Foreign Banks and Financial Development in Developing Countries: A Cross-Country Empirical Examination

Transcription

1 Foreign Banks and Financial Development in Developing Countries: A Cross-Country Empirical Examination Kang-Kook Lee Ritsumeikan University Abstract This paper examines the effects of foreign bank entry on financial development in developing countries. Foreign banks play an important role in the financial sector in many developing countries along with financial globalization bur their impacts on financial development are not clear. While many argue that foreign banks in developing countries promote financial development and efficiency, others emphasize that foreign bank presence in developing countries could reduce private credit and increase costs due to cream-skimming. This paper presents a cross-country empirical analysis of the effects of foreign banks on financial depth, cost efficiency and financial access, using a new dataset of the foreign bank share and a large sample of developing countries from 1995 to We find that foreign bank presence is negatively related with private credit and efficiency of the financial system in developing countries. In particular, foreign banks from high-income countries with a greater geographical and cultural distance exert significantly negative effects on financial development, while those from developing countries do not. JEL classification: F21, G21, O16 Keywords: Foreign Banks, Financial Development, Cost Efficiency, Developing Countries

2 I. Introduction It has been long argued that financial globalization spurs economic growth in developing countries by promoting investment and its efficiency. The development of the financial sector, in particular, is an important channel that financial globalization provides large benefits to developing countries. Developing countries usually suffer from underdevelopment of the financial system, which leads to serious financing constraints for investment and growth. Many expect that foreign bank entry and foreign capital inflows in developing countries would make an important contribution to economic growth in this regard. Foreign banks could make the financial sector more efficient by encouraging competition and bringing spillover effects, and increase credit provided by the financial sector. However, it is not evident that financial opening and foreign bank entry would be always beneficial. Financial opening could destabilize developing countries and foreign banks may channel external shocks. More importantly, the effects of foreign bank entry on financial development are not clear-cut because foreign banks may be involved in cream-skimming and reduce credit to small and more opaque firms. If this is serious, overall credit could decline and a higher foreign bank presence entry could exert negative effects on financial development and cost efficiency of the banking system in developing countries. There are already a number of empirical studies to report the segmentation of the financial market related with foreign banks cream-skimming (Berger et al., 2001; Mian, 2006). Another study using cross-country regressions finds that there is a negative relationship between foreign bank presence and financial development is (Detragiache et al., 2008). Moreover, there is no empirical evidence that financial globalization promotes economic growth, which leads economists to be generally disappointed by financial globalization (Kose et al., 2009; Rodrik and Subramanian, 2009). This paper aims at empirically examining the effects of foreign bank entry on financial development in developing countries. By using a new dataset of the foreign bank share from the World Bank and running cross-country regressions, it investigates how foreign bank entry affects various aspects of the financial sector. They include private credit, its growth, overhead costs and financial access. Our study demonstrates that the share of bank assets held by foreign banks is negatively associated with financial development and cost efficiency of the financial system in developing countries. We also find that origin of foreign banks matters since the negative effects on financial development were driven by foreign banks from high- 2

3 income countries. These findings are consistent with the prediction of the cream-skimming model. However, foreign banks do not make significant effects on access to financial services. This paper is organized as follows. Section II presents the overall picture of the increase in entry of foreign banks in developing countries and discusses its benefits in terms of efficiency and stability. Section III reviews related the theoretical and empirical literature about the effects of foreign banks on financial development measured by private credit. Section IV explains the data and methodology of our empirical models. Section V presents empirical results of various regressions and discussions on these results. Section VI summarizes our study and concludes. II. The Trend and Implications of Foreign Banks in Developing Countries 1. The Development of Foreign Bank Entry in Developing Countries The role of international has become substantial banks in many developing countries along with financial opening and globalization. This is outcome of the following factors: increasing demand for international banking services due to the integration of developing countries into the world economy, technological progress allowing banks to automatize processes across global supply chain, and regulatory reforms of both developing and developed countries (World Bank, 2008a). In addition, many countries have also allowed foreign bank entrance after a financial crisis with local banks suffering from nonperforming loans because of the need to recapitalize and reestablish their banking sectors. Foreign banks have keenly reacted to the demand for international banking in developing countries, motivated by the risk diversification strategy and attracted by the higher growth in these countries. They have expanded their operations in developing countries through Greenfield investment into the banking sector or the purchase of local banks. As a result, the share of foreign banks in total bank assets in developing economies has been growing rapidly although there are regional differences, as Figure 1 and Table 1 demonstrate. Claessens et al. (2008) report that the share of bank assets held all foreign banks out of all bank assets in developing countries rose from 10.1% in 1995 to 15.2%. Foreign banks in developing countries also come from other developing countries, called South-South banks, and their share in total foreign bank assets in developing countries was about 7 % over the same period 3

