The short-term effects of foreign bank entry on domestic bank behaviour: Does economic development matter?

https://doi.org/10.1016/S0378-4266(02)00393-XGet rights and content

Abstract

This paper investigates the short-term effects of foreign bank entry on the behaviour of the domestic banking sector. We hypothesise that these effects are dependent on the level of economic development of the host country. Our investigation shows that at lower levels of economic development foreign bank entry is generally associated with higher costs and margins for domestic banks. At higher levels of economic development the effects appear to be less clear: foreign bank entry is either associated with a fall of costs, profits and margins of domestic banks, or is not associated with changes in these domestic bank variables.

Introduction

Since the 1960s, international banking activity has grown quickly due to increased international trade flows and foreign direct investment activities, the globalisation of capital markets, and the liberalisation of domestic financial markets.2 International banking activities may involve cross-border activities and activities of banks outside their home country (i.e. foreign banks). Of these two aspects of international banking, especially the activities of foreign banks have received increased interest recently. In many emerging market economies in particular, the presence of foreign banks has increased dramatically, especially during the late 1990s. In south-east Asia foreign bank control of the domestic financial market (measured as the ratio of assets of banks where foreigners own more than 50% of total equity over total assets of the entire banking sector) rose from 1.6 % in 1994 to 6% in 1999. Foreign bank control rose from 7.5% to 25% during the same period in Latin America. In Eastern Europe the rise of foreign control was most dramatic: from almost 8% in 1994 to 52% in 1999 (IMF, 2000, p. 153). Among other things, these increases in foreign bank control are due to the fact that since the early 1990s many countries have implemented financial liberalisation policies, allowing foreign banks to set up branches and domestic banks to be foreign-owned.

The increased presence of foreign banks raises questions about their effects on the domestic banking sector. This paper aims at empirically analysing the effects of foreign banks on the operation of domestic banks. It provides an econometric analysis based on bank level data for 48 countries for the period 1990–1996 with respect to operations of domestic banks and investigates how foreign bank entry may influence the activities of domestic banks. In particular, we are interested in investigating the short-term effects of foreign bank entry on the efficiency of the domestic banking system. Our point of departure is a paper by Claessens et al. (2001). In this paper, Claessens et al. show that foreign entry improves the functioning of national banking markets through increased market competition and improved efficiency of domestic banks. We elaborate on this finding and investigate to what extent the short-term effects of foreign entry on domestic banks may depend on the level of economic development of the host country. Based on the theoretical literature there are good reasons to believe that the level of economic development plays a crucial role in determining the effects of foreign bank entry on the domestic banking system, at least in the short-term.3

The remainder of this paper is organised as follows. Section 2 provides a brief survey of the discussion on the effects of foreign bank entry on the domestic financial market. Section 3 discusses the data and the empirical model. Section 4 discusses the methodology and presents the results of the empirical analysis. Section 5 provides our interpretation of the results. Section 6 concludes.

Section snippets

Foreign bank entry and domestic bank behaviour: A brief survey

In the literature, several issues on the effects of foreign bank entry on domestic financial markets and institutions have been discussed. For instance, several papers focus on issues such as the differences in comparative advantages in financial services between countries and, the effects of foreign bank entry on the overall stability of the domestic financial system, etc.

Description of the data and the empirical model

In order to be able to investigate the short-term effects of foreign bank entry on the behaviour of domestic banks, we first need variables that measure the presence of foreign banks in a host country. In line with Claessens et al. (2001) we use two different variables to measure this. First, we take the ratio of the number of foreign banks to the total number of banks in the host country (FBNUM). This measure basically looks at the sheer presence of foreign banks. Second, we use the share of

Empirical analysis: Methodology and results

In order to be able to investigate whether and to what extent the level of economic development plays a role in determining the short-term effects of foreign bank entry on domestic bank behaviour we use two different approaches:

  • we estimate Eq. (1) and use a threshold estimation technique;

  • we incorporate an interactive term of foreign bank entry and the level of economic development in the regression model as specified in Eq. (1).

Interpretation of the results

We interpret our findings discussed in Section 4 as follows. At lower levels of economic development foreign bank entry may have a strong effect on domestic banks in terms of spill-overs of modern bank techniques and practices, since there is a large gap between the development of domestic and foreign banking. Yet, domestic banks need to make investments to implement these techniques and practices. Therefore, costs rise. At the same time, since domestic banks still have a relatively strong

Concluding remarks

This paper has empirically analysed the short-term effect of foreign bank entry on the behaviour of domestic banks. As our point of departure we take the study by Claessens et al. (2001), which is the only comprehensive study of this issue. They find supportive evidence of the hypothesis that foreign bank entry improves the efficiency of domestic banks, since income, profitability and costs of these banks are negatively associated with the presence (rather than the size) of foreign banks.

We go

Acknowledgements

Research for this paper has been financially supported by the European Commission’s ACE/Phare programme under contract number P98-1082-R. We thank two anonymous referees and the participants of the conferences on ‘Foreign Banks and Economic Transition’ in Poznan (September 2001) and Tallinn (April 2002) for their comments on an earlier version of the paper.

References (17)

  • S. Claessens et al.

    How does foreign entry affect domestic banking markets?

    Journal of Banking and Finance

    (2001)
  • B.E. Hansen

    Threshold effects in non-dynamic panels: Estimation, testing, and inference

    Journal of Econometrics

    (1999)
  • A. Barajas et al.

    Foreign investment in Colombia’s financial sector

  • T. Beck et al.

    A new database on the structure and development of the financial sector

    World Bank Economic Review

    (2000)
  • A.N. Berger et al.

    The efficiency cost of market power in the banking industry: A test of the “quiet life” and related hypotheses

    Review of Economics and Statistics

    (1998)
  • C.M. Buch

    Opening up for foreign banks: How Central and Eastern Europe can benefit

    Economics of Transition

    (1997)
  • K.R. Cho

    Foreign banking presence and banking market concentration: The case of Indonesia

    The Journal of Development Studies

    (1990)
  • B.G. Dages et al.

    Foreign and domestic bank participation in emerging markets: Lessons from Mexico and Argentina

    Federal Reserve Bank of New York Economic Policy Review

    (2000)
There are more references available in the full text version of this article.

Cited by (0)

1

Tel.: +31-50-363-3712; fax: +31-50-363-7356.

View full text