The Real Effect of Foreign Banks

Although foreign banks can act as catalysts for financial and economic development their role remains controversial because they might simply displace local lenders, thereby tightening firms’ overall access to credit. To settle this issue, we study their effect on economic activity in a large cross-section of developing and advanced countries, whose industrial sectors differ in their external financing needs. We find that foreign banks alleviate the consequences of financial constraints for firm performance and increase real growth net of the competitive reaction of local lenders. They also mitigate the adverse consequences of banking crises on firms but do not significantly affect real economic activity in advanced countries with well-functioning financial markets. Our results also suggest that foreign banks help to overcome informational and legal obstacles to lending, especially in developing countries, whose companies often lack access to alternative sources of finance.