Better the Devil that You Know: Evidence on Entry Costs Faced by Foreign Banks Arturo Galindo Alejandro Micco César Serra Research Department Inter-American Development Bank

Financial Liberalization and FDI Race

Foreign Bank Control (% of assets)

Main Objective Study the determinants of Foreign Bank Penetration. Focusing whether differences in the legal and institutional setup between host and source countries increase entry costs and deter the expansion of foreign banks to domestic financial systems.

Framework Introduction Previous Literature Data Broad Evidence Empirical Results Conclusion

Introduction What are the advantages and disadvantages of foreign bank penetration?  Efficiency Gains.  Stability of Credit Growth.  Market Segmentation.

Efficiency Gains Claessens, Demirgüç-Kunt and Huizinga (2001) and Martinez-Peria and Schmukler (1999) find that domestic banks tend to reduce interest margins and profits when foreign bank participation increases. Abut, Bigio and Siller (1999) show that the efficiency gains come from the need of local banks to overcome relative disadvantages as limited access to capital, delays in and higher costs of implementing new products, etc.

Stability of Credit Growth Dages, Goldberg and Kinney (2000) find that foreign banks in Mexico and Argentina have different lending patterns than domestically owned ones. Foreign banks tended to be more stable providers of credit, potentially reflecting a more diversified funding base. Crystal, Dages and Goldberg (2001) find that in Chile, Colombia and Argentina, foreign banks had stronger and more stable loan growth than domestic private banks.

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

Market Segmentation Foreign Banks can reduce access to credit to some segments of the market, in particular to small and medium firms that heavily depend on bank financing. Clarke et. al. (2001) find that foreign bank penetration improve financing conditions for all enterprises; however, the most benefited are the large ones. Clarke et. al. (2002) find that foreign banks lent less to small and medium enterprises; however, this is mainly driven by the behavior of small foreign banks.

Previous Literature Brealey and Kaplanis (1996) use bank-level data of the world’s largest 1000 banks and analyze if the number of their offices in other countries than their own is associated with trade and FDI. However, their data set is reduced to nearly 13 sources countries. Focarelli and Pozzolo (2000) analyzes the probability of an OECD bank investing abroad, but they only uses a subsample of banks that have at least one equity abroad.

Determinants Efficiency: Banks operating in developed markets are more efficient and more likely to hold comparative advantage regarding their domestic competitors. Grosse and Goldberg (1991) find that there is a positive correlation between the number of foreign banks in USA from a source country and the degree of financial development of that country. Economic Integration: Measure as geographical distance, bilateral trade flows and FDI. Studies have found a positive correlation between the presence of foreign banks and the measures of bilateral integration.

Determinants Regulatory Restrictions: Restrictions on entry reduce the degree of internationalization of a country’s banking system. Miller and Parkhe (1998) find that US banks prefer to expand in countries where capital requirements are less stringent. Local Market Opportunities: Banks prefer to invest their resources in countries with more stable conditions proxy as a country risk (Grosse and Goldberg (1991), Fisher and Molyneux (1996) and Yamori (1998)).

Data We use bank-specific ownership data from Fitch IBCA’s Bankscope for We include commercial, investment, saving and mortgage banks according to the definitions of Bankscope. Our sample includes 7912 banks from 176 countries: –Africa and the Middle East (57), –Asia and Pacific (32), –Latin America and the Caribbean (34), –North America w/o Mexico (2), –Europe (51).

Variables Bilateral Foreign Banking Control: where i and j are the source and host country, respectively. Legal/Institutional Indexes: Legal Origin, Banking Regulation, Regulatory Burden, Corruption, Rule of Law and Efficiency of the Judiciary. Abs(Difference of Host and Source Index) Difference of Host and Source Index

Cross-Border Shareholdings

Broad Evidence (whole sample)

Broad Evidence (non-zero sample)

Empirical Strategy Based on Gravity Equation log( 1 + FC ij ) =  1 CBord ij +  2 CLang ij +  3 log(Distance ij ) +  4 log( 1 + trade ij ) +  5 Inst/Leg ij +  6 Dhost +  7 DSource +  ij

Empirical Results

Bilateral FDI and Institutional and Legal Variables

Conclusions Legal and institutional differences across countries increase entry costs and reduce foreign bank participation. –Differences in legal origin leads to a reduction of nearly 13% of bilateral cross-border banking activity. –Differences in banking regulation can account for nearly 25% of foreign bank penetration. –In average, institutional differences imply nearly a 30% reduction in cross-border banking.