Regulations, foreign presence, and efficiency of local firms: A multiple country study in commercial banking

I analyze how regulations and institutions affect foreign bank presence and its effects on domestic bank efficiency. I study the effects of regulations and institutions on (1) the level of foreign bank presence and (2) the link between foreign bank presence and efficiency of local banks. I argue that a poor institutional environment that restrict healthy development of markets in general, and poor property rights protection and prevalence of corruption in particular, will make foreign investment less attractive, and limit the impact of foreign banks on local ones. Likewise, stricter regulations and bank supervision will result in less foreign investment and will dampen the efficiency-enhancing effects of foreign investment. However, if the local banks are already very efficient, the impact of foreign presence on efficiency will be minimal. Therefore, the efficiency-enhancing impact of foreign presence will be largest when regulations and institutions support markets rather than inhibit them, and there still is room for efficiency gains in local banks. I test these hypotheses in the global commercial banking industry, for the 1994--1999 period. Three key findings emerge. First, I find that regulations---activity restrictions to be specific---rather than institutions play a key role in determining the extent of foreign presence. Second, higher foreign bank presence reduces domestic bank margins, even after accounting for other factors. Third, the effect of foreign bank presence on domestic bank efficiency varies systematically across countries, but not always in the expected manner.