4 Figure 1 and Table 1 here The rapid growth of the share of foreign banks in local bank assets is highly pronounced in Europe and Central Asia, and Latin America and Caribbean. The reasons for increasing presence of foreign banks in developing countries are different across regions. In Sub- Saharan Africa it is because of limited reach of local banking infrastructure, in Europe it is along with regional integration into the European Union, in Central Asia it is related with easing entry barriers in connection with joining to the WTO, and in Latin America it is a way for governments to open their countries to foreign competition. Turning to determinants of foreign bank entry to developing countries, similar legal systems, institutions and banking regulations to those in origin countries of foreign banks matter (Galindo et. al, 2003). Common language, cultural similarity, geographic proximity and economic integration are other factors to affect international banks location (Claessens et al., 2008). 2. Benefits of Foreign Banks: Efficiency and Stability The dramatic increase of the participation of foreign banks in the financial systems of developing countries has drawn attention of researchers and policymakers. A large number of studies emphasize benefits of foreign banks including increasing competition and efficiency, access to better financial services, the development of supervisory and regulatory system. Host country residents get access to advanced financial services provided by foreign banks. Entry of more efficient foreign banks may improve the efficiency of financial systems by way of spillover effects. 1 They can bring advanced products and better management skill, and can stimulate competition, thus reducing the costs and improving the quality and availability of financial services (Claessens et al. 2001). Foreign bank participation can also improve infrastructure in the financial system via promoting the development of rating agencies, credit bureaus and auditors (Levine, 2001). Moreover, foreign bank entry may develop financial supervision, eliminate excessive interference of authorities and reduce connected lending 1 In developing countries as a group, foreign banks have higher value of such efficiency measures as overhead costs and cost-income ratio, while having lower value of net interest margin and loan loss reserves (World Bank, 2008). Claessens and Van Horen (2012a) also find that foreign banks in lowincome developing countries perform significantly better although a number of factors such as regulation and the market share are important to performance of foreign banks. 4

5 (Goldberg, 2007). Foreign banks may also promote financial stability in developing countries since they may perform better than domestic counterparts during the time of financial distress with a more diversified pool of liquidity and continue to provide people with credit (Clarke et al., 2003). However, the opposite possibility is also indicated. Foreign banks can import shocks from their home countries by cutting credit more and spread shocks from other developing countries in which they operate (Claessens and Van Horen, 2012b). Besides, strong competition with foreign banks can threaten survival of local banks, as foreign banks can only concentrate on a top segment of the market (Cull and Martinez Peria, 2010). Empirical studies generally support the positive effects of foreign banks related with financial efficiency and stability. Several studies using bank-level data state that higher foreign bank participation is correlated with more competition and efficiency in the host country s banking sector. It is associated with lower spreads, profitability, and cost for domestic banks in developing countries (Claessens et al., 2001; Claessens and Lee, 2003). According to Micco et al. (2007), more efficient foreign banks make domestic banks more efficient in the underdeveloped banking sector. Hermes and Lensink (2004) indicate that financial development does matter because foreign bank presence is associated with falling costs and margins of domestic banks at higher levels of financial development. There are also many regional studies on Eastern European countries (Bonin et al., 2005; Grigorian and Manole, 2006; Poghosyan T. and Poghosyan A., 2010) to check the efficiency of banking systems in the presence of foreign banks. Even though results are sometimes ambiguous, increase in foreign bank participation improves efficiency of financial systems on balance. 2 A study on Latin American countries also finds that high foreign bank participation leads to the reduction of operating costs and narrowing spreads (Martinez Peria and Mody, 2004). The argument for efficiency effects of foreign banks finds mixed support in the case of Asian countries. Sensarma (2006) compares the efficiency and productivity of state-owned, private and foreign banks in India and reports foreign banks were the worst. Wu et al. (2007) finds that the return on assets for Chinese banks that have foreign shareholders is, on average, was lower, and more foreign bank entry does not affect the operational performance of Chinese banks. However, Berger et al. (2009) obtained opposite results that foreign banks were most efficient and foreign ownership was associated with improved efficiency. Results 2 There are also single country studies including Kraft et al. (2002), Hasan and Marton (2003), Havrylchyk (2006), and Miklaszewska and Mikolajczyk (2009). They usually employ data envelopment analysis (DEA) and stochastic frontier approach (SFA). 5

