1918. How Does Foreign Entry Affect the Domestic Banking Market?

Stijn Claessens, Asl1 Demirgüç-Kunt, and Harry Huizinga
(June 1998)

Does the entry of foreign banks make domestic banks more competitive? This study shows that, in developing countries, increasing the number (even more than the share) of foreign banks reduces both profits and overhead expenses of domestic banks.

Banking markets are becoming increasingly international through financial liberalization and general economic integration.

Using bank-level data for 80 countries for 1988–95, Claessens, Demirgüç-Kunt, and Huizinga examine the extent of foreign ownership in national banking markets. They compare net interest margins, overhead, taxes paid, and profitability of foreign and domestic banks.

The comparative functions of foreign banks and domestic banks is very different in developing and industrial countries, possibly because of a different customer base, different bank procedures, and different regulatory and tax regimes:

• In developing countries foreign banks tend to have greater profits, higher interest margins, and higher tax payments than do domestic banks.
  
  
• In industrial countries it is the domestic banks that have greater profits, higher interest margins, and higher tax payments.

It is common to read, in the literature on foreign banking, that the entry of foreign banks can make national banking markets more competitive, thereby forcing domestic banks to operate more efficiently. Claessens, Demirgüç-Kunt, and Huizinga show that increasing the foreign share of bank ownership does indeed reduce profitability and overhead expenses in domestically owned banks—so the general effect of foreign bank entry may be positive.

Interestingly, the number of foreign entrants matters more than their market share, suggesting that they affect local bank competition more on entry rather than after gaining a substantial market share.

These effects hold even when controlling for the fact that foreign banks may be attracted to markets with certain characteristics, such as low banking costs.

This paper—a joint product of the East Asia and Pacific Region and the Development Research Group—is part of a larger effort in the Bank to study the effects of increasing global integration of financial services. Copies of this paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rose Vo, room MC4-404, telephone 202-473-3722, fax 202-522-2530, Internet address hvo1@worldbank.org. The authors may be contacted at cclaessens @worldbank.org, ademirguckunt@worldbank.org, or H.P.Huizinga@Kub.NL. (30 pages)

The full report is available in PDF format.