1

Foreign Bank Entry and Domestic Banks’

Performance: Evidence Using Bank-Level Data

Nihal Bayraktar and Yan Wang*

This draft: October 12, 2005

Abstract This paper attempts to empirically investigate the impact of foreign bank entry on the performance of domestic banks, and examine how this relationship is affected by the sequence of financial liberalization. Our data set is constructed from the BANKSCOPE database including 4500 banks from 30 developed and developing countries and covering the period from 1994 to 2003. When all countries are pooled together, the empirical results indicate that the banking sector gets more competitive with a higher share of foreign banks. Our results show that the sequence of financial liberalization matters. When the countries are grouped according to their order of financial liberalization, efficiency gains from foreign bank entry (i.e. lower profits, costs, and net interest margin) are the highest in countries which liberalized their stock market first, after other possible determinants are controlled for. The relationship between the performance indicators of domestic banks and the foreign bank share is relatively weak in countries which liberalized their capital accounts first. In countries where domestic financial markets liberalized first, foreign banks’ presence cannot improve the efficiency of domestic banks; thus, negative effects of foreign banks tend to overweight their positive effects. Policy implications of this paper are two folds. While openness to foreign bank entry would generally improve domestic banks’ efficiency, the extent of impact depends on the liberalization path of a particular country, on the current status of competition in the sector, and on whether the country is "over-banked" or not.

JEL Classification: G21, F10, F21.

⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯⎯ *Respectively, Penn State University – Harrisburg and World Bank. This is part of a larger

effort in WBIPR –Trade to develop materials for capacity building on trade in financial services. The authors thank Gerard Caprio, Stijn Claessens, Roumeen Islam, Will Martin, Aaditya Mattoo, Gianni Zanini, and trade team for encouragement and comments. The findings and views expressed in this paper are entirely those of the authors. They do not necessarily reflect the views of the Bank, its Executive Directors or the Countries the represent.

2

1. Introduction

In an effort to develop an efficient and competitive financial system, many countries have

liberalized financial services, especially the banking sector. In particular, foreign bank presence

as measured by the percentage of total bank assets increased from 19 percent in 1995 to 42

percent in 2000 in low-income countries (World Bank, 2002). Along with the expanded

participation in The General Agreement on Trade in Services (GATS), policymakers have come

to realize that the presence of foreign financial service providers can benefit the consumers, the

financial industry, and the economy as a whole. However, more than trade in goods, the gains of

trade in financial services depend on many factors, including structural reforms in the domestic

financial sector, the regulatory framework as well as the sequencing of liberalization.

This paper focuses exclusively on trade openness in the banking sector by employing

bank-level panel data analysis. Previous studies suggest that foreign bank presence can facilitate

increased competition, improve allocation of credits, and help easier access to international

capital markets.1 But there are also costs associated with foreign bank entry. For example, if

foreign banks attract the most profitable portion of domestic markets, this may pressure domestic

banks into more risk taking.2 Thus the evidence on the role of foreign banks in growth and

stability is mixed.

First we investigate how the performance of domestic banks changes with foreign bank

entry by using an indicator of banking sector openness based on data from BANKSCOPE. This

issue has been investigated by previous studies in the literature. 3 But our study is different in that

it includes more than 4,500 banks from 30 developing or developed countries for a more recent

period of 1994-2003.4 Thus, this paper will be useful to confirm the results of previous studies

with an additional dimension –the impact of sequencing.

In the process of financial liberalization or integration, countries have chosen alternative

paths: some have liberalized their domestic financial markets first, or they may have liberalized

their capital account first. Related to the order of financial liberalization, each country has a

unique experience. Kaminsky and Schmukler (2003) show that most industrial countries have 1 Claessens, Demirguc-Kunt, and Huizinga (2001) study effects of foreign bank entry on efficiency of domestic banks. 2 See for example, Hellmann, Murdock and Stiglitz (2000), World Bank (2002), International Monetary Fund (2000). 3 The paper extends Bayraktar and Wang (2004) in which empirical analyses were based on country-level aggregate data instead of bank-level data. 4 For example, the data set of Claessens, Demirguc-Kunt, and Huizinga (2001) includes approximately 2,000 banks from 81 countries.

3

liberalized their stock markets first while most developing countries had a tendency to open their

banking sector first. In the literature, some economists claim that domestic financial sector should

be liberalized first, another group of studies suggests that early capital account liberalization can

initiate broader economic reforms.5

Thus the second question we focus on is whether the sequence of financial liberalization

is important in determining the effects of foreign bank presence on the efficiency of domestic

banks. In the literature, the linkages between the sequence of financial liberalization and domestic

bank performance have not been examined by previous studies. Comparison of cross-country

experience on foreign bank entry taking into account the sequencing issue is crucial in drawing

lessons for countries which are in the process of liberalizing their banking sector.

In order to accomplish the two objectives, we examine the financial liberalization process

of 30 developed and developing countries, foreign bank shares, and the efficiency of domestic

banks. The paper is organized as follows. Section 2 presents a literature review on the impact of

foreign bank entry and the order of liberalization. Section 3 describes the empirical model and the

data set. Section 4 presents some descriptive statistics. Section 5 gives econometric results.

Section 6 concludes.

2. Literature Review

Related studies are classified in two groups. The first group of studies focuses on the

benefits and costs of foreign bank entry.6 Some of the benefits include: 1) Foreign bank entry

increases the efficiency of the domestic banking sector (World Bank, 2001; Claessens, Kunt, and

Huizinga, 2001; Demirguc-Kunt and Huizinga, 1999; Claessens, Demirguc-Kunt, and Harry

Huizinga, 2000; Claessens and Lee, 2002, among others). 2) The allocation of credits to the

private sector may be improved since it is expected the evaluation and pricing of credit risks to be

more sophisticated (Clarke, Cull, and Soledad Martinez Peria, 2001; Barth, Caprio, Levine, 2001;

Levine, 1996). 3) The presence of foreign banks helps build a domestic banking supervisory and

legal framework, and enhance the overall transparency. 4) It is expected foreign banks to provide

more stable sources of credit since they may refer to their parents for additional funding and they

have easier access to international markets. 5) Foreign banks may reduce the costs associated

with recapitalizing and restructuring banks in the post-crisis period. 6) Foreign bank participation

5 See Johnston (1998), and Johnston, Darbar, and Echeverria (1997) for details. 6 The World Bank (2002) summarizes these benefits and costs of foreign bank entry.

4

lowers the possibility that a country will experience a banking crisis by raising the efficiency of

domestic banks (Demirguc-Kunt, Levine, and Min, 1998).

The costs of foreign bank entry include: 1) If the franchise value of domestic banks

decreases with foreign bank entry, they may have an incentive to take on greater risks (Hellmann,

Murdock, and Stiglitz, 2000). 2) Since foreign banks attract the most profitable portion of

domestic markets with more advanced services and products, riskier sectors will be served by

domestic banks. 3) With increased foreign bank presence, access to credit may be impaired for

some sectors of the economy. 4) Since foreign banks have different priorities and business focus,

their lending pattern tends to ignore domestic priorities. 5) Foreign banks may increase financial

instability by pulling out of host countries or by contagion from problems in the home country.

(Agenor, 2001).

Hermes and Lensink (2004), and Mathieson and Roldòs (2001) show that the economic

development level of host countries may be an important factor in determining effects of foreign

banks. There are also many studies focusing on country experiences.7 Denizer (2000) indicates

that in Turkey foreign bank entry has a strong competitive effect on the banking sector, and it

lowers the return on assets and overhead expenses. Hasan and Marton (2000) show that in

Hungary banks with higher foreign bank ownership involvement are associated with higher

efficiency. Goldberg, Dages, and Kinney (2000) show that diversity in ownership tends to

contribute to greater stability of credit in times of crisis and domestic financial system weakness

in Argentina and Mexico. de Haan and Naaborg (2004) foreign bank entry has an impact on the

expansion of private bank loans in accession countries. Zajc (2002) show that foreign bank entry

reduces non-interest income and profit, and increase costs of domestic banks in Central and

Eastern Europe.