6 are more positive for other Asian countries including Korea, Thailand and Indonesia (Lee, 2003; Cull and Martinez Peria, 2010). Another strand of literature investigates the impact of foreign bank entry on banking sector stability of the host country. Dages et al. (2000) assert that foreign banks contribute to financial stability in times of financial turmoil in Mexico and Argentina in the late 1990s, with higher credit growth with lower volatility than domestic banks. Foreign banks in Latin American countries show more robust loan growth, a more aggressive response to asset deterioration, and greater ability to absorb losses than domestic banks during this period (Crystal et al., 2002). Arena et al. (2007) also find weak evidence that foreign banks credit levels are less sensitive to monetary conditions and their interest rates are more stable during periods of financial distress. De Haas and Van Lelyveld (2006) report that foreign banks have kept lending in Eastern European countries during systematic banking crises. A study of banks and firms in Eastern Europe finds that lending relationships of foreign banks tend to be more stable than those of domestic banks (Giannetti and Ongena, 2009). Examining the strategies of foreign banks in transition economies, Haselmann (2006) also finds that foreign banks follow long-term strategies, thus contributing to credit market stabilization. 3 Nevertheless, there is also evidence that foreign banks can transmit shocks from their home country and destabilize host country. For instance, according to Goldberg (2002), U.S. banks claims on foreign countries were sensitive to GDP growth in the U.S.. Another study finds that home country macroeconomic conditions and the health of parent banks are important for credit growth of foreign banks in the host country (De Haas and Van Lelyveld, 2006). Galindo et al. (2010) report that financial integration amplifies the impact of international financial shocks in Latin America after the late 1990s. Interest rates and loans of foreign banks respond more to external financial shocks than those of domestic banks. Finally, Claessens and Van Horen (2012) report that the higher foreign bank presence was closely related with lower credit growth during the global financial crisis since But Kamil and Rai (2010) find that the propagation of the global credit crunch was significantly more muted in Latin American countries where most of foreign bank lending was channeled in domestic currency. All in all, shortcomings of foreign banks appear to be outweighed by benefits in terms of efficiency and stability effects. 3 Financial instability in itself encourages foreign bank entry. According to Cull and Martinez Peria (2007), countries that experienced banking crises tend to have higher foreign bank participation because many governments remove entry barriers to rehabilitate banking sector by depending on foreign banks. 6

7 III. Foreign banks and financial development 3.1. Theoretical Models Considering all of these benefits, one may think that effects of foreign banks on financial development are significantly positive. International banking may increase credit to households and firms since foreign banks have greater variety of sources for funding (Goldberg, 2007). However, this may not be true because of a special feature of the financial market. Recently, theoretical studies on the effects of foreign banks on the financial market, using the model of banking based on asymmetric information, are under development. They demonstrate that foreign bank entry leads to segmentation of financial markets due to informational difference between domestic and foreign banks. Dell Aricca and Marquez (2004) suggest a model in which domestic banks are informed lenders with private information on firms while foreign banks are not. Their model demonstrates that how this affects the loan portfolio allocation of informed lenders. When faced with greater competition from outside lenders, banks reallocate credit toward more captured borrowers. Moreover, if borrower quality and captivity are sufficiently correlated, an increase in the competitiveness of uninformed lenders can worsen the informed lender s loan portfolio. The model explains observed consequences of financial liberalizations by predicting that local banks will reallocate portfolios toward borrowers whose quality is less discernible by external lenders. Sengupta (2007) also models foreign entry and bank competition as the interaction between uninformed foreign banks and informed domestic ones. In his model, the entrant s success in gaining borrowers of higher quality by offering cheaper loans increases with its cost advantage. Better information and stronger legal protection are shown to facilitate the entry of low-cost outside competitors into credit markets. This study suggests that foreign banks tend to lend more to large firms while they have difficulty in extending loans to informationally opaque small firms, which are mainly financed by better informed domestic banks. These studies predict that foreign bank entry and more competition will induce a segmented credit market structure, consistent with empirical findings (Berger et al., 2001; Gormley, 2010; Mian, 2006). Foreign banks in developing countries predominantly lend to the 7

8 safer and more transparent customers, such as multinational corporations and large domestic firms. Lending to informationally opaque firms is not easily carried out by foreign banks because of a great distance between headquarters and local offices. 4 Other theoretical models point to the possibility that foreign bank entry could reduce overall credit. Detragiache et al. (2008) present a model in which foreign banks are better than domestic banks at monitoring hard information but not at monitoring soft information. Their model shows that there could be four equilibrium outcomes. In some equilibrium outcomes foreign banks lend to hard information firms, while domestic banks lend to soft information firms only in the separating and credit constrained outcomes, or to both soft information and bad firms in the semi-pooling outcome. In this model, foreign bank entry could lead to a reduction in overall lending and efficiency in some parameter conditions. The intuition for this is that foreign bank entry causes cream-skimming. If foreign bank entry forces domestic banks out of the market, then more opaque firms may become credit constrained and aggregate credit may decline. Thus, they expect to find a negative correlation between foreign bank penetration and the ratio of credit to GDP. Finally, Gormely (2011) demonstrates that foreign bank entry could be negative to financial development, using a model in which foreign banks have higher screening costs bur lower interest rates than domestic banks. His model shows that lender entry has the potential to create a segmented market, which could reduce credit access for firms not targeted by the new lenders. It provides an explanation as to why open capital markets may not increase overall output in developing countries. Initially, domestic lenders pool risks, crosssubsidizing losses with gains. Because entering foreign lenders are disadvantaged in acquiring information about local firms, they enter via cream-skimming, which can redirect credit towards profitable firms. The switch to a separating equilibrium benefits cream firms with more lucrative contracts. It is possible, however, that domestic lenders cannot profitably screen average firms in the separating equilibrium and foreign lenders cannot offer an unscreened contract, pooling average and bad firms, under some cost structures. Then, overall credit could decline since the credit access of firms that rely on domestic lenders is reduced. The overall impact on financial development depends on the distribution of firms, the relative 4 However, the effects of foreign banks on financial development such as overall credit are not negative at least these models. See Gormely (2011) for more discussions. 8

