“Institutional reforms and foreign owned banks in

transition economies”

by

Stampoulis Sotirios

A Thesis submitted in partial fulfilment of

the requirements for the degree of
MSc in International Economics and Business

2010
 Abstract

“The present paper is an investigation of the importance of institutional reforms in 22

Transition Economies for the rising shares of foreign ownership in their banking
sectors through the period 1995-2008. Transition in general and specifically, large
scale privatization, governance and enterprise restructuring, trade and foreign
exchange liberalization, price liberalization and financial liberalization are significant
for explaining the asset share of foreign owned banks in Transition Economies.
Small scale privatization and competition policies do not have a similar significant
effect. That raises concerns about the credit supply of Small and Medium sized
Enterprise and the perceived benefits for the efficiency of the banking system by the
entry of foreign banks. Moreover the effect of informal institutions is examined and
evidence is found that increased government effectiveness, regulatory quality, rule of
law, voice and accountability and less corruption favour the formation of foreign
market shares in the banking sector of Transition Economies. Political instability and
the absence of violence in the host country do not seem to affect foreign shares.”
Table of contents

1. INTRODUCTION................................................................................................4
2. FDI in the banking sector of Transition Economies..................................................7
2.1 The banking sector in Transition Economies............................................................7
2.2 The determinants of FDI in the banking sector.......................................................15
a) Market opportunities..........................................................................................17
b) Level of integration...........................................................................................21
c) Institutional environment....................................................................................24
3. MULTINATIONAL BANKS AND INSTITUTIONAL REFORM IN TRANSITION
ECONOMIES.........................................................................................................27
3.1 FDI in banking and institutional reforms.................................................................31
4. HYPOTHESES.................................................................................................34
5. DATA AND DESCRIPTIVE STATISTICS.............................................................40
5.1 Institutional variables..........................................................................................46
6. RESEARCH METHODS AND RESULTS...............................................................49
6.1 Constructing an index of institutional reform...........................................................51
6.2 Transition indicators...........................................................................................54
6.3 Institutional Quality.............................................................................................64
7. CONCLUSIONS...............................................................................................70
LITERATURE.........................................................................................................72
APPENTICES........................................................................................................76
APPENTICES

CHAPTER 1
 1. INTRODUCTION

T
he rising though variable shares of foreign ownership in the banking sector
have been one of the most striking developments in the financial system of
many former communist countries since the mid 90’s. At the same time the
countries that once formed the Soviet Union and its satellite states had already
engaged in a long process of transition at the epicentre of which has been the
replacement of the main economic and political institutions created under central
planning, with new institutions that could support a market economy. Soon, a
diverging path in the rate of their convergence to the standards and norms of a
market economy had emerged among the Transition Economies (TEs). Transition
has created a plurality of market economies and institutions in the countries that
used to share similar institutional infrastructure and initial conditions. Those parallel
developments in their unique historical context make interesting the quest of specific
economic, legal, political and social reforms in a country’s approach to transition, that
could in many ways explain and determine foreign ownership in the banking sector.

That motivates the research on the effect of formal and informal institutional
change on the investment decisions of foreign banks. Levonian and Jaffee (2001)
identify three main categories of banking services. Banks provide their services in
the payment system which relate to the circulation of currency and the provision of
demand deposits and other forms of third party transfers. Moreover, banks provide
intermediation services which expedite the transfer of financial resources from
savers to investors, as well as investment banking services which may range from
selling and managing mutual funds to providing financial services to firms.
Institutional reforms are in position to change the costs, the risk and the size of the
main inputs and outputs in the banking system, suggesting that the entry of foreign
banks in TEs is determined, alongside with other factors, by the progress of
institutional reforms.

This is because institutional reforms have a dual impact on the location

decisions of foreign banks. On the one hand, privatization, financial liberalization, fair
competition policies, internal and external markets liberalization, have a direct effect
on foreign bank entry, as with any FDI project, to the extend that they explicitly of
implicitly allow FDI in banking. On the other hand, those institutional reforms have an
indirect impact on the timing and scale of foreign bank entry through their effect on
the decision of local and foreign agents to consume, save and invest in TEs, on the
demand conditions for financial services in the host country and the prospects for
viable economic growth, which altogether determine the expected return, the cost
and the risk of the investment. If that is the case, then the variable shares of foreign
ownership in the banking sector of TEs should be viewed as a structural
characteristic of the banking sector which is conditional on the stage of transition and
should be interpreted accordingly on the basis of structural or institutional changes in
TEs.

The effect of basic institutional reforms is not exhausted on spot but they
have a lasting impact on the domestic economy. Structural and institutional reforms
go beyond being just a signal. They generate real benefits to foreign investors by
affecting the key parameters upon which the decision to invest in a foreign country is
taken (Campos and Kinoshita, 2008). Since FDI is about long term investment
projects, the direction, the speed and the extend of those reforms can have a
profound impact on FDI activity. But even though, it is widely regarded that
institutions are important as location advantages in multinational business since they
represent the major immobile factors in a globalized economy (Bevan et al., 2004)
and despite of the significant body of literature devoted in understanding the
importance of institutional quality on FDI activity, there are only a handful of studies
that try to identify those specific institutions and institutional reforms that matter most
for foreign investors. This is especially true for FDI in the banking sector and this,
despite of its significance for policymakers in TEs who, faced with constraints in the
supply of financial services to their domestic economies, aim to attract FDI in the
banking sector. Since formal institutional reforms are above all political choices, this
paper tries to identify the policies in TEs that could invite foreign investors in the
restructuring and the recapitalization of their financial systems, an issue of central
importance for their overall economic performance.

The present Thesis is an effort to distinguish those aspects of institutional

reforms in TEs that have determined the high, yet variable shares of foreign
ownership in their banking sector. In doing so, it views the ownership percentage of
foreign banks as an equilibrium determined both by the motivation of foreign banks
to invest in TEs and the motivation of governments in TEs to permit foreign bank
entry. For that reason, the special characteristics of the banking sector in TEs are
first analyzed in Chapter 2. Chapter 3 provides a review the theoretical literature
regarding the determinants of foreign bank entry. Drawing from the previous
sections, in Chapter 4 several hypotheses are developed regarding the effect of
transition on banking FDI. In Chapters 5 and 6 the hypotheses are empirically tested
and Chapter 7 provides a summary of the conclusions.

CHAPTER 2

2. FDI in the banking sector of Transition Economies

T
he purpose of this section is to present the stylized facts and the main
theoretical arguments for the increasing shares of foreign ownership in the
banking sector of TEs. The first part is reviewing the development and the
discrete characteristics of the banking sector in TEs and the second part provides
the theoretical framework for the determinants of Banking Sector FDI as it stands out
of selected literature.

2.1 The banking sector in Transition Economies

The global surge in the levels of FDI observed around the mid 1990’s in the
banking sector of many emerging economies is not a new phenomenon. In a
historical perspective, this was the so called “third wave” of banking sector FDI,
major recipients of which were countries in Latin America, East Asia and Transition
Economies. The “second wave” of the financial institutions’ international expansion
began in the 1960’s and was primarily driven by the expansion of US banks in the
financial sector of other developed economies in order to better serve their
multinational clients. The epoch of multinational banking began in the 1830’s, when
British banks began to open their branches in the colonies where they settled.
However, the major difference with this wave of multinational banking is that it is
primarily North-South FDI which forces us to seek for explanations of this
development in new directions than those indicated in the academic literature prior to
the 1990’s.

The common fact behind the entry of foreign banks to emerging economies
is that it typically followed incidences of crisis in the local financial system which
undermined their economic and financial stability. The legislation allowing for greater
foreign ownership of banks was only introduced to many countries in Latin America,
which counts for the majority of this “third wave” of multinational banking, in the wake
of the Tequila, the Brazilian and the Argentine crisis and to Asian countries in the
aftermath of the Asia crisis (Soussa, 2004). The expansion to TEs is not an
exception to this observed pattern, as the banking system in those economies was
almost invariably shaken in the early 1990s. There are however some distinct
characteristics of the financial system TEs in relation to countries that have
liberalized their banking sector in other parts of the developing world.
 This brings the discussion to, perhaps, the most significant determinant of
banking sector FDI: the unilateral motivation of dominant states to open up their
financial sector to foreign competition. This decision was motivated by the necessity
to recapitalise and restructure their banking systems in the post crisis era. Foreign
bank entry, which mainly took the form of mergers and acquisitions (M&As) of
weakened domestic institutions by highly rated and globally active banks originating
from developed economies, was allowed on the premise that this would lead to
sounder and more efficient banking systems. Empirical evidence came in support of
these expectations (see for example Demirguc, Levine and Min, 1998) even though
more research is required on this issue, especially after the 2008 financial crisis.
What is special with the banking sector in TEs is that it first had to be created under
difficult initial conditions, which have determined its further development. Therefore
the history of financial development in TEs needs to be incorporated in the research
of the determinants of foreign participation in their banking sector.

All banks in transition countries have emerged at different points in time out
of the specialized departments of a mono-bank system in which central and
commercial banking functions were assumed by a single state bank. In the pre-
transition era, banks acted as record-keepers for the planning process and payment
agents among state entities rather than as financial intermediaries (Bonin and
Wachtel, 2008). Unlike banks in western countries, credit was granted based not on
credit risk analysis but on central plan decisions. In the beginning of the transition
process, priority was given to the reform of the banking sector as this was
considered essential in order to move to a market economy. First, a two tier system
was created with the separation of central and commercial banking and a number of
new banks have emerged out of the mono-bank’s departments which were expected
to support state owned enterprises in the evolving market economy (Bonin and
Wachtel, 2004). However, those new banks have inherited bad loans created under
the central planning system while the ability of many state owned firms to repay their
loans was further reduced by the transition process and the removal of government
subsidies. As a result, the newly created banks had a large share of non performing
loans in their balance sheet.

Figure 1: Non-performing loans (in per cent of total loans)

Note: Ratio of non-performing loans to total bank loans. Non-performing loans include sub-standard,
doubtful and loss classification categories of loans but excludes loans transferred to a state
rehabilitation agency or consolidation bank.
Source: EBRD survey of central banks.

Figure 1 shows the percentage of non performing loans only for the year
1995, which is the first year for which we have reliable data for a wide cross section
of countries. The percentage of bad loans is very high when compared with
developed but also with other developing countries. What it illustrates is not only the
difficult initial conditions of the banking sector, since by 1995 transition had
progressed significantly, but perhaps most importantly a serious deficiency in the
function of the banking sector in TEs: that of credit allocation. Despite of the actions
taken by many governments1 to restructure and recapitalise the banking sector, the
large volume of bad assets persisted because new banks had perverse incentives to
continue lending to loss making state owned and newly privatized enterprises.

Governance and enterprise restructuring was still underway with the

hardening of budget constraints and the promotion of corporate governance. But in
the absence of efficient supervision and legal frameworks, banks took on excessive
risks to remedy their expected losses while government bailouts have created a
moral hazard problem that encouraged credit misuse (Zoli, 2001). Moreover,
because of the specialized structure of the mono-bank system, the new banks had a
highly concentrated and risky portfolio of loans (Keren and Ofer, 2003) which made
the system vulnerable to external shocks.

There was however another important problem with respect to the allocation
of credit. The newly commercialized and privatized banks lacked the experience with
operating in a market oriented approach. The new banks continued to accumulate
more bad loans due to the general absence, both by banks and by firms, of the
needed knowledge to asses risk and distinguish between bad and good projects and
the weak corporate governance of the enterprises. In the early transition period and
under the difficult circumstances in which the banking sector was born, it can be said
that there was excess demand for human capital with skills to properly operate

1 Such actions were public guaranties, consolidation programmes with the writing off bad loans,
special government bonds, removal of bad loans into special state entities etc.
banks, capable of screening investment projects, of assessing and managing risk
and guiding enterprises in their restructuring process. These skills were scarce in
former communist countries that have only recently begun their transition. Even after
some banks became fully or partly privatized, most of the managers and personnel
of the new banks were the same people as under the old regime (Keren and Ofer,
2003). That has exaggerated the problem of credit misallocation which reached great
proportions in the absence of proper regulation and effective supervision of the
banking sector.

Poor supervision was the product of inexperienced supervisors, of the

extended corruption but mainly of the large number of new banks that have emerged
in the early transition period. In the early 90’s, most transition economies have
adapted a liberal policy regarding the establishing and licensing of new private
banks, with relatively lax capital and know-how requirements. It followed a boom in
the number of banks which put pressure in the supervisory authorities and further
deteriorated the performance of the banking sector (Keren and Ofer, 2003). After the
initial “big bang” in the number of banks, it started a major consolidation process in
the sector that was performed gradually with the merger into larger units, while some
weak banks were allowed to go bankrupt with controlled effects to the stability of the
underdeveloped financial system in TEs. The large number of banks did not equate
to financial deepening. This is graphically represented in figures 2 and 3 which
illustrate mean values from a sample of 27 TEs.

Figure 2: Number of commercial and savings banks, excluding cooperative banks.

Source: EBRD survey of central banks.

Figure 3: Domestic credit provided by the banking sector.

Note: Domestic credit provided by the banking sector includes all credit to various sectors on a gross
basis, with the exception of credit to the central government, which is net. The banking sector
includes monetary authorities and deposit money banks, as well as other banking institutions where
data are available. Examples of other banking institutions are savings and mortgage loan institutions
and building and loan associations.
Source: World Development Indicators, World Bank
 The data show that gradually more credit was provided by a diminishing
number of banking institutions, primarily to the expanding private sector of TEs.
However the banking sector in TEs remains significantly less developed in
comparison with mature market economies. As it will be discussed in the next part of
this section, this provides foreign banks the market opportunity to invest in TEs.
Bank credit represents the main channel of financing to private firms in TEs
(Cottarelli et al, 2004) except of CIS countries where non-bank institutions play an
important role in the system of financial intermediation (Sherif, Borish and Gross,
2003). The credit expansion was funded in some transition countries by an increase
in bank deposits, while in others it was supported mainly by increased net borrowing
from abroad (Cottarelli et al, 2004). Backe and Zumer (2005) report that credit
growth has been promoted by macroeconomic stabilization - especially the control of
inflation, by comprehensive reform programmes and privatization in the financial
sector and by the introduction of market institutions and legal reforms that have
reduced uncertainty and credit risk.

Expanded domestic credit was provided by a banking sector that was itself
changing and was becoming gradually more privatized. The asset share of state
owned banks has been declining constantly after 1994 when state owned banks
owned on average almost 60% of the banking sector assets in 26 transition
economies. By the end of 2007, the share of state owned banks in the domestic
banking system fell below 13%. In short, the new entry approach to banking reform,
witch includes the privatization of state banks and the liquidation of weak banks, had
prevailed in most transition economies over the rehabilitation approach, the
recapitalization of existing state banks (see Claessens, 1996 ). This was a major
structural change that was fostered by the realization in most countries that
rehabilitation led to a slow progress towards an efficient banking system and it came
with great economic costs. Often state banks acted as vehicles for patronage and
soft budget constraints that worsened the prospects for competitive market
development and inhibited the creation of a strong deposit base which was further
deterred by the general lack of confidence (see Sherif, Borish and Gross, 2003).

Figure 4: Asset share of state-owned banks

Note: Share of majority state-owned banks’ assets in total bank sector assets. The state includes the
federal, regional and municipal levels, as well as the state property fund and the state pension fund.
State-owned banks are defined as banks with state ownership exceeding 50 per cent, end-of-year.
Source: EBRD survey of central banks.

This was the general framework in which foreign banks came into play.
Many of the conditions and the developments in the banking sector of transitional
economies described in the preceding paragraphs were significant determinants
both for the decision of foreign banks to invest and of TEs to allow foreign bank
entry. Foreign banks, originating mainly from “old Europe” began to buy into the
deregulation of the financial system, the privatization of state banks as well as the
consolidation process in the banking sector by accumulating easily accessible
market shares. As a result, foreign banks have increased dramatically their
ownership share in the emerging banking systems of TEs and by the end of 2008
they owned on average 57% of all banking institutions and two thirds (66.67%) of all
banking assets in 26 transition economies.

The difference in the slope of the two lines in Figure 5 indicates that the
average size of foreign banks has increased vis-a-vis the size of their domestic
counterparts which allow us to discuss another stylized fact. The preferred mode of
entry for foreign investors was through M&As rather than through Greenfield
investments. That has allowed foreign banks to quickly acquire strategic market
shares in the domestic banking industry. Furthermore, the increase in the average
size of foreign banks can be attributed to factors that are not easily observable, such
as the preference of investors and depositors to foreign owned banks that may be
perceived as safer, offer a wider range of financial services and are more
competitive than local banks. That would certainly imply the possession of some
competitive advantage of foreign banks over their local counterparts.

Figure 5: Foreign ownership in the banking sector of TEs

Notes
1)Number of foreign banks to total banks: Ratio of foreign owned to total banks. Number of banks
refers to the number of commercial and savings banks, excluding cooperative banks. Foreign-owned
banks are defined as those with foreign ownership exceeding 50 per cent, end-of-year.
 2)Asset share of foreign-owned banks (in per cent): Share of total bank sector assets in
banks with foreign ownership exceeding 50 per cent, end-of-year.
Source: EBRD survey of central banks.

