correa-Bonilla, Laura D Amato, Monica Gabel, Francisco Gismondi, Socorro Heysen, Gonzalo Jimenez, Jorge Marshall, Carlos Enrique Masmela González, Javier Poggi, Luciana Rios-Benso, Luis Raúl Romero, and Jairo Zubieta-Vela. We have benefited from comments from Jerry Caprio, Augusto de la Torre, Jim Hanson, and Fernando Montes-Negret. Augusto de la Torre also assisted us in obtaining the necessary data. Ainur Bekturganova, Juan Miguel Crivelli, and Ivanna Vladkova- Hollar provided excellent research assistance. The Office of the Chief Economist for Latin America, the Financial Sector Board, and the Research Committee provided funding for this paper. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors and do not necessarily represent the views of the World Bank, its Executive or the countries they represent. Contact information: Maria Soledad Martinez Peria, The World Bank, 1818 H Street, N.W., Washington D.C., Phone: (202) Fax: (202) mmartinezperia@worldbank.org

2 Introduction Over the past decade, foreign bank participation has increased significantly in developing countries. In Central Europe, the percentage of assets controlled by foreign banks increased from 8 percent in 1994 to 56 percent in As of December 2000, foreign financial institutions controlled 38 percent of loans in the major countries of Latin America, up from 15 percent in In Asia, the numbers are less striking, but the trend is definitely visible. Foreign control in this region has increased from 2 to 13 percent. 1 Whether foreign bank participation will be beneficial for developing countries is controversial. Proponents argue that foreign banks bring new capital, improve management expertise, and promote efficient and competitive banking practices. Also, because foreign banks have access to alternative sources of funding other than local deposits, many argue that foreign bank participation may lead to lower volatility and higher growth of lending. In contrast, those opposing opening up financial systems to foreign ownership argue that foreign banks may decrease the stability of aggregate domestic bank credit by facilitating capital flight during crises and by increasing countries exposure to regional contagion and to shocks in the home countries of foreign banks. Another common argument against foreign bank participation is that these institutions might cherry pick the most profitable customers, reducing financing to some sectors, increasing the risk exposure of local banks, and thus, affecting the overall distribution of credit. One particular area of concern is the availability of credit to small businesses. A number of recent studies have shown that foreign bank participation seems to improve banking system efficiency and to contribute to overall banking stability in developing countries. 2 On the other hand, the effect of foreign bank participation on access to credit in developing countries remains largely unexplored. This issue is the focus of this study. In particular, this paper investigates whether bank origin has an impact on the share and growth of bank lending to small businesses. This question is important 1 All figures on foreign control come from IMF (2000). 1

3 since small businesses account for a very significant share of total value added and generate a large fraction of the total jobs in developing economies 3 At the same time, banks are perceived as having a comparative advantage over other financial institutions in small business lending. Therefore, a reduction in bank lending to small businesses could have important negative real effects. There are two sets of studies on small business lending that are relevant for this paper. First, there is a wide literature on bank lending to small businesses in the U.S. that has potential implications on how the size of foreign banks and their mode of entry could affect lending to small businesses. However, conclusions from this literature should be drawn with caution given the many differences between the U.S. and developing economies and, in particular, because the focus of the U.S. literature is not on foreign bank lending to small businesses, but on small business lending in general. Second, there are some recent studies on foreign bank lending to small businesses in developing countries, yet these are very few and yield mixed results. We review both sets of studies below. A significant number of U.S. based studies indicate that large and organizationally complex institutions find it difficult to lend to informationally opaque small and medium-sized enterprises. 4 These organizational diseconomies might explain why a number of studies have found that foreign banks, which as shown by Focarelli and Pozzolo (2001) are typically large, appear to allocate greater shares of their lending to activities and sectors dominated by large firms. 5 On the other hand, recent U.S. based studies argue that while large banks are unlikely to replicate the lending methods of small domestic banks, technological innovation could offer them an avenue for increasing small business lending. Mester (1997) argues that advances in credit scoring methodologies, 2 See Demirgüç-Kunt, Levine, and Min (1998), Levine (1999), Barajas et al. (2000), Claessens et al. (2000), Clarke et al. (2000), and Dages et al. (2000). 3 IERAL (1999), for example, reports that small and medium enterprises account for more than 50 percent of employment in Hong Kong, Korea, Mexico, and Thailand, among other countries. Escudé et al. (2001) report a similar figure for Argentina. 4 See Berger and Udell (1995), Berger et al. (1995), Keeton (1995), Levonian and Soller (1995), Berger and Udell (1996), Peek and Rosengren (1996), and Strahan and Weston (1996). 5 See Cho et al. (1987), Goldberg (1992), and Clarke et al. (2000). 2