The second group of empirical and theoretical studies focuses on the order of financial

liberalization. 8 Kaminsky and Schmukler (2003) establish a comprehensive chronology of

financial liberalization in 28 developed and emerging economies since 1973. They show that

while almost all G-7 countries liberalized their stock market first, European countries followed a

mixed strategy. One forth of them has deregulated their domestic financial sector first but most of

them liberalized their stock markets. Another result is that the liberalization of domestic financial 7 Claessens and Jansen (2000) present many country-level experiences. 8 McKinnon’s (1991) book is an essential reference on the order of economic liberalization. He focuses on transition economies. In his view, balancing the central government’s finances is the first step that should be taken. The second stage is the opening of the domestic capital market. The last step should be the liberalization of the foreign exchanges.

5

markets was before the opening of capital accounts in developed countries. They report that the

order of liberalization was different in developing countries. While Latin American countries

liberalized their domestic financial sectors first, East Asian countries implemented a mixed

strategy. Liberalization processes started in stock markets were the ones completed this process

fastest. Financial crisis are more severe in developing economies if the capital account is

liberalized first.

Claessens and Glaessner (1998) show that limits on foreign financial firms in Asia lead to

slower institutional development and more costly financial services provision. There are

important linkages between internationalization of financial services and domestic financial

deregulation and capital account liberalization. They point out that neither capital account

liberalization nor the internationalization of domestic financial services is a prerequisite for each

other; but some level of free capital mobility can be necessary for efficient internationalization.

Johnston (1998) investigates the relationship between the financial sector reform and

capital account liberalization. He shows that before opening capital accounts, the financial

intermediaries need to be strengthened in order to guarantee the efficient use of capital inflows.

Dobson (2003) focuses on three dimensions of liberalization: domestic deregulation, market-

opening, and capital account liberalization. She does not specify a sequence but points out that

those who have reformed and strengthened the domestic financial sector have met necessary

preconditions to relaxing restrictions on the capital account and full internalization.

Johnston, Darbar, and Echeverria (1997) present three different views on the issue of

sequencing financial liberalization. 1) There are preconditions of capital liberalization such as

macroeconomic stability and developing domestic financial institutions and markets before

liberalizing the capital account. 2) Early capital account liberalization can play an important role

in broader economic reforms. 3) Capital account liberalization should be a part of the overall

macroeconomic and structural reform. They indicate that the balance of benefits, costs, and risks

of following one strategy rather than another may vary across countries.

6

3. Empirical Model Specification and Data

This section introduces the empirical model used through out this paper and gives

information about the data set.

3.1 Model

In order to examine the relationship between foreign bank entry and the performance of

domestic banks we need a full model of determinants of bank performance.9 In addition, we

observe how these results change when countries are grouped according to their sequence of

financial liberalization. Building on the empirical model by Claessens, Demirguc-Kunt, and

Huizinga (2001), changes in domestic banks’ performance indicators are modeled as follows:

DIijt = a0j + b0*FSjt + b1*Bijt + b2*Xjt + error term,

where

DIijt = changes in different performance indicators of domestic banks;

FSjt = level of foreign bank share;

Bijt = bank variables of domestic banks;

Xjt = countries’ macroeconomic variables;

a0j = fixed effects;

i = bank

j = country

t = year

The dependent variable consists of domestic banks’ performance indicators. We apply the

same performance indicators used by Claessens et al (2001)10. The first performance indicator is

the net interest margin defined as the ratio of net interest income to total assets. This variable,

9 Claessens, Demirguc-Kunt, and Huizinga (2001) also analyze this question in their paper. But we focus on a different time period and a different set of countries. 10 Other studies using similar performance indicators include Demirguc-Kunt and Huizinga (1999), Demirguc-Kunt, Levine, and Min (1998), Denizer (2000), Claessens and Lee (2002), Hermes and Lensink (2002).

7

which shows the difference between earnings from interest and expenses on interest, is an

important indicator of competitiveness. As a banking sector gets more competitive, it is expected

the lending rate to drop, but the deposit rate to increase. The second performance indicator is the

ratio of non-interest income to total assets. Since foreign banks possibly provide better services to

their customers, it is expected domestic banks’ non-interest income to fall as a result of increased

competition from foreign banks.

The share of before tax profits in total assets is another performance indicator used in this

study. In closed and imperfectly competitive banking sectors, it is expected the profit rate to be

higher. In such sectors, banks pay low interest rates for funds and also charge higher interest rates

on loans. They also require high service fees. Because of this, profits are expected to decrease

with an increasing share of foreign banks. The ratio of overhead costs to total assets is another

performance indicator included in the paper. Foreign bank entry may have two opposite effects

on domestic banks’ costs. Assuming that foreign banks may have lower costs, domestic banks try

to cut their costs in order to compete with foreign banks, thus their costs drop. But it is also

possible that foreign bank entry and domestic banks’ costs are negatively related. One

explanation is that domestic banks may need to invest heavily on technology in order to attract

customers from foreign banks if they are not technologically developed enough to compete with

foreign banks. This leads to an increase in domestic banks’ costs in the short run. But these costs

are expected to drop in the long run.

The last dependent variable is the ratio of loan loss provisions to total assets. This

indicates the health of domestic banks. The higher is this ratio, the higher will be the probability

of problematic loans. There are two possibilities on how foreign bank entry might be linked to

this ratio. On the one hand, the presence of foreign banks may reduce the ratio since domestic

banks start issuing loans more carefully to avoid losses with increased competition. On the other

hand, loan loss provisions may increase with a rising foreign bank share because domestic banks

may start taking higher risks to compete with foreign banks.

Since one of our main targets is to determine the relationship between domestic banks’

performance indicators and foreign bank entry, the first independent variable introduced is the

asset share of foreign banks. In order to analyze the possible effects of changes in the foreign

bank share on domestic banks’ performance, it is necessary to control for other determinants of

domestic banks’ performance. Two sets of independent variables are introduced to accomplish

this purpose. While the first set consists of bank variables, the second set of variables includes

macroeconomic indicators. The bank variables are equity, non-interest earning assets, customer

8

and short term funding, and overhead costs - all in percent of total assets. The tax rate of banks

which is measured as taxes paid by domestic banks over their pre-tax profit is also included in

this group of variables. The macroeconomic indicators are real GDP per capita, the growth rate of

real GDP, the inflation rate, the real interest rate, and the share of domestic credits by banking

sector in percent of GDP.

This empirical model is, first of all, estimated at the bank level pooling all the countries

together. Second, these countries are grouped according to the sequencing of their financial

liberalization. Then, the model is estimated separately at the bank level for different groups of

countries in order to understand the importance of the order of financial liberalization on

domestic banks’ performance. Our expectations about how the sequencing of financial

liberalization may determine the role of foreign banks in improving domestic banks’ performance

are as follows. We expect foreign banks to be relatively more effective in countries which

liberalized their domestic financial markets or their stock markets first. This issue is partially

related to the basic role of foreign banks in supplying international funds in the presence of

capital account restrictions. Thus, foreign banks are expected to play an important role in

determining the performance of domestic banks in countries liberalized domestic services first.

Foreign banks would have more opportunities in this group of countries as well. For example,

they can make longer term investments such as purchasing equities in the stock market. Foreign

banks can also be more helpful in institutional development of financial intermediaries and in less

costly financial services provision in these countries. Thus, the presence of foreign banks is

expected to have a positive effect on the performance of domestic banks.

Besides these positive effects, domestic banks may have a disadvantage in terms of

unequal access to international capital markets compared to foreign banks in countries where

domestic financial services liberalized first. As a result of this disadvantage, domestic banks may

not be able to improve their efficiency; thus, the negative effects of foreign bank entry on

domestic banks may overweight its positive effects, at least in the short run, if the banking sector

is not ready for a higher level of competition. Besides that, foreign bank entry may cause an

additional problem if a country liberalizes its domestic financial sector first before liberalizing the

stock market. Since foreign banks do not have an access to longer term investment instruments

when they are first involved in the domestic banking sector, they would only provide shorter-term

funds. This may affect the health of the banking sector negatively, thus the efficiency gain of

domestic banks.