The shares of foreign ownership in the banking sector have increased

considerably since the mid 90’s in TEs. Foreign bank entry was done on a massive
scale despite the political opposition of those in favour of nationalistic arguments or
from insiders that earned rents from the imperfections of the banking system. On top
of the benefits to the local economy2, FDI in the banking sector was allowed on the
basis of its effects in the special environment of TEs. It could offer a solution to many
of the problems briefly discussed in this section: confidence to depositors, transfer of
technology, knowledge and managerial skills that would allow credit rationing and
effective enterprise restructuring, resistance to political influence, better
diversification of bank assets as the banks that have entered hold assets in
geographically dispersed countries, a lobby for prudential legislation and for the
effective supervision of the banking system as well as a source of credit supply that
would moreover be less depended on local economic conditions. The privatization
of state owned banks and the removal of legal barriers to foreign entry opened the
door to foreign investors willing to undertake equity investments in the banking
sector of TEs. This was a necessary, though insufficient condition for bank FDI in
TEs. The decision of foreign banks about where and how much to invest has been
motivated by factors commonly referred in the literature about the determinants of
banking sector FDI.

2.2 The determinants of FDI in the banking sector

The rising shares of foreign ownership in the banking sector of emerging

economies have attracted the interest of many researchers on the determinants of
this development. Most empirical studies examine FDI flows in banking either in the
modified framework of Dunning’s (OLI) eclectic paradigm, or in the context of the

2 see Linda S. Goldberg (2004) for an excellent description of the effects of foreign bank
entry to host country economies
Internalization Theory of multinational production. In the OLI paradigm, multinational
banking is determined by the combination of Ownership (O), Location (L) and
Internalization (I) advantages for the bank from its international expansion.
Ownership advantages may include specialized banking services, large domestic
capital and deposit base as well as intangible assets such as creditworthiness,
reputation for efficiency, superior management quality, technological edge and
unique banking techniques. As it was discussed in the first part of this section,
foreign banks had a competitive advantage in those dimensions over domestic
banks in TEs which they could best exploit through their internationalization rather
than through arm’s length agreements.

A bank may find it valuable to combine these unique assets, with assets or
endowments that are tied to a particular foreign Location. These assets include host
country institutions and regulations, market size and potential or customers of the
bank that have entered into business transactions in the host country. Banks are
found to be attracted to foreign markets in order to exploit favourable foreign banking
environments and/or to take advantage of local banking opportunities (Mutinelli and
Piscitello, 2000). Finally, Internalization advantages are related more with efficiency-
seeking FDI which takes place when the firm can gain when there is a common
governance of geographically dispersed activities and presence of economies of
scope and scale. In the banking sector, FDI can serve as an excellent tool for risk
diversification. Banks can diversify their income base by operating in a foreign
country, obtaining gains in terms of their risk-return profile (Herrero and Simón,
2003). The Internalization Theory on the other hand, emphasizes the importance of
information asymmetries and transaction costs in imperfect markets and views FDI in
banking as a way to escape those imperfections by organizing an internal market
within the boundaries of the firm (Williams, 1997).

Given the majority of studies that adopt the OLI paradigm as their starting
point for analyzing FDI in banking and the emphasis that it puts on location factors,
the current paper is structured on a conceptual framework stemming from the
eclectic paradigm approach. However, we need to address the concerns that it alone
cannot explain all the motives and effects of foreign banks’ activities, especially since
it does not cover the structural changes and market liberalization effects in TEs
(Uiboupin and Sõrg, 2006 ) which constitute the main focal point in this Thesis.
Empirical research offers us valuable insights on the determinants of banking sector
FDI. Most papers have employed gravity models in order to distinguish various pull
and push factors that affect foreign bank entry. Emphasis here is given to the pull
view, as we are most interested to understand the host country characteristics that
attract foreign investors to the banking sector. A review of the empirical literature
reveals that out of different country samples, time periods and research methods, a
relative consensus emerges on the main determinants of multinational banking
which can be summarized on the following factors.

a) Market opportunities
The exploitation of local market opportunities is an important determinant of
the pattern of bank internalization (Focarelli and Pozzolo, 2005). This should hardly
cause any surprise given the way in which the international trade of financial
services is conducted. The provision of financial services, usually – even though
gradually less due to improvements in technology - demands the proximity between
the supplier and the consumer of these services. That often requires the commercial
presence of the service provider to the territory of the service consumer which is the
3rd Mode of service supply in the GATS agreement between the members of the
WTO. This is the main mode of supply of financial services and is directly related to
FDI. The duplication of a stage of production in some TE in order to better serve the
local market would classify banking FDI to Horizontal FDI which is mainly determined
by the existence of local market opportunities. Foreign banks need to establish a
physical presence abroad in order to provide many kinds of financial services other
than direct lending to large customers (Focarelli and Pozzolo, 2005). The presence
of local market opportunities is mainly determined by the following two factors.

• Host country economic environment

The characteristics of the host economy and most importantly its size, level
of development, growth rates and macroeconomic stability can provide foreign
investors with an indicator about profit opportunities. A robust result in the empirical
literature is that the size of the local economy, measured either by the levels of GDP
(Goldberg and Johnson, 1990, Brealey and Kaplanis, 1996, Buch, 2003), population
(Papi and Revoltella, 1999, Buch, 1999) or by industrial production (Buch, 2003) has
a positive effect on banking sector FDI. The results are somewhat more ambiguous
regarding the impact of the host country economic development. Yamori (1997),
Papi and Revoltella (1999), Buch (1999) and Wezel (2004) report a positive relation
between the levels of development in the host country - usually the level of GDP per
capita- and FDI in banking. They argue that this is because the level of development
can provide a valid indicator for the demand conditions for financial services in the
host country. Instead, Focarelli and Pozzolo (2005) suggest that banks are more
likely to be present in countries with higher expected economic growth and find
evidence that this happens when per capita GDP is lower. This is consistent with
Goldberg and Johnson (1990) who report the same result for the growth in the asset
size of US bank branches abroad, but a positive effect of GDP per capita on the
number of US branches.

The economic environment in the host country is associated not only with
new business opportunities for foreign banks, but also with the costs and the risk of
their investment. Therefore most studies analyzing banking FDI incorporate some
measure of macroeconomic stability in the host country. In this context it has been
found by Papi and Revoltella (1999), Buch (1999), Mathieson and Roldos (2001) as
well as Focarelli and Pozzolo (2005) that inflation had a negative impact on the
location decisions of foreign banks. Another hypothesis frequently examined in the
literature is the negative effect of exchange rate volatility on banking FDI. However,
most studies report insignificant results except of Moshirian (2001) who found that a
depreciation in the local currency increased FDI by German, American and English
banks, as it became cheaper for them to invest. Finally, real interest rates in the host
country have been employed by Yamori (1997), Buch (1999) and Wezel (2004) as a
proxy for the potential profitability of foreign banks, the degree of competition and
macroeconomic stability in the host country. Their results however did not indicate a
significant causal relation as in the case of studies that have explicitly related the risk
in the host country (Yamori, 1997, Wezel, 2004) economic and political instability
(Papi and Revoltella 1999) with decreased FDI to the banking sector.

• Features of the local banking system

The location decisions of foreign banks are determined by the features of the
banking system in their home or in the host countries. Regarding the latter case, it
has been found that the size and the efficiency of the local financial system play an
important role in the location decisions of foreign banks. Most researchers would
agree that more developed financial systems attract larger FDI flows to their banking
sector. Papi and Revoltella (1999) have explicitly analyzed the issue of FDI in the
banking sector of TEs. Their results suggest that FDI in banking is positively related
with the degree of development of the host banking sector which is approximated by
the ratio between currency and M2. Moreover, they find that banking FDI in TEs is
also related with the stability (average level of bank capitalization) and the profit
opportunities (average spread on bank interest rates) in the host country. They
conclude that foreign banks prefer those Central and Eastern European TEs where
the banking sector is relatively more developed and stable, and where there are
large interest rate margins to exploit. However, only the development of the local
banking sector proved to be significant for the strategic decision of foreign banks to
acquire majority control (shareholding larger than 50 percent) of host country
banking institutions.

Various measures have been employed as a proxy for the development, the
efficiency and the stability of the banking sector. Miller and Parke (1998) use the
sum of demand deposits and time deposits in a year as a proxy for the size of the
banking market in a particular country. They find that it positively affects the amount
of assets and the number of offices (branches and subsidiaries) of US multinational
banks, both in developed and developing countries. Buch (2003) finds that the gross
financial assets of banks (portfolio investments and FDI) in BIS reporting countries
are positively related with the size of the financial system in the host countries as
measured by the ratio of credit provided by the domestic banking sector to GDP. She
also uses interest rate spreads (the spread between lending and deposit rates) in the
host country as a proxy for the ability of foreign banks to earn excess returns without
however establishing a significant causal relationship. An important issue regarding
the relationship between banking FDI and the efficiency of the host banking sector is
that the direction of causality is not always clear (Bol et al, 2002).

Some studies use bank level data to proximate profit opportunities in the
host country. Without dealing in depth with those studies which typically employ
financial ratios such as return on equity (ROE) or return on assets (ROA), we briefly
mention Focarelli and Pozzolo (2005) who investigate the determinants of the
patterns of banks’ foreign investment from a sample of 260 large banks in OECD
countries. When they use separately the ratio of stock market capitalization over
GDP and the size of the banking sector as proxies for the financial development of
the host countries, they find that both have a significant positive effect on banking
FDI. Moreover they find that foreign bank entry-in particular for subsidiaries that
compete directly with local banks- is negatively correlated with the degree of bank
concentration in the host country, which they interpret as an implicit barrier to foreign
entry which may be posed by governments that wish to have the largest institutions
in their nations domestically owned.

The empirical literature offers some contradictory results with respect the
effect of financial development on multinational banking. Goldberg and Johnson
(1999) report a negative relationship between the degree of banking activity in the
host country measured by the size of domestic deposits and the expansion of US
banks. They argue that this is because countries with large levels of domestic
deposits offer fewer opportunities for US branches to serve their market which will be
most likely serviced by domestic and other foreign banks. However, when Goldberg
and Grosse (1994) examine the determinants of banking FDI in the US, they find that
foreign banks are attracted to states with higher value of total banking assets. To
some extent this may simply reflect the choice of different variables to capture the
effect of financial development, the different motivation of foreign investors when
they enter markets at different stage of development, or a more fundamental change
in the pattern of banks foreign expansion.

Pozzolo (2008) finds evidence for his argument that the determinants of
cross-border Mergers and Acquisitions (M&As) in the banking sector have changed
over time. By considering deals between 1990 and 2006 from a large sample of
countries, he finds that similarities between the country of origin and the country of
destination in the levels of GDP, GDP per capita and financial development have
progressively lost their significance in explaining the pattern of cross border M&As.
Moreover, banks are more likely to be acquired in countries with less developed
financial systems. Even though Pozzolo’s research regards the mode of foreign bank
entry, it offers us insights on the location determinants of banking FDI.

To this attests Wezel (2004), who even though he finds that German banks
are attracted to emerging economies with more developed financial systems, this
effect becomes insignificant in the case of European transition economies. The
author argues that German banks have entered in TEs despite the lack of well-
established financial markets, in order to firmly establish their market share when
business would take off in the process. Dopico and Wilcox (2001) also report a
negative relation between host country’s size of the banking sector and foreign bank
asset shares. Finally, Wezel uses the ratio of M2 to gross international reserves as
proxy for incipient banking crises. He finds this early warning indicator to have a
significant impact on the timing and the location decisions of German banks. The
effect of banking crises on banking FDI was also addressed by Mathieson and
Roldos (2001). They found that banking crises in the host country lead to larger
foreign participation in the banking sector, as they make the authorities more inclined
to allow foreign bank entry in order to contain the fiscal costs associated with
restructuring banks.

a) Level of integration
An important finding in the empirical literature is that the pattern of bank
internationalization is correlated with the degree of integration between the home
country of the parent bank and the country where the branch or the subsidiary is
hosted. Integration relates both to strictly economic variables, such as the levels of
trade or FDI, and to non-economic aspects such as linguistic and cultural similarities.
The theoretical arguments behind this empirical fact outline the importance of two
important determinants of multinational banking: the “follow the client” motivation of
international banks and the information costs associated with operating financial
institutions in different countries. The importance of information in banking have
persuaded some researchers that perhaps the Internalization Theory is more
appropriate for explaining banking FDI. In this section we briefly discuss the main
theoretical advances and the empirical literature regarding these two aspects of
multinational banking.

• Economic Integration

The internationalization of banks may have followed the expansion of their

corporate customers into foreign markets. This is the “follow the client” hypothesis in
multinational banking which states that banks “follow” the client firms from their home
countries into overseas markets as those firms engage in a growing volume of
international trade and FDI. Often, especially in the framework of the Internalization
Theory, bank internationalization is viewed as a defensive reaction to the
internationalization of their customers in order to defend their unique bank-client
relationship. Once a bank has established a relationship with a firm it has a
competitive advantage, stemming from private information, in serving that firm’s
operations in foreign markets (Herrero and Simón, 2003). Banking is an information
intensive industry and over the years, banks gain proprietary information about their
clients’ particular financial needs. This knowledge is –at least initially- unavailable to
incumbent local banks which allow foreign banks to offer complex and specialized
services to their customers at low marginal cost. Then, in the Internalization
framework, multinational banking emerges with market failure: The internal
information cannot be traded on markets and therefore needs to be exploited by the
institutions possessing it (Wezel, 2004). Banks expand abroad in order to preserve
existing banking relationships in the home country before they could be eventually
substituted by a new banking relationship (Williams, 1997).

Empirical evidence generally supports the theoretical notion that strong trade
links ( Brealey and Kaplanis, 1996, Yamori, 1997, Miller and Parkhe, 1998, Papi and
Revoltella, 1999, Moshirian, 2001, Wezel, 2004, Voinea and Mihaescu, 2006) ,
greater volume of FDI (Goldberg and Grosse, 1994, Brealey and Kaplanis, 1996,
Miller and Parkhe, 1998, Voinea and Mihaescu, 2006) and FDI in the real economic
sector of the host countries (Goldberg and Grosse, 1994, Yamori 1997, Papi and
Revoltella, 1999, Esperanca, 2000, Moshirian, 2001, Wezel, 2004), stimulate FDI in
banking. Those factors are considered as crucial Location advantages in the OLI
framework. In the eclectic paradigm, banking FDI is regarded as less of a defensive
reaction and more of an investment in order to exploit local market opportunities. The
financial services of foreign banks are not provided exclusively nor primarily to their
home country corporate customers (Esperanca, 2000) and the follow may the client
motivation, although significant, has more limited applicability than once thought,
especially in developing countries (Miller and Parkhe, 1998, Seth et al., 2001). With
technological advances and better communications, banks are increasingly able
serve the trade and project related financial needs of their customers, without
needing to establish affiliates themselves in foreign markets (Claessens, 2007). The
importance of trade and FDI linkages on the pattern of foreign bank entry succeeds
in addressing the importance of information and information costs in multinational
banking.

• Cultural proximity
 Transaction costs are important for banking FDI as with any kind of Foreign
Direct Investment. However, the transaction costs in multinational banking comprise
mainly by information costs and regulatory barriers. A hypothesis frequently tested in
gravity-type models is that foreign bank entry will occur predominantly in those
countries where it entails the least informational costs for the foreign bank. Cultural
proximity affects the costs of internal organization and economic risk as it affects the
availability of information about the local economic environment and the personal
interaction between local and foreign individuals (Bevan et al., 2004). The concept of
geographic distance between source and host country, even though one would
expect that to be irrelevant in multinational banking since financial services are
intangible, has been employed in many studies to capture the information costs
associated with cultural distance. The informational disadvantage of foreign banks
and information costs tend to reduce with distance as countries which are
geographically near each other tend to know more about each other (Shen and Lin,
2007). Empirical evidence strongly suggests that FDI activity in the banking sector
will be stronger between countries which are in close proximity (Papi and Revoltella,
1999, Buch, 1999, Buch, 2003, Focarelli and Pozzolo 2005, Voinea and Mihaescu,
2006)

Besides geographic proximity, various other measures have been used to

proxy cultural similarities and assess their importance for the scale and the mode of
foreign bank entry. Such proxies include sharing common borders (Pozzolo, 2008),
common language or religion (Buch, 2003, Focarelli and Pozzolo 2005, Shen and
Lin, 2007), common legal system (Buch, 2003) or composite indexes of cultural
proximity (Esperanza, 2000). Other models use regional dummy variables to control
for cultural differences between the regions under study (Yamori, 1997, Mathieson
and Roldos, 2001) in order to reach the conclusion that these differences are
significant for explaining differences in the location decisions of foreign banks. The
information costs for foreign banks and their informational disadvantage in
comparison with local banking institutions, is determined not only by cultural
considerations, but also by the formal and informal institutional arrangements - by
implicit and explicit barriers to foreign bank entry.
 a) Institutional environment
According to Buch (2003), information costs and regulatory barriers
distinguish international financial markets from national ones. Formal and informal
institutions, by defining the “rules of the game” in the host economy, may constitute
explicit or implicit barriers to foreign bank entry. Formal institutions may define with
regulatory acts the framework of acceptable banking activities, the level of protection
for creditors and shareholders rights, impose limits in the participation of foreign
banks or otherwise restrict foreign bank entry. Informal institutions comprise of social
norms, conventions and moral values that constrain individuals and organizations in
pursuit of their goals (Raiser, 2001) and they too may define transaction costs for
foreign banks. The empirical literature has dealt with both sets of institutions and
offers valuable insights on their effect to foreign bank entry.

