Foreign banks and credit booms: Hidden harbingers of financial crises?

New research examines how foreign banks and small lenders disproportionately drive risky lending in the years preceding banking crises

In 2008, Iceland’s banking system collapsed spectacularly after years of rapid growth fuelled largely by foreign lenders. Between 2004 and 2008, total assets in Iceland’s banking system ballooned from 100% to 900% of GDP, with much of the growth coming from cross-border lending. When the global financial crisis hit, Iceland’s overextended banks were unable to refinance their short-term debts, leading to bank failures and a severe economic downturn.

This pattern of foreign-led credit booms preceding crises has played out in other countries as well. In the lead-up to the 1997 Asian financial crisis, foreign bank lending to East Asian economies surged. According to data from the Bank for International Settlements, international bank claims in the region grew by over 50% between 1995 and 1997. When sentiment turned, these foreign lenders rapidly withdrew capital, exacerbating the crisis.

More recently, the Baltic states experienced a similar dynamic before the 2008 global financial crisis. In Latvia, for example, Swedish banks aggressively expanded lending in the mid-2000s, with foreign-owned banks accounting for over 60% of banking assets by 2007. When the crisis hit, these banks sharply curtailed lending, contributing to a severe recession that saw Latvia’s economy contract by 18% in 2009.

These real-world examples illustrate the risks that can arise when credit growth is driven by foreign lenders and banks with small market shares in a country. New research published in Management Science sheds light on how the composition of lenders during credit booms can signal an increased risk of future banking crises. The research paper, Who Lends Before Banking Crises? Evidence from the International Syndicated Loan Market, was co-authored by Yeejin Jang, Associate Professor in the School of Banking and Finance at UNSW Business School together with Mariassunta Giannetti, a Professor of Finance at the Stockholm School of Economics.

Foreign banks drive pre-crisis lending booms

The study examined international syndicated lending data from 1986 to 2016, covering 64 banking crises across 46 countries. It found that in the years leading up to banking crises, foreign banks and those with small market shares in a country tended to increase their lending more aggressively compared to domestic banks and those with large market shares.

The study uncovered several ways that foreign and low market share banks take on greater risk in pre-crisis periods. They were more likely to lend to borrowers in non-tradable sectors like real estate, which are particularly vulnerable during downturns. They also increased loans to smaller firms, highly leveraged companies, and those with low-interest coverage ratios. This shift in lending patterns suggests a general loosening of credit standards and a potential misallocation of capital towards riskier segments of the economy.

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“Not only do foreign lenders extend credit to riskier borrowers during pre-crisis periods, but they also lend less efficiently,” the researchers stated. Foreign banks were found to increase the proportion of loans to low-profitability and low-productivity borrowers compared to normal times. This behaviour could contribute to the build-up of systemic risk by supporting less viable businesses and potentially crowding out more productive investments.

Additionally, these lenders were more prone to issuing loans without collateral or covenants during pre-crisis years. They also tended to shorten loan maturities, contributing to the build-up of short-term debt that can amplify financial instability. The shift towards looser lending terms and shorter maturities can create vulnerabilities in the financial system, making it more susceptible to shocks and increasing the risk of sudden stops in credit availability.

Importantly, the researchers found that foreign and low market share lenders did not compensate for this added risk by charging higher interest rates. In fact, for some categories of risky borrowers, they offered lower rates during pre-crisis periods. “We find no evidence that foreign lenders charge a premium on the loans they extend during pre-crisis periods,” the researchers explained.

“If anything, foreign lenders provide loans at lower interest rates to risky and low-quality borrowers during pre-crisis periods.” This failure to price risk appropriately suggests that competitive pressures or overly optimistic assessments of borrower quality may be driving lending decisions, rather than prudent risk management.

Understanding the drivers of risk

The study explored potential explanations for why less established lenders behave differently in pre-crisis periods. One possibility is that these banks have less accurate expectations about borrowers’ future performance due to information disadvantages. This could be particularly relevant for foreign banks entering new markets or smaller lenders attempting to gain market share.

However, the evidence suggested this was not the primary factor. When examining lending to tradable industries, where knowledge is more easily transferred across borders, foreign and low-market-share banks actually increased exposure to familiar industries more during pre-crisis times.

