claim that domestic financial sector should be liberalized first, the other group of studies proposes that early capital account liberalization can initiate broader economic reforms.<sup>3</sup> The third question we focus on is whether the sequence of financial liberalization is important in determining the effects of foreign bank presence on the efficiency of domestic banks. First, we examine the issue by simply looking at the averages, and then we investigate the issue by pooled cross country regressions controlling for macroeconomic variables and health indicators of the domestic banking sector. In the literature, the linkages between the sequence of financial liberalization and domestic bank performance have not been examined by previous studies. Comparison of cross country experience on foreign bank entry taking into account the sequencing issue is crucial in drawing lessons for other countries, such as China, which is in the process of liberalizing their financial sectors including banks.

In order to accomplish the three objectives, we examine the financial liberalization process of 30 developed and developing countries, foreign bank entry into these countries, and the efficiency of domestic banks. Our panel data set is constructed for the period of 1995-2002 using bank-level data from The BANKSCOPE.

The descriptive analysis shows that the degree of openness to foreign bank entry varies a great deal, which is <u>not correlated</u> with average income levels or with GDP growth. When countries are grouped according to their sequence of financial liberalization (domestic financial markets first, or stock market first, or capital account first), the foreign bank shares in each group are almost the same. But this share is much higher for the Asian and Latin American countries which liberalized either their stock market first or their capital accounts first. Domestic banks’ net interest margin, non-interest income, overhead costs, and loan loss reserve get the lowest values in the countries which liberalized their stock markets first. This implies that the competition is the toughest in the banking sector of these countries.

Building on a model based on Claessens et al (1998), our pooled cross-country regression results indicate first, that changes in foreign bank share is not significantly associated with domestic banks’ performance when all countries are pooled together. Domestic banks’ performance is significantly associated with the equity asset ratio, the overhead cost ratio, and several macroeconomic factors. Thus, the efficiency gain of domestic banks with foreign bank entry is not statistically significant. Our results are largely consistent with results from Claessens et al (1998), even though they find some statistically significant domestic bank efficiency gains.

Second, the sequence of financial liberalization matters for the performance of domestic banking sector: After controlling for macroeconomic variables and grouping countries by their sequence of liberalization, foreign bank entry has significantly improved domestic bank competitiveness in countries which liberalized their stock market first. In these countries, both profit and cost indicators are negatively related to the share of foreign banks, indicating a more competitive environment. Countries which liberalized their capital account first seem to have benefited less from foreign bank entry as compared to the other two sets of countries, as the relationship between the performance indicators and the foreign bank share is the weakest in these countries.

The paper is organized as follows. Section 2 presents the literature review on the impact of foreign bank entry and the sequence of liberalization. Section 3 describes the empirical model and the data set. Section 4 reports some descriptive statistics. Section 5 presents econometric results. In the section 6, two case studies are provided on the Turkish and Chinese banking sectors. Section 7 concludes.

> 3 See Johnston (1998), and Johnston, Darbar, and Echeverria (1997) for details.

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