Better the Devil that You Know: Evidence on Entry Costs Faced by Foreign Banks Arturo Galindo...

Better the Devil that You Know:Better the Devil that You Know:Evidence on Entry Costs Faced by Foreign Evidence on Entry Costs Faced by Foreign

BanksBanks

Arturo GalindoArturo Galindo

Alejandro MiccoAlejandro Micco

César SerraCésar Serra

Research DepartmentResearch DepartmentInter-American Development BankInter-American Development Bank

Financial Liberalization and FDI RaceFinancial Liberalization and FDI Race

1.40

1.60

1.80

2.00

2.20

2.40

2.60

2.80

3.00

1973 1976 1979 1982 1985 1988 1991 1994 1997 2000

0

100

200

300

400

500

600

700

800

900

1000

Financial Liberalization Index(1-3)

FDI in Financial Services(billions of US$)

Foreign Bank Control (% of assets)Foreign Bank Control (% of assets)

0 10 20 30 40 50 60 70 80 90 100

Czech Republic

Hungary

Poland

Turkey

Mexico

Argentina

Peru

Chile

Venezuela

Brazil

Colombia

Malaysia

Korea

Thailand

1994

2001

Main ObjectiveMain Objective

• Study the determinants of Foreign Bank Penetration.

• Focusing whether differences in the legal and institutional setup between host and source countries increase entry costs and deter the expansion of foreign banks to domestic financial systems.

FrameworkFramework

• Introduction• Previous Literature• Data• Broad Evidence• Empirical Results• Conclusion

IntroductionIntroduction

• What are the advantages and disadvantages of foreign bank penetration?

Efficiency Gains.

Stability of Credit Growth.

Market Segmentation.

Efficiency GainsEfficiency Gains• Claessens, Demirgüç-Kunt and Huizinga (2001) and

Martinez-Peria and Schmukler (1999) find that domestic banks tend to reduce interest margins and profits when foreign bank participation increases.

• Abut, Bigio and Siller (1999) show that the efficiency gains come from the need of local banks to overcome relative disadvantages as limited access to capital, delays in and higher costs of implementing new products, etc.

Stability of Credit GrowthStability of Credit Growth• Dages, Goldberg and Kinney (2000) find that

foreign banks in Mexico and Argentina have different lending patterns than domestically owned ones. Foreign banks tended to be more stable providers of credit, potentially reflecting a more diversified funding base.

• Crystal, Dages and Goldberg (2001) find that in Chile, Colombia and Argentina, foreign banks had stronger and more stable loan growth than domestic private banks.

• However, Caballero (2002) shows that local and foreign banks in Chile increased their positions in foreign assets during the 1998 recession, but this increase was substantially more pronounced for foreign banks who allocated less credit as a proportion of the deposit base than domestic ones.

Stability of Credit GrowthStability of Credit Growth

Market SegmentationMarket Segmentation• Foreign Banks can reduce access to credit to some

segments of the market, in particular to small and medium firms that heavily depend on bank financing.

• Clarke et. al. (2001) find that foreign bank penetration improve financing conditions for all enterprises; however, the most benefited are the large ones.

• Clarke et. al. (2002) find that foreign banks lent less to small and medium enterprises; however, this is mainly driven by the behavior of small foreign banks.

Previous LiteraturePrevious Literature

• Brealey and Kaplanis (1996) use bank-level data of the world’s largest 1000 banks and analyze if the number of their offices in other countries than their own is associated with trade and FDI. However, their data set is reduced to nearly 13 sources countries.

• Focarelli and Pozzolo (2000) analyzes the probability of an OECD bank investing abroad, but they only uses a subsample of banks that have at least one equity abroad.

DeterminantsDeterminants• Efficiency: Banks operating in developed markets

are more efficient and more likely to hold comparative advantage regarding their domestic competitors. Grosse and Goldberg (1991) find that there is a positive correlation between the number of foreign banks in USA from a source country and the degree of financial development of that country.

• Economic Integration: Measure as geographical distance, bilateral trade flows and FDI. Studies have found a positive correlation between the presence of foreign banks and the measures of bilateral integration.

DeterminantsDeterminants• Regulatory Restrictions: Restrictions on entry

reduce the degree of internationalization of a country’s banking system. Miller and Parkhe (1998) find that US banks prefer to expand in countries where capital requirements are less stringent.