4 coupled with enhanced computer power, and increased data availability, are likely to change the nature of small business lending. Furthermore, using survey data on whether and how large banks in the U.S. use small business credit scoring models, Berger et al. (2002) find that the adoption of these technologies is associated with expanded quantities of small business credits. 6 These studies suggest that there could be a nonlinear relation between bank size and lending to small businesses. On the left-hand side, would be small domestic banks engaged in relationship lending for services not amenable to scoring. On the righthand side, would be large, possibly foreign, banks offering more standard products to small businesses based on credit scoring. The literature on small business lending for the U.S. also indicates that the mode of bank entry may affect lending patterns to this sector. For example, the evidence from the U.S. indicates that de novo entrants seem to devote larger shares of their assets to small businesses relative to other banks. 7 The U.S. results are driven to a large extent by the fact that de novo entrants tend to remain small. However, these findings may not carry over to the case of foreign entry in developing countries, where most of the foreign banks setting up de novo operations are large international banks that can increase their local presence very quickly (see Focarelli and Pozzolo (2001)). Therefore, the impact of de novo foreign entry on small business lending in developing countries may differ from that documented for the U.S. The U.S. evidence on the impact of mergers and acquisitions (M&As) on small business lending is mixed. Some U.S. studies find that M&As among small banks lead to increased propensity to lend to small businesses following their consolidation. 8 However, when medium-sized and large banks are involved, a number of recent papers have reached conflicting conclusions. Keeton (1996) and Berger et al. (1998) found that M&As tend to result in a reduction in small business lending when large banks are involved, but Strahan and Weston (1998) found no significant change in the ratio of small business loans to assets following M&As between large banks. 6 This applies primarily to loans of under $100, See Goldberg and White (1998), DeYoung et al. (1999), and Jenkins (2000). 3

5 To date, most of the M&As between foreign and domestic banks in developing countries have involved the union of large banks. Thus, a priori, based on U.S. studies of M&As between large banks, we might expect to find a decline in foreign bank lending to small businesses as a result of merger activity involving foreign banks. However, it is possible that credit to small businesses might increase following M&As if foreign banks view these transactions as a way to get inside knowledge on the sector and expertise on how to lend to small businesses through the acquisition of domestic banks that might already have the know-how to target this sector. Argentina is the only developing country for which we could find studies on the impact of foreign bank participation on lending to small businesses. However, these studies are few in number; are largely based on comparing ratios of foreign and domestic bank lending to small businesses without controlling for other factors that might explain the share of lending to small businesses; and yield mixed results. For example, Bleger and Rozenwurcel (2000) indicate that foreign bank participation in Argentina was associated with a reduction in bank lending to small businesses from around 20 to 16 percent of total lending between 1996 and In contrast, Escudé et al. (2001) find that despite their lower tendency to lend to small businesses, foreign banks increased both their propensity and their market share of lending to the sector between 1998 and Finally, using a rich data set on Argentinean business debtors in December 1998, Berger, Klapper, and Udell (2001) find that large banks and foreign owned banks are less inclined to extend credit to smaller firms, which are likely to be informationally opaque. A potential limitation of this study is that the authors run separate models for the probability that a small business receives a loan from a large bank and the probability of receiving a loan from a foreign bank, making it harder to assess whether it is bank size or foreign ownership that limits access for small borrowers. Furthermore, the paper does not control for other bank characteristics that might also affect the propensity to lend to small businesses. Finally, the evidence from this paper is only for one period, December Walraven, (1997), Berger et al. (1998), Peek and Rosengren (1998), and Strahan and Weston (1998). 4

6 Given the paucity of research on the impact of foreign bank participation on access to credit and due to the importance of this issue from a policy standpoint, further work in this area is clearly warranted. We view this paper as a first step in this direction. Using bank level data for Argentina, Chile, Colombia, and Peru during the mid-1990s, this study empirically investigates whether bank origin affects the share and growth rate of bank lending to small businesses, while controlling for other bank characteristics that might influence these variables (including mergers and acquisitions and de novo entry). After Eastern Europe, Latin America has been the region that most rapidly and widely allowed foreign bank entry. Moreover, our study focuses on four of the most important countries in the region that have witnessed the largest increase in foreign bank participation in recent years. While we find that on average foreign banks tend to lend less to small businesses than their domestic counterparts in some countries, our results reveal an important asymmetry in the behavior of small and large foreign banks. In a number of instances, primarily for Argentina and Chile, we find that large foreign banks surpass large domestic banks in terms of the share and growth rate of lending to small businesses. Consequently, our results suggest that the size of the local operations of foreign banks is an important determinant of the extent to which these banks will discriminate against small businesses. Countries that allow foreign bank participation and wish to promote bank lending to small businesses should pursue policies that encourage foreign banks to increase the size of their local operations in the country, by taking steps such as improving the quality of the contracting environment, providing access to good borrower data, and promoting macroeconomic stability. The remainder of the paper is organized as follows. Section II presents a brief overview of the Argentinean, Chilean, Colombian, and Peruvian banking sectors. Section III discusses the data used in this paper and presents descriptive statistics on the extent to which foreign banks lend to small businesses vis-à-vis their domestic counterparts. Section IV explains the econometric methodology, while section V presents the empirical results. In Section VI we conduct a preliminary exploration of the cross-country differences in our results. Finally, section VII concludes. 5

