foreign bank entry and domestic banks’ performance
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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.
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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.
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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.
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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.
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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.
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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).
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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
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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.
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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.
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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.
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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
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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
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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.
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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
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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
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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).
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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.
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