• Formal Institutions

The surge in the levels of banking FDI observed since the mid 1990s in
many TEs, as well as globally, was often the product of financial liberalization and
market based reforms that have allowed greater foreign participation in the banking
system (BIS, 2004). This development has provided foreign banks with the
regulatory opportunity to enter in new markets or in new market segments that were
once heavily regulated. The hypothesis that regulatory barriers restrict foreign bank
entry has been confirmed in a number of studies. Goldberg and Johnson (1990)
report a significant relationship between their scaled variable measuring the
restrictiveness of bank regulation for US banks in the host country and the assets
and number of US branches operating in that country. Miller and Parkhe (1998) use
dummy variables to capture entry barriers by organizational form, in order to capture
their effect on US bank branches and subsidiaries. They find that both the assets of
US banks and the number of bank offices, whether branches or subsidiaries,
negatively respond to entry barriers especially in developing countries.

Papi and Revoltella (1999) use the tax rate for banks in the host country and
a categorical variable to account for the Government’s attitude towards foreign banks
as a proxy for the host country’s attitude to foreign financial institutions. The
Government's attitude appeared to be significant but taxation did not seem to be an
important determinant of banking FDI to TEs. Dopico and Wilcox (2001) find that
foreign banking had greater presence in countries that were generally more open to
letting banks engage in wider ranges of activities. Wezel (2004) uses an index for the
financial liberalization in the host country and another combining financial
liberalization and barriers to entry as they apply to FDI flows. He finds that German
FDI in banking responds only to changes in the second index, though the
significance of this variable was moderate. Focarelli and Pozzolo (2005) look at the
effect of explicit barriers to foreign entry, which they proxy with an index of limitations
on domestic banking activities, as well as implicit barriers measured by the degree of
bank concentration. Their results suggest that both implicit and explicit institutional
barriers play a crucial role in the pattern of bank internationalization.

Another set of studies shows that differences in bank regulation between the
home and the host country can reduce foreign bank entry. This approach puts in
perspective the defensive expansion approach in multinational banking which was
discussed before, according to which banks may expand abroad in order to escape
restrictive home country regulations. Shen and Lin (2007) show that the greater the
difference between the home and the host country in the levels to which they restrict
banks from engaging in securities, insurance, real estate and non-financial activities,
the less subsidiaries of foreign banks will be hosted in Asian countries. In another
research, Galindo et al. (2003) use a large sample of foreign bank cross-border
shareholdings in 176 countries to show that absolute pair country differences in
financial regulation and regulatory restrictions reduce the participation of foreign
banks as they imply learning costs related with how to manage a bank in a different
environment and the development of specific skills to deal with those differences
effectively. Moreover they find that banks are more willing to invest in countries with
which they share a common legal origin as in those countries the regulations that
protect creditors and shareholders evolve in similar fashions and the costs of
adapting to the new environment are minimized.

• Informal Institutions

Informal institutions relate more with the implementation of law in books and
with various measures of institutional quality. They can be as important as formal
institutions for the location decisions of foreign banks. Clarke et al (1998) show that
foreign controlled banks hold the largest share of assets in countries where the rule
of law is well established but the financial sector is relatively underdeveloped.
Focarelli and Pozzolo (2005) argue that banks are more likely to expand in countries
where the rule of law is stronger as they are interested to enter in countries where
the enforcement of contracts is easier. They find that the presence of a stronger law-
and-order tradition in a country increases the probability that it will host foreign
subsidiaries, but it decreases the probability that it will host foreign branches. Voinea
and Mihaescu (2006) find that the perceived lack of corruption in the recipient
country attracts foreign banks in TEs located in Central Europe.

Similarly with the empirical literature on the effect of formal institutions, some
studies have examined how absolute differences in informal institutions between
home and host country affect banking FDI. Claessens and Van Horen (2007) collect
bilateral data of bank ownership for 138 countries over 1995-2006 to examine
whether banks seek out those markets where institutional familiarity provides them
with an advantage over competitor banks. They find that institutional competitive
advantage significantly affects the location decisions of foreign banks, especially for
M&As. Moreover, similarities in disaggregated measures of institutional quality
between the source and the host country in relation to competitors, such as political
freedom and stability, government effectiveness, rule of law, quality of bureaucracy
and control of corruption have a positive effect on foreign bank entry. Thus, their
findings agree with that of Galindo et al. (2003) as well as Shen and Lin (2007) who
find that differences in the levels of corruption, rule of law, government effectiveness
and in the efficiency of the judiciary between source and host country are significant
for explaining the variation in the levels of FDI in the banking sector.

CHAPTER 3
1. MULTINATIONAL BANKS AND INSTITUTIONAL REFORM IN
TRANSITION ECONOMIES

T
he transition process from a centrally planned to a market economy started
more or less simultaneously in nearly thirty countries. The fall of the Berlin
Wall on November 1989 marks the beginning of a new era in the history of
many former communist countries, even though communism had not officially ended
until the dissolution of the Soviet Union (USSR) on December 1991. The states and
 the satellite states of the Soviet Union inherited similar institutions, similar initial
conditions and income levels and they were set out to implement major economic
and political reforms. Institutional reforms introducing greater openness (Tglasnost),
restructuring (Tperestroika), democratization (Tdemokratizatsiya) and acceleration of
economic development (Tuskoreniye) have initiated across the countries of the
eastern block in 1986 when General Secretary of the Soviet Union was Mikhail
Gorbachev and were the result of chronic economic stagnation. The pace of
institutional reform after the dissolution of the Soviet Union has been decided
independently by the new states. From the beginning, two schools of thought
developed; one advocating for a shocking therapy approach and another supporting
gradual change (Godoy and Stiglitz, 2006). Countries have opted for different
strategies in reforming their economic and political system and ended up
experiencing dramatically different outcomes in many areas, including FDI flows.

One of the best understood reasons for the economic underperformance in

the Soviet Union has been the lack of effective private incentive schemes that would
increase productivity and would lead to economic growth. This was the main reason
for the reform policies that were adopted prior to the fall of eastern block. The
collapse of the socialist systems and the initiation of the transition process have
shocked the societies in many former communist countries and came at the expense
of wide social groups that were accustomed to the old regime. But at the same time,
it has provided myriads of investment opportunities for locals and foreigners willing to
invest in the transition process. This process regards all aspects of the political,
economic and social system, but is summarized in the progress of some key
dimensions of institutional reform. The EBRD3 offers various indicators of the
transition progress since this has began for a large group of countries which are
presented in table 3.1.

Table 3.1: The progress of Transition (1989 – 2008)

Banking Securities
Large reform & markets &
Small scale Enterprise Price Trade &
scale Competitio interest non-bank
privatisatio restructuri liberalisati Forex
privatisat n Policy rate financial
n ng on system
ion liberalisati institution
on s
Year
’89 ’08 ’89 ’08 ’89 ’08 ’89 ’08 ’89 ’08 ’89 ’08 ’89 ’08 ’89 ’08
Country

3 European Bank for Reconstruction and Development (EBRD)

 SOVIET UNION

1 3.7 1 4 1 2.3 1 4.3 1 4.3 1 2.3 1 2.7 1 2.3

ARMENIA
AZERB. 1 2 1 3.7 1 2 1 4 1 4 1 2 1 2.3 1 1.7
BELARUS 1 1.7 1 2.3 1 1.7 1 2.7 1 2.3 1 2 1 2 1 2
ESTONIA 1 4 1 4.3 1 3.7 1 4.3 1 4.3 1 3.7 1 4 1 3.7
GEORGIA 1 4 1 4 1 2.3 1 4.3 1 4.3 1 2 1 2.7 1 1.7
KAZAKHST. 1 3 1 4 1 2 1 4 1 3.7 1 2 1 3 1 2.7
KYRGYZ. 1 3.7 1 4 1 2 1 4.3 1 4.3 1 2 1 2.3 1 2
LATVIA 1 3.7 1 4.3 1 3 1 4.3 1 4.3 1 3 1 4 1 3
LITHUANIA 1 4 1 4.3 1 3 1 4.3 1 4.3 1 3.3 1 3.7 1 3.3
MOLDOVA 1 3 1 4 1 2 1 4 1 4.3 1 2.3 1 3 1 2
RUSSIA 1 3 1 4 1 2.3 1 4 1 3.3 1 2.3 1 2.7 1 3
TAJIKISTAN 1 2.3 1 4 1 1.7 1 3.7 1 3.3 1 1.7 1 2.3 1 1
TURKMEN. 1 1 1 2.3 1 1 1 2.7 1 2 1 1 1 1 1 1
UKRAINE 1 3 1 4 1 2 1 4 1 4.3 1 2.3 1 3 1 2.7
UZBEKIST. 1 2.7 1 3.3 1 1.7 1 2.7 1 2 1 1.7 1 1.7 1 2
SOVIET SATELITE STATES
ALBANIA 1 3.3 1 4 1 2.3 1 4.3 1 4.3 1 2 1 3 1 1.7
BULGARIA 1 4 1 4 1 2.7 1 4.3 1 4.3 1 3 1 3.7 1 3
CZECH
1 4 1 4.3* 1 3.3* 1 4.3* 1 4.3* 1 3 1 4* 1 3.7*
REPUBLIC
HUNGARY 1 4 1 4.3 1 3.7 2.7 4.3 2 4.3 1 3.3 1 4 1 4
POLAND 1 3.3 2 4.3 1 3.7 2.3 4.3 1 4.3 1 3.3 1 3.7 1 3.7
ROMANIA 1 3.7 1 3.7 1 2.7 1 4.3 1 4.3 1 2.7 1 3.3 1 3
SLOVAKIA 1 4 1 4.3 1 3.7 1 4.3 1 4.3 1 3.3 1 3.7 1 3
Notes
• The measurement scale for the transition indicators ranges from 1 to 4+, where 1 represents
little or no change from a rigid centrally planned economy and 4+ represents the standards of
an industrialised market economy.
• Data for the Czech Republic are not available for the year 2008. The numbers marked with *
correspond to the year 2007.
Source: EBRD

As it can be seen on the table, virtually all countries began their transition
from the same institutional framework. In 1989 for most of the countries, except for
Poland and Hungary which were the quickest reformers, private ownership was
limited, most prices were formally controlled by the government and there was weak
corporate governance at the enterprise level which was amplified by soft budget
constraints. Competition legislation and institutions did not yet exist, but there were
widespread import and export controls and very limited access to foreign exchange.
The financial sector have only then started to emerge with the establishment of a
two-tier system in banking while there was virtually no market for non bank financial
institutions and for securities exchanges. By 2008 and after almost twenty years of
transition, many of the market institutions and mechanisms have been fairly
established, but to a much different extend between transition countries. Countries in
Central and Eastern Europe, as well as the three Baltic states of Estonia, Latvia and
Lithuania, have made the largest progress in their transition process.

As transition was unfolding, a tremendous diversity of economic and political

regimes has emerged in the countries that were formerly under Soviet control. The
diverging paths in the institutional development of TEs gave new impetus to the
literature regarding the varieties of capitalism (see for example Hall and Soskice,
2001, Knell and Srholec, 2005, Chavance and Magnin, 2006). This literature
highlights the importance of complementarities among market institutions in the
sense that the presence (or efficiency) of one institution increases the returns from
(or efficiency of) the other. Moreover, it emphasizes that the process of institutional
reform is not deterministic but can lead to a variety of outcomes regarding the
degree of reliance to market mechanisms to resolve coordination problems. TEs may
converge to Liberal market economies, where more emphasis is given to the
strengthening formal institutions and pricing signalling in order for the firm to resolve
coordination problems in relation with its employees, other enterprises, its suppliers
of finance or governments. On the other hand, TEs may converge to Coordinated
market economies where there are several non-market institutions, such as
collaborative relationships and networks for the exchange of private information, that
influence the process of strategic interaction among the firm and other economic
actors.

Institutions that support coordination, like for example business associations,

will be prevalent in Coordinative market economies while market institutions, such as
strict competition policies, will be stronger in Liberal market economies. The varieties
of capitalism theory maintain that these differing institutions lead to comparative
institutional advantages in national models of capitalism. However, the theory does
not offer clear predictions regarding the effect on banking FDI as foreign entry will
generally be more liberal in Liberal market economies -typical example of which are
Anglo-Saxon countries, but the financial system will be largely centred around banks
in Coordinated market economies - like for example in Germany and other countries
in continental Europe. Dermott (2004) elaborates on the Czech and Polish
experiment with institutional reform and attributes the differences in output growth
and the creation of manufacturing firms to differences in the diffusion of public
power. The Czech Republic opted for the depoliticization approach, which involves
the institution of rules and the rapid implementation of reforms from above which
allow economic actors to strike “efficient bargains”. The approach of Poland to
privatization, bankruptcy legislation and market liberalization involved a variety of
actors and was based on negotiations between regional development agencies,
stakeholders, firms and sub-national governments. Despite of slowing down
institutional reforms, Poland’s approach gradually led to greater firm and bank
restructuring and encouraged the creation of new firms. More reform is not
necessarily the best practice.

It needs to be emphasized that these differences in the systems of national

political economy refer to market economies which have already attained a certain
level of institutional development. Competition policies, financial, internal and
external markets liberalization are assumed to have been fairly established.
Therefore any distinction between liberal and coordinated markets does not apply to
countries like Turkmenistan or Belarus which lag far behind in introducing market
mechanisms and institutions in their economies. This laggard may help explain the
low levels of foreign participation in the financial but also in the manufacturing sector.
Foreign investors view institutions as an important aspect of the location advantages
of a potential host country as they represent the major immobile factors in a
globalized market. Once institutions are set, they form part of the “created assets” of
the economies, that have arguably become increasingly significant relative to more
conventional ‘‘natural assets’’, like raw materials or cheap labour.

Starting with this exact argument, Bevan, Estrin and Meyer (2004) examine
the relationship between FDI location and institutional development in TEs. The
authors argue that the transition temporarily creates an incomplete institutional
framework which increases transaction costs for foreign investors and that these
costs are variable across transition economies because the speed of adjustment to
the market economy differs enormously. By utilizing a sample of bilateral FDI flows
between 1994 and1998 from the major source countries to twelve TEs, they find that
institutional development in general boosts FDI and further identify specific
institutions with positive influence on FDI inflows. Private sector growth, development
of the banking sector, foreign exchange and trade liberalization as well as legal
development have a significant effect while the financial sector outside banking,
domestic price liberalization and competition policy do not appear to enhance FDI.
3.1 FDI in banking and institutional reforms

Drawing on the empirical results of Bevan et al. (2004), it seems useful to

make a sectoral division on FDI inflows. The prediction is that reforms in formal
institutions will have a magnified impact in the case of banking FDI. The differences
in foreign ownership presented in Table 3.2 can be attributed to the differences in the
speed of institutional reforms of table 3.1. This is because foreign banks are not only
directly affected by these reforms as any other FDI project, but their motivation to
invest is indirectly influenced by the “reform effect” on others. To the extent that the
“follow the client” motivation holds, any reform that impact’s with the location
decisions of foreign investors has an indirect effect on foreign bank entry. Moreover,
market institutions by providing the “formal and informal rules of the game” provide
the incentives to private agents, which were so poorly served under the old regime of
state intervention, to restructure and develop their business, to innovate and create
new firms which at a macro-level determine the growth prospects and the demand
conditions for financial services in the local economy.

Table 3.2: Number of banks and foreign bank share by country

Regions and Asset share of foreign

Number of Banks Foreign owned
countries owned banks (in per cent)
South-eastern Europe 88.4
Albania 16 14 93.6
Bulgaria 30 22 83.9
Romania 32 27 87.7
Eastern Europe and the Caucasus 42.28
Armenia 22 12 50.5
Azerbaijan 46 9 9.1
Belarus 31 20 20.6
Georgia 20 16 90.8
Moldova 16 8 31.6
Ukraine 184 46 51.1
Central Asia 28.7
Kazakhstan 37 13 12.9
Kyrgyz Republic 21 10 72.0
Tajikistan 12 4 na
Turkmenistan 11 2 1.2
Russia 1108 102 18.7
Central Europe and the Baltic states 85.77
Czech Republic 37 30 84.7
 Estonia 17 15 98.2
Hungary 39 25 84.0
Latvia 27 16 65.7
Lithuania 17 5 92.1
Poland 70 60 76.5
Slovak Republic 26 16 99.2
Year: 2008
Source: EBRD

The only empirical studies that have directly addressed this issue are those
of Bol, Lensink and De Haan (2002) for eight European TEs between 1992 and 2000
and of Iryna Tsahelnik (2006) for CIS countries. Bol et al. (2002) test whether
reforms and political freedom have positively contributed to foreign bank entry and
also via which channels had reforms affected the percentage of foreign ownership in
the banking sector. By applying Principal Component and Factor Analysis they find
that reforms, such as privatization, banking and interest rate liberalization, trade and
foreign exchange liberalization and the extent of transition within enterprises, have
significantly increased FDI in the banking sector by enhancing the efficiency of the
financial sector, by changing the structure of the financial sector, and by stimulating
domestic investments. The effect of political freedom on banking FDI, composed by
the degree of civil rights and an indicator for the degree of democracy, is less bold as
it enters insignificantly in some of their specifications.

Iryna Tsahelnik (2006) repeated the exercise for the case of twelve members
of the Commonwealth of Independent States (CIS) for the years 1994 to 2004. By
applying factor analysis, she found her economic reform variable, composed by the
share of the private relative to the public sector, banking sector and enterprise
reform and the transition of trade and foreign exchange system, to exert a significant
positive influence on the levels of FDI in banking. She also includes an indicator for
political reforms in the host country which measures the progress in establishing
democratic institutions and argues that foreign banks are more likely to enter in
democratic countries rather than dictatorships. However, the effect of political
reforms is sensitive to the depended variable employed to measure foreign bank
entry whereas economic reforms have unambiguously a significant positive effect on
foreign bank entry. Moreover she finds that economic reforms significantly improve
the efficiency of the financial sector in CIS countries.