7 II. Banks in Argentina, Chile, Colombia, and Peru: An Overview Both the number of banks and the distribution of their sizes vary across the four countries, something that could have implications for lending to small businesses (see Figure 1). Colombia with a population of 41.6 million had the second lowest number of banks (27) in Chile, which has a population of 15.0 million, or just over one-third that of Colombia, had 28 banks. Peru resembles Colombia more than Chile. Its 25.2 million residents are served by 19 banks. Finally, Argentina had the highest number of banks per resident 91 banks serve a population of 36.6 million. Not only are there more banks per capita in Argentina and Chile, but also they are larger than those in Colombia and Peru. In both Chile and Argentina, the largest banks have between 15 and 20 billion dollars in assets. In Colombia, the largest banks have 3 to 4 billion dollars in assets. In Peru, this figure ranges between 4 to 6 billion dollars. Relatively small banks comprise an inordinate share of the total in all four countries. In Argentina, there are still a large number of small banks despite the process of bank closures and mergers and acquisitions that followed the Tequila crisis in In the early 1990s, Argentina had more than 200 financial institutions. Less than half of that number were in operation in late 2000, and some of those were new entrants. While several banks have failed, many have been acquired by or merged with other entities. In the period covered by our data (June 1998 to March 2000), there were twenty-eight mergers or acquisitions, fifteen of which involved foreign banks. 9 The period between the Tequila Crisis in late 1994 and the beginning of our sample witnessed even greater consolidation (see World Bank 1998). Argentina experienced the most mergers and acquisitions in the late 1990s. However, Chile, Colombia, and Peru have also undergone a similar process of consolidation. In Colombia and Peru, there were six mergers or acquisitions, two of which involved foreign banks. Chile had eleven such 9 Due to missing balance sheet or income statement data it is possible that not all banks that took part in these transactions are included in our regressions. 6

8 transactions, half involving foreign banks. Argentina also led the way with six de novo entrants, compared to two for Peru and none in either Chile or Colombia. In our empirical analysis, we control for the effects of mergers, acquisitions, and de novo entry on the share and growth rate of lending to small businesses. The ratio of banking sector assets to GDP provides another indication that Colombia and Peru have a lower level of financial intermediation than Argentina and Chile (see Figure 2). Both for Colombia and Peru that ratio hovered near forty percent, and was declining at the end of our sample period. To some extent, these dips were due to Colombia s internal conflict and banking crisis and to Peru s scandals at the end of the Fujimori administration. By way of comparison, in Argentina the ratio of banking sector assets to GDP went from 48 percent in 1998 to 56 percent in Owing to the hyperinflation of the late 1980s, Argentina started the 1990s with a very low ratio of banking sector assets to GDP. However, with the exception of the Tequila Crisis, that ratio grew relatively steadily after the adoption of the Convertibility Plan in 1991, which brought about price and exchange rate stability. Chile s banking development occurred earlier. By 1996, banking sector assets were nearly 140 percent of GDP, and that figure had grown to over 180 percent by It is true that much of the Chilean banks assets are in assets other than loans, and that the ratio of banking assets relative to GDP may overstate their relative level of development. However, Chile holds a sizable advantage over the other three countries on other measures of financial development such as the ratio of private credit to GDP. 10 The evidence on foreign bank participation also indicates that Chile and Argentina differ from Colombia and Peru (see Figure 3). In Colombia, foreign banks comprise forty percent of the total number, but they account for only a quarter of banking sector loans. In Peru, over half the banks are foreign-owned, but they are responsible for forty percent of total system loans. Furthermore, there is a key difference between these countries. In Peru, the share of loans held by foreign banks grew 10 In 2000, Chile s ratio of private sector credit to GDP was 66 percent. This figure was 26 percent for Peru, 23 percent for Argentina, and 19 percent for Colombia. 7

