Obstacles to a global banking system: “Old Europe” versus “New Europe”

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Abstract

“Old Europe” – the developed nations of continental Europe – averages only about 15% foreign bank ownership, whereas “New Europe” – the transition nations of Eastern Europe – averages about 70%. Similar findings hold elsewhere in the world – developed nations tend to have much lower foreign bank ownership shares than developing nations. We examine the causes of the differences within Europe with an eye toward more general conclusions. Our findings suggest that the low foreign bank shares in “Old Europe” – and perhaps developed nations more generally – may primarily result from net comparative disadvantages for foreign banks and relatively high implicit government entry barriers. The high foreign penetration in “New Europe” – and perhaps developing nations more generally – may be due to net comparative advantages for foreign banks and low government entry barriers, particularly in nations that reduced their state bank ownership.

Introduction

“Old Europe” – the developed nations of continental Europe – tends to have relatively low foreign bank ownership, whereas “New Europe” – the transition nations of Eastern Europe – often has most of its banking services provided by foreign banks. To illustrate, the three largest developed economies in continental Europe – Germany, France, and Italy – each have less than 10% of assets owned by other European-based foreign banks and less than 15% foreign bank penetration overall. In contrast, three of the largest transition economies – Poland, Czech Republic, and Hungary – each have more than 50% of assets owned by banks headquartered in other European-based foreign banks alone. In this paper, we focus primarily on the causes of the differences in foreign bank ownership between “Old Europe” and “New Europe” with an eye toward drawing more general conclusions about the connections between the level of development and foreign bank ownership.

The differences in foreign bank ownership between “Old Europe” and “New Europe” may seem surprising. Most of the “Old Europe” nations – including the three nations cited – are long-term members of the European Union (EU), which has explicitly tried to create a single banking market. These countries in most cases share a common currency and close geographic proximity, reducing the costs consolidating across borders. The “New Europe” nations, in contrast, often had state domination of banking fewer than 20 years ago. Most have now significantly reduced state ownership of banks have lowered other explicit and implicit barriers to entry and allowed foreign banks to control most of their banking assets. In some extreme cases – such as Estonia, Czech Republic, and Croatia – state bank market shares are less than about 5% and foreign bank shares are about 90% or more.

The experiences of “Old Europe” and “New Europe” are not atypical of developed and developing nations, respectively, elsewhere in the world. Foreign banks control only about 10% of banking assets in most developed nations in North America and East Asia. While there are exceptions, foreign bank penetration in developed nations is generally quite low relative to many developing nations. To illustrate, the average foreign bank share in the developing nations of Latin America is over 40% and foreign shares are well over 50% in some individual developing nations in Asia and Africa. In a few developing nations – e.g., Belize in Latin America, Macau in Asia, Lesotho in Africa – foreign banks have virtually taken over the banking markets, with market shares of about 90% or more.

The relatively low foreign penetration in developed nations may seem surprising. Most of these countries have removed many of the explicit government regulatory barriers to foreign bank entry. The nations of “Old Europe” have adhered to the Single Market Programme (SMP) designed to make the EU as close as possible to a single banking market with a single banking license that may be used across the member nations. Technological advances have also encouraged globalization of the banking system. Improvements in information processing, telecommunications, and financial technologies have all facilitated greater reach across borders. The newer technologies allow banks to manage information flows from more locations and to evaluate and manage risks at lower cost without geographic proximity. In addition, globalization of trade and enlarged cross-border activities of nonfinancial companies have increased demand for banks that can provide services across international boundaries.

The low foreign shares in developed nations relative to developing nations may also be surprising because the latter more often have high explicit barriers to foreign entry. In addition, developing nations tend to present difficulties for foreign banks headquartered in developed nations in processing “soft” information about local conditions because of significant cultural and market differences and because these banks are more accustomed to using quality “hard” information – such as credit bureau data and certified audited financial statements – which are often lacking in developing nations. Developing nations also often have significant market shares for state-owned banks. These banks may “crowd out” foreign competition with subsidized services and lax enforcement of loan repayment schedules that make them particularly attractive to borrowers.

To analyze the causes of the differences in foreign bank ownership, we use a simple framework in which the primary determinants of foreign bank market shares in a nation are (1) the economic comparative advantages and disadvantages of foreign banks in that nation; and (2) the explicit and implicit barriers to foreign bank competition erected by that nation’s government. To the extent that the comparative advantages of foreign ownership outweigh the disadvantages, foreign banks should be more efficient relative to domestic institutions, giving stronger incentives for foreign banks to enter and expand to exploit these net comparative advantages. To the extent that disadvantages dominate, the associated inefficiencies should discourage foreign bank market penetration. However, even if foreign banks are relatively efficient, their market shares may be relatively small if explicit or implicit government barriers are relatively high and thwart the economic rationale for international banking.

