Impact of Foreign Entry on Banks' Operating Efficiency: The Role of the Pre-Existing Competitive Environment in Emerging Markets

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ABSTRACT

This study re-examines the short-term impact of foreign entry on domestic banks' operating behavior and performance in emerging markets. Based on a panel of banks in 30 developing countries/economies, the study finds that foreign bank entry on average is not associated with immediate improvement of intermediation and cost efficiency in domestic banks. The efficiency impact of foreign entry is affected by the pre-existing competitive condition in the host market. In particular, immediate efficiency gains, if any, are only concentrated in more competitive banking sectors, especially those with higher levels of banking freedom.

Keywords: Foreign entry, Banking, Competitive environment, Emerging markets

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INTRODUCTION

Starting from the second half of the 1990s, foreign banks have been expanding their presence in many emerging markets. In Argentina and Chile, in Latin America, and in the Czech Republic, Hungary, and Poland, of Eastern Europe, foreign-owned banks have accounted for 50 percent or more of total banking assets (Clarke, Cull, Peria, and Sanchez, 2003). In Asia, the proportion of foreign-owned banks remains relatively low, but it has increased dramatically since the Asian financial crisis and is expected to increase more rapidly (Montgomery, 2003). Crystal, Dages, and Goldberg (2002) suggest that the trend as reflected the need for recapitalization of local banking sectors in the wake of crises and may also be a result of the broader market trends of consolidation, integration, privatization, and liberalization of the late 1990s.

However, whether foreign entry in the banking sectors should be allowed and to what extent the incentives for foreign penetration should be provided remains a sensitive issue in many developing countries. Bank regulators may view banking sectors as strategically important in affecting economic independence, stability, and development because some immature financial systems in developing countries rely heavily on banks to channel financial resources to development priorities. In some cases, foreign entry in the banking sector is connected with nationalistic feelings, too.

The central issue is the comparison of benefits vs. costs yielded by the openness of the banking sector. Arguments in favor of foreign entry mainly build upon the efficiency gains realized by domestic banks due to competitive pressures and spillover effects. Foreign entrants intensify the competition level in a banking system, which forces domestic banks to become more efficient if they wish to survive. Spillover effects refer to the transfer of new technologies, products, and management techniques to local banks (Agénor, 2003; Spencer, 2005). Domestic banks benefit directly from foreign banks' operation by learning from the new competitors more sophisticated banking skills, risk management techniques, and personnel training. At the industry and country level, foreign bank presence can also improve allocation of credits and help obtain easier access to international capital markets (Claessens et al., 2001).

However, the positive impact can be eliminated or weakened due to foreign banks' alleged "cherry pick" lending practice (Agénor, 2003; Song, 2004), the likelihood of taking additional risks by domestic banks in dealing with excessive competition (Vivies, 2001), the possible increase in concentration due to M&As (Agénor, 2003), and even the failure of infant domestic banks as a result of the "crowding out" effect (Song, 2004).

In tandem with the two sides of the argument, short-term impact of foreign bank entry on local banks' operating efficiency is widely studied in the empirical literature. The cross-country study of Claessens, Demirguc-kunt, and Huizinga (2001) detects efficiency gains for local banks. One of the biggest shortcomings of the analysis, however, is that the results only hold "on average" across a large group of countries; but pooling countries with very different financial characteristics is questionable (Agenor, 2001). …