Foreign bank entry: a liquidity based theory of entry and credit market segmentation

This paper analyses how entry by an international bank into a developing economy affects the credit market equilibrium. It offers a novel explanation of how a foreign entrant overcomes asymmetric information problems, and complements extant hard vs. soft information based theories of credit market segmentation. In the model, the banks are protected by limited liability. This introduces an agency problem since, in certain states of the world, it is optimal for the banks to lend to negative net present value projects. The agency problem has an asymmetric impact on the local and the foreign bank. The model illustrates how the diversification of the foreign bank's loan portfolio eliminates the agency problem. In contrast, in certain states of the world, the agency problem frustrates the local bank's ability to raise finance. The paper explores the importance of the foreign bank.s ability to provide finance during local liquidity shortages, and illustrates how this can lead to a segmentation of the credit market. In equilibrium, the foreign bank .nances local firms with a low exposure to the local economy, and the local bank finances firms with a high exposure to the local economy. The model predicts, that foreign entry increases the domestic .nancial sector.s vulnerability to liquidity shocks.