• Local Market Opportunities: Banks prefer to invest their resources in countries with more stable conditions proxy as a country risk (Grosse and Goldberg (1991), Fisher and Molyneux (1996) and Yamori (1998)).

DataData

• We use bank-specific ownership data from Fitch IBCA’s Bankscope for 2001.

• We include commercial, investment , saving and mortgage banks according to the definitions of Bankscope.

• Our sample includes 7912 banks from 176 countries:– Africa and the Middle East (57),

– Asia and Pacific (32),

– Latin America and the Caribbean (34),

– North America w/o Mexico (2),

– Europe (51).

VariablesVariables

k

kkji assetsshareIControlBankForeign )50( i

• Bilateral Foreign Banking Control:

where i and j are the source and host country, respectively.

•Legal/Institutional Indexes:

•Legal Origin, Banking Regulation, Regulatory Burden,

•Corruption, Rule of Law and Efficiency of the Judiciary.

Abs(Difference of Host and Source Index)

Difference of Host and Source Index

Cross-Border ShareholdingsCross-Border Shareholdings

Host Region Africa & Asia & Latin USA & Transition Europe3 TOTAL

Source Region Middle East Pacific America1 Canada Economies2

Africa & Middle East 7.68 0.05 0.11 0.08 0.01 0.34 0.34 Asia & Pacific 0.14 1.32 0.23 0.68 0.26 2.49 1.64 Latin America1 0.00 0.00 1.47 0.03 0.02 0.03 0.05 USA & Canada 1.89 1.22 18.81 0.95 4.45 3.34 2.47 Transition Economies2 0.03 0.00 0.06 0.00 1.39 0.02 0.02 Europe3 3.66 3.30 26.64 8.61 34.69 15.89 11.25 TOTAL 13.39 5.89 47.32 10.34 40.82 22.11 15.77

Source : IDB estimates based on data from Fitch IBCA's Bankscope database.

Note : Ownership data reflect changes up to 2001 while balance sheet data are the most recent available.1 Excludes The Bahamas, Caymand Islands and Panama.2 Includes economies in transition from central and eastern Europe.3 Excludes Europe in transition.

Broad EvidenceBroad Evidence(whole sample)(whole sample)

Host Source

Different Legal Origin 0.48 Different Legal Origin 0.38Same Legal Origin 2.96 Same Legal Origin 2.41

Difference -2.48*** Difference -2.03***Observations 506 Observations 3059


Difference -0.02*** Difference -0.11***Observations 3059 Observations 17556

*** Significant at 1%

Developed

Developing

Developed Developing

Broad EvidenceBroad Evidence(non-zero sample)(non-zero sample)

Host Source


Difference -3.51** Difference -8.15***Observations 206 Observations 435


Difference 0.21 Difference -1.97Observations 122 Observations 288

*** Significant at 1%

Developed

Developing

Developed Developing

Empirical StrategyEmpirical Strategy

• Based on Gravity Equation

log( 1 + FCij ) = 1CBordij + 2CLangij +

3log(Distanceij) + 4log( 1 + tradeij ) +

5Inst/Legij + 6Dhost + 7DSource + ij

Empirical ResultsEmpirical ResultsDependent Variable: Log ( 1 + Foreign Bank Control ij )

(1) (2) (3) (4) (5) (6) (7)

Common Border 1.468 3.342 2.740 1.383 1.411 1.392 4.314(0.132)*** (0.614)*** (0.286)*** (0.144)*** (0.136)*** (0.136)*** (0.505)***

Common Language 0.239 2.064 0.371 0.322 0.266 0.278 0.292(0.070)*** (0.382)*** (0.162)** (0.082)*** (0.075)*** (0.075)*** (0.345)

Log(Distance) -0.334 -1.088 -0.593 -0.356 -0.348 -0.346 -0.655(0.031)*** (0.168)*** (0.067)*** (0.035)*** (0.033)*** (0.033)*** (0.156)***

Log(1+tradeij) 0.306 0.486 0.333 0.256 0.272 0.259 0.171(0.016)*** (0.084)*** (0.032)*** (0.018)*** (0.017)*** (0.017)*** (0.093)*