9 throughout the late 1990s, while in Colombia it declined slightly. Still, foreign banks held about a quarter of total loans in both countries throughout most of the period. By the end of the period, foreign banks held over 50 percent of Argentina s banking sector loans, and almost 45 percent of Chile s. Chile s foreign bank share climbed throughout our sample period. In Argentina, most of that growth occurred prior to our sample period. However, data on lending to small businesses for Argentina was only available since 1998, and thus our sample period is shorter than that for Chile. The key point, however, is that foreign banks comprised a consistently larger share of bank loans in Argentina and Chile than in Colombia or Peru. Judging from the empirical evidence from the U.S. one might expect that small borrowers would fare relatively worse in Argentina and Chile. Those countries experienced greater foreign bank participation and had much larger banks than in Colombia or Peru. Moreover, in Argentina foreign entry coincided with a massive consolidation in which many small banks left the market either through merger or failure. Section V tests these conjectures explicitly. III. The Data To analyze domestic and foreign bank lending to small businesses, we assembled a comprehensive bank level database for Argentina, Chile, Colombia, and Peru during the 1990s. These countries bank superintendencies were our main sources of data. In the first place, we gathered data on the distribution of bank lending by size. When information about small business loans was not available as a separate category, small business loans were defined by the size of the loan, instead of borrower size. For the case of Argentina, a study on small business lending conducted by the central bank prior to the recent devaluation, indicated that loans to this sector went to businesses with total debt between 50,000 and 2.5 million dollars. 11 Since we do not have information on borrowers total debt, we use bank level information on total lending stratified by loan size for the period 8

10 According to the aforementioned study, a small business with up to 2.5 million dollars in debt, on average borrowed up to 1 million dollars from any individual bank. Thus, for the period , we define as loans to small businesses all loans up to this amount. For Chile, small business loans are identified based on the total debt of the business rather than the size of individual loans. Total debt is measured by the Chilean Banking Superintendency in unidades de fomento (UF), which are equal to a fixed quantity of Chilean pesos indexed to inflation. Following the guidelines provided by the Superintendency, we define as small business lending all loans to borrowers with less than UF50,000 in total debt, which is roughly equal to 1.5 million dollars. 12 The Superintendency of Banks in Colombia requires banks to keep a separate record of the amount of loans they give to small firms registered with the Superintendency of Businesses. According to Colombian regulations, small businesses are those with assets up to 1.7 million dollars. For each bank in Colombia, we obtained quarterly information on the loans to the 4,067 small businesses registered with the Superintendency of Businesses over the period Because this might be a partial list of all small businesses in Colombia, we should be careful in trying to draw conclusions across countries. Officials from the Peruvian Banking Superintendency estimate that small business loans range between $20,000 and $500,000. Thus, using a breakdown of bank lending by size for loans to businesses prepared by the Peruvian Banking Superintendency, we define small business loans as loans to businesses up to $500,000. Together with data on bank lending to small businesses, we also gathered information on the origin (foreign or domestic) of each bank in these countries throughout the sample. Moreover, we identified whether foreign banks entered or increased their local presence in the four countries through a process of mergers and acquisitions with previously existing domestic institutions or by creating a new 11 See Escudé et al. (2001). 12 We also have data on lending to borrowers with less than UF10,000 (roughly $300,000) and less than UF200,000 (roughly $6 million) in total debt. Empirical results are robust to these alternative definitions of small business lending. 9

11 institution or de novo bank. In general, the first type of entry is likely to result in higher bank concentration, especially if foreign banks acquire large domestic institutions. Finally, we collected balance sheets and income statements for all the financial institutions to control for the performance and health of domestic and foreign banks when comparing lending patterns across these institutions. Table 1 summarizes the definition, source, data frequency, range and average of all the variables used in our analysis for each of the four countries. Table 2 compares the share and growth rate of small business lending (constructed from the data described above) by domestic and foreign banks in Argentina, Chile, Colombia, and Peru during the late 1990s. 13 We find that on average foreign banks in all four countries in our sample devote a lower share of their total lending to small businesses. However, these shares are not significantly different in the case of Colombia. In fact, Colombia looks very different from the other countries not only because the shares of small business lending by domestic and foreign banks are not significantly different from each other, but also because these Colombian shares are several orders of magnitude smaller than what we find for other countries. While for the other three countries the share of lending to small businesses ranges between 18 and 30 percent depending on the country and the origin of the bank, for Colombia this share does not exceed 2 percent. Again, this might be due to the fact that data on small business lending is available only for the 4,067 firms registered with the Superintendency of Businesses. Thus, while it seems acceptable to compare the share of small business loans for foreign and domestic banks in Colombia, it might not be appropriate to make compare small business lending shares in Colombia and the remaining countries. Differences across countries in the share of small business loans might also reflect the relative abilities of their companies to access outside sources of finance, particularly international capital markets. 14 To the extent that the largest firms in a country are able to access foreign bond and equity 13 The exact sample period varies by country. See Table 1 for a description of the data frequency and range for each country. 14 We thank an anonymous referee for this insight. 10

