LEO FERRARIS RAOUL MINETTI Foreign Lenders and the Real Sector We develop a theory of the interaction between the entry of lenders and the real sector. The high liquidation skills of incumbent lenders render them too tough in terminating high-risk/return projects. Being “foreign” to the market, newcomers have lower ability to liquidate than incumbents. This makes them softer in liquidating high-risk/return projects but renders their funding more costly. We show that the entry of lenders and the share of high-risk/return projects can reinforce each other through firms’ liquidation values. This interaction dampens the output impact of liquidity shocks. Hence, financial liberalization can enhance stability. JEL codes: E44, F49, G15 Keywords: foreign lenders, real sector, liquidation values, output stability. IN THE LAST two decades several financially liberalized coun- tries, such as the United States, the United Kingdom, the Nordic countries, the East Asian countries, have experienced an aggressive entry of new lenders into their credit markets. Cross-border lending has played an important role in this process. Japanese banks increased their presence in the United States during the 1980s and in East Asia during the 1990s (Peek and Rosengren 2000a). In the United States, after the abo- lition of interstate branching restrictions by the 1994 Riegle–Neal Act, banks have expanded beyond state borders. This process is likely to continue in the future. In Eu- rope policy makers are considering to relax regulatory and supervisory barriers that inhibit banks’ cross-border expansion and the integration of national banking sys- tems. The impact of financial liberalization has had a functional dimension besides a We wish to thank Heski Bar-Isaac, Alberto Bennardo, Matteo Iacoviello, Nobuhiro Kiyotaki, John Moore, Marco Pagano, Rowena Pecchenino, Michele Piccione, and seminar participants at Ente Ein- audi/Bank of Italy, London School of Economics, Michigan State University, University of Salerno (CSEF), and University of Warwick for helpful comments and discussions. All remaining errors are ours. LEO FERRARIS is Assistant Professor, Department of Economics at Universidad Carlos III (E-mail: leo.ferraris@uc3m.es). RAOUL MINETTI is Assistant Professor, Department of Eco- nomics, at Michigan State University (E-mail: minetti@msu.edu). Received February 15, 2005; and accepted in revised form January 30, 2006. Journal of Money, Credit and Banking, Vol. 39, No. 4 (June 2007) C  2007 The Ohio State University