# **1. Introduction**

The opening of financial services and the structural reforms of domestic financial sector are two interwoven processes, both aimed at developing an efficient and competitive financial system to facilitate economic growth. The degree of financial liberalization and integration has risen significantly in the 1990s. In particular, foreign bank presence as measured by percentage in total bank assets in low income countries has increased from 19 percent in 1995 to 42 percent in 2000 (World Bank 2002). Along with the expanded participation in The General Agreement on Trade in Services (GATS), policymakers have come to realize that the presence of foreign financial service providers can benefit the consumers, the financial industry through learning-bydoing, and the economy through efficiency gains. However, foreign bank entry is not without risks especially if it is conducted in the absence of strengthening the institutional framework. More than trade in goods, the gains and costs of trade in financial services depend on many factors including the structural reforms in domestic financial sector, the regulatory framework as well as the sequencing of liberalization.

This paper takes a purely empirical approach by focusing on trade in the banking sector only. Country experiences seem to suggest that foreign bank presence can facilitate increased competition, improve allocation of credits, and help easier access to international capital markets.<sup>1</sup> But there are also costs associated with foreign bank entry. For example, if foreign banks attract the most profitable portion of domestic markets, this may give pressure to domestic banks, giving them an incentive for more risk taking.<sup>2</sup> Thus the evidence on the role of foreign banks in growth and stability is mixed. Therefore, our first step is asking naïve questions: how open countries are in terms of foreign bank entry/presence? Is the degree of openness in banking sector correlated to average income levels or economic growth or other factors? Are open countries more efficient and more competitive in their banking sectors and thus grow faster or vise versa? An indicator of banking sector openness is constructed using data from BANKSCOPE.

Second, we investigate how the performance of domestic banks changes with foreign bank entry. This issue has been investigated extensively in the literature. But our study is different in that it covers different countries for the period of 1995-2002. Thus, this paper will be useful to confirm the results of previous studies. Since the basic expected role of foreign banks is to increase competitiveness in the banking sector, we specifically try to answer the question of whether domestic banks become more competitive with lower profits, lower costs, and lower net interest margin as more foreign banks participate in their industry.

In the process of financial liberalization or integration, countries have chosen alternative paths: some have liberalized their domestic financial markets first, including the banking sector and stock market, or they may have liberalized their capital account first. Related to the order of financial liberalization, each country has their unique experience. Kaminsky and Schmukler (2003) show that most industrial countries have liberalized their stock markets first while most developing countries had a tendency to open their banking sector first. In the literature, there is no clear-cut solution to the financial liberalization sequencing problem. While some economists

> 1 Claessens, Demirguc-Kunt, and Huizinga (1998) study effects of foreign bank entry on efficiency of domestic banks.

> 2 See for example, Hellmann, Murdock and Stiglitz (2000), World Bank (2002), International Monetary Fund (2000).

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