9

Since it is expected that foreign banks have an easier access to international funds, the

most important effect of foreign bank entry would be the provision of additional funds to the

domestic banking sector. But if capital accounts are liberalized first in an economy, this positive

effect of foreign bank entry would be relatively limited since both foreign and domestic banks

may have an easy access to international capital markets. Thus, the share of foreign banks is

expected to be less effective in determining the efficiency of domestic banks in this group of

countries.

3.2 Data

In this study we include the countries investigated by Kaminsky and Schmukler (2003).11

The list of countries is Argentina, Brazil, Canada, Chile, Colombia, Denmark, Finland, France,

Germany, Hong Kong, Indonesia, Ireland, Italy, Japan, Korea, Malaysia, Mexico, Norway, Peru,

Philippines, Portugal, Spain, Sweden, Taiwan, Thailand, United Kingdom, United States, and

Venezuela. China and Turkey are also included in this set. Thus, the total number of countries is

30. We separate countries into three groups according to their order of financial liberalization:

domestic financial liberalization first, stock market liberalization first, or capital account

liberalization first. 12

The BANKSCOPE database is the main data source. This database provides information

on individual private and state banks. Our data set covers the years 1994 to 2003. All domestic

banks in the banking sector are included. The exceptions are France, Germany, Italy, Japan,

Spain, United Kingdom, and United States, for which we include only the top several hundred

banks with the highest total asset level.

Banks are defined as foreign-owned if at least 51 percent of their shares is foreign-

owned. There are two alternative ways to measure the degree of foreign bank entry. One way is to

calculate the asset share of foreign banks as a share of total assets in the banking sector. As it is

pointed out by Claessens et al (2001), this measure is appropriate if foreign banks have an effect

on the pricing and profitability of domestic banks only after obtaining substantial size. The

alternative way is the number of foreign banks as a share of total number of banks in the banking

sector. Claessens et al (2001) say that this measure is appropriate if the number of foreign and 11 Kaminsky and Schmukler (2003) conduct a chronology of financial liberalization in 28 countries. The list of countries in each set are determined using the information give in Table 1 of Kaminsky and Schmukler (2003). 12 The definitions of financial liberalization and the list of countries in each group are given in the appendix.

10

domestic banks determines competitive conditions. We define the foreign bank share by taking

into account their asset shares.

The data set is constructed at the bank level for each country. It includes 4437 banks, 740

of which are foreign banks. Detailed information about the number of banks in each country is

given in Table 1. Domestic banks incorporate both private and state banks. Statistical analyses are

conducted by calculating country-level averages over the time period of 1994 to 2003. On the

other hand, the regression analyses are based on bank-level panel data.

4. Descriptive Analysis

The section presents the results of descriptive analyses. The first set of analyses is based

on the data set obtained by pooling all countries listed in the previous section. The second set of

analyses is accomplished by grouping countries according to the sequence of financial

liberalization.

The statistics related to the foreign bank penetration are presented in Table 1. Countries

are ranked according to their foreign bank share. Two different measures of the foreign bank

share are calculated in this table. While the first measure is the share of foreign banks’ assets in

total assets, the second one shows the number of foreign banks in percent of total number of

banks. The major result is that the degree of openness to foreign bank entry varies a lot among

countries. The asset share of foreign banks ranges from 0.2 percent in China to 61.6 percent in

Hong Kong, China. There is a considerable gap between the highest and the lowest values of the

foreign bank share among developed countries as well. While the United Kingdom has the

highest foreign banks’ asset share with 33.9 percent, it is only 1.7 percent in Sweden. Similar

results are obtained when the foreign bank penetration is measured with the number of foreign

banks. But in this case, while Japan has the lowest share with 1.6 percent, Ireland is the most

open country with the foreign bank share of 60.8 percent.

In order to understand whether there is a relationship between countries’ GDP growth

and their degree of openness to foreign banks, we calculated the correlation coefficient which

equals 0.07. This low correlation indicates that unlike trade openness in goods, the openness of

the banking sector for foreign banks is neither correlated to countries’ growth rates nor to their

income levels.

11

Table 2 reports the average values of the performance indicators separately for foreign

banks and domestic banks at the country level between 1994 and 2003. The variables change a lot

among countries. In general, foreign banks’ revenue indicators (net interest margin, non-interest

income, and profits) and their overhead costs are lower. Another result is that countries with a

higher foreign bank share tend to have more competitive domestic banks - cost and profit

indicators are lower. One way of answering the question of how domestic banks’ performance

indicators differ across countries with quite different foreign bank shares is to compare individual

countries. For example, the indicators of domestic banks in Brazil with the foreign bank share of

6.9 percent, and Mexico with the foreign bank share of 54.2 percent can be compared to each

other. Domestic banks’ net interest margin, profits, and overhead costs are lower in Mexico; only

non-interest income is higher in this country. We obtain similar results when we compare

developed countries such as Sweden with the foreign bank share of 1.7 percent and the United

Kingdom with the foreign bank share of 33.9 percent. The values of the performance indicators

are lower in the United Kingdom. The last set of results is consistent with the available literature

such as World Bank (2002), which shows that in poor countries where foreign bank entry is

higher than average, the cost of financial intermediation is lower than the one observed in

countries with low levels of foreign bank penetration.

As indicated before, our main objective is to investigate the possible effects of the order

of financial liberalization on efficiency gain of domestic banks with increasing foreign bank

participation. Almost all developed countries have liberalized their stock markets first while

developing countries have completed either their domestic financial market liberalization first, or

their capital accounts first.

Table 3 reports statistical information on domestic banks’ performance indicators when

countries are grouped according to the sequence of financial liberalization. Each group of

countries is separated into two sub-groups depending on their geographical location. While Asian

and Latin American countries (emerging market economies) are included in the first set,

European and G7 countries (developed countries) take place in the second set. The values of the

asset share of foreign banks are on average close to each other in each group. While the share is

20.7 percent in the countries liberalized their capital accounts first, it is 18.3 percent in the

countries liberalized their stock markets first, and 20.3 percent in the countries liberalized their

domestic financial markets first. If we investigate emerging market economies and developed

economies separately, differences in their foreign bank shares are more obvious. The banking

sectors of the Asian and Latin American countries, which liberalized either their stock market

12

first or their capital accounts first, are relatively more open to foreign banks. While the asset share

of foreign banks is 40.1 percent in the first group, it is 25.8 percent in the second group. The

European and G7 countries, which liberalized their domestic financial sector first, also have a

relatively high foreign bank penetration rate (i.e. 26 percent). The least open markets in terms of

foreign bank entry (only 10.6 percent) belong to the European and G7 countries which liberalized

their capital accounts first. Thus, there is no obvious trend between the level of economic

development and foreign bank entry.

In addition to the foreign bank share, Table 3 also gives information about the

performance indicators in different groups of countries. Domestic banks’ net interest margin, non-

interest income, overhead costs, and loan loss provision get the lowest values in the countries

which liberalized their stock markets first. This means that the competition is higher in these

countries’ banking sector. On the other hand, the highest values of net interest margin, overhead

costs, and loan loss provision belong to the Asian and Latin American countries which liberalized

their domestic financial markets first. Even though the competition is limited in these countries,

the asset share of foreign banks with 19 percent is close to the overall average value of 19.6

percent. Thus, the presence of foreign banks is not sufficient to increase competition in the

banking sector.

If we summarize our findings, the descriptive statistics indicate that the countries which

liberalized their stock market first tend to have a more competitive banking sector even though

their foreign bank entry rate is not much different from other groups of countries. But we cannot

conclude whether the order of liberalization plays a role in determining the performance of

domestic banks since other important factors such as macroeconomic indicators are also effective

in this process. Because of this, we need to control for additional determinants. In order to

accomplish this purpose, we apply econometric analyses to investigate the relationship between

foreign bank entry and the performance indicators of domestic banks, and the possible role of the

sequence of financial liberalization in this process. These results are presented in the next section.