A possible drawback with these studies is that they fail to address the
specific policies needed to attract FDI in banking. Moreover, both studies seek to
single out the determinants of foreign bank entry, which they proxy by using the ratio
of foreign bank to total bank assets or the ratio of the number of foreign to total
banks. The present paper treats those ratios as a structural characteristic of the
banking sector in TEs. They are determined both by deliberate government policies
to liberalize their financial sector and allow foreign bank entry, and by the
attractiveness of a certain location to foreign banks. Deregulating the financial sector
may be a prerequisite but is not sufficient for attracting foreign investors. The added
value of the present paper is that it identifies specific institutional reforms that weight
more in the investment decisions of foreign bank

CHAPTER 4
1. HYPOTHESES

I
n this section the main hypotheses regarding the effect of institutional reforms on
the share of foreign ownership in the banking sector are presented. The Data
made available by the EBRD on the progress of institutional reform in TEs and
by the Heritage Foundation on the degree of financial liberalization, make possible to
test different hypotheses and connect them with the empirical literature in other
aspects of multinational banking. From the econometric results that follow in the next
sections, one will be able to identify and recommend specific policies that may help
attract foreign investors in the construction of an efficient banking sector in TEs. The
first interesting hypothesis to be tested, regards the effect of the total progress of
transition to the share of foreign owned banks. The expectation is that the observed
levels of foreign ownership are conditional to the levels of transition.

H0: Countries that have progressed further in their transition process will get higher
shares of foreign ownership in their banking sector
 Ownership of private property is the central mechanism by which incentives
are created for the efficient use of resources in a free market economy. The
expectation is that greater engagement of the private sector in the economic activity
will boost FDI in banking as foreign banks are affected directly and indirectly by the
process of privatization. On the one hand privatization creates opportunities for
acquisitions and joint ventures in the banking sector, but it also encourages FDI in
other sectors and boosts demand for financial services in order to restructure and
develop private businesses. One first evidence that privatization matters comes from
Campos & Kiroshita (2008) who find that privatization, measured by the proceeds for
the government, is a significant determinant of FDI inflows in TEs whose financial
sector is dominated by foreign investors. It is useful however, given the availability of
data, to make a distinction regarding the size of the enterprises involved in the
privatization process.

Privatization may refer to large state enterprises or to Small and Medium

sized Enterprises (SMEs) which make it interesting to examine whether foreign bank
entry is determined primarily by the process of large-scale or small-scale
privatization. Berger et al. (2002), argue that the banking industry may never become
fully globalized as some banking services such as relationship lending to
informationally opaque small businesses may always be provided primarily by small
local institutions while other services, such as syndicated loans to large borrowers,
are more likely to be provided by large, global institutions. Clarke et al (2006) by
combining responses from a survey of over 4,000 enterprises in 38 developing and
transition economies with data on the degree of foreign bank penetration, find that
even if foreign banks focus primarily on serving large customers foreign bank entry
might still benefit small borrowers as heightened competition forces some banks out
of the business of serving large customers, into providing credit to SMEs. They
argue that this is because larger share of foreign bank entry is related with higher
banking sector efficiency which results in an expansion of total lending. Therefore
the amount of lending to SMEs may increase, even if the relative share of lending to
them falls.

De Haas et al. (2009) are keen to the notion that domestic banks have a
comparative advantage in serving local SMEs as they have better understanding of
local businesses. They argue that local banks base their lending decisions on ‘soft’
qualitative information and develop long term relationships with SMEs which enables
them to collect information about borrowers’ capacity to repay. Foreign banks on the
other hand may have difficulties in processing soft information. They often grant
loans on a transaction-by-transaction basis, based on ‘hard’ information like financial
ratios calculated on the basis of financial statements and therefore foreign banks that
lack local knowledge grant credit primarily to large and foreign owned firms.
However, when they test this hypothesis based on a survey on bank activities that
was conducted on 2005 across 20 transition economies, they find that foreign banks
are relatively strongly involved in mortgage lending besides lending to SMEs and
subsidiaries of international firms. This finding is consistent with a previous study by
De Haas and Naaborg (2006) where it was found that the acquisition of local banks
by foreign banks did not lead to a persistent bias in the amount of credit to SMEs in
Central Europe and the Baltic States.

The present study offers the opportunity to re-examine the hypothesis by

looking at how did the investment decisions of foreign banks were affected by the
process in these two dimensions of privatization. Based on previous empirical results
we expect that both large and small scale privatization attract FDI in banking. A
different result may indicate that foreign banks focus on serving different market
segments than local banks. If foreign bank entry appears to respond less to the
privatization of SMEs, then the prime motivation for entering a TE would be the
service of large enterprises. Therefore hypotheses (2) and (3) are also tested in this
paper:

H0: Countries that have progressed further in their privatization process will get
higher shares of foreign ownership in their banking sector (1)

H0: Countries that have progressed further in large scale privatization will get higher
shares of foreign ownership in their banking sector (2)

H0: Countries that have progressed further in small scale privatization will get higher
shares of foreign ownership in their banking sector (3)

The liberalisation of prices in both domestic and international markets is an

important step in transforming a centrally planned to a market economy. The
transition to a market economy cannot be thought of without the introduction of
flexible relative prices, the lifting of administered prices and the procurement of the
state at market prices. Without price liberalization, countries cannot credibly commit
to market reforms while inducing profit maximizing behaviour in distorted markets
does not lead to allocative efficiency. Price liberalization creates new investment
opportunities for foreign and local investors (Bevan et al. 2004) and is therefore
expected to boost demand for financial services provided by foreign banking
institutions.

H0: Countries with more extensive liberalization in domestic markets will get higher
shares of foreign ownership in their banking sector (4)

The liberalization of the trade and foreign exchange system (FOREX) is

expected to attract FDI in banking. The abolishment of quantitative and
administrative import or export restrictions, the transparency of the foreign exchange
regime and the ability of foreigners to freely convert any of a country's currency they
earn in trade is essential for the development of multilateral trade and in extension
for the motivation of foreign banks to follow their customers in international business.
The abolition of exchange restrictions and of multiple exchange rates allows the
repatriation of profits and reduces transaction costs which are regarded important
both for foreign banks and their corporate clients. However, in contrast with the clear
prediction that international markets liberalization is an impetus for banking FDI,
Campos and Kinoshita (2008) report that progress towards their measure of trade
liberalization has an insignificant effect on FDI to TEs, while this effect becomes
significantly negative for TEs whose financial sector is dominated by foreign
institutions.

H0: Countries with more extensive liberalization of international markets will get
higher shares of foreign ownership in their banking sector. (5)

The crucial next step in establishing efficient markets, beyond the plain
establishment of market mechanisms, is the institution and the enforcement of
prudent competition policies. That precludes the lifting of market entry restrictions as
well as enforcement actions to promote a competitive environment and reduce the
abuse of market power by dominant firms. The creation of an environment of fair
competition facilitates new market entries which boosts demand for start-up capital
and encourages existing firms to undertake new investments in order to upgrade
their capacity and expand their operations. Competition policy is especially important
for foreign investors who shout for equal treatment in the host market in order to
deploy their competitive advantage.

Foreign firms lack the access of incumbent local firms to political and
bureaucratic decision makers and their entry decision will be based upon the
institution and enforcement of fair competition policies in order to overcome this
disadvantage. The design and the implementation of competition policies may
constitute implicit barriers to foreign entry imposed by the government in order to
favour certain groups of insiders or to promote the development of infant industries
and national champions. Therefore the expectation is that progress in the
establishment and enforcement of prudent competition policies will invite FDI in the
banking industry. However, concerns can be expressed for small TEs in which some
foreign investors command considerable market shares. Bevan et al. (2001) attribute
the insignificant impact of competition policy reforms to FDI inflows in TEs, to the
possible preference of foreign investors in monopolistic markets.

H0: Countries with more developed competition policies will get higher shares of
foreign ownership in their banking sector (6)

Governance and enterprise restructuring is a reform variable employed by

the EBRD in order to describe the movement from a regime of soft budget
constraints (lax credit and subsidy policies that weaken financial discipline at the
enterprise level) and poor corporate governance, to a regime where effective
corporate control exercised through domestic financial institutions and markets,
foster market-driven restructuring (EBRD transition indicators). Critical to this
transition, is the promotion of corporate governance i.e. through privatization and
competition combined with the tightening of credit and subsidy policies and the
enforcement of bankruptcy legislation. Therefore, governance and enterprise
restructuring may help attract foreign banks as it enhances transparency and thus
the information gap between borrowers and lenders, it reduces the probability of
loans becoming non-performing and can limit the exposure of banks to the credit risk
of its corporate clients.

A particular point of central importance for banks in TEs is the enforcement

of bankruptcy legislation. The objective of bankruptcy laws is to ensure that the
liquidation process is carried out in a systematic and organized manner to avoid a
wasteful run on the assets of the firm and are important drivers for the credit supply
decisions of banks in emerging and transition economies (Haselman et al., 2005).
Therefore the decision of foreign banks to enter in TEs is critically affected by the
level of creditor rights protection in those countries. Haselman et al. (2005) argue
that the strengthening of formal creditor rights protection is an important way for
reducing the informational and cultural disadvantage of foreign banks in relation to
local banks, which may allow them to fully optimize their comparative lending
advantage. In support to this argument, they empirically find that foreign banks
increase their lending volume in response to legal change in creditor rights such as
Bankruptcy and Collateral law more than domestic banks do in a sample of banks
operating in twelve TEs over the period 1995-2002. Finally, restructuring itself may
create demand for bank finance. Bevan, Estrin and Meyer (2001) often refer to the
acquisition of post-socialist firms both by local and foreign investors, as “brownfield”
investment in order to describe the considerable investments that need to be
undertaken in enterprise restructuring and in reforming corporate strategy,
organisational structure and culture.

H0: Countries that have progressed further in governance and enterprise

restructuring will get higher shares of foreign ownership in their banking sector (7)

There is significant empirical evidence that financial liberalization in general

promotes FDI in banking. Financial liberalization (Wezel, 2004) or some of its
aspects such as restrictions on bank activities and explicit regulatory restrictions in
the size or mode of foreign bank entry have been found to deter foreign bank entry.
The hypothesis is that countries with greater government influence in the financial
system will have banking sectors with less percentage of foreign ownership. The
extend of government influence is determined by the extent of government regulation
of financial services, the extent of state intervention in banks and other financial
services, the difficulty of opening and operating financial services firms (for both
domestic and foreign individuals) and government influence on the allocation of
credit. Importantly, the financial liberalization variable employed to test this
hypothesis captures important aspects of the unilateral motivation of the
governments in TEs to open up to foreign investors and the perceived benefits to the
efficiency of the financial sector.
H0: Countries that have progressed further in liberalizing their financial markets will
get higher shares of foreign ownership in their banking sector (8)

CHAPTER 5
2. DATA AND DESCRIPTIVE STATISTICS

T
he elaboration of the present study is motivated by the rising, though
variable shares of foreign ownership in the banking sector of former
communist countries. In an effort to reach causal interpretations for this
development, it utilizes an unbalanced dataset containing information about 22
former members and satellite states of the Soviet Union for a time period of 14
years, from 1995 to 2008, when the main wave of foreign bank expansion to TEs has
been observed. The dependent variable is the asset share of foreign owned banks in
TEs which is provided and defined by the EBRD as the share of total bank sector
assets in banks with foreign ownership exceeding 50 per cent. From the summary
statistics provided in table 5.1 it becomes apparent that the levels as well as the
change in the levels of foreign bank ownership differ markedly between TEs for the
above mentioned time period.

Table 5.1 : Asset share of foreign-owned banks (in per cent)

country N mean sd min max

ALBANIA 11 60.56364 32.396 14.4 94.2
ARMENIA 14 45.6 10.44045 16.1 57.6
AZERBAIJAN 9 5.933333 1.620185 4.1 9.1
BELARUS 14 9.935714 8.222914 .7 20.6
BULGARIA 11 71.23636 17.18809 32.5 83.9
CZECH 14 62.33571 30.14219 15.5 89.1
ESTONIA 14 78.25714 37.22273 1.6 99.4
GEORGIA 14 40.2 32.79205 4.5 90.8
HUNGARY 14 67.43571 14.8616 36.8 85
KAZAKSTAN 14 18.63571 15.10118 4.6 56.9
KYRGYZ 12 48.78333 22.08244 16.5 73.6
LATVIA 14 60.32143 12.89175 34.6 79.1
LITHUANIA 14 67.07857 31.42726 0 96.1
MOLDOVA 11 30.53636 6.834219 19.6 39.8
POLAND 14 54.30714 27.98751 4.4 76.5
ROMANIA 12 54.73333 25.06106 11.5 87.9
RUSSIA 14 9.464286 4.298946 3 18.7
SLOVAKIA 13 66.95385 36.01985 12.7 99.2
TAJIKISTAN 11 29.26364 31.26219 1.8 71.9
TURKMENISTAN 14 1.107143 .4445642 0 1.7
UKRAINE 12 19.53333 14.26855 8.2 51.1
UZBEKISTAN 10 2.36 1.381786 .1 4.4

Source: EBRD

The choice of the explanatory variables is motivated by the theory on

multinational banking, which has been reviewed and discussed in the previous
sections. It needs to be emphasized from the beginning that the lack of sufficient
and proper data had inhibited the development of a more systematic approach on
the determinants of foreign bank entry in a large cross section of TEs. The lack of
important data also holds to some extend in the present study, a problem which is
hopefully tackled with the methodological specification. Based on the existing
literature, the percentage of foreign bank assets in TEs is expected to be determined
by the following factors4:

• Population: The number of inhabitants in a TE constitutes a proxy for the

effect of market size on foreign bank entry. Larger countries offer greater
opportunities for profitable FDI in the banking sector as they can generate higher
4 The sources and the definitions of the main explanatory variables are presented in
Appendix 3.
demand for financial services, larger deposit base and the opportunity to foreign
banks to benefit from economies of scale. Goldberg and Johnson (1990), Buch
(1999) and Papi and Revoltella (1999) for the case of European TEs, have all
included this variable to test the “market opportunity hypothesis” and found that
larger markets attract higher FDI flows in banking. However, those studies have only
considered the volume of absolute or bilateral FDI in the banking sector and not the
relative shares of foreign owned banks. An argument can be made that smaller
countries may have banking sectors dominated by foreign institutions since the small
size of their economies may inhibit the creation of a competitive domestically owned
banking sector.

• Quasi money to GDP ratio: The presence of local market opportunities is

determined not only by the country’s size but also by its level of economic and
financial development. In reviewing the theory on the determinants of foreign bank
entry, it has been demonstrated that the level of economic development in the host
country, most frequently tested by measures such as GDP per capita, and the
features of the financial sector, predominantly its size, are significant for explaining
banking FDI. However, their inclusion in the same regression is problematic since
economic and financial development are in general highly correlated. Financial
development is an important feature of the financial system which in the context of
many studies was found to exert a positive influence on banking FDI. Quasi money
as a percentage of GDP is included here as a proxy for the financial depth in the
host country and refers to the share in GDP of time, savings, and foreign currency
deposits of resident sectors other than the central government.

• Concentration: The conditions of competition in the host country’s banking

sector may be significant for explaining the location decisions of foreign banks. Bank
concentration, defined as the assets of the three largest banks as a share of the
assets of all commercial banks, is an important feature of the market structure in the
host country which not only captures sufficiently the degree of competition, but is
also related with the efficiency of the banking system. The later is usually examined
in bilateral models by proxies such as the spread between deposit and lending
interest rates or the average net interest margins in the banking sector. However,
there is considerable evidence that foreign bank entry may affect the efficiency of the
host banking system and therefore such measures cannot be included directly in the
regressions (see for example Bonin et al. 2005). Focarelli and Pozzolo (2005)
interpret bank concentration as an implicit barrier to foreign bank entry and find that it
exerts a negative impact on the location decisions of large international banks
originating from OECD countries. A positive relationship on the other hand, would
indicate the preference of foreign banks to oligopolistic markets through the
acquisition of large domestic institutions.

• Money and quasi money (M2) to gross international reserves ratio:

Various indicators have been employed in the literature about the determinants of
foreign bank entry, to measure the effect of risk for the solvency of the banking
system stemming either from economic and political factors or by the probability of
crisis in the banking sector. Regarding the latter case, some authors have examined
the effect of the adoption of the Basel Capital Accord to banking FDI that presumably
increases the transparency and promotes the development of sounder banking
systems (see Miller and Parkhe, 1998, Buch, 2003). Wezel (2004) on the other hand
uses the ratio of M2 money to gross international reserves as a proxy for the
probability of incipient banking crises in the host country.
This “early warning indicator” significantly explained the location decisions of
German multinational banks as it addresses sources of risk for foreign banks related
both with the fragility of the banking system and with exchange rate imbalances in
the host country. Both sources of risk are of particular concern for foreign banks and
therefore the same ratio is regarded in the present study as a risk factor that deters
foreign bank entry in TEs. What is striking is that this ratio is extremely accurate in
predicting episodes of banking and currency crises in TEs with its value taking large
upward deviations above its mean soon before or during crisis episodes in the
banking sector5. This was the case with all banking crises in TEs after 1995; the
1996 crises in Bulgaria and the Czech Republic and the1998 crises in Ukraine,
Russia and Slovakia.