9 costs of lenders, and the cost of acquiring information. 5 In sum, these models implicate that foreign bank entry could lead to a change in equilibrium to one with less credit. The predictions fit recent evidence that the more foreign bank penetration is not always associated with financial and economic development. Foreign banks could skim off the best customers of domestic banks, and may be reduce overall credit Empirical Studies on Foreign Banks and Credit According to the World Bank, several developing countries, particularly in Europe and Central Asia experienced rapid credit expansion along with foreign bank entry (World Bank, 2008), but there are also many counterexamples. Researchers perform more rigorous empirical studies on credit effects of foreign banks. Based on the theoretical model of creamskimming, Detragiache et al. (2008) presents empirical evidence of this theory. Using crosscountry analysis of 89 low income countries and the share of foreign bank assets out of all bank assets over the period from 1995 to 2002, they find that foreign bank presence is negatively associated with the private credit to GDP ratio and its growth. This result holds when they use panel regressions and instrumental variable regressions to address potential endogeneity. Cull and Martinez Peria (2007) looks more closely at the timing of foreign entry and argue that those associations might be driven by the nonrandom entry of foreign banks after financial crises. They present evidence that foreign bank entry from 1995 to 2002 is largely outcome of those crises, and that the higher foreign bank entry in the post-crisis period is negatively related with private credit using panel regressions. But this fall in credit is mainly because foreign banks acquired financially distressed banks. In many countries foreign banks were brought in to buy weak domestic banks and thus re-capitalize banking sectors after crises. 6 According to them, foreign banks play a role of a stabilizing force. However, a more recent study by Claessens and Van Horen (2012b) finds that foreign banks made a 5 If there are more cream firms and screening costs are lower, the separating equilibrium with foreign bank entry could increase overall credit. This suggests that policies to strengthen institutions such as credit rating agencies or enforcement of account standard may lower screening costs and lessen the negative effects of cream-skimming. Also, policies to prohibit the acquisition of domestic lenders may worsen them by increasing screening costs. 6 Moreover, they notice that when foreign bank presence was not crisis-induced, implying that it was comparably high and steady from the beginning, private credit level was much higher than in other countries. 9

10 significantly negative effect on private credit in the mid-2000s, using parsimonious specification, especially in developing countries. The negative effect was also significant during the global financial crisis. There is also empirical literature on difference in lending styles between foreign and domestic banks, which affirms segmentation of the financial market. A study of 1600 banks in developing countries from 1992 to 1999 concludes that foreign banks have access to external liquidity from their parent banks but their local branches have little discretion to make lending decisions based on anything other than hard information (Mian, 2003). Consequently, informationally opaque borrowers have hard time borrowing from foreign banks. Mian (2006) uses data of 80,000 loans in Pakistan for the period and finds that providing credit is more based on hard information when geographic distance and cultural difference between the headquarters of a foreign bank and its branches in the host country is big. Berger et al. (2001) finds similar results, using the borrowing profiles of over 60,000 firms from 115 banks in Argentina in A bank-level study on Argentina, Chile, Colombia, and Peru also finds that foreign banks typically lend a smaller share of their portfolios to SMEs (Small and Medium Enterprises) than domestic banks (Clarke et al., 2005). In a study of the Indian banking system in the 1990s, Gormley (2010) indicates that foreign bank entry expanded access to credit for only a small subset of profitable firms following entry and there was a systematic drop in domestic bank loans foreign bank entry. The negative effects are well known in the case of Mexico. Haber and Musacchio (2005) analyze Mexico s experience of privatization and foreign bank entry in the 1990s. They find that as the presence of foreign banks grew, lending to the private sector declined and this was more pronounced in foreign banks. But other studies report opposite results. De Haas and Naaborg (2006) presents the survey result that there is no intended prejudice toward lending to large multinationals. Increased competition and the improvement of lending technologies lead foreign banks to expand into the SME and retail markets. Yi et al. (2009) report that the increase in foreign bank ownership doesn t directly reduce loans to smaller firms in Korea. Competitive pressure from foreign banks could force domestic banks to pursue new market niches. Competition in lending also makes managers of foreign banks begin lending to small businesses because (Jenkins, 2000). Notwithstanding foreign banks reliance on hard information, Beck et al. (2010) assert that there is no difference in the extent of their commitment with these firms relative to large domestic and government-owned banks. Clarke et al. (2006) examine over 10