5. Empirical Results

The regression results are reported in Tables 4 to 6. All equations are estimated using the

weighted least square technique with heteroscedasticity-corrected standard errors. Bank level data

across 28 countries are pooled for the period 1994-2003. As reported in Table 1, the number of

banks in each country differs from each other. In order to correct for these varying number of

13

banks across countries, each variable is weighted by the inverse of the number of domestic banks

in a country in a given period. Country and year dummy variables are also included to remove

country specific effects and time effects. Detailed information about the definition of variables is

given in the appendix.

In the regressions, only domestic banks are included since the aim of the paper is to

explain changes in the performance of domestic banks. In each table, five different dependent

variables are used as performance indicators of domestic banks as explained in the model section

of the paper. While all dependent variables are in the first differences, all independent variables

are in levels.13 The foreign bank share is the asset share of foreign banks in total assets of the

banking sector.

Table 4 reports the regression results when all countries in our data set are pooled

together. 14 One of the expected positive effects of higher foreign bank share is increased

competition in the banking sector, which can be indicated by falling net interest margin, overhead

costs, non-interest income, and profits. This is what we see in the results. The level of the foreign

bank share is a statistically significant, negative determinant of all performance indicators except

the ratio of loan loss provisions to total assets. The sign of the foreign banks share is positive but

statistically not significant in explaining loan loss provisions. One possible reason for this

positive sign can be the case that domestic banks start taking more risks as the share of foreign

banks rises.

Other bank variables are also successful in explaining the profitability and efficiency

indicators. Especially the ratio of non-earning assets to total assets and the tax rate paid by banks

are statistically and economically significant. As the non-earning assets ratio increases, all

performance indicators drop, which may indicate that domestic banks become more competitive.

When the level of the tax rate, which is measured as a share of tax payments to pre-tax profits,

increases, all performance indicators rise as well, except overhead costs. This indicates that banks

paying higher taxes tend to be less competitive. Similarly, the results show that competitiveness

of domestic banks gets lower with higher overhead costs. Increasing overhead costs result in a

higher net interest margin, loan loss provisions, and non-interest income, but lower before tax

profits. 13 We also run the regression equations by taking the first difference of the independent variables. The results are not reported in the paper but available upon request. We check the sensitivity of results by running the regressions by dropping different bank and macroeconomic variables. The results are robust. They are available upon request. 14 Taiwan is excluded due to missing data points and China is excluded since her financial liberalization process has not been completed as of 2005.

14

When we check the macroeconomic variables, the economically and statistically most

significant determinants of the performance indicators are the GDP growth rate, the inflation rate,

and the real interest rate. On the one hand, as the level of the growth rate increases, changes in the

net margin, non-interest income, overhead costs, and loan loss provision falls. This means that

faster growing countries have a more competitive banking sector. On the other hand, in the

presence of high real interest rates, domestic banks tend to have a higher net interest margin, non-

interest income, and overhead costs, indicating lower competition. While a higher inflation rate

increases the net interest margin and costs, it decreases non-interest income and profits. As the

inflation rate and real interest rates increase, and as the growth rate of real GDP falls, loan loss

provisions increase. In summary, the banking sector tends to be less competitive in case of a weak

macroeconomic environment.

Our empirical model closely follows the one created in Claessens et al (2001). The main

difference is the time period covered and the number of countries and banks included in the

study. They focus on the period of 1988-95; our data set covers the years from 1994 to 2003.

While they investigate the banking sector of 80 different countries, we include only 28 countries,

almost half of which are developed countries. Even though the number of countries is smaller in

our paper, the number of data points and banks is higher. For example, while the number of

observations is approximately 4,600 in their study, we have approximately 16,000 data points.

The definition of foreign bank share is also different. While their definition is the share of number

of foreign banks, our definition is the asset share of foreign banks.

Despite these differences, when the estimated coefficients of the foreign bank share as a

determinant of domestic banks’ profitability and efficiency are compared, it can be seen that our

results are similar to the results of Claessens et al (2001). They also find a negative relationship

between all performance indicators and the foreign bank share. One difference is that while their

results show that as the foreign bank share increases, loan loss provisions fall, our estimated

coefficient indicates a positive relationship between these two variables.

Another paper that we can compare our results to is Bayraktar and Wang (2004). They

also investigate determinants of performance indicators but they use country-level aggregates in

their analyses. At the aggregate level, none of the performance indicators is statistically

significantly determined by the foreign bank share. But, disaggregated bank-level data reveal the

significance of the foreign bank share in explaining the performance indicators as seen in Table 4.

As indicated before, analyses are repeated by grouping countries according to their order

of financial liberalization. The purpose is to better understand the importance of the sequence of

15

financial liberalization in determining the relationship between the foreign bank share, and

profitability and efficiency indicators. The same empirical model is used in these analyses. The

empirical results obtained by grouping countries according to their sequence of financial

liberalization are presented in Tables 5 and 6.

We report the results for the countries liberalized their stock market first in Table 5. The

number of countries in this group is 12, and 10 of them are industrial countries. The foreign bank

share is statistically significant in explaining changes in profits, costs, and loan loss provisions.

Foreign bank entry decreases profits and costs, thus increases the efficiency of domestic banks.

On the other hand, it increases loan loss provisions. As explained by Claessens et al (2001), there

can be two alternative reasons for this result. As the share of foreign banks rises, domestic banks

might be left with relatively less creditworthy customers, or alternatively improved provisioning

regulations may affect all banks. The relationship between the foreign bank share and the net

interest margin and non-interest income is also negative but statistically insignificant. These

results indicate that as the share of foreign banks increases, domestic banks become more

competitive and efficient. As the ratios of equity, non-earning assets, and short term funds to total

assets increases, the net interest margin drops. But increasing costs positively affect the net

margin. High GDP per capita and lower real interest rates also improve the efficiency of domestic

banks. Bayraktar and Wang (2004) find similar results at the aggregate level as well. They show

that domestic banks get more efficient and competitive as the share of foreign banks increases.

We run the same set of regression equations for groups of countries which liberalized

their domestic financial market first, and their capital account first. When we pool the countries

liberalized the domestic financial market first, 9 countries are included in the set; only 2 of them

are industrial countries. The number of observations in this group is approximately 2,200. On the

other hand, the number of countries liberalized their capital account first is 6; 4 of which are

emerging market economies. The approximate number of data points is 2,300 in this group. The

whole set of results is not reported but they are summarized in Table 6.

Table 6 combines the estimated coefficients of foreign bank participation for different

groups of countries. The empirical model in each set of results is the one given in Tables 4 and 5.

The first row reports the estimated coefficients of the foreign bank share when all countries are

pooled together, which shows that as the share of foreign banks increases in an economy, the net

interest margin, non-interest income, profits, and overhead costs fall. The successive rows show

the estimated coefficients of the foreign bank share for different groups of countries. Foreign

16

bank participation promotes competition and efficiency relatively more in countries liberalized

their stock market first, in terms of lower profits, net interest margin and costs.

The third row of Table 6 reports the coefficients of the foreign bank share for countries

liberalized their domestic financial markets first. All coefficients except the one in the before tax

profits regression are statistically significant, but their signs unexpectedly positive. Higher

foreign bank entry increases non-interest income, costs, net interest margin, and loan loss

provisions. This means that an increasing share of foreign banks has a negative effect on

efficiency and competitiveness of domestic banks. In other words, negative effects of foreign

banks overweight positive effects in this group of countries. There might be different

explanations for negative effects of foreign banks.

One possible reason for increasing costs with a higher foreign bank share would be that

domestic banks may have technological deficiencies compared to foreign banks. In this case, they

need to increase their overhead costs to finance technology related investments in order to

compete with foreign banks and improve the quality of their services. Thus, overhead costs would

be higher as a share of foreign banks rises. Higher costs may also be reasoned by increasing

wages paid to employees. Assuming that foreign banks offer higher wages to employees,

domestic banks also need to offer higher wages in order to keep their employees. Given the fact

that most of the countries in this group are emerging market economies, both of these

explanations may lead to higher overhead costs.