• Inflation: This is a standard measure of macroeconomic stability in the host

country that has been frequently tested in models that try to explain the determinants
of banking FDI. High and volatile inflation can have a magnified importance in

5 Source: Laeven and Valencia, 2008. "Systemic Banking Crises: A New Database", IMF
Working Paper.
banking since it can diminish the value of savings and adversely affect the banks’ net
interest income. Inflation is expected to have a negative impact on the levels of
foreign bank entry.

• Trade: The relative openness of an economy to international trade is

expected to have a significant positive effect on the share foreign bank ownership.
This expectation is based on the “follow the customer” hypothesis which has been
frequently examined in the related literature. A country’s openness to trade is
measured by the sum of imports and exports divided by GDP in the host country.
Banks are present more in countries where the trade related needs of their
customers are bolder. Therefore, the share of foreign bank ownership is expected be
higher in countries that are more closely integrated with the global economy.

• Internet: As an innovation to the banking FDI literature, the level of

development of modern infrastructure in TEs is regarded as a potential determinant
of the asset share of foreign owned banks. The variable internet corresponds to the
number of internet users per hundred of inhabitants. Often the competitive
advantage of foreign banks in relation to local banks rests on their ability to use on
their benefit, more efficiently the available infrastructure. Foreign banks possess
superior technology, the experience and the “know how” to offer complex and
superior quality financial services to their customers. However, this competitive
advantage in offering innovative and specialized services, in possessing superior
technology and better banking techniques, is conditional on the level of the available
infrastructure. For example online banking services cannot be provided to countries
without the necessary infrastructure. The emergence of e(lectronic)-commerce
requires the intermediation of banks. However this form of transaction needs to be
supported by modern infrastructure. The theoretical starting point for including this
variable in the baseline estimation model is the importance of information in banking.

The capacity of banks to gather information from a variety of sources at low

marginal cost, process and communicate this information in their internal operations,
depends on the availability of infrastructure that can reduce transaction costs. The
development of e-banking services has the potential of reducing operating costs as
well as generating new demand for financial services. Simpson (2002) showed that
e-banking will lead to lower overhead ratios and higher net interest margins for
banks in markets where e-banking is more established, as opposed to emerging
bank markets where e-banking is less developed. Internet infrastructure is also likely
to spur FDI in other sectors as it leads to improvements in productivity (Choi, 2003).
The variable internet is expected to have a positive effect on the market share of
foreign owned banks as it constitutes a proxy for the development of modern
infrastructure in the host country and an indicator for the potential of developing a
market for e-banking services in which banks originating from countries with more
developed financial systems would have a competitive advantage.

• Dummy for CIS: Cultural and geographic proximity are important for
explaining banking FDI. Excluding gravity models, proximity can be controlled for by
including regional dummies (Yamori, 1997, Mathieson and Roldos, 2001). In the
case of TEs however, it seems meaningful to make a distinction between countries
based on the extend and the timing in which they came under soviet control. A useful
distinction is between former soviet and non soviet TEs, with the added condition
that former communist countries came under soviet control before or after 1940. The
first group includes countries that were former member of the Soviet Union except of
the three Baltic States and the second group includes the satellite states of the
Soviet Union and the Baltic Republics of Estonia, Latvia and Lithuania. This is
captured with the inclusion of a dummy variable named cis which takes the value of
1 if the country was formerly a member of the USSR and currently member of the
Commonwealth of Independent States (CIS) and the value of zero otherwise. There
are many reasons that validate this distinction:
• The annexation of the Baltic States into Soviet control was made by
occupation and thus maintained a certain degree of independency.
• Legal origin differs between the two groups of country. Most countries of the
Soviet Union were part of the Russian empire and for the most part inherited
Russian legal codes (Harper et al., 2005). In contrast, the non Soviet European
countries and the Baltic States had different legal origins to which they have returned
after the dissolution of the USSR (Djankov, McLiesh and Shleifer, 2004). This
difference signals different levels of creditor rights protection which is important for
the financial development in the host country and for foreign bank entry.
• The Baltic countries and the European non Soviet TEs are in closer
geographic and cultural proximity with the West.
 • Baltic and non Soviet TEs have already been acceded in the European Union
or are in the process of joining the EU. The Czech Republic, Estonia, Hungary,
Latvia, Lithuania, Poland and Slovakia are members of the EU since2004, Romania
and Bulgaria acceded on 2007 and Albania has already applied for membership in
the EU. Institutions in those countries had to be reformed in line with their prospect
of joining the EU. The rest of TEs joined in the CIS6 which is a more loose
association of states, possessing coordinating powers in the realm of trade, finance,
lawmaking and security. This is important for understanding the different levels of
foreign bank ownership observed between the two groups of countries (Appendix 1).

5.1 Institutional variables

The focal point of this paper regards the effect of transition on the asset
share of foreign owned banks in TEs. Institutional reform primarily refers to the
change in formal institutions and its pace is determined mainly by the policies
adopted from the ruling authorities in TEs. However, the empirical literature offers
many examples where informal institutional arrangements – the “quality” of
institutions - seemed to display an important role in the investment decisions of
foreign banks. Given the opportunity, their effect in the asset share of foreign
owned banks is re-examined with the ambition that it can provide more depth in the
analysis regarding the effect of institutional change on banking FDI.

Formal Institutions
The progress of transition is summarized in the progress along the above
dimensions of formal institutions:

• Private sector share in GDP (privatesharegdp)

• Large scale privatization (largescale)
• Small scale privatization (smallscale)
• Enterprise restructuring (enterestruct)
• Trade and Foreign Exchange System (forex)
• Competition Policy (competition)
• Price Liberalization (pricelib)

6 Georgia effectively withdrew from the CIS after the South Ossetian war in
2008.
 • Financial Liberalization (financialib)

All of the variables are provided by the EBRD except of the Financial
Liberalization index which is taken by the Heritage Foundation. The later variable
effectively replaces the relevant EBRD variables named “Bank reform and Interest
rate liberalization” and “Securities markets and non-bank financial institutions” since
those two variables measure the progress in best practices, standards and
performance of the financial system which are very much likely to be endogenous in
the asset share of foreign owned banks. The Financial Liberalization index on the
contrary, measures the degree of government invention in the financial system
which presumably is unaffected by the degree of foreign bank penetration. All
observations about the reform variables are annual and - not surprisingly - strongly
correlated with each other as shown in table 5.1.

Table 5.2: Correlation Matrix – Institutional reform variables

privat~
larges~e smalls~e entere~t pricelib forex compet~n financ~b
p

privatesharegdp 1.0000

largescale 0.8728 1.0000

smallscale 0.9101 0.8409 1.0000

enterestruct 0.7931 0.8210 0.7719 1.0000

pricelib 0.7987 0.7488 0.7757 0.6811 1.0000

forex 0.8177 0.7523 0.8027 0.6797 0.8559 1.0000

competition 0.6426 0.6810 0.6429 0.8380 0.5206 0.5394 1.0000

financialib 0.6799 0.7082 0.6168 0.7562 0.6618 0.6686 0.6648 1.0000

Informal Institutions
A more frequently examined hypothesis in the academic literature, regards
the effects of Institutional Quality on banking sector FDI. North (1994) is making a
useful distinction between formal institutions – which are for example laws and
regulations- and informal institutions which comprise of social conventions and
norms of behaviour. Informal institutions are of equal, if not of greater importance
for foreign investors. The availability of data regarding different aspects of
institutional quality make interesting the comparative study of the effects of formal
and informal institutions on the degree of foreign bank entry by including variables
regarding informal institutional change in the regressions. Institutional quality is
measured by the Worldwide Governance Indicators (WGI) developed by Kaufmann,
Kraay and Mastruzzi (2009). The value of the six governance indicators presented
below, ranges from -2.5 to +2.5 and they are constructed for the years 1996, 1998,
2000 and annually from 2002 to 20057.

• Voice and accountability index (voiceaccount)

• Control of corruption index (controlcorr)
• Government effectiveness index (goveff)
• Political stability and absence of violence index (politstabil)
• Rule of law index (ruleoflaw)
• Regulatory quality index (regqual)

Table 5.3: Correlation Matrix – Informal Institutions

voicea~t polits~l goveff regqual ruleof~w contro~r

voiceaccount 1.0000

politstabil 0.7301 1.0000

goveff 0.9194 0.7574 1.0000

regqual 0.9394 0.6922 0.9251 1.0000

ruleoflaw 0.9223 0.8107 0.9556 0.9087 1.0000

controlcorr 0.9077 0.7876 0.9508 0.8904 0.9636 1.0000

7 For a definition of the variables look at Appendix 3c.

CHAPTER 6
6. RESEARCH METHODS AND RESULTS

T
he empirical procedure that is adopted for understanding the driving forces
behind the rising shares of foreign bank ownership in TEs, is based on the
following framework. First, an aggregated index of the transition progress is
constructed in order to examine the pure impact of formal institutional reform on the
levels of foreign bank ownership. The net effect of the change in informal institutions
is also examined with the construction of an aggregated index for institutional quality.
By estimating and comparing the significance and the effect of institutional change
on banking FDI, we will be able to provide policy recommendations to those
governments aiming to attract foreign investments in their banking sector. For that
purpose, the effect of the aggregated measures of institutional change and most
importantly the effect of the specific institutional variables that they encompass is
estimated with different econometric methods. In each case, the empirical results are
based on the estimation of the following model:

Equation 1:
foreignassetit=
β0+β1logpopit+β2loginflit+β3quasi2gdpit+β4tradeit+β5m2reservesit+β6conce
ntrationit+ β7internetit+ β8cisi+β9REFORMit+t+νit

This model specification seems proper as it includes the factors most

frequently cited as significant in the banking FDI literature. It needs to be
emphasized that limits in data availability or indeed limits in the applicability of data
have restricted in many ways the research on the determinants of foreign bank entry
in TEs and have led to a variety of results depending on the choice of the
explanatory variables, the group of countries under study and the methods employed
to overcome the shortcomings of data scarcity. A constant source of concern is that
of endogeneity, either due to simultaneity or omitted variables bias. Bilateral models
implicitly assume that bilateral banking FDI flows can be examined without regard to
their effect on the efficiency, the size or the risk for the local financial system. This
option however, is not open to general models. The choice of the explanatory
variables was careful in this respect; however the concern about omitted variables
that may impact with the investment decisions of foreign banks is present in this
study, as with similar research papers in the field (see for example Bol et al., 2002
Wezel, 2004 ) Hopefully this problem is tackled with the methodological specification
for estimating Equation 1.

The composite error term in Equation 1 consists

of the unobserved time-constant effects ( ) that may affect the foreign banks

asset share in TEs and the idiosyncratic time-varying error . Due to outliers and

their skewed distribution, population and inflation are taken in logs. In addition, a
linear time trend (t) is included in the model since the dependent variable displays a
clear trend over. Holding all other factors fixed in the model, t measures the change
in the dependent variable from one period to the next due to the passage of time8. By

8 A Fisher-type unit-root test for the asset share of foreign owned banks based on augmented
Dickey-Fuller tests, confirmed that assetshare is stationary about its trend, at least in some panels.
 including a trend, we recognize that the average increase in the mean value of the
dependent variable through time may as well be explained by the strategic
considerations and the interaction of multinational banks. The rising shares of foreign
bank ownership in TEs observed between 1995 and 2008, coincided with a period of
increased international liquidity and capital mobility. As financial liberalization in
internal and external markets has been unfolding, international banks or banks in
developed countries that till recently operated only in their domestic markets,
attempted to acquire strategic stakes in the virgin markets of former communist
countries. This “third wave” of multinational banking may not be adequately
explained by the rest of the factors already included in the model, but to some
extend the investment decisions of foreign banks may have been motivated by a sort
of hoarding behaviour and their competition for entry in new markets.

6.1 Constructing an index of institutional reform

As a first step in estimating model 1 an aggregated index for the transition
progress needs to be constructed in order to examine the effect of formal institutional
change on the levels of foreign bank entry. As the institutional reform variables are
strongly correlated with each other, they cannot be included simultaneously in the
same regression in order to avoid problems with multicollinearity. However, while
each reform variable picks up different aspects of the transition progress, it is their
totality that may matter most in the investment decisions of foreign banks as they
contribute together in the creation of the formal institutional environment in TEs. The
method used here to construct such an overall index is the Principal Components
Analysis. First, an index for privatization is constructed based on three available
measures of the progress in this dimension of institutional reform. These are:

• Private sector share in GDP (in per cent)

• Large scale privatization index
• Small scale privatization index

All of the privatization variables are provided by the EBRD and their correlations are
presented in table X below.

Table 6.1: Correlation Matrix for Privatization variables

 privateshare largescale smallscale

privateshare 1.0000
largescale 0.8699 1.0000

smallscale 0.9063 0.8423 1.0000

Table 6.2: Principal components Table 6.3: Privatization variables’ weight

eigenvalues for the privatization variables allocation in the first principal component

Component Eigenvalue Variable Comp1

Comp1 2.74593 privateshare 0.5840

Comp2 .164036 largescale 0.5699

Comp3 .0900349 smallscale 0.5781

The main objective of PCA is to reduce the dimension of observations

without loosing too much information (Hardle and Simar, 2003). In result, we have a
smaller set of variables which explain most of the variation in the original variables.
The amount of the principal components that is extracted is equal to the number of
the reform - in this case the privatization variables. PCA applies an orthogonal linear
transformation that places a projection of the data with the greatest variance on the
first principal component. The components are uncorrelated and ordered so that the
first few retain most of the variation present in all of the original variables. The
eigenvalues displayed in table 6.2 describe the total variance accounted by each
principal component and their sum always equals the number of the variables. Given
the eigenvalues of the three components presented in table 6.2, it might be inferred
that it is the first principal component that captures a meaningful amount of the
variation from the original variables since it is the only component whose eigenvalue
is larger than 1. Consequently it is the only component that is retained to construct
an overall index for the progress of privatization in TEs.

Table 6.3 presents the relative importance of each privatization variable in

the first principal component. In this case the PCA method assigns similar weights in
each variable. Thus the privatization “quality” that they embody is almost equally
represented in the final index. The privatization index is then used to apply PCA in
the rest of the reform variables of interest. Table 6.4 presents the output of the PCA
method in the reform variables that lead to the construction of a reform index based
on the first principal component.

Table 6.4: Principal components’ Table 6.5: The weight allocation of the
eigenvalues for the Reform variables Reform variables in the first principal
component

Variable Comp1
Component Eigenvalue
privatization 0.4340
Comp1 4.5815
enterestruct 0.4270
Comp2 0.67457
pricelib 0.4047
Comp3 0.33026
forex 0.4085
Comp4 0.16672
competition 0.3768
Comp5 0.14723
financialib 0.3958
Comp6 0.09970

The tables indicate that the first component captures adequately the largest
amount of variance present in all of the original variables. Privatization as well as
government and enterprise restructuring are represented more in the first principal
component which is the only component retained to construct the institutional reform
index. Less weight is assigned to the rest reform variables, especially in competition
policy and financial liberalization. Not surprisingly, the aggregated reform variable
has a mean value of (almost) zero and its values range from -5.59 to 3.45. Lastly, an
index for institutional quality is constructed using the same method. The output of
this procedure is presented in tables 6.6 and 6.7. Again, there is one Principal
Component based on which an aggregated index is created with values ranging from
-4.31 to 3.99. The correlation between the aggregated institutional reform and
institutional quality indexes is not surprisingly highly and positive; thus the effect of
formal and informal institutional change – as well as the effect of the disaggregated
variables that help in their construction- have to be tested separately in the
estimation of model 2.

Table 6.6: Principal components’ Table 6.7: The weight allocation of the
eigenvalues for Institutional Quality Institutional Quality variables in the
variables first principal component

Component Eigenvalue Variable Comp1

Comp1 5.36763 voiceaccount 0.4133

Comp2 0.37130 politstabil 0.3610
Comp3 0.12327 goveff 0.4201
Comp4 0.06374 regqual 0.4087
Comp5 0.04071 ruleoflaw 0.4237
Comp6 0.03332 controlcorr 0.4193

6.2 Transition indicators

The choice of the proper Least Squares method in order to estimate
Equation 1 depends primarily on the assumptions about the relationship between the

unobserved fixed effect and the set of the explanatory variables. The Pooled
OLS model makes the assumption that the error term , so both and

are uncorrelated to the rhs variables of Equation 1 at all time periods in order to
consistently estimate the parameters β. The second estimation method utilized for
estimating Equation 1 is Fixed Effects. The fixed effects method provides consistent

and unbiased estimates of Eq. 1 provided that the unobserved country effect is

correlated with the set of explanatory variables while the strict exogeneity
assumption still holds. In that way, some of the factors that are fixed over time such
as language, culture, geography, legal tradition etc are allowed to be correlated with
the rhs variables. This assumption is plausible for the case of banking FDI where it
has been demonstrated that such factors have a significant influence. Finally, Eq. 1
is estimated with Random effects where again we make the assumption of strict

exogeneity and that is uncorrelated with each explanatory variable in all time

periods. However, unlike Pooled OLS, the Random effects method explicitly controls

for the nature of and takes account of the fact that the composite error term is

effectively serially correlated across time. Heteroskedasticity and autocorrelation

tests are performed in all the models that follow, primarily with the Breusch-Pagan
and the Breusch-Godfrey tests. These tests have indicated the presence of
heteroskedasticity and autocorrelation in all of the estimated models thereof, thus the
results reported in table 6.8 as well as in the rest tables are robust to both
heteroskedasticity and autocorrelation.