12 markets, or receive syndicated loans from banks outside the country, they will rely less on bank loans from their home country. Small businesses would therefore account for a higher share of in-country bank loans. Because cross-country comparisons of small business lending shares are susceptible to measurement problems of the sort described above, we focus primarily on within-country comparisons between foreign and domestic banks. If lending to small businesses grows at a slower pace than other types of lending, it is possible that the share of lending to this sector could be dropping, while the growth rate of the level could still be positive. Thus, to distinguish between the behavior of the share and the level of small business lending, Table 2 present tests of differences in mean growth rates of small business lending across domestic and foreign banks for all four countries. Table 2 shows that in Argentina, Chile, and Colombia, the annual small business lending growth is lower for foreign banks relative to domestic banks. Peru is the one case where the growth rate of small business lending by foreign banks is positive and significantly different from that observed for domestic banks. IV. Empirical Methodology Differences in the mean share or average growth rate of lending to small businesses between domestic and foreign banks might be driven by factors other than bank origin that are not taken into account in the tests reported in Table 2. Thus, we now turn to regression analysis for a detailed study of the impact of bank origin on small business lending. For each country, we estimate equation 1 below in order to examine the impact of bank origin on the share of lending to small businesses, controlling for other factors that might influence this ratio. 11

13 j P i,t j j j j j j j j j j j j ln ( ) = α + β SIZE + β SIZE *FOREIGN + β FOREIGN + β 'FCIAL + β PUBLIC 1 P 1 i,t = 0 2 i,t = 0 i,t 3 i,t 4 i,t = 0 5 i,t i,t i,t j j j j j j j j + β 'YEAR + β FOREIGN DE NOVO + β FOREIGN DE NOVO AGE + β FOREIGN M&A 6 i,t 7 i,t 8 i,t 9 i,t j j j j j j + β FOREIGN M&A AGE + β OTHER M&A + β OTHER M&A AGE + ε j i,t (1) 10 i,t 11 i,t 12 i,t Equation 1 is estimated in log-odds logit form where j=1...x is the country identifier, i=1...n captures each individual bank within a country, and t=1...t refers to the time periods considered. P it is the proportion of loans made by banks to small businesses. Focusing on the log odds ratio rather than the share gets around the problem that shares are by definition bounded between 0 and 1. The error terms in equation (1) are likely to be correlated for observations from the same bank. This could lead us to underestimate the size of the standard errors on coefficients, and hence overestimate t-statistics (see, for example, the discussion of this issue in Moulton, 1986). To take account of this problem, we use Huber- White robust standard errors, which allow for correlation across observations from the same bank (i.e., we allow for clustered standard errors). 15 Equation 1 models the ratio of small business loans to total loans as a function of a number of bank indicators, including bank origin. In particular, to assess whether foreign and domestic banks have different lending patterns, we include FOREIGN, a dummy variable equal to one if the bank is over fiftypercent owned by foreign interests. SIZE refers to the log of real initial total assets. 16,17 By interacting size with FOREIGN, this equation allows for the possibility that the impact of size on the share of bank lending to small businesses is different between domestic and foreign banks. In most countries in our sample, there are three kinds of foreign banks, namely, those that had been operating in the country for a number of years before our sample starts (e.g. Citibank in all four 15 See Huber (1967) and Rogers (1993). 16 In regressions not reported here, we included each bank s market share and number of branches. These variables were highly collinear with SIZE, making it difficult to interpret our results. DeYoung et al. (1998) also find that the number of branches is not a significant determinant of small business lending when also controlling for size. 12

14 countries), de novo foreign banks that opened up their business at some point in the sample, and banks that within our sample acquired other domestic or foreign banks. As noted in the literature, there are reasons to expect that these types of banks might behave differently towards small businesses. For example, in the U.S. literature de novo banks are more apt to lend to small businesses than other foreign entrants, while mergers among large banks have resulted in lower shares of small business lending. We note, however, that de novo banks in the U.S. tend to remain small and thus are constrained to make small loans due to borrower concentration limits. In a developing country, where banking sectors tend to be less competitive, a large multinational bank could enter and grow quickly, and thus rely less on lending to small businesses. 18 To allow for differences in the impact that the mode of entry by foreign banks has on the share of lending to small businesses, we include separate dummies for foreign de novo banks (FOREIGN DE NOVO) and for those foreign banks that either entered the system or increased in size by acquiring domestic institutions (FOREIGN M&A). Both of these dummy variables are also interacted with a variable measuring the time since entry or acquisition (AGE) to capture changes in banks small business lending as they became better established in the market. 19 Because consolidation by domestic banks or between two foreign banks could have an impact on the share of small business lending, we include a dummy for mergers that did not involve a foreign bank merging with or acquiring a domestic institution (OTHER M&A). We also interact this variable with AGE to control for the dynamic impact of bank consolidation (independent of ownership) on lending to small businesses. Publicly owned banks operate in three out of the four countries in our sample (Argentina, Chile, and Colombia). Because lending decisions at state-owned banks could be governed by politics or special 17 This variable is lagged one period to prevent the first size observation for each bank from being simultaneously determined with the share of small business lending. 18 We thank an anonymous referee for this interpretation. 19 For example, in Argentina where data is monthly, age would equal 1/12 one month after a merger, acquisition or de novo entry. 13