Increasing non-interest income, as the share of foreign banks increases, would be the case

if domestic banks improve the quality of banking services in order to compete with foreign banks.

Another negative effect of a rising foreign bank share in these countries is on the net

interest margin of domestic banks. Foreign banks cannot help reduce the net interest margin of

domestic banks. As discussed above, one possible reason for this negative effect would be related

to the sequence of financial liberalization. Foreign banks could not find an opportunity to make

longer-term investment decisions since they would be restricted from investing in capital markets

such as stock market. In this case, they would focus on shorter-term investment opportunities

which may limit the positive effects of foreign bank entry. As a result, the efficiency gain that

might be obtained by raising the share of foreign banks would be the lowest for a group of

countries which liberalized their domestic financial markets first. The other important point is that

the most of the countries in this group is emerging market economies; thus, it is expected that the

initial development level of domestic banks was low when they first encountered with foreign

banks. This may also restrict the positive effects of foreign banks.

17

The last row of Table 6 presents the estimated coefficients of the foreign bank share for

countries liberalized their capital account first. In this case, the only statistically significant

coefficients belong to the profits and loan loss provisions regressions. The foreign bank entry

tends to decrease overhead costs but it is not statistically significant. The sign of net interest

margin is positive but again it is not statistically significant. For this group of countries, it is

expected both domestic and foreign banks to have an equal access to international funds

throughout the liberalization process since their capital accounts are liberalized first. This may

reduce the positive effect of an increasing foreign bank share. Thus, efficiency gains of domestic

banks might be limited in these countries.

When these new findings are compared to the ones in Bayraktar and Wang (2004), both

papers show that domestic banks in countries liberalized their stock markets first benefit

relatively more from foreign bank entry in terms of efficiency gains and increased competition.

The main difference is that negative effects of an increasing share of foreign banks in countries

liberalized domestic financial markets first can be seen better when bank-level data are used.

In summary, the results indicate that efficiency gains from foreign bank entry (i.e. lower

profits, costs, and net interest margins) are the highest in countries liberalized their stock markets

first after other possible determinants are controlled for. Thus, it can be said that the potential

negative effects of foreign bank entry are dominated by the positive effects in these countries.

Even though the results show some positive effects of foreign bank entry in countries liberalized

their capital accounts first, the relationship between the performance indicators and the foreign

bank share is relatively weaker. On the other hand, we cannot say the same things for countries

liberalized their domestic financial markets first. In these countries, foreign banks cannot help

domestic banks in improving competitiveness and efficiency, thus the negative effects of foreign

banks seem to overweight positive effects, at least in the short run.

6. Conclusions

This paper investigates the relationship between the efficiency of domestic banks and

foreign bank entry, and also examines the possible role of the sequence of financial liberalization

in this process. This paper is an extension of Bayraktar and Wang (2004) in a way that a larger

data set is introduced, and statistical and regression analyses are based on a bank level data set

instead of country-level aggregate data. We focus on 4,400 banks in 30 different countries for the

period 1994-2003.

18

First we study how foreign bank openness differs from one country to another and we try

to answer the question of whether foreign bank entry is related to the level of economic

development. Another issue that we investigate is whether changes in the foreign bank share are a

significant determinant of domestic banks’ performance indicators such as the net interest margin,

non-interest income, profits, overhead costs, and loan loss provisions. Finally, we check how the

link between the share of foreign banks and performance indicators of domestic banks changes

when countries are grouped according to the sequence of their financial liberalization.

Throughout our analyses, we control for other bank variables and macroeconomic indicators.

The descriptive statistics indicate that the values of the bank-level variables change a lot

among countries. But foreign banks’ revenue indicators and their overhead costs are relatively

lower. Another result is that countries with a higher foreign bank share tend to have more

competitive domestic banks - cost and profit indicators are lower. The degree of openness to

foreign bank entry varies a lot among countries. There is a considerable gap between the highest

and the lowest values of the foreign bank share among countries. The degree of openness to

foreign bank entry is not correlated with average income levels or with GDP growth.

When countries are grouped according to their sequence of financial liberalization

(domestic financial markets first, or stock market first, or capital account first), descriptive

analysis show that the foreign bank shares in each group are almost the same. But domestic

banks’ net interest margin, non-interest income, overhead costs, and loan loss provisions get the

lowest values in the countries that liberalized their stock markets first. This implies that

competition is highest in the banking sector of these countries.

Building on a model based on Claessens et al (2001), our panel regression results indicate

that changes in foreign bank share are significantly associated with domestic banks’ performance

and efficiency indicators when all countries are pooled together. Domestic banks’ performance is

also significantly related to the non-earning asset ratio, the overhead cost ratio, the tax rate, and

several macroeconomic factors. Our results are largely consistent with results presented in

Claessens et al (2001) in a way that foreign bank entry leads to efficiency gains in the banking

sector.

The regression analyses show that the sequence of financial liberalization matters for the

performance of the domestic banking sector: After controlling for macroeconomic variables and

grouping countries by their sequence of liberalization, foreign bank entry has significantly

improved domestic bank competitiveness in countries that liberalized their stock market first. In

these countries, both profit and cost indicators are negatively related to the share of foreign banks,

19

indicating a more competitive environment. These findings support the findings of Bayraktar and

Wang (2004). Relationship between the performance indicators and the foreign bank share is

relatively weaker in the countries which liberalized their capital accounts first. In the countries

which liberalized their domestic financial markets first, foreign banks cannot help improve the

efficiency of domestic banks and their negative effects seem to overweight positive effects at

least in the short run.

In general, gains from trade in financial services come from three difference sources: the

standard gains from comparative advantages and specialization; learning by doing from attracting

foreign direct investment into the financial sector; and efficiency gains from finance/banking as

an intermediate input to the goods sector. The study of many of these broad gains is beyond the

scope of this paper. This paper focuses narrowly on the issue of whether foreign bank entry can

improve the performance of the domestic banking sector, which is then expected to benefit the

goods sector and economic growth. This paper does not address the issues of whether a country

has comparative advantage in banking, or whether there should be more cross country

specialization or not.

Due to the limitation of this paper, policy implications should be treated cautiously.

While openness to foreign bank entry would generally improve domestic banks’ efficiency

according to our results, the extent of impact depends on the liberalization path of a particular

country, on the current status of competition in the sector, and whether the country is "over-

banked" or not. Transition countries such as China with limited extent of liberalization may gain

more from foreign bank entry because it is possible for China to combine internationalization

with restructuring in the banking sector and with learning by doing from foreign investors. And

this is happening right now: several international banks have invested in significant stakes in

China's state owned banks. Whereas in countries which have already liberalized their interest

rates and domestic banking sectors, foreign bank entry may have a small positive, or negative

effect on domestic banking performance. A lower profit margin may force some of domestic

banks out of business, which may be good for growth and efficiency. One may see a higher

degree of concentration and specialization in these countries. However, this issue is beyond the

scope of this paper.

20

APPENDIX – Definitions

A1. Bank Variables The source is BANKSCOPE.

Net interest Margin: The net interest income in percent of total assets.

Non-interest income: Ratio of other operating income to total assets.

Pre-tax operation income: Ratio of profit before tax to total assets.

Overhead Costs: Ratio of overhead costs to total assets.

Loan Loss Provision: Ratio of loan loss provision to total assets.

Equity: Ratio of equity to total assets.

Non-interest assets: Ratio of non-interest earning assets to total assets.

Customer and short term funds: Ratio of deposits to total assets.

Tax rate: Ratio of taxes paid to profit before tax.

Foreign bank share: Ratio of total assets of foreign banks to total assets in the banking sector.