Table 6.8: The effect of Reform with different methods

Variable Pooled OLS Random Effects Fixed Effects

-1.54 0.72 -39.85

logpop
(1.78) (2.78) (119.95)

-1.60 -2.22 -2.45

loginfl
(1.65) (1.88) (2.08)

trade 0.074 0.18** 0.42**

 (0.08)
(0.05) (0.16)

-0.35** -0.40 -0.46

quasi2gdp
(0.16) (0.26) (0.34)

0.40 -0.70 -2.23

m2reserves
(1.80) (1.80) (1.98)

0.29** 0.32* 0.35*

concentration
(0.11) (0.16) (0.19)

-0.20 -0.20 -0.22

internet
(0.25) (0.28) (0.24)

3.89*** 3.47*** 2.38**

t
(1.03) (1.17) (1.03)

-25.84*** -23.10***
cis -
(5.39) (7.50)

7.66*** 9.63*** 13.81***

reform
(1.70) (2.17) (3.79)

31.34 -13.73 611.02

constant
(33.19) (54.78) (1920.32)

Table 6.8 presents the results obtained with different methods for the
estimation of Equation 1. The effect of the variable reformit, obtained with PCA, is
positive and statistically very significant in all three specifications. However, the
magnitude of its effect on foreign banks asset share differs between the three
models, which makes necessary to correctly specify the estimation method. The
parity in significance levels also holds in different degrees with respect to the
coefficient of concentrationit ,the linear time trend (t) and the time constant dummy

, indicating that it makes a difference in the levels of foreign bank market

shares whether a country belongs to the family of CIS countries or has been in the
process of joining the European Union.
 The market structure is a significant determinant of the percentage of foreign
bank ownership. Foreign investors show a clear preference to oligopolistic markets
that may signal greater profit opportunities for banks commanding dominant market
shares. In any case, the effect of concentration on bank profitability will be
dependent upon other institutional characteristics such as competition policies that
restrict the abuse of market power by dominant banks. Although the acquisition of
large domestic institutions by foreign banks may not have a direct impact on the
banking sector structure, endogeneity may arise if foreign bank entry will lead to a
gradual crowding out of local banking institutions in favour of established banks.
These hypotheses remain to be tested in the case of TEs. The hypothesis made
here is that concentration is not dependent on the foreign banks asset share at all
time periods, although much depend on the regulatory environment in the host
country and especially competition policies.

Market opportunities and risks steaming from inflation do not seem to display
a critical role in determining foreign ownership of local banking institutions. The effect

of and is insignificant in all specifications, there is

however some preliminary evidence that banks prefer to acquire dominant shares in
less “deep” financial markets. That is consistent with the explanation that banks
enter in less developed financial systems with the expectation that their profits may
increase with the development of the financial intermediation system in TEs. There is
also some ambiguity about the effect of openness which puts in question the “follow
the customer” motivation, even though this is strongly dependent on the model

specification. The ratio of M2 money to total reserves ( )–

an indicator for the risk of currency and banking crises in the host economy - does
not seen to affect significantly the dependent variable once the rest of the control
variables are taken into account. The same is true for the level of infrastructure in the

host country reflected by the insignificant effect of in all

specifications of Equation 1.
 The choice of the proper model in order to consistently estimate the effect of
the aggregated reform measure is based on two supportive tests. First a Breusch -
Pagan Lagrangian multiplier test for random effects indicated that there are
significant country effects that make proper the use of the random effects method.
However, a Hausman test, supported by the use of Mundlak’s estimation procedure,
has indicated that fixed effects are more appropriate for estimating the effect of
reform. In light of this information, the discussion about the effect of the independent
variables on foreign banks asset share is restricted on the results obtained with the
fixed effects method in Table 6.8. Note that the foreign banks asset share is already
expressed in per cent - i.e. the mean value of the dependent variable is 41.9 (%).
Therefore the effect of the rhs variables in Eq. 1 is interpreted as percentage point
changes in the dependent variable9.

A one percentage point increase in international trade will raise foreign

banks asset share by 0.42 percentage points. Thus it is confirmed that a country’s
openness is significant for explaining FDI in banking which may be explained by the
internationalization of banks in order to serve the trade related needs of their
corporate customers. The significance of this effect dominates that of market
considerations except of the effect bank concentration in the host market which
appears to encourage FDI in banking. A one percentage point increase in the assets
of the three largest banks as a share of the assets of all banking institutions will
increase the assets share of foreign owned banks by 0.35 percentage points. Finally,
the model predicts that the average foreign share will increase on average by 2.38
pp10 each year for factors that are captured in the time trend but which we have not
modelled in Eq.1. Besides of the economic interpretation provided previously, the
inclusion of a linear trend is important once we take account of the fact that the
internet variable, also exhibits a linear trend over time. Therefore excluding the trend
from the model would lead to spurious results regarding their relation11.

Regarding the effect of institutional reform, the model predicts that a one unit
increase in the reform variable, which is a continuous ranging from -5.59 to 3.45, will

9 Summary statistics of the explanatory variables are provided in appendix 2

10 pp= percentage points

11 in Equation 1 becomes significant at a 2.2% level

increase the foreign banks asset share in TEs by 13.81 percentage points. The
result is economically and statistically very significant. Hypothesis 1 is not rejected
even at the 1% confidence level. This result should urge governments in TEs to
implement fast and rigorously their transition programme if they wish to attract FDI in
the banking sector. Foreign banks entry decisions are depended upon the host
country’s stage of transition, but this does not say much about the specific reforms
needed to attract FDI in banking. The examination of the effect of specific
institutional reforms reveals an interesting controversy regarding the unobserved
country effects. While in the case of the aggregated reform variable the Hausman
test indicates that there are significant country specific effects correlated with the
explanatory variables in Eq. 1 which make Fixed effects the appropriate estimation
method, the same does not hold when the individual reform variables are included
separately in the model.

The Breusch and Pagan Lagrangian multiplier test for random effects,
indicated that in all cases Random effects was the appropriate method for estimating
Eq. 1, except of the case of large scale privatization where the pooled OLS method
was followed as no significant country effects were detected. For the rest of the
models encompassing only certain aspects of institutional reform, respective
Hausman tests have suggested that Random effects should be used, except for the
case of competition policy where there appear to be significant country effects.
These country effects include factors that are typically slow to change such as ethno-
linguistic, cultural, and geographic characteristics that have been regarded as
significant in the related literature of multinational banking. Their interaction with the
progress of transition in general and with the adopted competition policies in specific,
appears to be significant in co-determining the levels of foreign ownership in
banking. Instead, there is no meaningful correlation with the rest of the reform
variables once the differences between CIS and non CIS, European TEs are taken
into account.

The similarities within those two broad groups of countries as well as the
differences between them are already controlled for with the inclusion of cisi in Eq 1.
However, country effects are individualized when the general speed of transition is
regarded. The significance of country effects in the specification encompassing
competition policies is more difficult to explain. Perhaps there are country specific
aspects such as generally accepted norms or established practices regarding
competition –for example informal institutions and networks in support of a
coordinated market economy - that together with competition legislation can have an
impact on foreign bank participation. With each estimation method, the significance
level of competition does not change much. Competition remains insignificant in a
level above 20%.What changes is the level of significance of bank concentration
which is at 8.7% with fixed effects, while it has a statistically insignificant (11.1%)
effect with the random effects method.

Table 6.9 provides the results after correctly specifying the method to
estimate each model. A first broad conclusion is that market considerations have
been of secondary importance for foreign banks who acquired majority control of
banking institutions in TEs. Market size and to a less extent the depth of the financial
system have been of secondary importance in their investment decisions. This result
is not at odds with previous studies that have also rejected the market opportunities
hypothesis in TEs. The openness of a TE to international trade on the other hand,
seems to explain at a significant degree this country’s ratio of foreign owned to total
bank assets, thus providing some evidence for the “follow the customer” hypothesis.
The invariably significant effect of a time trend, while taking regard of the secondary
importance of market considerations, can be explained by the motivation of foreign
banks to swiftly acquire strategic market shares in the local banking market. Once
the underdeveloped banking markets in TEs opened up to foreign investments,
foreign banks may have rushed in to establish their presence. This decision was
depended more on their capacity –as large banking institutions originating from
developed countries have been the main investors in TEs- as well as on hoarding
behaviour, competition and strategic interaction between them. If anything, less
developed financial systems attracted more foreign banks as the significant effect of
quasi2gdp in some models is indicating.

Bank concentration in the host country has been particularly regarded in the
investment decisions of foreign banks. More concentrated markets receive higher
shares of foreign owned banks. This result puts in perspective the market power
hypothesis put forward by Lanine and Vennet (2007) in their empirical investigation
of the microeconomic determinants of the acquisition of Eastern European banks.
According to this hypothesis, foreign banks target large domestic banks with the
objective to build up market power without improving the efficiency of the acquired
banks. On the other hand, under the efficiency hypothesis, foreign banks would
target smaller, inefficient banks in order to upgrade their efficiency with the transfer
of their superior technologies and management practices and in order to utilize
unexploited profit opportunities. The results of Lanine and Vennet (2007) indicate
that large Western European banks have targeted relatively large and efficient
Central and Eastern European (CEE) banks with an established presence in their
local retail banking markets and found no evidence that cross-border bank
acquisitions in CEE are driven by efficiency motivations. To the extend that foreign
banks adopt “cream-skimming” strategies when they enter in TEs, with the
acquisition of better performing institutions with high shares in the domestic market,
the benefits that are expected to accrue for the overall efficiency of the domestic
banking sector by the entry of foreign banks are certainly limited.

The models in table 6.9 indicate that it makes a big difference if a country
belongs to the CIS countries which are projected to receive significantly less foreign
bank shares than non CIS countries. As it was discussed, besides of the broad
cultural, legal and historical differences between those two country groups, they
have engaged at different degrees to a commitment about future policy reforms. Non
CIS countries are members or candidate members of the EU, a much stronger
association of countries that obey to a certain set of rules. The CIS is a more loose
association that does not oblige its members to undertake specific reforms. The
status of membership or probable membership in the EU signals commitment to
certain market oriented institutions that make reforms on behalf of TEs credible,
even though country specific characteristics co-determine the effect of institutional
reforms in general. Taking this difference into account, the level of modern
infrastructure in the host country does not seem to display a critical role in the
investment decisions of foreign banks. Their entry does not seem to have been
motivated by their superior capacity to offer sophisticated and specialized banking
services, neither have they chosen locations where better infrastructure could
minimize the cost of their internal or external operations. The host country’s risk
stemming either from foreign exchange and banking system fragility (installed in
m2reserves) or macroeconomic stability (installed in inflation) also seem to have
been of secondary importance in most specifications.
 Table 6.9: Correctly specified models12
Variable FE1 RE2 POLS3 RE4 RE5 RE6 RE7 RE8 FE9

-62.41
-39.85 -.052 -1.72 0.27 -0.78 0.82 1.58 1.11
logpop
(141.46
(11.9) (2.76) (1.68) (3.10) (3.13) (2.84) (2.5) (3.05)
)

-2.53 -2.43 -2.40 -2.45 -3.12* -2.52** -1.96

-2.45 -2.23
loginfl
(2.08) (2.22)
(1.75) (2.29) (2.13) (2.11) (1.67) (2.24) (2.35)

0.04 0.20** 0.17** 0.21*** 0.15** 0.20*** 0.43**

0.42** 0.17**
trade
(0.16) (0.08)
(0.05) (0.09) (0.08) (0.08) (0.07) (0.07) (0.18)

-0.38** -0.35 -0.27 -0.33 -0.42 -0.37* -0.46

-0.46 -0.38
quasi2gdp
(0.34) (0.25)
(0.14) (0.26) (0.28) (0.23) (0.26) (0.23) (0.34)

0.95 -1.66 -1.05 -0.37 -2.60* -1.16 -2.82

-2.23 -1.07
m2reserves
(1.98) (1.79)
(1.87) (1.87) (1.81) (1.61) (1.48) (1.76) (2.21)

0.30* 0.28** 0.29 0.30* 0.29* 0.25 0.28 0.35*

concentrati 0.35*
on (0.19)
(0.17) (0.11) (0.18) (0.18) (0.17) (0.16) (0.17) (0.19)

-0.05 0.02 -0.18 -0.02 -0.09 0.03 -0.21

-0.22 0.04
internet
(0.24) (0.28)
(0.23) (0.29) (0.31) (0.26) (0.26) (0.27) (0.30)

2.38** 3.78*** 3.56*** 3.77*** 3.58*** 3.56*** 3.43*** 3.20***

3.21***
t
(1.20)
(1.03) (0.87) (1.23) (1.23) (1.06) (1.14) (1.11) 1.23)

-32.64*** -30.50*** -39.98*** -26.94*** -34.57*** -34.69*** -37.35***

cis - -
(9.04) (4.96 (8.79) (8.18) (7.01) (6.68) (8.33)

13.81***
reform
(3.79)

6.60***
privatization
(2.45)

14.29***
largescale
(3.70)

4.82
smallscale
(5.76)

12 FE=Fixed Effects method followed

POLS=Pooled OLS method followed
RE=Random Effects method followed
 17.24***
enterestruct
(4.94)

20.61***
pricelib
(6.32)

0.51***
financialib
(0.11)

6.89**
forex
(2.81)

14.10
competition
(10.75)

611.02 7.11 -26.8 -13.87 -26.80 -95.38 -32.78 -36.03 938.38

constant
(192.3) (54.79) (47.88) (71.06) (59.00) (66.51) (53.22) (65.31) 2268.9

R2 0.41 0.71 0.74 0.68 0.69 0.71 0.73 0.69 0.25

The reform variables on the other hand are together and individually
significant, except of competition policies and small scale privatization. The results
presented in table 6.9 raise concerns about the case that foreign bank entry reduces
the access of SMEs13 to bank credit. Foreign banks are attracted more by
privatization policies, when they concern large enterprises. This is taken as evidence
that foreign banks focus primarily on serving their financial needs instead of those of
SMEs. The results obtained in this paper add to the related academic debate with
the rejection of Hypothesis 3. They are more consistent with the results of Brown and
Maurer (2005) who from a sample of nearly 6000 firms in 26 countries of Eastern
Europe and the former Soviet Union found that larger asset shares for foreign owned
banks enhance the availability of credit for larger firms but make access to credit for
SMEs more difficult, especially in a poor legal environment. Theses results raise
serious concerns about the perceived benefits from the presence of foreign banks to
the efficient allocation of credit in TEs. Even if foreign entry results in more stable
and efficient financial systems, the new financial structure is not providing the
optimal answer to the real sector demands if access to credit by SMEs - which are
more dynamic than large firms in TEs (Brown and Maurer, 2005) - is restricted.

13 Small and Medium sized Enterprises

However, it is the creation and the development of SMEs that can generate the
highest gains in TEs – as in other parts of the developing world – in terms of
employment, poverty alleviation, innovation and ultimately economic growth
(Ayyagari et al., 2002).

The insignificant effect of competition policies may be explained by the

banks preference to oligopolistic markets. It seems that this preference makes banks
more willing to accept practices of market power abuse, unrestricted formation of
dominant conglomerates and restrictions to new bank entries. This should be a
source of concern for the host country’s policy makers as it may be taken as an
indication that foreign banks are interested to earn rents by the imperfections of
competition policies. This is not the same as saying that foreign banks are attracted
by those imperfections, however it is easy to imagine of cases where foreign banks
processing dominant market shares may “tolerate” such situations. Moreover, there
is some consistency with the results obtained for the case of small scale
privatization. As progress in competition policies is determined by the promotion of a
competitive environment in the whole of the economy, foreign bank shares are not
as affected as they would have if they focused equally on serving the financial needs
of SMEs. However, the development of SMEs is adversely affected by the
inefficiencies in this dimension of institutional reform. This is the indirect effect of
competition policies on foreign bank asset shares

Not surprisingly, price liberalization and financial liberalization have a

significant positive impact on the foreign banks’ asset share. The later variable has
by far the most significant impact and is the playground for policy reforms that can
boost banking FDI. Financial liberalization is measured on a scale from 0 to 100 and
the results indicate that a 10 units increase in the score of this index which is the
usual unit of change, will result in a 5.1 pp increase in the dependent variable. In
order to facilitate comparisons with the rest institutional variables that range from 1 to
4.33 it is mentioned that a 25 units increase in financial liberalization will result to a
change in the foreign banks asset share by almost 13 pp. The marginal effects of
each explanatory institutional variable are not to be taken literally as they are merely
indicators for the transition process in each particular institutional dimension.
However, they offer for comparing the effect of institutional variables measured on
the same scale. All that can be said for financial liberalization is that - as predicted -
greater independence of the financial system from government control can enhance
the potential for FDI in the banking sector of TEs.

The liberalization of the trade and foreign exchange system has also a
significant effect at a level below 5%. A one unit increase in this index of institutional
reform can increase the dependent variable by 6.1 percentage points. Trade and
forex are not correlated almost at all in the sample (Pair wise correlation is only
0.041). However, since they are conceptually similar, Model 7 in table 6.9 is also
estimated with only one of those variables. The Hausman test still sponsors the
Random Effects method while forex looses its significance when trade is not
incorporated in the model. Trade on the other hand gains significance when included
alone. Given that the two variables are conceptually but not statistically related they
are included together in model 7 of table 6.9 where they are individually and together
very statistically significant. The magnitude of the forex effect receives the following
interpretation: Holding all other factors fixed in Model 7– and thus the current levels
of international trade - a one unit increase in the EBRD index of trade and foreign
exchange system will increase the asset share of foreign owned banks by 6.89 pp.