Instead, the researchers concluded that less established lenders likely fail to fully account for the broader economic consequences of their actions. Banks with large market shares have more incentive to consider how excessive lending could negatively impact their entire loan portfolio if economic conditions deteriorate.

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“High market share banks internalise the negative spillovers of high leverage on the economy because of their current exposure and the impact on their future business,” the paper explained. This finding provides new insight into why higher banking sector concentration may enhance financial stability in some cases. It suggests that a more fragmented lending market could be an indicator of growing systemic risk.

Implications for crisis prediction

The study demonstrated that incorporating data on lender composition could improve early warning models for financial crises. When the researchers added variables capturing the share of lending from foreign and low market share banks to standard crisis prediction models, it increased explanatory power significantly. This improvement in predictive capability could be valuable for both policymakers and business leaders in assessing and preparing for potential financial instability.

For instance, the probability of a crisis increased from 1.9% to 6.7% when the growth in foreign bank lending moved from the bottom quartile to the top quartile. Similarly, a decrease in the average market share of lenders was associated with higher crisis risk. These quantitative findings provide concrete benchmarks that risk managers and policymakers can use to gauge the level of systemic risk in credit markets.

“Our findings are important for macroprudential policy: by supplying more credit to riskier borrowers without offering more restrictive contracts and requiring higher interest rates, less established lenders contribute disproportionately to frothy market conditions,” the researchers concluded.

They also suggested policymakers should consider not just the quantity of credit growth, but also which types of lenders are driving the expansion. This could help distinguish between healthy financial deepening and more dangerous credit booms, allowing for more targeted and effective regulatory interventions.

Practical takeaways and risk management strategies

For business leaders and risk managers, the study offers several key lessons and actionable insights:

Monitor lender composition: Track the market share of your company’s lenders and be alert to a shift toward less established banks, especially foreign lenders. This could signal growing systemic risk. Regularly review your company’s lending relationships and consider the stability and local market commitment of your creditors. Developing a diverse set of lending relationships that includes both established and newer market entrants can help balance access to credit with systemic risk exposure.

Assess loan terms carefully: Be wary if lenders start offering unusually favourable terms, particularly for riskier borrowers. This may indicate broader risk-taking behaviour in the market. When negotiating loans, consider whether the terms reflect an appropriate assessment of your company’s risk profile. Unusually lenient terms may be a red flag for broader market volatility. Consider maintaining some stricter covenants or collateral requirements as a form of self-discipline, even if lenders are willing to offer looser terms.

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Consider broader economic context: The study found that lending patterns were especially predictive of crises that followed financial liberalisation or coincided with real estate booms. Factor in these macro trends when evaluating credit market conditions. Stay informed about regulatory changes in the financial sector and monitor real estate market indicators. If your industry is particularly sensitive to real estate cycles, consider developing contingency plans for a potential downturn.

Look beyond interest rates: The research showed that risky lending was not always reflected in higher rates. Examine other loan features like collateral requirements, covenants, and maturities for a fuller picture of lender risk appetite. Develop a comprehensive framework for assessing loan terms that goes beyond just the interest rate. Consider how different loan features might perform under stress scenarios and aim for a balanced mix of financing structures.

Diversify funding sources: While the study focused on lender behaviour, it highlights the potential dangers of relying too heavily on a narrow set of creditors, especially those without deep roots in the local market. Explore a range of financing options, including bonds, private placements, and alternative lenders, to reduce dependence on any single source of credit. This diversification can provide a buffer against potential credit market disruptions.

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Enhance internal risk assessment: Use the insights from this research to improve your company’s own credit risk models. Consider incorporating metrics on lender composition and behaviour into your assessment of overall financial market health. Regularly stress-test your company’s financial position against scenarios of sudden credit tightening or economic downturns.

Engage with policymakers: For larger corporations or industry associations, consider engaging with financial regulators to share insights on credit market conditions from a borrower’s perspective. This dialogue can contribute to more effective macroprudential policies that balance financial stability with access to credit.

By incorporating these insights into their risk assessment processes, businesses can better navigate credit cycles and prepare for potential financial turbulence. The ability to spot early warning signs of excessive risk-taking in the banking sector could prove invaluable in an increasingly interconnected global economy. While it’s impossible to predict crises with certainty, a nuanced understanding of lending dynamics can help companies build resilience and make more informed strategic decisions.