A2. Definition of Liberalization

Kaminsky and Schmukler (2003) construct a chronology of financial liberalization in 28 mature and emerging economies since 1973. In the paper, the countries are grouped into three categories according to this chronology. The liberalization process is defined as follows: Liberalization of domestic financial sector: They evaluate the regulations on deposit interest rates, lending interest rates, allocation of credit, and foreign-currency deposits (Kaminsky and Schmukler, 2003 p.6). Liberalization of capital account: They evaluate the regulations on offshore borrowing by domestic financial institutions, offshore borrowing by non-financial corporations, multiple exchange rate markets, and controls on capital outflows (Kaminsky and Schmukler, 2003 p.6). Liberalization of stock market: They analyze the evolution of regulations on the acquisition of shares in the domestic stock market by foreigners, repatriation of capital, and repatriation of interest and dividends (Kaminsky and Schmukler, 2003 p.7). A3. List of Countries and The Order of Liberalization The following classification of countries is based on Table 1 in Kaminsky and Schmukler (2003) except China and Turkey. Economies that Liberalized Stock Market First: Canada, Denmark, France, Germany, Hong Kong (China), Italy, Malaysia, Portugal, Spain, Sweden, United Kingdom, United States

21

Economies that Liberalized Domestic Financial Market First: Argentina, Brazil, Chile, Colombia, Indonesia, Ireland, Korea, Norway, Peru, Taiwan (China), Turkey Countries Liberalized Capital Account First: Finland, Japan, Mexico, Philippines, Thailand, Venezuela

Other: China

22

References Agenor, Pierre-Richard, 2001, “Benefits and Costs of International Financial Integration: theory and

Facts,” unpublished paper (March 19).

Barth, James R., Gerard Caprio, Jr. and Ross Levine, 2001, “Bank Regulation and Supervision: What Works Best?” Policy Research Working Paper 2725, World Bank (November).

Bayraktar, Nihal, and Yan Wang, 2004, “Foreign Bank Entry, Performance of Domestic Banks and the Sequence of Financial Liberalization,” China Journal of Finance, Vol. 2. No. 2, 2004, pages 1-39.

Clarke, George, Robert Cull, and Maria Soledad Martinez Peria, 2001, “Does Foreign Bank Penetration Reduce Access to Credit in Developing Countries? Evidence from Asking Borrowers,” World Bank Working Paper No. 2716 (November).

Claessens, Stijn, Asli Demirguc-Kunt, and Harry Huizinga, 2000, “The Role of Foreign Banks in Domestic Banking Systems,” in: Claessens, S. and M. Jansen (eds.), The Internalization of Financial Services: Issues and Lessons for Developing Countries, Boston, Kluwer Academic Press.

Claessens, Stijn, Asli Demirguc-Kunt, and Harry Huizinga, 2001, “How Does Foreign Entry Affect the domestic banking markets?” Journal of Banking and Finance, 25, 891-911.

Claessens, Stijn and Tom Glaessner, 1998, “Internationalization of Financial Services in Asia,” World Bank Working Paper, No. 1911 (April).

Claessens, Stijn and Marion Jansen (eds.), 2000, The Internationalization of Financial Services, World Bank and World Trade Organization, Kluwer Law International, The Hague.

Claessens, Stijn and Jong-Kun Lee, 2002, “Foreign Banks in Low-Income Countries: Recent Developments and Impacts,” mimeo, The World Bank (June).

De Haan, Jakob, and Ilko Naaborg, 2004, “Financial Intermediation in Accession Countries: The Role of Foreign Banks,” mimeo.

Demirguc-Kunt, Asli and H. Huizinga, 1999, “Determinants of Commercial Bank Interest Margins and Profitability: Some International Evidence,” World Bank Economic Review, Vol. 13, No. 2, (May).

Demirguc-Kunt, Asli, Ross Levine, and Hong-Ghi Min (1998) “Opening to Foreign Banks: Issues of Stability, Efficiency, and Growth,” in Proceedings of the Bank of Korea Conference on the Implications of Globalization of World Financial Markets (December).

Denizer, Cevdet A., 2000, “Foreign Entry in Turkey’s Banking Sector: 1980-97,” the World Bank WP No: 2462 (October).

Dobson, Wendy, 2003, “Finances Services and International Trade Agreements: the Development Dimension,” unpublished draft (August).

Goldberg, Linda, B. Gerard Dages, and Daniel Kinney (2000) “Foreign and Domestic Bank Participation in Emerging Markets: Lessons from Mexico and Argentina,” NBER Working Paper No. 7714 (May).

Hasan, Iftekhar and Katherin Marton, 2000, “Development and Efficiency of the Banking Sector in a Transitional Economy: Hungarian Experience,” Bank of Finland Institute for Economies in Transition, BOFIT Discussion Papers No.7.

Hellmann, Thomas, Kevin Murdock, and Joseph Stiglitz, 2000, “Liberalization, Moral Hazard in Banking and Prudential Regulation: Are Capital Requirements Enough?” American Economic Review, Vol. 90, No.1, pp. 147-165.

Hermes, N. and Lensink, R. (2002): "The Impact of Foreign Bank Entry on Domestic Banks in Less Developed Countries: An Econometric Analysis". In Kowalski, T., Lensink, R. and Vensel, V. (editors): Foreign Bank and Economic Transition - Paper in Progress. Poznan: Faculty of Economics, Poznan University, pp. 129-146.

Hermes, N. and R. Lensink (2004), “Foreign bank presence, domestic bank performance and financial development”, Journal of Emerging Market Finance, 3, 2, pp. 207-229.

23

Johnston, R. Barry, 1998, “Sequencing Capital Account Liberalizations and Financial Sector Reform,” IMF Working Paper No: PPAA/98/8 (July).

Johnston B., S.M. Darbar, and C. Echeverria (1997) “Sequencing CA liberalization: lesson from the experiences in Chile, Indonesia, Korea, and Thailand,” IMF WP no: 157 (November).

Kaminsky, Graciela L. and Sergio L. Schmukler, 2003, “Short-Run Pain, Long-Run Gain: The Effects of Financial Liberalization,” NBER Working Paper No. 9787 (June).

Levine, Ross, 1996, “Foreign Banks, Financial Development and Economic Growth,” in Claude E. Barfield, ed. International Financial Markets: Harmonization versus Competition. Washington D.C.: AEI Press.

Mathieson and Roldòs, 2001, “The Role of Foreign Banks in Emerging Markets, May, mimeo, IMF, presented at the World Bank, IMF, Brookings Institution Third Annual Financial markets and Development Conference, May 19-21, New York.

McKinnon, Ronald I., 1991, The Order of Economic Liberalization, The Johns Hopkins University Press, Baltimore and London.

World Bank, 2001, Finance for Growth: Policy Choices in a Volatile World, Washington, D.C.

World Bank, 2002, Global Development Finance, Washington, D.C.

Zajc, Peter, 2002, “The Effect of Foreign Bank Entry on Domestic Banks in Central and Eastern Europe,” mimeo (November).

24

Total number of banks

Total number of foreign banks

Asset share of foreign banks (in % of total

assets)

Number of foreign banks as a share of total number

of banksArgentina 156 41 China 0.2 Japan 1.6Brazil 213 39 Sweden 1.7 Taiwan, China 3.0Canada 81 22 Japan 2.1 Korea, Rep. 4.5Chile 39 8 Taiwan, China 4.6 Italy 6.3China 61 5 Italy 5.1 Germany 7.4Colombia 64 8 Korea, Rep. 5.3 China 8.2Denmark 125 12 Germany 5.4 Venezuela 9.4Finland 23 3 Thailand 6.1 Denmark 9.6France 372 69 Spain 6.8 Sweden 10.0Germany 447 33 Brazil 6.9 United States 12.0Hong Kong, China 155 59 United States 8.5 Colombia 12.5Indonesia 111 26 Turkey 11.0 Spain 13.0Ireland 79 48 Philippines 13.2 Finland 13.0Italy 429 27 France 13.9 Norway 13.8Japan 322 5 Canada 14.9 Turkey 14.7Korea, Rep. 66 3 Indonesia 17.9 Malaysia 14.7Malaysia 95 14 Denmark 18.5 Brazil 18.3Mexico 68 14 Malaysia 18.6 Thailand 18.4Norway 65 9 Finland 19.0 France 18.5Peru 29 9 Colombia 20.7 Chile 20.5Philippines 51 12 Argentina 20.7 Mexico 20.6Portugal 61 17 Norway 23.9 Indonesia 23.4Spain 192 25 Ireland 28.0 Philippines 23.5Sweden 50 5 Venezuela 29.8 Argentina 26.3Taiwan, China 66 2 Portugal 30.7 Canada 27.2Thailand 49 9 Chile 30.9 Portugal 27.9Turkey 75 11 United Kingdom 33.9 Peru 31.0United Kingdom 357 143 Peru 53.1 Hong Kong, China 38.1United States 451 54 Mexico 54.2 United Kingdom 40.1Venezuela 85 8 Hong Kong, China 61.6 Ireland 60.8

Table 1: Number of Banks and Ranking of Countries According to the Share of Foreign Banks, 1994-2003

Source: Authors' calculations using data from BANKSCOPE.