Finally, governance and enterprise restructuring has statistically and

economically a significant effect. This is very natural since this dimension of
institutional reform represents the outcome of different reform policies. Assisted by
the hardening of budget constraints, the effective enforcement of bankruptcy
legislation and the strengthening of competition, the rest of the reform variables
combine to promote corporate governance and enterprise restructuring. By including
it as a separate variable in Equation 1, we assume that the degree of foreign
ownership in the banking sector does not have a causal impact on enterestruct. It is
recognized however that this assumption is somehow strong as in many cases the
reason for allowing foreign bank entry has been was to help in the restructuring
process. Having stressed that concern, enterestruct will continue to be treated as
exogenous. That assumption is justified by the definition of this institutional variable,
which incorporates government restructuring and central government policies that
accommodate enterprise restructuring14, and by the fact that progress in this index
score is determined more by the progress in the rest of the reform variables.
Therefore its inclusion in Eq. 1 is not expected to cause any serious biasness in the

14 Appendix 3b
 results15. The bottom line is that policies directed towards governance and enterprise
restructuring can significantly improve foreign owned bank shares. Holding all other
factors fixed, a one unit increase in the score of this index can increase assetshare
by as much as 17.24 pp.

6.3 Institutional Quality

In order to depict aspects of the reform in informal institutional arrangements
that may have an impact on the foreign banks asset share, the above exercise is
repeated for the case of the institutional quality variables. The general model that is
estimated regards the effect of general as well specific aspects embedded in the
quality of institutions that can affect the asset share of foreign owned banks in TEs.

Equation 2:

foreignassetit=
β0+β1logpopit+β2loginflit+β3quasi2gdpit+β4tradeit+β5m2reservesit+β6concentrati
onit+ β7internetit+ β8cisi+β9INSTQUALITYit+t+νit

Lower institutional quality, represented both in the aggregated index as well

as in each disaggregated measure, is expected to constitute a barrier to the
formation of strong market shares for foreign owned banks. This prediction is based
on previous empirical work and on the hypothesis that foreign banks may find it more
difficult than domestic banks to deal with host country’s regulations, bureaucracy, the
local judicial system, domestic violence and corruption. As with Eq. 1, Equation 2 is
estimated with Least Squares methods where in place of INSTQUALITYit a variable
of institutional quality is included one at a time in order to avoid problems with
multicollinearity. The results presented in table 6.1 0reveal the similarities as well as
the differences between different estimation methods in the estimation of Eq. 2. The
only variables that retain their significance at a level below 10% are loginflit ,
instqualityit and the linear time trend t. Institutional quality has unambiguously a

15 Lagged values of enterestruct are alternatively included in the model without

significant differences
positive effect as it remains significant in all models at a level below 5%. However,
depending on the estimation method used we can reach different conclusions about
the significance of the rest explanatory variables, except for the effect of logpopit ,
m2reservesit and internetit which are in each case insignificant.

Table 6.10: Institutional Quality

Variable Pooled OLS Random Effects Fixed Effects

-2.13 -0.34 1.41
logpop
(2.36) (3.38) (109.24)
-3.78** -3.36* -3.67*
loginfl
(1.61) (1.77) (1.89)
0.001 0.12 0.38**
trade
(0.08) (0.10) (.15)
-0.08 -0.37* -0.55*
quasi2gdp
(0.18) (0.25) (0.30)
-2.35 -1.95 -2.40
m2reserves
(1.94) (2.05) (1.93)
0.35** 0.31* 0.21
concentration
(0.15) (0.17) (0.14)
-0.21 -0.21 -0.06
internet
(0.28) (0.31) (0.25)
-22.95** -18.29
cis -
(9.87) (16.35)
4.22*** 4.05*** 2.49*
t
(1.17) (1.37) (1.24)
instquality 5.99** 8.69** 16.62***
 (2.78) (3.85) (4.74)
47.70 8.89 -35.30
constant
(42.83) (64.20) (1749.45)

R2 0.59
R2 within 0.55 0.59
.73
R2 between 0.71 0.56
R2 overal 0.70 0.55

One problem with this model specification is the high correlation between
cisi and INSTQUALITYit and that regardless of the of the individual institutional
quality measure used to estimate Eq. 2. It seems that CIS countries have lower
institutional quality, whether that corresponds to the rule of law, control of corruption
or any other measurable institutional variable. There are not really many ways to
deal with this potential problem but to be careful about its effects on the estimation
results. Multicollinearity inflates the standard errors of the coefficient estimates which
make more difficult the inference of their significance. That explains the
insignificance of many of the variables included in the model. However, even
extreme multicollinearity (so long as it is not perfect) does not violate the OLS
assumptions even though it will lead to less efficient estimators. Omitting the dummy
cis from Eq. 2 in order to avoid problems with multicollinearity can result to omitted
variables bias which is of much greater importance for the reliability of the results. A
Hausman test indicated that the Random Effects method is more appropriate for
estimating Eq. 2 so attention is paid on the results obtained with this method. The
standard errors reported in Table 6.10 are robust to heteroskedasticity and
autocorrelation which are both present in any of the model specifications that follow.
The results are somewhat different than the results obtained with fixed effects for
estimating the effect of reformit .

The effect of concentrationit , instqualityit and the time trend (t) remain
significant. However, the coefficient of trade looses its significance in contrast with
the coefficient of loginflit which now becomes significant at a 5.8% level. Countries
that pursue macroeconomic policies consistent with lower levels of inflation will
receive higher share of foreign banks. Its economic impact is also significant. .
Holding all other factors fixed a 1 % increase in the rate of inflation results in 0.034
pp decline in the asset share of foreign owned banks. An increase in inflation at
double levels from its current rate will reduce foreign bank shares by 3.4pp. The
magnitude of the trend informs that the average share of foreign owned banks will
increase by 4.05pp each year for factors not controlled for in the model which is
economically a very significant result. Foreign banks seem once again to be
attracted by oligopolistic markets as the coefficient of concentrationit informs that a
1pp increase in bank concentration will result – ceteris paribus- to a 0.31pp increase
in the asset share of foreign banks. The effect of institutional quality is statistically
significant at a 2.4% level and the model predicts that a 1 unit increase in this
aggregated index of institutional quality will lead ceteris paribus to a 8.69pp increase
in the dependent variable.

Having established the significance of institutional quality in the host country

for FDI inflows in the banking sector, we turn to its specific aspects that may impact
with the investment decisions of foreign banks. Their effect is estimated with the
random effects method which is more appropriate for examining the effect of specific
informal institutions. That holds for all of the individual variables, except for the Rule
of Law index where the Hausman test indicated that it should be estimated in fixed
effects. As in the case with the reform variable and competition, there appear to be
significant country specific fixed effects that are correlated with the rhs variables in
Eq 2 when ruleoflaw is included in the regressions and co-determine their impact.
The Rule of Law is expected to have the largest effect on foreign bank entry as the
value of the property rights system or the value of the judicial system which
correspond to the components of this indicator are of great importance in banking.

This expectation is confirmed by the results in table 6.11 where the results
are reported with the estimation methods chosen by respective Hausman tests.
Heteroskedasticity and autocorrelation were present in all regressions, therefore the
table presents the results with clustered standard errors. In interpreting the results
one should pay attention to the potential problems caused by the high correlation of
cis with the institutional variables. The large standard errors reported make difficult to
uncover the partial effect of each variable. However, cis is not dropped in any of the
random effects models since it is jointly significant with any of the institutional
reforms variables in all models. A country’s membership to an organization such as
 the EU or the CIS together with the level of it’s institutional quality are jointly highly
significant for explaining the observed levels of foreign bank ownership16.

Table 6.11: Correctly specified models

Variable RE_1 RE_2 RE_3 RE_4 RE_5 FE_6 RE_7

-0.34 -1.36 -0.90 -0.79 0.38 -16.16 -0.46

logpop
( 3.3) (3.05) (3.13) (2.90) (2.87) (117.29) (2.99)

-3.36* -3.49** -3.00 -3.12* -3.00 -4.30* -2.95

loginfl
( 1.77) (1.68) (2.16) (1.87) (2.03) (2.15) (1.92)

0.12 0.08 0.15 0.12 0.12 0.41** 0.12

trade
(0.10) (0.09) (0.09) (0.09) (0.08) (0.18) (0.10)

-0.37 -0.37* -0.36* -0.33* -0.26 -0.70** -0.39*

quasi2gdp
(0.25) (0.23) (0.23) (0.23) (0.25) (0.31) (0.23)

-1.95 -1.81 -2.32 -2.15 -1.33 -2.20 -2.13

m2reserves
(2.05) (1.61) (2.04) (2.10) (1.90) (2.16) (2.10)

0.31* 0.34** 0.27 0.30* 0.34* 0.24 0.30*

concentration
(0.17) (0.15) (0.17) (0.17) (0.17) (0.17) (0.16)

-0.21 -0.22 -0.07 -0.15 -0.18 -0.23 -0.15

internet
(0.31) (0.29) (0.32) (0.33) (0.31) (0.27) (0.31)

-18.2 -0.66 -43.74*** -29.48*** -25.81*** -31.18***

cis (omitted)
(16.35) (11.22) (9.64) (10.12) (9.74) (11.94)

4.05*** 4.62*** 3.90*** 3.94*** 3.78*** 3.59*** 4.03***

t
(1.37) (1.29) (1.41) (1.45) (1.30) (1.25) (1.31)

8.69**
instquality
(3.85)

32.22***
voiceaccount
(5.66)

politstabil 3.38

16 In any case the exclusion of cis from the model does not change the significance of the
institutional variables. It remains the same. However, this approach is not suggested as it may lead to
biased estimates due to the exclusion of an important explanatory variable.
 (6.77)

17.98**
goveff
(7.692)

16.36***
regqual
(6.02)

39.40***
ruleoflaw
(12.72)

17.37*
controlcorr
(9.88)

8.89 16.97 33.1 26.97 -.74 254.83 27.21

_cons
(64.2) (59.44) (59.35) (57.31) (58.11) (1879.32) (56.84)

R2 within 0.55 0.59 0.51 0.53 0.53 0.57 0.53

R2 between 0.71 0.78 0.69 0.73 0.75 0.40 0.71

R2 overal 0.70 0.74 0.68 0.71 0.72 0.48 0.70

The coefficients of all the institutional quality variables are statistically very
significant. The highest gains for TEs in terms of greater volume of banking FDI is
expected to accrue from improvements in the rule of law index. Holding all other
factors fixed in the model, a one unit increase in the score of this index is expected
to generate as high as 39 pp larger foreign shares in the banking sector. This is
consistent with the banks caring about contracts enforcement in the host country, a
point which was stressed earlier by Clarke et al (1998) and Focarelli and Pozzolo
(2005). The next in line largest effect is expected from improvements in the voice
and accountability index, where a unit increase can add 32.22 pp in the relative
asset share of foreign banks. This effect may be explained by the fact that foreign
banks have more troubles in interpreting local information and higher transparency
will be especially beneficial for them. Moreover it has been repeatedly demonstrated
that democratic institutions provide stronger protection of property rights, increase
the transparency of the political system, help firms to better predict future policy
changes and provide foreign investors with the ability to legally lobby the government
for favourable policy changes.
 The control of corruption is regarded as significant for foreign banks who are
interested to invest in TEs as it influences the cost efficiency of foreign banks by
lowering the costs of bribing. This finding agrees with a previous study of Voinea and
Mihaescu (2006) for TEs. Finally, government effectiveness and regulatory quality
also have a significant impact, with a one unit increase in the score of theses indices
leading to an increase in the foreign banks asset share by 17.8 and 16.3 percentage
points respectively. This results follow the fact that foreign banks face more
difficulties in dealing with foreign bureaucracy and regulations –especially the quality
of banking supervision - are in position to change the costs and the risk faced by
foreign banks with operating in a foreign country The only variable that has an
insignificant impact is the political stability and absence of violence index. This
finding is surprising, given that the absence of violence in the host country may lower
security costs for foreign banks and political stability can significantly reduce the
political risk for foreign banks. In the absence of any guidance from empirical results
regarding this relation, the conclusion is that further research is required on the
issue.
CHAPTER 7
7. CONCLUSIONS

T
he rising shares of foreign ownership in the banking sector of Transition
Economies observed in the years from 1995 to 2008 do not have an easy
interpretation. There are many factors that may have powered this trend that
are not easily captured in a unified model. On the one hand the researcher may look
for possible explanations for this development in the traditional determinants of
banking sector FDI. The economic environment, features of the banking system,
transaction costs and the regulatory environment in the host countries, have the
potential of becoming a major attraction for foreign banks. However, they alone do
not seem to provide convincing evidence that they have been the determining factors
for the exceptionally large shares of foreign ownership in the banking sector of many
TEs. Otherwise, similar levels of foreign ownership would have been observed
elsewhere. That shifts the research interest to factors that are specific to TEs. The
transition itself has been creating an economic, institutional and political environment
that favoured private initiatives, greater openness and generated demand for
investments in the new economic architecture that was bound to emerge from the
replacement of socialistic with market oriented institutions.

This paper provides some preliminary evidence that reforms have been the
main attraction for foreign banks and the crucial “missing link” for the observed
pattern of the foreign banks expansion to TEs. However, not all aspects of the
transition process weighted equally in the investment decisions of foreign banks.
Empirical evidence provides support to the hypotheses that privatization, price
liberalization, financial liberalization and the liberalization of the trade and foreign
exchange system have a profound impact on the total market share of foreign owned
banks. However, it was the progress in large scale privatization that has been the
major attraction for foreign banks rather than the privatization of Small and Medium
sized Enterprises. This finding provides support to the notion that as foreign banks
focus on serving large corporate customers, they may restrict the availability of credit
to SMEs. The validity of this argument can have further repercussions for the
economies in transition as their growth prospects are dependent on the development
of SMEs.

Moreover, concerns can be expressed for the insignificant effect of prudent

competition policies on the foreign bank asset shares. The later seem to evolve
independently of policies that aim to secure conditions of fair competition and are
moreover positively and significantly related with more concentrated banking sectors.
That mixture should be a source of concern as it supports the argument that foreign
banks acquire large market shares in countries where it is easier for them to abuse
their dominant position. In that case the expected benefits for the local economy
related with increased foreign ownership in the banking sector, like for example
improvements in the efficiency of the local banking system, diminish severely.

Finally, the present study provides additional evidence that the quality of
institutions in TEs is significant for determining FDI in banking. Increased
government effectiveness, regulatory quality and importantly the rule of law, greater
levels of transparency in the political system and less corruption ensure a welcoming
environment for FDI in the banking sector of TEs. Political stability and the absence
of violence on the other hand are not a prerequisite for the development of significant
shares of foreign ownership in the banking sector. In any case, the effects of formal
and informal institutions are supportive in the sense that the efficiency of one
institution depends on the efficiency of others. Taken together, reform policies and
the quality of institutions are in general very significant for explaining the rising,
though variable shares of foreign bank ownership in transition countries.
 LITERATURE