11 3000 firms in 35 developing and transition countries, and reveal that foreign bank presence is associated with improved financing conditions for all firms. Another study on firms in Eastern Europe and Central Asia also finds that foreign bank lending is connected with growth in firms sales and assets, specifically helpful to young start-ups (Giannetti and Ongena, 2009). Bruno and Hauswald (2009) finds that foreign banks stimulate the growth of industries with higher dependence on finance, hence making real positive effects of relaxing financing constraints. Foreign bank presence may affect financial inclusion people s access to financial services in the host country too since they have informational disadvantage and face higher transaction costs. Detragiache et al. (2008) provide empirical evidence that foreign bank entry is negatively related with financial access measured by geographical and demographic penetration of banking services. Using a sample of 49 countries, Sarma and Pais (2010) find that the high share of foreign ownership in the banking system is also negatively associated with financial inclusion in bivariate correlation. These are generally in line with the creamskimming model. In a study to investigate the consequences of foreign bank entry to financial access in Mexico, Beck and Martinez Peria (2010) find that primarily rich and urban municipalities benefited from the significant increase in foreign bank participation between 1997 and Nevertheless, Beck et al. (2008a) find that barriers for bank customers are lower where there is more foreign bank participation based on information from 2009 banks in 62 countries. Beck et al. (2007) report that foreign bank penetration is not related with access to financial services, using the data of 99 countries in To summarize, the implication of foreign bank presence to private credit and financial access is not very evident. It might differ across countries based on the level of institutional development, competition in the domestic banking sector and the capacity of banks to overcome information problems. IV. The Empirical Test: Data and Methodology 3.1. Sample and Variables We employ common cross-country regression approach to examine the effects of foreign banks on financial development in developing countries, following Detragiache et al. (2008). 11

12 We investigate how foreign bank penetration is related with financial development, financial efficiency and financial inclusion. First, we limit our sample to developing countries because cream-skimming of foreign banks and segmentation of the financial market are more likely to occur in developing countries far from headquarters of foreign banks. We use the World Bank definition of low income and middle income countries in Detragiache et al. (2008) use a poor country sample including low and lower middle income countries only. However, there is no reason that slightly richer developing countries are very different from poorer countries as the Mexican case demonstrates. The total number of countries that has the foreign bank data is 102 for the period between 1995 and 2005, but it varies among the different set of regressions depending on the availability of data on control variables. 7 As for the dependent variable for financial development, we use the most common measurement of the volume of credit: the ratio of commercial bank credit to the private sector to GDP, which is called financial depth. This is from the Financial Development and Structure database from the World Bank constructed by Beck et al. (2009) and Cihak et al. (2012). We use the average of this variable over final years from 2001 to 2005 to address the effects of economic cycles. 8 The variable for cost efficiency of the financial system is overhead costs out of total assets of banks over the same period from the same dataset. Higher level of overhead costs indicates lower level of banking efficiency as it measures all costs incurred by banks except for the interest paid on liabilities. This indicator is an unweighted average across all banks of a country for a given year. Finally, several variables to represent financial access or inclusion are used, including the composite index of financial access, demographic branch penetration, geographic branch penetration and a number of deposit accounts. These data are from Beck et al. (2007) and World Bank (2008), referring to information over We identify bank ownership using the data of the share of assets held by foreign banks out of total bank assets, constructed by Claessens et al. (2008) covering 138 countries for the period. The first dataset on foreign bank assets was made by Micco et al. (2004). They combine information of the Bankscope database with individual bank information from outside sources for 104 developing countries over the period. More recently, 7 We exclude outliers such as China, Thailand, Malaysia and Panama in our regressions. The overall results do not change after including these countries. 8 This is similar to Detragiache et al. (2008) that use the average from 1999 to We do not include the financial development data in 2006 because the foreign bank share dataset has several missing values in