15 mandates rather than by commercial factors, we include a dummy for public banks (PUBLIC) in our estimations. 20 FCIAL refers to the initial value of two financial health and performance indicators, return on assets and the ratio of administrative expenses to total assets. 21 In some specifications, we also include the initial value of equity capital over total assets and of the share of non-performing loans. The expected signs on all of these variables are unclear. For example, banks with positive return on assets and a higher degree of capitalization might be more able to grow over time and to expand into areas where it takes time and effort to acquire the know-how of the business, like lending to small borrowers. At the same time, banks with low return on assets, a high share of non-performing loans, and low equity capital might be more willing to gamble for resurrection by venturing into higher risk segments, like lending to small businesses. Banks with higher ratios of administrative expenses to assets might be better suited to lend to small businesses, if their high expenses are associated with a more extensive branch network and a larger labor force that can provide the personalized attention and monitoring that is often needed when lending to small businesses. On the other hand, banks with high administrative expenses might be at a disadvantage in competing with other banks in lending to small businesses. Finally, the share regressions include year dummies (YEAR) to control for changes in the share of lending to small businesses associated with macroeconomic variables or any other factors that are common among banks over time. The share regressions provide important information about the impact of foreign bank participation on lending to small businesses, but they cannot tell us for certain whether such lending increased or decreased during this period. For example, those regressions could indicate that the share of lending to small businesses by foreign banks was falling relative to shares at domestic banks while, at the same time, foreign banks total lending to small businesses was actually increasing. The decline in the 20 Public banks in Argentina, Colombia, and Chile account for 30, 25, and 10 percent of banking assets, respectively. 21 Like we do with initial size, we lag these variables one period to avoid the potential simultaneity between these variables and the first observation of the share of small business lending for each bank. 14

16 share of small business lending would occur if that line of business was not growing as fast as other types of lending by foreign banks, but there would be real growth in small business lending nonetheless. For these reasons, we also run regressions in which the dependent variable is the growth rate in real lending to small businesses. Equation 2 examines the impact of bank origin on the growth rate of real lending to small businesses (SBLGROWTH), again allowing for the possibility that the impact of size on lending to small businesses might depend on bank origin. j j j j j j j j j j j SBLGROWTH i,t = µ + δ 1 SIZE i, t = 0 + δ 2 SIZE i,t = 0 * FOREIGN i,t + δ 3 FOREIGN i, t + δ 4 ' FCIAL i, t = 0 j j j j j j j j j j + δ 5 PUBLIC i,t + δ 6 'YEAR i, t + δ 7 FOREIGN M & A i, t + δ 8 FOREIGN M & A AGE i,t + δ 9 OTHER M & A i,t j j +δ OTHER M & A AGE j 10 i,t + ω i, t (2) Once again, j=1...x is the country identifier, i=1...n captures each individual bank within a country, and t=1...t refers to the time periods considered. All regressors are defined above. The growth in small business lending for a given month is calculated relative to its level in the same month in the previous year (so-called year-on-year growth rates). Since both of those levels must be available to calculate a growth rate, this method implies fewer observations in the growth rate regressions than in the share regressions. In the growth regressions, therefore, we no longer have observations when a de novo entry occurred, and thus those dummy variables do not appear in equation 2. While the year-on-year process helps eliminate distortions stemming from seasonality or excessive monthly volatility, it could introduce autocorrelation among the observations for each bank. However, the clustered standard errors that we use also correct for any autocorrelation and therefore should take care of this problem. V. Empirical Results Share regressions Table 3 reports the results from equation 1, which allows the impact of size on the share of lending to small businesses to differ for domestic and foreign banks. For our purposes, one key variable 15

17 from the share regressions is the foreign ownership dummy, which is negative in most cases, but significant only in the case of Chile and for one model for Peru (model 3.13). Therefore, controlling for other factors, it appears that a typical foreign bank did not devote a significantly lower share of its lending to small businesses in Argentina and Colombia during our sample period. In the models for Chile and Peru where the foreign ownership dummy is negative and significant, the interaction between bank size and foreign ownership is significant and positive, which suggests that small domestic banks devoted a larger share of their lending to small businesses than small foreign banks. However, as bank size increases the disparity between domestic and foreign banks also declines. In fact, for both Chile and Peru, our models indicate that large foreign banks devoted a higher share of lending to small businesses than large domestic banks. In the share regressions, size has a negative impact on lending to small businesses. This effect is significant only in the case of Peru and one model for Colombia (model 3.10). Private domestic banks generally appear to lend more to small businesses (as a share of total lending) than state-owned banks, after controlling for other factors that might affect lending. The coefficient on the dummy indicating government ownership is negative and statistically significant in the regressions for Argentina (models 3.1 and 3.2) and Chile (models 3.5 and 3.6). In Colombia, the only other country with state-owned banks, the coefficient is positive in one specification, negative in another. One frequently heard justification for state banks is that they resolve credit market failures by emphasizing lending to small businesses. These results appear to undercut that justification. The regressions also include a series of dummies to control for the effects of mergers, acquisitions, purchases of existing domestic banks by new foreign entrants, and de novo entry by foreign banks. These variables are included to control for the possibility that banks involved in mergers within our sample and banks that have only recently entered the system might experience a sudden jump in their share of lending to small businesses and it might take them some time to reach their desired portfolio allocations. To allow banks to slowly adjust their portfolio allocations, variables representing the time since the merger or entry occurred are also included. In Argentina, where the largest number of 16