25

Asse

t sha

re o

f fo

reig

n ba

nks

(in %

of

tota

l ass

ets)

Net

m

argi

n/ta

Non

-inte

rest

in

com

e/ta

Bef

ore

tax

prof

its/ta

Ove

rhea

d/ta

Loan

loss

pr

ovis

ion/

taN

et

mar

gin/

taN

on-in

tere

st

inco

me/

taB

efor

e ta

x pr

ofits

/taO

verh

ead/

taLo

an lo

ss

prov

isio

n/ta

Arge

ntin

a20

.75.

74.

8-4

.88.

93.

66.

55.

7-5

.59.

83.

7Br

azil

6.9

10.7

2.3

3.1

8.2

2.1

9.8

0.4

3.1

6.6

1.2

Can

ada

14.9

2.1

2.9

2.1

3.4

0.6

1.7

2.7

3.5

3.2

-0.3

Chi

le30

.95.

42.

21.

44.

11.

33.

91.

31.

43.

40.

7C

hina

0.2

2.0

1.3

1.2

2.3

0.3

2.2

0.3

1.4

1.2

0.3

Col

ombi

a20

.73.

55.

40.

07.

91.

95.

66.

10.

210

.11.

5D

enm

ark

18.5

4.5

1.2

1.4

4.0

0.6

1.7

2.2

2.9

3.8

0.2

Finl

and

19.0

1.9

2.4

0.0

3.7

0.0

3.8

17.7

15.8

5.0

0.7

Fran

ce13

.92.

41.

61.

12.

80.

42.

12.

30.

63.

60.

4G

erm

any

5.4

2.4

0.7

0.6

2.0

0.4

2.2

1.8

0.8

2.6

0.3

Hon

g Ko

ng, C

hina

61.6

2.5

2.4

0.8

2.8

1.3

3.6

3.3

2.2

3.7

1.0

Indo

nesi

a17

.93.

91.

7-0

.73.

72.

44.

62.

50.

82.

83.

9Ire

land

28.0

1.6

3.7

3.9

1.6

0.1

1.4

0.7

0.9

1.0

0.2

Italy

5.1

3.3

1.3

1.2

3.4

0.5

3.5

0.9

0.9

3.2

0.6

Japa

n2.

12.

20.

90.

12.

00.

71.

30.

4-0

.11.

11.

1Ko

rea,

Rep

.5.

31.

51.

6-0

.32.

41.

22.

21.

10.

82.

31.

9M

alay

sia

18.6

3.2

1.0

3.6

1.4

1.2

2.8

2.1

2.4

1.5

0.8

Mex

ico

54.2

3.4

4.7

0.3

6.7

1.2

4.2

3.3

-0.3

6.5

1.3

Nor

way

23.9

2.8

1.6

1.5

2.6

0.4

2.2

3.4

0.4

2.8

0.4

Peru

53.1

8.6

1.0

0.7

8.4

1.6

9.7

1.2

1.2

7.7

2.5

Philip

pine

s13

.23.

92.

01.

24.

00.

64.

01.

90.

44.

60.

9Po

rtuga

l30

.72.

71.

40.

92.

60.

72.

01.

70.

92.

40.

4Sp

ain

6.8

3.0

1.2

1.1

2.6

0.3

2.5

1.6

0.4

3.3

0.3

Swed

en1.

72.

21.

20.

72.

30.

516

.92.

810

.89.

0-0

.1Ta

iwan

, Chi

na4.

62.

21.

81.

21.

90.

72.

40.

70.

21.

81.

3Th

aila

nd6.

12.

31.

0-0

.62.

21.

62.

00.

8-2

.72.

82.

6Tu

rkey

11.0

9.6

0.4

0.3

7.2

1.4

14.3

3.9

5.9

11.3

0.3

Uni

ted

King

dom

33.9

1.7

2.8

1.3

3.0

0.1

1.6

3.1

1.3

3.4

0.4

Uni

ted

Stat

es8.

53.

52.

81.

93.

90.

52.

02.

11.

12.

60.

3Ve

nezu

ela

29.8

13.1

3.7

3.9

10.5

1.6

10.7

2.6

3.2

8.5

1.4

AVER

AGE

18.9

3.9

2.1

1.0

4.1

1.0

4.4

2.7

1.8

4.4

1.0

Tabl

e 2:

Per

form

ance

Indi

cato

rs a

t Cou

ntry

Lev

el, 1

994-

2003

(ave

rage

, in

perc

ent)

FOR

EIG

N B

ANKS

DO

MES

TIC

BAN

KS

Sour

ce: A

utho

rs' c

alcu

latio

ns u

sing

dat

a fro

m B

ANKS

CO

PE.

26

Num

ber o

f co

untri

es

Fore

ign

bank

ass

et

shar

eN

et

mar

gin/

ta

Non

-in

tere

st

inco

me/

taBe

fore

tax

prof

its/ta

Ove

rhea

d/ta

Loan

loss

pr

ovis

ion/

ta

All c

ount

ries

2919

.55

3.99

2.13

0.96

4.16

1.02

C

ount

ries

Libe

raliz

ed S

tock

Mar

ket F

irst

1218

.29

2.78

1.71

1.39

2.85

0.59

Asia

n an

d La

tin A

mer

ican

Cou

ntrie

s2

40.0

92.

831.

682.

172.

131.

24

Euro

pean

and

G7

Cou

ntrie

s10

13.9

42.

771.

721.

233.

000.

46

C

ount

ries

Libe

raliz

ed D

omes

tic F

inan

cial

Mar

ket F

irst

1120

.27

5.05

2.41

0.58

5.19

1.51

Asia

n an

d La

tin A

mer

ican

Cou

ntrie

s9

19.0

05.

682.

350.

115.

871.

80

Euro

pean

and

G7

Cou

ntrie

s2

25.9

92.

212.

662.

692.

100.

24

C

ount

ries

Libe

raliz

ed C

apita

l Acc

ount

Firs

t6

20.7

34.

472.

450.

824.

870.

98

Asia

n an

d La

tin A

mer

ican

Cou

ntrie

s4

25.8

25.

672.

861.

225.

871.

28

Euro

pean

and

G7

Cou

ntrie

s2

10.5

52.

051.

630.

022.

870.

39

(Ave

rage

, in

perc

ent)

Tabl

e 3:

Per

form

ance

Indi

cato

rs o

f Dom

estic

Ban

ks, 1

994-

2003

Sour

ce: A

utho

rs' c

alcu

latio

n us

ing

data

from

BAN

KSC

OPE

.

Not

e: C

hina

is n

ot in

clud

ed in

the

anal

ysis

sin

ce th

e fin

anci

al li

bera

lizat

ion

proc

ess

was

not

com

plet

ed a

s of

200

5 in

this

cou

ntry

.