13 Claessens et al. (2008) have constructed a more reliable and extensive, and longer dataset that reports the number and the share of bank assets of foreign banks. This also has information of the origin of foreign banks by classifying foreign banks into two groups including those from high-income countries and those from developing countries. Their database comprises 3342 banks and covers the banking sectors of all developing countries with more than five active banks in A bank is considered foreign-owned if 50 percent or more of its shares are held by foreign nationals in a given year. The share of foreign bank assets to total bank assets in each country is computed aggregating individual bank information. This dataset is different from that of Micco et al. (2007) in several aspects as well as the time span. In the database of Claessens et al. (2008), bank ownership is determined for 94% of banks, while in the Micco et al. (2007) database ownership is only determined for those banks that capture 75% of the bank assets. Besides, the Micco et. al (2007) database determines the ownership of a bank based on indirect ownership, while Claessens et al. (2008) focus on direct ownership. 9 Previous studies use the Micco et al. (2004) data but we use the more recent dataset of Claessens et al. (2008). 10 The initial value of the share of all foreign bank assets in 1995 is used in our cross-sectional regressions so that we avoid joint endogeneity problems. 11 We also examine potentially different effects of the origin of banks in separate regressions, by using the asset of foreign banks from developed countries and developing countries respectively. The foreign bank share data may have a limitation due to changes in coverage of Bankscope, but it does not lead to any bias in our results as long as broadening coverage does not disproportionately affect banks of different ownership (Detragiache et al., 2008). More recently, Claessens and Van horen (2012b) have extended their data toward However, we do not use the data after 2006, taking great effects of the global financial crisis into account The Model Specification 9 The data of Micco et al. (2007) includes 104 developing countries in total, while Claessens et al. (2008) includes 102 of them. However, the number of countries in regressions using the data of Claessens et al. (2008) is 99, while that using the data of Micco et al. (2007) is 89 because the latter database have more missing values in the 1990s. 10 Detragiache et al.(2008) and Cull and Martinez Peria (2007) use the Micco et al. (2007) data. Bruno and Hauswald (2009) is the only study to use the Claessens et al. (2008) data. We also check our results by using the Micco et al. (2007) data. 11 The data for 1996 is used for countries that do not have data for 1995, though they are very few. 13

14 A. The Empirical Model Using these variables and other control variables, we set up commonly used cross-country and panel regressions. First, the several versions of the following cross-sectional equation will be estimated for the level of financial development, cost efficiency and financial access. We include interaction terms of the foreign bank share and other precondition variables in this specification so as to examine potential threshold effects. y i = α + βfs i + γx i + u i where, - y i : dependent variable including the ratio of private credit to GDP and others - fs i : the initial share of bank assets held by foreign banks - X i : a matrix of control variables (log of GDP per capita, inflation, lack of corruption etc.) - u i : error term - α, β, and γ : parameters to be estimated Cross-sectional regressions give us important information but naturally have limitations such as endogeneity and omitted variable problems. Even using the initial data of independent variables may not be perfect because of serial correlation of variables. Following Detragiache et al. (2008), we employ other methodologies including growth rate regression, panel estimation, and instrumental variable estimation. First, Detragiache et al. (2008) suggest the regression for the growth of private credit including the initial value of private credit level in the control variable set. It can reduce biases from omitted country characteristics or shocks to some extent because they are captured by the initial value of the performance indicator. The set of regressions to be estimated is as follows: gr i = α + βfs i + δ i y i0 + γx i + u i where the variables are defined as above, gr i is the growth rate of financial development measured by log difference of the level of private credit, and yio is the initial level of financial 14

15 development. Second, using panel data, we can control for unobserved country-specific fixed characteristics that might affect private credit, and estimate within-country effects of foreign banks, similar to the difference-in-difference approach by Bruno and Hauswald (2009). The equation of the panel regression is as follows: y i,t = α + βfs i,t + γx i,t + δ i + λ t + u i,t effect. where the variables are same as above, δ i is a country fixed effect and λ t is a time fixed Because of restriction in data, we use annual panel data and estimate the model with OLS using country and time fixed effects. In addition, we also employ the dynamic panel specification by including the lagged dependent variable as a control variable, and estimate the model with a system GMM (Generalized Method of Moment estimator. We apply the same panel regressions to investigation of the relationship between foreign banks and cost efficiency too. An alternative approach to deal with endogeneity concerns is instrumental variable estimation. This regression can be run by using exogenous instrumental variables that are related with the foreign bank share but not affected by financial development. We perform the similar instrumental variable estimation, using instrumental variables in Detragiache et al. (2006; 2008), and yet we find that those instrumental variables are not valid. 12 We do not report these results since they appear to be not reliable. B. Control variables The specification of our regression model includes control variables that are commonly used by current empirical studies. In principle, the values for independent variables in the 12 Detragiache et al. (2006) use religion and population in the host developing country as instrumental variables and Detragiache et al. (2008) use the former colonizer s bank share out of the top 100 world largest banks, dummy for European official language and population. We have utilized all of them separately and together but do not have had valid results. The language variables and the former colonizer s bank share are not significant, and the F-test statistic in the first stage regression is rather low even when using the language and population variable. Even when using the same sample and variables in their studies, their instrumental variables are weak and not valid. 15

