1. _Introduction_

Recent years have seen an increased importance of international trade in goods and financial services. To facilitate such trade, many banking institutions have also become international.<sup>2</sup> Banks expand internationally by establishing foreign subsidiaries and branches or by taking over established foreign banks. The internationalization of the banking sector is facilitated by the liberalization of financial markets worldwide. Developed and developing countries alike now increasingly allow banks to be foreignowned.

Financial liberalization of this kind proceeds on the premise that the gains to domestic market participants from foreign entry outweigh any losses to domestic banking institutions. Several authors have addressed the potential benefits of foreign bank entry for the domestic economy in terms of better resource allocation and higher efficiency (see Levine (1996), Walter and Gray (1983), and Gelb and Sagari (1990)). Levine (1996) specifically mentions that foreign banks may (i) improve the quality and availability of financial services in the domestic financial market by increasing bank competition, and enabling the application of more modern banking skills and technology, (ii) serve to stimulate the development of the underlying bank supervisory and legal framework, and (iii) enhance a country's access to international capital.

As yet, little cross-country systematic evidence exists that these presumed benefits of an internationalization of the banking sector indeed materialize. The literature, however, contains several case studies of financial liberalization episodes. McFadden ( 1994) reviews foreign bank entry in Australia, and finds that this has lead to improved domestic bank operations. Bhattacharya (1993) reports specific cases in Pakistan, Turkey, and Korea, where foreign banks helped to make foreign capital accessible to fund domestic projects. Pigott (1986) describes the policies that have made increased foreign bank activity possible in nine Pacific Basin countries, and he provides some aggregate statistics on the size and scope of foreign banking activities.<sup>3</sup> Using aggregate accounting data, Terrell (1977, Table 20-2) further compares the banking markets of 14 developed countries (8 of which allow foreign bank entry) for 1976 and 1977. Interestingly, countries that allow foreign bank entry on average experience lower gross interest margins, lower pre-tax profits, and lower operating costs (all scaled by the volume of business). Terrell (1977), however, does not control for influences on domestic banking other than whether or not foreign banks are permitted to enter. This paper aims to provide a systematic study of how foreign bank presence has affected the domestic banking markets in 80 countries. To do this, we use bank-level accounting data and macroeconomic data for the 1988-1995 period.

2 See Aliber (1984) for an early survey of the literature on the internationalization of banking. _3_ Cho and Khatkhate (l 989) provide in-depth case studies of financial liberalization in five Asian countries, however with no particular emphasis on foreign bank entry. Liberalization, though, is shown to lead to faster growth of the financial system and to increased competitiveness of the banking system, even ifthere is no conclusive evidence that financial liberalization leads to lower intemediation margins. In their comparative study, Frankel and Montgomery (199 I) also bypass the issue of internationalization.

2