Log(1+FDIij) 0.662(0.047)***

Non Sharing Legal Origin -0.139 -0.388 -0.226 -0.146 -0.151 -0.135 -0.444(0.041)*** (0.219)* (0.090)** (0.047)*** (0.044)*** (0.044)*** (0.194)**

Non Sharing Bank Regulation -0.140(0.048)***

Abs(Diff in Corruption) -0.360(0.027)***

Abs(Diff in Reg. Burden) -0.438(0.036)***

Abs(Diff in Rule of Law) -0.369(0.026)***

Abs(Diff in Eff. of Judiciary) -0.173(0.054)***

Observations 18042 3057 6860 15704 16926 16926 2628Number of Source Countries 145 22 88 133 139 139 52Notes: All specifications include host and source country dummies.

Dependent Variable: Log ( 1 + Foreign Bank Control ij )

(1) (2) (3) (4) (5)… … … … … …… … … … … …

Non Sharing Legal Origin -0.226 -0.146 -0.151 -0.135 -0.444(0.090)** (0.047)*** (0.044)*** (0.044)*** (0.194)**

Non Sharing Bank Regulation -0.140(0.048)***

Diff in Bank Regulation Index 0.115(0.062)*


Diff in Corruption Index 0.104(0.118)


Diff in Reg. Burden Index 0.049(0.063)


Diff in Rule of Law Index 0.168(0.074)**

Abs(Diff in Eff. Judiciary) -0.173(0.054)***

Diff in Eff. Judiciary Index 0.297(0.114)***

Observations 6860 15704 16926 16926 2628Number of Source Countries 88 133 139 139 52Notes: All specifications include host and source country dummies.

Bilateral FDI and Institutional and Legal Bilateral FDI and Institutional and Legal VariablesVariablesDependent Variable: Log ( 1 + FDI ij )

(1) (2) (3) (4) (5) (6)

Common Border 0.990 0.840 0.872 0.905 0.774 -0.112(0.270)*** (0.269)*** (0.274)*** (0.268)*** (0.268)*** (0.395)

Common Language -0.252 -0.330 -0.120 -0.286 -0.204 0.339(0.169) (0.168)** (0.186) (0.176) (0.176) (0.338)

Log(Distance) -0.555 -0.331 -0.538 -0.545 -0.550 -0.954(0.069)*** (0.074)*** (0.071)*** (0.069)*** (0.069)*** (0.120)***

Non Sharing Legal Origin -0.365 -0.255 -0.314 -0.373 -0.283 -0.328(0.096)*** (0.096)*** (0.103)*** (0.099)*** (0.099)*** (0.183)*

Log(1+trade90) 0.281(0.037)***




Abs(Diff in Eff. Of Judiciary) -0.298(0.047)***

Observations 3057 3057 2810 2932 2932 1064Number of Source Countries 22 22 22 22 22 21

Notes: All specifications include host and source country dummies. FDI is the stock for 1998.

Dependent Variable: Log ( 1 + FDI ij )

(1) (2) (3) (4)… … … … …… … … … …

(0.071)*** (0.069)*** (0.069)*** (0.120)***Non Sharin Legal Origin -0.314 -0.373 -0.283 -0.328

(0.103)*** (0.099)*** (0.099)*** (0.183)*Abs(Diff in Corruption) -0.810

(0.078)***Diff in Corruption Index 0.402

(0.216)*Abs(Diff in Reg Burden) -1.550

(0.130)***Diff in Reg Burden Index 0.064

(0.136)Abs(Diff of Rule of Law) -1.113

(0.092)***Diff in Rule of Law Index 0.132

(0.147)Abs(Diff in Eff. Of Judiciary) -0.298

(0.047)***Diff in Eff. of Judiciary Index -0.260

(0.092)***Observations 2810 2932 2932 1064Number of Source Countries 22 22 22 21

Notes: All specifications include host and source country dummies. FDI is the stock for 1998.

ConclusionsConclusions

• Legal and institutional differences across countries increase entry costs and reduce foreign bank participation.– Differences in legal origin leads to a reduction of nearly

13% of bilateral cross-border banking activity.

– Differences in banking regulation can account for nearly 25% of foreign bank penetration.

– In average, institutional differences imply nearly a 30% reduction in cross-border banking.

Better the Devil that You Know: Evidence on Entry Costs Faced by Foreign Banks Arturo Galindo...

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