16 period earlier than the period for dependent variables are used for the purpose of addressing joint endogeneity concerns. We mainly use the average values of independent variables in the 1990s in our estimations. In regressions for financial development, main control variables include the level of growth, inflation, and freedom from corruption. Later, we include more variables to conduct sensitivity analysis to test robustness of results. Existing theory and empirical study indicate that there is a broad set of potential determinants of financial development. Among them, we first include the level of GDP, measured by GDP per capita, as a control variable since many find that the level of growth is important to the level of financial development (Detragiache et al., 2008). We also include inflation, measured by the CPI (consumer price index) growth rate because it is found to be generally negative to financial development (Boyd et al., 2001). It is widely acknowledged that institutions matter for financial development and economic growth (Rodrik et al., 2004; La porta et al, 2008). A legal and regulatory system involving protection of property rights, contract enforcement and good accounting practices has been identified as essential for financial development (Law and Demetriades, 2006; Maurer, 2008). We use the data of freedom from corruption from the World Bank governance indicator because lack of corruption is the most essential to institutional development. 13 Rather than institutions, the real market infrastructure associated with the business environment may be also important to financial development. We use the availability of information to creditors from the Doing Business database by the World Bank. 14 We also control for trade openness because several studies find it significant to financial development (Law and Demetriades, 2006; Chinn and Ito, 2006) In addition, the transition country dummy is used as another control variable. We include more control variables for robustness check. The set of similar cross-sectional and panel estimations is used for cost efficiency of the financial system and financial access. In regressions to examine overhead costs, we use several control variables that are relevant to the efficiency of the financial sector. Most variables used in financial development regressions could be important to cost efficiency. We include GDP per capita and inflation by assuming that overhead costs could be higher when 13 There are many other variables related with institutional quality such as corruption, law and order, government bureaucracy and political stability from various sources, but most are highly correlated. Lack of corruption from the World Bank covers the largest number of developing countries, which is also used by Detragiache et al. (2008). 14 Detragiache et al. (2008) include creditor information and the time it takes to enforce contracts. But we find both are insignificant after controlling for other variables. 16

17 countries are poorer and with higher inflation. One may well expect that the financial sector becomes more efficient if countries grow up and their macroeconomic stability is higher. We also include population density since banks in countries with higher population density tend to have lower costs. In regressions for financial access, basically we include GDP per capita first, following many other studies that find outreach of the banking services is highly associated with the level of growth (Detragiache er al., 2008; Sarma and Pais, 2010). An infrastructure variable, that is the number of telephone lines, is also included because physical infrastructure can facilitate financial access (Beck et al., 2007; Sarma and Pais, 2010). Additionally, we include other control variables such as population density and institution since financial access could be promoted in countries with higher population density and higher institutional development. V. Empirical Results 5.1. Cross-sectional OLS Regressions A. Cross-sectional Results Table 2 presents the results of various cross-country OLS regressions of financial development on the share of foreign bank assets and other control variables. When we control for GDP per capita, the coefficient of the foreign bank share is negative and significant. As we expect, inflation is significantly negative and adding inflation in control variables results in an increase in the size and significance of the coefficient of the foreign bank share. When we introduce the lack of corruption variable, the coefficient and significance of foreign share become larger and the fit of the regression model improves highly. It should be noted that the coefficient of GDP per capita becomes insignificant after including lack of corruption perhaps because lack of corruption is correlated with the level of growth but is much more important to financial development in developing countries. Overall, the variables have the signs predicted by the theory and have significant coefficients. The size of the effect of foreign bank presence on private credit is considerable. An increase in the foreign bank share by one standard deviation, that is about 28.5 percentage points, would lead to a reduction in the ratio of private credit to GDP of about 4.3 percentage points. Figure 2 graphically illustrates the negative relationship between foreign bank presence and financial development. 17

18 Additional controls, such as the trade openness and population density are not significant. Also, the transition country dummy and the creditor information index are not significant either, different from Detragiache et al. (2008) due to the difference in data and sample. Table 2, Figure 2 here Table 3 demonstrates the results of several robustness tests. When we limit our sample to low and lower middle income countries in the first column, the coefficient of the foreign bank share is still significant though its size is a bit smaller. In these poorer countries, lack of corruption does not dominate the effect of the growth level. The coefficient of the foreign bank share changes smaller and less significant, though still significant at 90% level, when we use the data of the foreign bank share constructed by Micco et al. (2007) for our sample. Although we do not report it here, we find that the result using the all country sample is not significant since there is no negative relationship between foreign bank presence and financial development in developed countries. 15 In fact, the initial foreign bank share is zero in almost all high-income countries, while there is high variety in that for upper middle income countries. This could also justify our examination of the sample of all developing countries including them. Table 3 here Including more control variables does not change the original result in general. Banking crises may cause a reduction in private credit and an increase in the foreign bank share, thus omitting this variable may bias the results (Cull and Martinez Peria, 2007). However, the relationship between the foreign bank share and private credit hardly changes after controlling for banking crises at least in cross-sectional estimations. 16 Besides, adding capital account openness does not affect the result at all. When we use exogenous determinants of institutions by including latitude instead of lack of corruption and the legal origin variable, 15 The coefficient of the foreign bank share in the high income country sample is positive and significant in a few specifications. However it becomes insignificant after excluding a few outliers such as Ireland and Hong Kong. 16 We also use the number of years for the banking crises instead of the dummy for banking crises, from the data of Laeven et al. (2012), because the dummy variable may not represent the intensity of the crisis properly. However, the number of crisis years is not significant either. 18