27

Change in net

margin/ta

Change in Non-

interest income/ta

Change in before tax profits/ta

Change in overhead/ta

Change in loan loss

provision/ta

Foreign bank asset share -0.002*** -0.009*** -0.007*** -0.003*** 0.001(-2.793) (-4.963) (-2.711) (-3.951) (0.885)

Equity/ta 0.000 0.000 0.013*** 0.000 -0.001***(1.070) (0.325) (5.710) (-0.677) (-2.946)

Non-interest earning assets/ta -0.009*** -0.002* -0.003** -0.004*** -0.001(-8.269) (-1.654) (-2.566) (-4.954) (-1.053)

Customer and ST funds/ta -0.002*** -0.001*** 0.000 0.000*** 0.000***(-9.285) (-5.209) (1.227) (-3.111) (-3.521)

Overhead/ta 0.028*** 0.015*** -0.002 0.005***(8.048) (6.520) (-0.653) (3.335)

Tax/pre-tax profit 0.000** 0.001*** 0.001*** -0.001*** 0.000***(1.985) (6.868) (5.613) (-6.938) (-3.659)

GDP per capita 0.000 0.000*** 0.000** 0.000*** 0.000***(-0.843) (3.318) (2.405) (-4.300) (7.212)

GDP growth -0.015*** -0.014*** 0.055*** -0.006*** -0.054***(-4.481) (-4.437) (8.081) (-4.043) (-19.220)

Inflation 0.021*** -0.009*** -0.082*** 0.023*** 0.035***(4.681) (-3.505) (-13.751) (11.270) (18.248)

Real interest rate 0.005* 0.009*** -0.069*** 0.023*** 0.035***(1.685) (3.662) (-12.709) (9.395) (17.753)

Domestic credit by banking sector/GDP 0.000*** 0.001*** 0.000 0.000** 0.000***(-2.729) (4.199) (0.147) (-2.085) (3.410)

R2 0.169 0.271 0.917 0.132 0.491Adjusted R2 0.166 0.269 0.917 0.129 0.489No. of obs 16176 16169 16199 16056 15375No of banks 3194 3189 3192 3170 2991

(all countries)(Weighted Least Squares Estimation with country and year dummies, heteroskedasticity corrected standard errors)

Table 4: Determinants of Bank Profitability and Efficiency

Note: The data are for domestic banks only for the period 1994-2003. The estimation technique is weighted OLS with heteroscedasticity-corrected standard errors. All variables are weigthed by the inverse of total number of domestic banks in each country. Fixed effects are also included to remove country effects. Taiwan is not included due to lack of data points and China is not included since she has not completed her financial liberalization process yet. Panel data are at the bank level. t-statistics are reported below estimated coefficient values. *,**, and *** indicate 10 percent, 5 percent, and 1 percent significance levels successively.

28

Change in net

margin/ta

Change in Non-

interest income/ta

Change in before tax profits/ta

Change in overhead/ta

Change in loan loss

provision/ta

Foreign bank asset share 0.000 -0.001 -0.004*** -0.002*** 0.001***(-1.092) (-1.502) (-4.580) (-5.281) (3.962)

Equity/ta -0.002*** 0.011*** 0.041*** 0.002*** -0.004***(-6.265) (4.313) (22.081) (8.986) (-6.523)

Non-interest earning assets/ta -0.003*** 0.002** 0.005*** 0.003*** 0.001*(-3.648) (2.146) (4.713) (3.013) (1.706)

Customer and ST funds/ta -0.001*** 0.000 0.001*** 0.001*** -0.001***(-8.541) (-0.951) (3.432) (3.964) (-3.883)

Overhead/ta 0.005** 0.001 -0.059*** 0.002**(2.455) (0.326) (-16.460) (2.410)

Tax/pre-tax profit 0.000 0.001*** 0.001*** -0.001*** 0.000***(1.241) (4.954) (8.045) (-11.195) (-3.324)

GDP per capita 0.000*** 0.000** 0.000*** 0.000*** 0.000***(-18.559) (-2.217) (-3.092) (-4.527) (3.667)

GDP growth 0.036*** 0.003 0.028*** 0.007*** -0.028***(15.839) (0.880) (5.923) (3.135) (-9.422)

Inflation 0.014*** -0.027*** -0.084*** 0.012*** 0.027***(4.530) (-7.455) (-12.325) (4.113) (7.727)

Real interest rate -0.003* -0.007*** -0.024*** 0.004* 0.012***(-1.744) (-3.039) (-6.870) (1.755) (6.683)

Domestic credit by banking sector/GDP 0.001*** 0.001*** 0.001*** 0.000*** 0.000(11.044) (4.868) (2.656) (3.886) (-1.439)

R2 0.839 0.324 0.656 0.146 0.099Adjusted R2 0.838 0.322 0.656 0.144 0.097No. of obs 11629 11626 11652 11576 11187No of countries 2080 2076 2079 2067 1953

(countries liberalized stock market first)(Weighted Least Squares estimation with country and year dummies, heteroskedasticity corrected standard errors)

Table 5: Determinants of Bank Profitability and Efficiency

Note: The data are for domestic banks only for the period 1994-2003. The estimation technique is weighted OLS with heteroscedasticity-corrected standard errors. All variables are weigthed by the inverse of total number of domestic banks in each country. Fixed effects are also included to remove country effects. Panel data are at the bank level. t-statistics are reported below estimated coefficient values. *,**, and *** indicate 10 percent, 5 percent, and 1 percent significance levels successively.

29

Cha

nge

in

net

mar

gin/

ta

Cha

nge

in

Non

-in

tere

st

inco

me/

ta

Cha

nge

in

befo

re ta

x pr

ofits

/taC

hang

e in

ov

erhe

ad/ta

Cha

nge

in

loan

loss

pr

ovis

ion/

taFo

reig

n ba

nk a

sset

sha

re

Tota

l-0

.002

***

-0.0

09**

*-0

.007

***

-0.0

03**

*0.

001

(-2.

793)

(-4.

963)

(-2.

711)

(-3.

951)

(0.8

85)

Stoc

k m

arke

t lib

eral

ized

firs

t0.

000

-0.0

01-0

.004

***

-0.0

02**

*0.

001*

**(-

1.09

2)(-

1.50

2)(-

4.58

0)(-

5.28

1)(3

.962

)

Dom

estic

fina

ncia

l mar

kets

libe

raliz

ed fi

rst

0.01

5***

0.01

6***

0.00

10.

021*

**0.

013*

**(2

.820

)(3

.767

)(0

.141

)(6

.646

)(3

.526

)

Cap

ital a

ccou

nt li

bera

lized

firs

t0.

002

-0.0

02-0

.008

**-0

.001

-0.0

05**

*(1

.284

)(-

0.85

3)(-

2.34

7)(-

0.31

8)(-

2.64

2)

(dom

estic

ban

ks)

(Wei

ghte

d Le

ast S

quar

es e

stim

atio

n w

ith c

ount

ry a

nd y

ear d

umm

ies,

het

eros

keda

stic

ity c

orre

cted

sta

ndar

d er

rors

)Ta

ble

6: S

umm

ary

Tabl

e - F

orei

gn B

ank

Shar

e as

a D

eter

min

ant o

f Per

form

ance

Indi

cato

rs

DEP

END

ENT

VAR

IAB

LES

Sour

ce: T

he fi

rst t

wo

lines

of t

he e

stim

ated

coe

ffici

ents

of t

he fo

reig

n ba

nk s

hare

are

take

n fro

m T

able

s 5

and

6. T

he e

stim

ated

coe

ffici

ents

of t

he

fore

ign

bank

sha

re in

the

last

two

lines

are

obt

aine

d by

runn

ing

an e

xact

set

of r

egre

ssio

n eq

uatio

ns a

s in

Tab

le 5

and

6 b

ut in

clud

ing

only

cou

ntrie

s w

hich

libe

raliz

ed th

eir d

omes

tic fi

nanc

ial f

irst i

n th

e fir

st s

et a

nd th

en in

clud

ing

coun

tries

whi

ch li

bera

lized

thei

r cap

ital a

ccou

nt fi

rst i

n th

e se

cond

set

.

Not

e: t-

stat

istic

s ar

e re

porte

d be

low

est

imat

ed c

oeffi

cien

t val

ues.

*,**

, and

*** i

ndic

ate

10 p

erce

nt, 5

per

cent

, and

1 p

erce

nt s

igni

fican

ce le

vels

su

cces

sive

ly.