18 transactions took place, we are able to include more dummies than in the other countries. However, since there were very few mergers during our sample period in most of the countries, and because some observations are lost due to missing or incomplete data, the coefficient estimates are often based on only a few merger/entry observations. Consequently, these variables might be best thought of as controlling for temporary disequilibria following mergers and new entry and results for them should be interpreted with caution. Given the limited number of observations, it is not surprising that the merger/entry variables do not tell a very consistent story across countries. We briefly mention some of the results from those variables. First, the very limited evidence on de novo entry, which comes only from the share regressions for Argentina, appears to indicate that contrary to the U.S. experience, foreign de novo entrants do not concentrate on small business financing. Second, the FOREIGN PURCHASE dummy (which controls for cases where an outside foreign bank purchases a domestic bank) is positive and significant in the Argentina share regressions, indicating that some foreign banks entered that market by purchasing domestic banks that devoted a high share of their lending to small businesses. The rest of the merger/entry variables show little consistency across types of regression or across countries. For example, the coefficient for FOREIGN M&A (i.e., existing foreign banks acquiring or merging with domestic banks) is negative and significant for one model for Chile (model 3.6), but insignificant for Argentina, Colombia, and Peru. The interaction between FOREIGN M&A and AGE is insignificant for Argentina and Colombia, negative and significant for one specification for Chile, and positive and significant for Peru. Similar inconsistencies across countries are found for all the regression types discussed below. The effect of the mode of entry on the lending behavior of foreign banks is an important topic. We simply lack the number of observations necessary to provide consistent evidence on this issue Again, part of this stems from the short time period covered and the low number of banks, and part stems from our inability to merge the respective country datasets as described above. 17

19 Growth regressions Table 3 also includes regressions based on equation 2, with the annual growth of small business lending as the dependent variable. 23 The coefficient on the dummy indicating foreign ownership is negative and statistically significant in the regressions for Argentina and one specification for Chile (model 3.7). For Colombia and Peru, this variable is insignificant. Controlling for other factors, the growth rate of lending to small businesses for the typical foreign bank in those two countries was similar to that for domestic banks. The statistically insignificant coefficient on the interaction term between size and foreign origin for both Colombia and Peru suggests that size affected growth of small business lending similarly for foreign and domestically owned banks in these countries. In the specifications for Argentina and Chile where the foreign ownership dummy is negative and significant, the interaction between foreign ownership and bank size is positive and significant. As in the share regressions, this suggests that small business lending growth at small domestic banks was higher than at small foreign banks, but for larger banks the disparity between domestic and foreign banks was much smaller. In fact, for both countries our models indicate that large foreign banks experienced higher growth in lending to small businesses than large domestic banks. 24 There is also broad consistency between the share regressions and the growth rate regressions with respect to state-owned banks. The coefficient on the dummy variable for state ownership in the growth regressions is negative and statistically significant in two of the countries with state-owned banks, Chile and Colombia, indicating that lending to small businesses by state-owned banks was growing at a slower pace than lending by private domestically owned banks. For the final country with state-owned 23 Since the growth rates are calculated based upon annual growth rates (i.e., growth over a full year), data are omitted for a full year following a merger or acquisition to prevent such transactions from affecting results. For example, a merger that doubles the size of a bank will result in abnormally large annual growth rates for a full year after a merger even if the merged bank makes no new loans over this period. Consequently, many observations involving mergers and new entries are dropped from the analysis and several dummies are dropped from the growth regressions entirely. For example, if a merger occurs one year before the end of the period, all post-merger information is lost from the growth regressions, whereas it would be included in the share regressions. 18