By way of preview, the analysis suggests that the relatively low foreign bank shares in “Old Europe” – and to some extent developed nations more generally – may primarily be the result of a combination of (1) net comparative disadvantages for foreign banks in these countries; and (2) relatively high implicit barriers raised by the governments of these nations. The research is consistent with the notions that foreign banks are relatively inefficient in “New Europe” and developed nations generally and that these nations have relatively low explicit government barriers to foreign banks. The framework also suggests that the very high foreign penetration in “New Europe” – and to some extent developing nations more generally – may be due to a combination of (1) net comparative advantages for foreign banks in these countries, and (2) relatively low government entry barriers in some of these nations, particularly the low state bank ownership. The research finds that foreign banks tend to be relatively efficient in “New Europe” and developing nations generally and that these nations have in many cases reduced the implicit barrier to foreign bank entry of state ownership because of transition from socialism or in response to crises. Finally, in some cases in both “Old Europe” and “New Europe” and in both developed and developing nations elsewhere, the “New Zealand effect” occurs. That is, foreign banking organizations from nearby large developed nations take large market shares in a small nation that has created no large private-sector banks to compete with the foreign organizations.

The remainder of the paper is organized as follows. Section 2 provides recent data on foreign bank penetration in the EU, distinguishing between “Old” and “New” nations. Section 3 discusses the comparative advantages and disadvantages of foreign banks, some of which differ for developed versus developing nations. Section 4 reviews the empirical research on the relative efficiency of foreign and domestic banks in both categories of nations using data from a number of different countries. Section 5 highlights some of the major explicit and implicit government barriers to foreign bank competition in developed and developing nations. Section 5 displays some data on cross-border banking around the world to illustrate the net effects of the economic comparative advantages and disadvantages and the explicit and implicit government barriers. Finally, Section 7 draws some tentative conclusions.

Section snippets

Recent data on “Old Europe” and “New Europe”

For a number of years, the EU has been implementing the Single Market Programme (SMP). This is designed to make the EU as close as possible to a single banking market, and has dramatically reduced explicit government barriers to cross-border competition among the 15 nations that were members prior to 2004 (EU15). As well, many of the regulations have been harmonized and most of the EU15 nations now share a single currency – changes which would also be expected to result in increased

Economic comparative advantages and disadvantages of foreign banks

One potential comparative advantage for foreign banks is that their organizations may be able to diversify and absorb risks across nations and regions of the world. This may raise profits through higher revenues and/or lower costs. Higher revenues may occur because lower risk allows these institutions to invest in some higher risk–higher expected return investments and/or to provide superior financial stability for which customers may be willing to pay higher rates and fees. Lower costs may be

Empirical evidence on the relative efficiency of foreign banks

A number of recent papers compare the average efficiency of foreign and domestic banks, which may suggest whether the economic comparative advantages or disadvantages dominate. That is, a finding that foreign banks are relatively efficient may suggest that the comparative advantages of foreign ownership tend to outweigh the disadvantages and vice versa if the foreign banks are found to be relatively inefficient.

Efficiency measures differ from profitability and other financial ratios mainly in

Explicit and implicit government barriers to foreign bank competition

There are both explicit and implicit government barriers to foreign competition. Explicit barriers are the rules and regulations that overtly limit the entry and behavior of foreign banks or treat these institutions differently from domestic banks in a formal way. Historically, explicit restrictions on foreign entry were quite common, but many of these barriers have been lowered over time, including the single banking license in the EU discussed earlier. Empirical research on entry barriers

Brief look at worldwide data on cross-border banking

We next examine data on the extent of cross-border banking around the world to show the net effects of the economic comparative advantages/disadvantages and explicit/implicit government barriers. Fig. 1 illustrates some of the variation in foreign bank market shares across regions and within regions. To be comprehensive, we use the most recently available data from the World Bank that covers most of the nations of the world. The data are as of year end 2001 are drawn from the World Bank data

Conclusions

We analyze the important research and policy issue of why foreign bank competition as measured by market share has been surprisingly weak in developed nations – particularly those in “Old Europe” – and much stronger in many of the developing nations – particularly those in “New Europe.” Under our analytical framework, the main determinants of foreign bank penetration are the economic comparative advantages and disadvantages of foreign banks and the explicit and implicit government barriers to

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    The opinions expressed do not necessarily reflect those of the Federal Reserve Board or its staff. An early working version of this paper was presented at the Federal Reserve Bank of Chicago/World Bank Conference on Cross-Border Banking. The author thanks the editors, anonymous referees, Lamont Black, John Boyd, Phillip Hartmann, Iftekhar Hasan, Sole Martinez Peria, Mingming Zhou, and conference participants for helpful suggestions and Phil Ostromogolsky and Reid Dorsey-Palmateer for outstanding research assistance.

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