In recent years, international trade in goods and financial services has become increasingly significant To smooth the progress of such trade, a lot of banking institutions have also become international.1Banks have expanded internationally by establishing foreign subsidiaries and branches or by taking over established foreign banks. The internationalization of the banking sector has been spurred by the liberalization of financial markets worldwide. Developed and developing countries alike now increasingly allow banks to be foreign-owned and allow foreign entry on a national treatment basis.
Financial liberalization of this kind proceeds, among other reasons, on the premise that the gains from foreign entry to the domestic banking system outweigh any losses. Several authors have addressed the potential benefits of foreign bank entry for the domestic economy in terms of better resource allocation and higher efficiency (see Levine, 1996; Walter; Goldberg and Gelb and Sagari, 1990). Levine (1996) specifically mentions that foreign banks may (i) improve the quality and availability of financial services in the domestic financial market by increasing bank competition, and enabling the greater application of more modern banking skills and technology, (ii) serve to stimulate the development of the underlying bank supervisory and legal framework, and (iii) enhance a country's access to international capital.
There may also be costs to opening financial markets to foreign competition. Stiglitz (1993), for instance, discusses the potential costs to domestic banks, local entrepreneurs, and the government resulting from foreign bank entry. Domestic banks may incur costs since they have to compete with large international banks with better reputation; local entrepreneurs may receive less access to financial services since foreign banks generally concentrate on multinational firms; and governments may find their control of the economy diminished since foreign banks tend to be less sensitive to their wishes.
As yet, little evidence exists of the effects of an internationalization of the banking sector other than several case studies of foreign bank entry. McFadden (1994) reviews foreign bank entry in Australia, and finds that this has led to improved domestic bank operations. Bhattacharaya (1993) reports on specific cases in Pakistan, Turkey, and Korea, where foreign banks facilitated access to foreign capital for domestic projects. Pigott (1986) describes the policies that have made increased foreign bank activity possible in nine Pacific Basin countries, and provides some aggregate statistics on the size and scope of foreign banking activities in these markets. 2 Using aggregate accounting data, Terrell (1986, Table 20-2) compares the banking markets of 14 developed countries (8 of which allow foreign bank entry) for 1976 and 1977. Interestingly, in this sample, countries that allowed foreign bank entry on average experience lower gross interest margins, lower pre-tax profits, and lower operating costs (all scaled by the volume of business). Terrell (1986), however, does not control for influences on domestic banking other than whether or not foreign banks are permitted to enter.
This paper aims to provide a systematic study of how foreign bank presence has affected domestic banking markets in 80 countries. To do this, they used bank-level accounting data and macroeconomic data for the 1988-1995 period. First examine the scale of foreign bank operations in each of the 80 countries. Then define a bank to be foreign if at least 50% of its shares is foreign-owned, i.e., when there is foreign control of a bank's operations. As measures of foreign bank presence, we consider the importance of foreign banks both in terms of numbers and in terms of assets.
Then extend the work on the accounting decomposition of interest margins by Hanson and Rocha (1986) and, more recently, Demirg-Kunt and Huizinga (1999). Specifically, use the data to investigate how foreign banks differ from domestic banks in terms of interest margins, taxes paid, overhead expenses, loan loss provisioning, and profitability. We find that, while foreign banks have lower interest margins, overhead expenses, and profitability than domestic banks in developed countries (consistent with Terrell's (1986) findings), the opposite is true in developing countries. This suggests that the reasons for foreign entry, as well as the competitive and regulatory conditions found abroad, differ significantly between developed and developing countries.
Next, we estimate empirically how increased foreign bank presence, measured as the change in the ratio of the number of foreign banks to the total number of banks, affects the operation of domestic banks. We find that increased presence of foreign banks is associated with reductions in profitability, lower non-interest income, and overall expenses of domestic banks.