20 banks, Argentina, the coefficient on the dummy variable indicating state ownership is positive, but statistically significant in only one specification. The results provide further indication that small business lending might not be a primary objective of state-owned banks. The coefficients on the bank performance/characteristics variables are rarely significant and often inconsistent across countries in the growth rate regressions. Bank size, for example, is insignificant in all specifications. The one exception is the share of administrative expenses to assets, which is positive and significant in the growth regressions for Argentina, Colombia, and Peru. This is consistent with the hypothesis that banks with higher ratios of administrative expenses to assets might offer a more extensive branch network and a larger labor force that can provide the personalized attention and monitoring that is often needed when lending to small businesses. The small business lending by foreign banks in Colombia and Peru may have been qualitatively different than that undertaken by large foreign banks in Argentina and Chile, but we do find evidence from the loan growth regressions from all four countries that suggests that foreign banks (or a subset of them) were expanding such lending at least as fast as both private domestic and state-owned banks during this period. These results appear to undercut claims that foreign banks are unable or unwilling to enter the small business lending niche in developing countries. Parent Bank Size Our results so far controlled for foreign bank size using the total assets of their local operations. However, for multinational bank subsidiaries or branch operations, the size and the complexity of the parent bank (or bank holding company) might be more indicative of overall financial strength and technological and management expertise. Foreign banks might rely on this expertise to lend to small businesses. Table 4 presents regression results that control for the assets of the parent bank to help determine whether its local presence or the size of its global operations make a foreign bank more (or 24 These results for Argentina could still be consistent with those obtained by Berger et al. (2001) since their estimations focus only on December 1998, a period towards the start of our sample and our results are significant for the growth of lending rather than the share of lending, which is most similar to their dependent variable. 19

21 less) likely to engage in small business lending. Data on foreign banks parent size comes from Fitch- IBCA s Bankscope database. Once parent bank assets are included in the regressions, it becomes more difficult to see how foreign ownership affects the share of lending to small businesses based simply upon the coefficient values. To make it easier to interpret the results, Figures 4, 6, 8, and 10 show the estimated share of lending to small businesses for foreign and domestic banks. 25 Estimated shares are calculated in the final period for each country for banks of different sizes using coefficients in Table 4 and the mean values of continuous variables (other than size) for banks of that type. Parent bank size is set to the median sample value. We assume also that the bank was not involved in any mergers or acquisitions. For all four countries, medium and large domestic banks lend less to small businesses (as a share of total lending) than small domestic banks. The pattern for foreign-owned banks appears quite different from the pattern for domestic banks. Although foreign banks with a small local presence lend considerably less to small businesses than small domestic banks in all four countries, banks with a medium to large local presence generally appear similar to medium and large domestic banks. In fact, in three of the four countries, Chile, Colombia, and Peru, estimated shares of small business lending for large foreign banks are larger than for large domestic banks (see Figures 6, 8, and 10). In Argentina, although foreign banks of all sizes lend lower shares than similar domestic banks, the difference is smaller for large banks than it is for small banks (Figure 4). However, only the estimates for Chile are derived from a model in which the foreign ownership dummy and the foreign ownership/size interaction term are both significant. In Peru, the interaction is positive and significant in model (4.13), but the result is not robust to the inclusion of non-performing loans and bank equity among the regressors (see model 4.14). Figures 5, 7, 9, and 11 show the estimated growth in lending to small businesses for foreign and domestic banks based on coefficients from Table 4 controlling for parent bank size. In Argentina, Chile, 25 Estimated shares are calculated for banks between the 5 th and 95 th percentile based upon size. 20

22 and Peru, estimated growth rates for the largest foreign banks (based on assets of their local operations) are higher than for the largest domestic banks. The results for Argentina are more reliable because both the foreign ownership dummy and the foreign ownership/size interaction term are significant in all specifications. In summary, our results indicate that foreign banks with a large local presence have a higher propensity to lend to small businesses. On the other hand, the coefficient on parent bank assets is negative in the share regressions for all four countries, but only consistently significant in the case of Argentina. Parent bank size is never significant in the growth regressions. Appendix table A.1 shows the roster of foreign banks operating in each country along with the country of origin, the size of the local operations, the assets of the parent banks, and the average share and growth of lending to small businesses. As can be seen from this table the majority of the banks operating in Latin America are internationally renowned institutions that are likely to possess the technology to lend to whatever sectors they choose to, including the small business sector. However, some of them like Bank of Tokyo in Argentina and Chile, ABN-Amro in Colombia, and Bank Boston in Peru have chosen to maintain a small local presence and a limited involvement in the small business loan market. Based on this table and the empirical results discussed above, it appears that what matters for small business lending might not be whether the bank possesses the technology to target this sector, but whether it also has the commitment or local presence to put it to use in the foreign markets it enters. Banks from Spanish Speaking Countries Due to cultural affinities such as a shared language, banks from some countries might have advantages over others in lending to small businesses in the four countries that we study. To test that proposition, we add to our base specifications a dummy variable equal to one for all banks from countries whose native language is Spanish or Portuguese (Table 5). 26 In practice, this includes all banks from 26 In principle, we would like to control for differences in bank nationality at the most disaggregated level (i.e. including separate bank dummies for each country of origin). However, as can be seen from Table A.1, in the 21