Backe P. and T. Zumer. (2005) “Developments in Credit to the Private Sector in Central and
Eastern European EU Member States: Emerging from Financial Repression — A
Comparative Overview.” In: Focus on European Economic Integration 2/05. Vienna:
Oesterreichische Nationalbank.
Berger, Allen N., Qinglei Dai, Steven Ongena, and David C. Smith, (2003), “To what extent
will the banking industry be globalized? A study of bank nationality and reach in 20 European
nations”, Journal of Banking and Finance 27, 383-415.
Bevan A., Estrin S., Meyer K. (2004), “The determinants of foreign direct investment into
European transition economies”, Journal of Comparative Economics, Volume 32, Issue 4,
Pages 775-787
Bevan A., Estrin S., Meyer K. ,(2004), “Foreign investment location and institutional
development in transition economies”, International Business Review , Volume 13, Issue 1,
Pages 43-64
BIS (2004) “Foreign direct investment in the financial sector of emerging market economies.”
Report submitted by a Working Group established by the Committee on the Global Financial
System.
Bonin J. P., Hasan I., Wachtel P. (2008), “Banking in Transition Countries”, BOFIT Discussion
Paper No. 12/2008, Bank of Finland.
Bonin J. P., Hasan I., Wachtel P., (2005) “Bank performance, efficiency and ownership in
transition countries”
Bonin J. P., Wachtel P. (2004), “Dealing with financial fragility in transition economies”,
Systemic financial crises: resolving large bank insolvencies, World Scientific, pg 141-156
Brealey R.A. and Kaplanis E.C. (1996), “The determination of foreign banking location”,
Journal of International ?Money and Finance, Vol. 15, No. 4, pp. 557-597
Brown M., Maurer M. R., (2005), “Bank Ownership, Bank Competition, and Credit Access:
Firm-Level Evidence from Transition Countries”, Working paper, Swiss National Bank.
Buch C. M. (2000), “Why Do Banks Go Abroad?—Evidence from German Data”, Financial
Markets, Institutions & Instruments, Volume 9, Issue 1, pages 33–67, February 2000
Buch M. C. (2003), “What Drives the International Activities of Commercial Banks?” , Journal
of Money, Credit and Banking, Vol. 35, No. 6, Part 1, pp. 851-869
Campos, N. and Kinoshita, Y. (2008), “Foreign Direct Investment and Structural Reforms:
Evidence from Eastern Europe and Latin America”, IMF Working Paper No. 08/26,
International Monetary Fund, Washington.
Chavance B., Magnin E.,(2006), “Convergence and diversity in national trajectories” in “The
hardship of nations: exploring the paths of modern capitalism” By Benjamin Coriat, Pascal
Petit, Geneviève Schméder
Choi, C. (2003) “Does the Internet Stimulate Inward Foreign Direct Investment?”, Journal of
Policy Modeling 25: 319-26.
Claessens S., (1996), “Banking reform in Transition Countries”, Policy Research Working
Paper 1642, Background paper for World Development Report 1996
Claessens, S. and van Horen, N. (2007). “Location decisions of foreign banks and institutional
competitive advantage”, De Nederlandsche Bank Working Paper No.172/2008.
Clarke G. R., Cull R, Martinez Peria M.S., (2006), “Foreign bank participation and access to
credit across firms in developing countries”, Journal of Comparative Economics 34 (2006)
774–795
Clarke G., Cull R., Martinez Peria M. S. and. Sánchez S. M., “Foreign Bank Entry:
Experience, Implications for Developing Economies, and Agenda for Further Research”, The
World Bank Research Observer, vol. 18, no. 1 (2003), pp. 25-59
Cottarelli C., Dell’Ariccia G. and Vladkova-Hollar I.,(2005) “Early birds, late risers, and
sleeping beauties: Bank credit growth to the private sector in Central and Eastern Europe and
in the Balkans”, Journal of Banking & Finance, Volume 29, Issue 1, January 2005, pp 83-104
Daniel Kaufmann, Aart Kraay and Massimo Mastruzzi (2009). "Governance Matters VIII:
Governance Indicators for 1996-2008". World Bank Policy Research
De Haas R., Ferreira D., Taci A., (2009), “What determines the composition of banks’ loan
portfolios? Evidence from transition countries”, Journal of Banking & Finance 34, pp.388–398
De Haas, R.T.A., Naaborg, I.J., 2006. “Foreign banks in transition countries: To whom do they
lend and how are they financed?” Financial Markets, Institutions and Instruments 15, 159–
199.
Demirgüç-Kunt A., Levine R. and Min H (1998), “Opening to Foreign banks: Issues of
Stability, Efficiency, and Growth”, World Bank mimeo
Dopico L. G., Wilcox J. A.(2001), “Openness, profit opportunities and foreign banking” ,
Journal of International Financial Markets, Institutions and Money
Esperanca J. P., Gulamhussen M. A. “(Re)Testing the ‘follow the customer’ hypothesis in
multinational bank expansion”, Journal of Multinational Financial Management 11 (2001) 281–
293
Focarelli D., Pozzolo A.F.,(2001) “Where do banks expand abroad? An empirical analysis.”
Bank of Italy, Working Paper.
Galindo, A., A. Micco and C. Serra (2003). “Better the Devil that You Know: Evidence on
Entry Costs Faced by Foreign Banks”, IADB, Working Paper 477.
Godoy, S., Stiglitz J. E., (2006), “Growth, Initial Conditions, Law and Speed of
Privatization in Transition Countries: 11 Years Later”, Working Paper 11992, NBER.
Goldberg L. G. and Johnson A. ,(1990), “The determinants of US banking activity abroad”,
Journal of International Money and Finance, 9, 123-137
Goldberg, L.G. and Grosse, R. (1994) 'Location choice of foreign banks in the United States',
Journal of Economics and Business 46(5): 513-533.
Goldberg, Linda, 2004, “Financial-Sector Foreign Direct Investment and Host Countries: New
and Old Lessons,” NBER Working Paper No. 10441
Hall, P. A., & Soskice, D. (2001), “Varieties of capitalism: The institutional foundations of
comparative advantage.” Oxford University Press.
Harper J.T., McNulty J.E., “Legal origin, legal systems and bank lending to the private sector
in the former communist countries”
Hardle, W. and Simar, L. (2003), “Applied multivariate statistical analysis.”
Haselmann R., Pistor K., Vig V., (2005), “How law affects lending”, Working paper, Columbia
University.
Herrero, A., Simon, D. (2003) “Determinants and impact of financial sector FDI to emerging
economies: a home country’s perspective.” Banko de Espano.Report, parer №0308.
Jaffee D., Levonian M. ,(2001), “The Structure of Banking Systems in Developed and
Transition Economies”, European Financial Management, Volume 7, Issue 2, pages 161–181
Keren M., Ofer G. (2003), “Globalization and the Role of Foreign Banks in Economies in
Transition”, in Emerging market economies: Globalization and development, Ashgate
Publishing, Ltd.,
Knell, Mark and Martin Srholec (2006), “Emerging Varieties of Capitalism in Central and
Eastern Europe”. www.paisley.ac.uk/business/cces/documents/KnellSrholec.pdf
Lensink, R. and De Haan, J. (2002). ‘Do reforms in transition economies affect foreign bank
entry?’ International Review of Finance, 3, pp. 213–232.
Lanine G., Vennet R. V., (2007), “Microeconomic determinants of acquisitions of Eastern
European banks by Western European banks”, Economics of Transition, Volume 15(2) 2007,
285–308
Laeven, Luc and Fabian Valencia, 2008, “Systemic Banking Crises: A New Database”, IMF
Working Paper, WP/08/224
Meghana Ayyagari, Thorsten Beck and Asli Demirguc-Kunt (2002), “Small and Medium
Enterprises across the Globe: A New Database”, mimeo
Mathieson D. J. and Roldos J. (2001) “Foreign banks in emerging markets”, In: Open doors:
foreign participation in financial systems in developing countries, Brookings Institution Press
McDermott, G.A. (2004). “Institutional Change and Firm Creation in East-Central Europe. An
Embedded Politics Approach.”, Comparative Political Studies, 2: 188-217.
Miller S. R. and Parkhe A., (1998), “Patterns in the Expansion of U.S. Banks' Foreign
Operations” , Journal of International Business Studies, Vol. 29, No. 2 , pp. 359-389
Moshirian F., (2001), “International investment in financial services” Journal of Banking &
Finance, Volume 25, Issue 2, pp. 317-337
Mutinelli M. and Piscitello L. ,2000, “Foreign direct investment in the banking sector: the case
of Italian banks in the ’90s”, International Business Review 10 (2001) 661–685
North, D. (1994), “Economic performance through time.” The American Economic Review,
84(3), 359-368.
Papi L. and Revoltella D. (2000), “Foreign Direct Investment in the Banking Sector: A
Transitional Economy Perspective”, in Claessens, Stijn and Jansen, Marion : The
Internationalization of Financial Services .Issues and Lessons for Developing Countries
(Kluwer Law International: The Hague, 437-457).
Pistor, K., M. Raiser and S. Gelfer, (2000), ‘Law and Finance in Transition Economies,’
Economics of Transition, 8_2_, pp. 325-368.
Pozzolo, Alberto Franco, (2008), "Bank Cross-Border Merger and Acquisitions (Causes,
Consequences and Recent Trends)" , Economics & Statistics Discussion Papers esdp08048,
University of Molise, Dept. SEGeS
Seth, R., Nolle D.E., Mohanty S.K., (1998), “Do Banks Follow Their Customers Abroad?”,
Financial Markets, Institutions, and Instruments 7: 1–25.
Shen, Chung-Hua and Mei-Rong Lin (2007), “The Determinants of Cross-Border Merger and
Acquisition Activity in the Financial Sector in Asia: Did the Asian Financial Crisis Change
Them?” Working paper, National Taiwan University.
Sherif K., Borish M. S., Gross A., (2003), “State-owned banks in the transition: origins,
evolution, and policy responses”, World Bank Publications
Simpson J., (2002), “The impact of the Internet in banking: observations and evidence from
developed and emerging markets”, Banking and Finance, Curtin University of Technology
Soussa , F. ,(2003), “ A Note on Banking FDI in Emerging Markets: Literature Review and
Evidence from M&A Data.” Preliminary Draft. Bank of England.
Tsahelnik I. (2006). ‘Foreign Bank Entry in CIS Countries’, MA Thesis, National University of
“Kyiv-Mohyla Academy”, Economics Education and Research Consortuim.
Uiboupin J. and M. Sorg, (2006), “The Entry of Foreign Banks into Emerging Markets: An
Application of the Eclectic Theory”, EMS
Voinea L., Mihaescu F. (2006) “The Determinants of Foreign Banking Activity in South East
Europe: Do FDI, Bilateral Trade and EU Policies Matter?” Global Development Network
Southeast Europe
Wezel, T.,( 2004). “Foreign bank entry into emerging economies: An empirical assessment of
the determinants and risks predicated on German FDI Data.” Deutsche Bundesbank
Discussion Paper – Series 1 01/2004.
Williams B. (1997), “Positive Theories of Multinational Banking: Eclectic Theory Versus
Internalisation Theory”, Journal of Economic Surveys, Volume 11, Issue 1, pages 71–100,
March 1997
Yamori N. (1998), “A note on the location choice of multinational banks: The case of
Japanese financial institutions”, Journal of Banking & Finance 22 , pp.109-120
Zoli E., (2001), “Cost and Effectiveness of Banking Sector Restructuring in Transition
Economies”, IMF Working Paper 01/157, October 2001.

APPENTICES

Appendix 1: Difference in the dependent variable between CIS and non-CIS

 cis | N mean sd min max
0 | 131 64.37634 27.77978 0 99.4
1 | 125 26.1176 22.79693 0.7 90.8
Total | 256 45.69531 31.83248 0 99.4

Appendix 2: Summary statistics

Variable Obs Mean Std. Dev. Min Max

logpop 308 15.94816 1.080669 14.10868 18.81367
loginfl 303 2.337523 1.380337 -2.99537 6.964489
trade 308 101.3047 34.26105 36.55481 199.6796
quasi2gdp 281 17.24034 12.62485 1.172106 54.4238
m2reserves 278 2.337195 1.297778 .0000329 8.569061
concentration 260 71.30064 18.02269 14.00598 100
internet 293 11.79618 16.27239 0 66.21
t 308 7.5 4.037689 1 14
cis 308 0.545454 0.498739 0 1
reform 287 7.60e-09 2.140443 -5.591146 3.456065
instquality 220 -1.35e-09 2.316815 -4.312807 3.99554

Appendix 3: Variable definitions and sources

a) Control variables

Variable Definition Source

Money and quasi money comprise the

sum of currency outside banks,
demand deposits other than those of
the central government, and the time,
Money and savings, and foreign currency deposits
quasi money of resident sectors other than the World Development
m2reserves
(M2) to total central government. Total reserves Indicators
reserves ratio comprise holdings of monetary gold,
special drawing rights, reserves of IMF
members held by the IMF, and holdings
of foreign exchange under the control of
monetary authorities.

Ratio of
Quasi money refers to time, savings,
Quasi money
and foreign currency deposits of World Development
quasi2gdp (current LCU)
resident sectors other than the central Indicators
to GDP
government
(current LCU)
 Ratio of non-performing loans to total
Non- loans. Non-performing loans include
performing sub-standard, doubtful and loss
badloans loans (in per classification categories of loans, but EBRD
cent of total excludes loans transferred to a state
loans) rehabilitation agency or consolidation
bank, end-of-year.

Privatization
revenues Government revenues from cash sales
privrev (cumulative, of enterprises, not including investment EBRD
in per cent of commitments.
GDP)

Asset share
Share of total bank sector assets in
of foreign-
assetshare banks with foreign ownership EBRD
owned banks
exceeding 50 per cent, end-of-year.
(in per cent)

Financial Structure
Database by Beck and
Assets of three largest banks as a share of assets of all
concentration Demirgüç-Kunt
commercial banks.
(siteresources.worldbank.
org/INTRES/Resources/Fi
nStructure_2008_v4.xls)

Inflation, consumer prices (annual %) World Development

Inflation
Indicators

privatesharegd Private sector share in GDP (in per cent)

EBRD
p

Trade (% of GDP) World Development

trade
Indicators

United Nations Millennium

internet Internet users per 100 population Development Goals
Indicators

Population, total World Development

population
Indicators

b)
Institutional Reform Variables Definition
Transition indicators provided by the EBRD except for Financial Freedom (Heritage Foundation)

Variable Definition
1 Little private ownership.

2 Comprehensive scheme almost ready for implementation; some sales

completed.

3 More than 25 per cent of large-scale enterprise assets in private hands or in the
process of being privatised (with the process having reached a stage at which the
Large state has effectively ceded its ownership rights), but possibly with major
unresolved issues regarding corporate governance.
Scale
4 More than 50 per cent of state-owned enterprise and farm assets in private
ownership and significant progress with corporate governance of these
Privatization enterprises.

4+ Standards and performance typical of advanced industrial economies: more

than 75 per cent of enterprise assets in private ownership with effective corporate
governance.

1Little progress.

Small 2 Substantial share privatised.

3 Comprehensive programme almost ready for implementation.

Scale
4 Complete privatisation of small companies with tradable ownership rights.
Privatization
4+ Standards and performance typical of advanced industrial economies: no
state ownership of small enterprises; effective tradability of land.

1 Soft budget constraints (lax credit and subsidy policies weakening financial
discipline at the enterprise level); few other reforms to promote corporate
governance.

Governance 2 Moderately tight credit and subsidy policy, but weak enforcement of bankruptcy
legislation and little action taken to strengthen competition and corporate
and enterprise governance.
restructuring
3 Significant and sustained actions to harden budget constraints and to promote
corporate governance effectively (for example, privatisation combined with tight
credit and subsidy policies and/or enforcement of bankruptcy legislation).

4+ Standards and performance typical of advanced industrial economies:

effective corporate control exercised through domestic financial institutions and
markets, fostering market-driven restructuring.

Price 1 Most prices formally controlled by the government.

liberalisation 2 Some lifting of price administration; state procurement at non-market prices for
the majority of product categories.

3 Significant progress on price liberalisation, but state procurement at non-market

prices remains substantial.

4 Comprehensive price liberalisation; state procurement at non-market prices

 largely phased out; only a small number of administered prices remain.

4+ Standards and performance typical of advanced industrial economies:

complete price liberalisation with no price control outside housing, transport and
natural monopolies.

1 Widespread import and/or export controls or very limited legitimate access to

foreign exchange.

2 Some liberalisation of import and/or export controls; almost full current account
convertibility in principle, but with a foreign exchange regime that is not fully
Trade and transparent (possibly with multiple exchange rates).
foreign 3 Removal of almost all quantitative and administrative import and export
exchange restrictions; almost full current account convertibility.

system 4 Removal of all quantitative and administrative import and export restrictions
(apart from agriculture) and all significant export tariffs; insignificant direct
involvement in exports and imports by ministries and state-owned trading
companies; no major non-uniformity of customs duties for non-agricultural goods
and services; full and current account convertibility.

4+ Standards and performance norms of advanced industrial economies:

removal of most tariff barriers; membership in WTO.

1 No competition legislation and institutions.

2 Competition policy legislation and institutions set up; some reduction of entry
Competition restrictions or enforcement action on dominant firms.
policy 3 Some enforcement actions to reduce abuse of market power and to promote a
competitive environment, including break-ups of dominant conglomerates;
substantial reduction of entry restrictions.

4+ Standards and performance typical of advanced industrial economies:

effective enforcement of competition policy; unrestricted entry to most markets.

Financial freedom is primarily a measure of independence from government

control. State ownership of banks and other financial institutions such as insurers
and capital markets reduces competition and generally lowers the level of
available services. The Index scores this component by determining the extent of
Financial
government regulation of financial services; the extent of state intervention in
Freedom
banks and other financial services; the difficulty of opening and operating
financial services firms (for both domestic and foreign individuals); and
government influence on the allocation of credit. This analysis is used to develop
a description of the country’s financial climate and assign an overall score on a
scale of 0 to 100.

c) Institutional Quality

Source: WGI, Kaufmann et al. (2009)

 Variable Definition
Reflects the perceptions of the degree to which the public
Control of corruption index
authorities utilize their power for extracting personal benefits.

Reflects the perceptions of public services’ value, the proficiency of

civil servants and the level of their resistance to pressures from the
Government effectiveness
political circles, as well as the value of the designed and executed
index government policies and the degree to which the government
officials adhere to them.

Reflects the perceptions of the possibility that the government

Political stability and
might be posed to a threat of destabilization through illegal actions
absence of violence index such as revolts, terrorism or other forms of violence.

Measures the extent to which countries’ residents trust

Rule of law index in and are willing to adhere to the established communal rules, as
well as the value of the property rights system, the judicial system,
the competence of the police authorities, etc.

Reflects the perceptions of the state authorities’ abilities to commit

Regulatory quality index to the creation and realization of reliable policies contributing to the
sustainable development of the private sector

Voice and accountability Reflects the perceptions of the degree to which the countries’
index residents are able to take part in the process of their governments’
selection as well as countries’ capability to provide unconstrained
environment for media, expression and association.

Appendix 4: Correlation Matrix of independent variables

| logpop loginfl trade quasi2 m2res concen internet t cis reform instquality
logpop | 1.0000

loginfl | 0.2659 1.0000

trade | -0.4285 -0.0195 1.0000

quasi2gdp | 0.0360 -0.1723 0.1962 1.0000

m2reserves | 0.1078 0.1697 0.1243 0.3247 1.0000

concentration | -0.5835 -0.0986 0.3201 -0.0876 0.1602 1.0000

internet | -0.2308 -0.2245 0.5496 0.2227 0.1147 0.1064 1.0000

t | -0.0470 -0.2204 0.1892 0.1769 -0.1330 -0.1441 0.5973 1.0000

cis | 0.2663 0.3160 -0.2985 -0.5676 -0.1702 -0.0939 -0.4785 0.0505 1.0000

reform | -0.2645 -0.4604 0.2749 0.3658 -0.1834 -0.0470 0.5670 0.2190 -0.7068 1.0000

instquality | -0.2591 -0.2968 0.4368 0.3815 0.0563 0.0313 0.6072 0.0208 -0.8593 0.8582 1.0000