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# **4. The Specific Benefits and Costs of Foreign Entry**

Openness to foreign entry is an important element in determining the degree of contestability in the financial system (Levine 1996 and Claessens and Glaessner, 1998). Entry policies for foreign financial institutions are determined by a variety of domestic regulations, some of which can be bound in international agreements such as the WTO Financial Services Agreement of December 1997. Table 3 presents a comparison of the degree to which some key countries have committed themselves under the Financial Services Agreement to permitting foreign commercial presence in the banking system and insurance sector (see further Qian, 1999). On this index (ranging from closed, 0, to 1, completely open), Japan and Argentina score the highest, 0.8, followed by Germany, US, and the UK. At the lower end of the spectrum are Chile, the Philippines and Thailand with a score of 0.2.

While liberal entry to foreign banks potentially lowers the franchise value of (domestic) banking institutions, empirical evidence suggests that foreign entry can provide important benefits to the domestic banking system. A study of 2,000 banks (of which 500 foreign) in 80 countries shows that larger ownership share of the banking system is associated with reduced profitability and lower overall expenses of domestically-owned banks (Claessens, DemirgucKunt, Huizinga 1998). These results suggest that foreign bank entry improve the fimctioning of national banking markets, with positive welfare implications for banking customers. Openness to foreign competition also puts additional pressure on domestic firms to improve their productivity and services, and allows firms access to foreign technologies and ideas to help them raise efficiency.<sup>2 2</sup> Argentina, Colombia, Hungary, Spain, Ireland, Portugal, and others both opened up internationally and deregulated rapidly domestically, and reaped substantial gains.<sup>23</sup> Moreover, cross-country experience indicates that increased foreign entry can bolster the framework for financial services provision: entry creates a constituency for improved regulation and supervision, better disclosure rules, and improvements in the framework for the provision of financial services. Openness also adds to the credibility of rules. EU-acceding countries, for example, consolidated their reform efforts and quickly aligned their regulatory regimes with those of the EU and other international best practice, while opening up to foreign entry (see Pastor, 1999 for the case of Spain).

Opening up to foreign competition need not imply that foreign banks will dominate. In the EU after the opening up of the systems to foreign competition, cross-border banking mergers and acquisitions were limited and the share of assets held by foreign-owned banks has not exceeded more than 15%-20% in many countries (Gardener et al. 1999.) And opening to foreign competition need not be complete to reap some of the benefits of foreign competition. Empirical work shows that it is the number of entrants which matters rather than their market share. This indicates that foreign banks affect local bank competition upon entry rather than after they have gained substantial market share.

Finally, from a stability point of view, it would be prudent to assure that there is sufficient diversity among foreign financial institutions in terms of their country of origin to avoid the risks

> 22 However, it should also be noted that there have also been cases of "bad" foreign bank entry, for example, the Bank of Credit and Commerce International, and Meridian banks.

> 23 For reviews of the Argentine, Colombian, Greece and Portugal country experiences: see respectively Clarke, Cull, D'Amato (1999); Honahan (1999); and Steiner, Barajas, Salazar (1999).