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 real 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 and increase real growth. The greater their presence the less does external financial dependence impede firm performance. Foreign banks also mitigate the adverse consequences of banking crises on growth but do not significantly affect economic activity in advanced countries with well-functioning financial markets. Our results provide strong evidence that foreign entry alleviates financial constraints without hurting economic growth prospects, especially in developing countries whose companies often lack access to alternative sources of finance.