19 either separately or together, the result does not change. The variable of government ownership of banks in 1995 from La Porta et al. (2002) enters significantly negative and reduces the number of sample, but the foreign bank share is still highly significant. 17 Finally, one may naturally wonder if using the initial data of foreign bank assets might lead to incorrect conclusion because it cannot capture information of foreign bank entry after the late 1990s. We scrutinize this possibility using the average of the foreign bank share from 1995 to 2000 and the average over the whole period. But the result hardly changes although they are not reported. 18 All in all, cross-sectional regressions present strong evidence that a larger foreign bank presence is associated with lower financial development in developing countries. B. Origin of foreign banks and threshold effects Now, let s turn to some extension of the OLS cross-sectional regressions. First, foreign banks from developing countries may exert qualitatively different effects from high-income country foreign banks on financial development in developing countries. Van Horen (2007) argues that origin of foreign banks matters in that foreign banks from developing countries are regionally concentrated and are relatively more important in low-income countries (Van Horen, 2007). So we use the foreign bank share data from different origin, that is highincome developed countries and developing countries, as is specified in the Claessens et al. (2008) dataset. 19 The first two columns in Table 4 show the results of this separate regression. We find that the share of bank assets held by foreign banks from developed countries is negative and significant to financial development, while the share held by developing country foreign banks is not significant. This is empirical evidence that the negative influence of foreign banks in developing countries on private credit is driven by those from developed countries. The geographical and cultural distance is rather great between foreign banks from developed countries and the financial market in developing countries. Therefore, they are 17 We also include the enforcement of contract indicator following Detragiache et al. (2008) but do not find its coefficient significant, while the significant result of the foreign bank share still holds. Inclusion of other institutional variables such as government antidiversion index does not change the result. The results are also robust to controlling for regional effects such as inclusion of the Sub-Saharan Africa dummy 18 Using the difference in the foreign bank share in 2005 and that in 1995 to represent the change of foreign bank presence does not produce a significant result. 19 Van Horen (2007) reports that 27% of all foreign banks in developing countries in the early 2000s are owned by a bank from another developing country. But the share of bank assets in developing countries held by foreign banks from developing countries is much smaller. The value in 1995 in our sample is about 4.3%. 19

20 likely to be involved in more cream-skimming since they have less local knowledge and higher screening costs as Gormely (2011) predicts. This could be much less problematic to foreign banks from the third world that are mostly from the same region since they have a closer relationship with and better understanding on the local financial markets and local firms (Van Horen, 2007). Table 4 here We also examine threshold effects of foreign banks on financial development by including interaction terms of the foreign bank share and other condition variables. We obtain the result that the interaction of the foreign bank share and lack of corruption is significantly negative in column 3 of Table 4. This suggests that a larger foreign bank presence in countries where there is more corruption increases private credit. The result is also driven by foreign banks from developed countries. This is counterintuitive since one may well expect that foreign bank presence would be more helpful to financial development in countries with better institutions and less corruption. However, Gormely (2011) also argues that foreign bank presence may increase overall credit if there are a larger number of cream firms with high return that benefit from entry of new lenders. A higher level of corruption may be related with the increase in cream firms since it can provide great profit opportunity to them. 20 This result could be understood in this aspect but it should be noted that it is not very robust because we do not obtain the same result in low and lower middle income country sample. We may well consider other preconditions such as banking crises and financial reform. Foreign banks might reduce loans more in countries with banking crises and increase them in countries with more financial reform such as financial liberalization and privatization. But we do not find any evidence to support for other threshold effects in cross-sectional regressions. In sum, we find a negative and significant relationship between foreign bank penetration and financial development measured by private credit in developing countries from the OLS cross-sectional regressions. The negative relationship is driven by foreign banks from highincome countries, while there is no such relationship between foreign banks from developing countries and financial depth. 20 This might be also due to the fact that the financial sector in countries with the lowest institutional development is such underdeveloped that credit from domestic banks is too small even to high-return firms. The entry of developed country foreign banks with greater capacity in those countries might increase private credit. 20