Developing countries often receive international financial aid intended to strengthen their economies and banking sectors. But does an influx of foreign capital actually make local banks more secure?
A recent study published in Applied Economics investigates this question. The research revealed that an increase in aid targeted specifically at a country’s financial sector is associated with higher rates of bad loans and greater default risk.
Investigating the impact of aid
While past studies have looked at how aid affects broad economic growth, less is known about its specific impact on the stability of individual banks. Chien-Chiang Lee of the City University of Macau and his colleagues sought to untangle this relationship.
To understand the study, it helps to know how economists measure bank health. Bank stability is often tracked by the proportion of non-performing loans, which are loans that borrowers have stopped repaying.
Another key concept is macroprudential policy. These are the rules that government regulators use to protect the entire financial system, such as capping how much money a person can borrow compared to the value of the property they are buying.
Tracing the flow of capital
The researchers analyzed data spanning from 1992 to 2016. They combined international aid records with financial performance metrics from thousands of banks, primarily across Europe and Asia.
The team tracked how much aid was directed to a country’s financial sector and compared it to the health of the local banks three years later. They used several statistical techniques to isolate the effect of the aid and account for other economic variables.
The baseline analysis showed that as financial aid increased, local banks experienced a rise in non-performing loans. The authors identified two opposing processes that explain this outcome.
First, financial aid was linked to improved financial development, meaning more local businesses were able to secure bank loans. This broader market development was associated with a decrease in bad loans and an improvement in overall stability.
However, a second process counteracted that benefit. The researchers found that when countries received more financial aid, policymakers tended to relax their macroprudential policies.
With looser regulations in place, banks were encouraged to lend more aggressively and take on borrowers with lower credit ratings. The researchers interpret this drop in loan quality as the primary driver behind the overall increase in bad loans.
Regional differences and regulatory safeguards
The study highlighted that the destabilizing effect of financial aid was not universal. The link to higher non-performing loans was stronger in developing nations and particularly pronounced in Asian countries compared to European ones.
The researchers suggest that Europe’s stricter regulatory environment likely blunted the negative effects of the incoming capital. The adverse impact was also heavily concentrated during times of global economic stress, such as the 2007 to 2009 financial crisis.
The size and status of the bank also played a role in how it handled the influx of aid. Institutions designated as Systemically Important Financial Institutions (SIFIs) did not see the same decline in stability.
These massive banks are already subject to stringent capital and liquidity requirements to prevent them from failing. The authors argue that this heavy regulation acts as a safeguard against the risky lending behavior seen in smaller banks.
A warning for policymakers
The researchers outline clear takeaways for government regulators in countries receiving financial aid. When foreign capital arrives, policymakers might feel pressure to ease lending restrictions to spur immediate economic growth.
To maintain bank stability, the authors suggest regulators should take the opposite approach. They recommend tightening macroprudential tools, such as implementing strict limits on loan-to-value ratios and capping debt-to-income limits.
