Banking sector globalization

and bank performance:

-A comparative analysis of low income
countries with emerging markets and advanced
economies-
 1. Importance of the article

A key feature of financial services liberalization is the increasing presence of foreign banks in a
nation. This research paper examines the impact of banking sector globalization on bank profits
and cost efficiency by using a panel of 169 nations spanning 1998–2013. Employing both fixed-
effects and GMM (Generalized Method of Moments) estimations, and including banking-
industry and macroeconomic controls, the author Amit Ghosh1 found greater banking-sector
globalization to reduce both profits and cost inefficiency, thereby reflecting increased
competitiveness and informational asymmetries in host markets, as well as assimilation of better
technology, managerial practices by domestic banks. The results are further examined for nations
across different levels of economic development and with different degrees of foreign bank
presence. Only in emerging markets and in nations with more than 50% foreign banks, greater
banking sector globalization positively affects profits. From a policy perspective, the findings
call for banking regulatory authorities to implement polices to reduce informational asymmetries
in host markets.

2. Article review- main highlights of the article

The banking industry was in the eye of the recent global financial crisis (GFC) where several
nations witnessed unprecedented declines in banks’ earnings. Such deteriorating bank
performance is often a harbinger of bank failures and banking crises, along with their subsequent
adverse consequences on the overall economy. Therefore, the determinants of bank performance
have attracted the interest of academic research as well as of bank management, financial
markets and bank supervisors, as a soundly performing banking industry is better able to
withstand negative shocks and contribute to the stability of the financial system.
The last two decades have seen a rapid increase in the process of banking-sector globalization.
However, arguments supporting a policy of openness toward the banking industry in a host
nation are far from universally accepted. In the aftermath of the recent global financial crisis,
there has been considerable academic focus and policy attention on the roles of foreign banks in
creating economic vulnerability in host countries. The literature the author chose for the article
is: Cetorilli and Goldberg, 2012; De Haas and Van Horen, 2011; Klomp and Haan, 2015; Cull
and Peria, 2007 and Peek and Rosengren, 2000.
In the backdrop of this financial landscape described previously, the research conducted by
Professor Ghosh examines the impact of the banking sector globalization on two key facets of
bank performance – profitability and cost efficiency by using a panel dataset of 169 nations
encapsulating the most updated time period 1998–2013. The past two decades is marked by
increase in financial globalization, especially in low income countries and emerging markets.
One aspect of such liberalization is the introduction of regulatory reforms in the banking sector
as well as participation in a wider range of financial services by banks. Yet the recent global
financial crisis has not left the banking system unscathed in almost any nation. A conspicuous

1
Associate Professor at Department of Economics, Illinois Wesleyan University, USA

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feature of the banking industry in most nations was declining bank profits. The presented study
makes three key contributions to the literature. First, using different measures of banking sector
globalization, the author examine their impact on bank performance. Secondly, he scrutinizes not
only the macroeconomic and external determinants of bank performance but also the banking-
industry specific factors. Thirdly, he provides a comparative perspective by examining the results
for low income countries (LICs) with emerging and developing market economies (EMs) and
advanced economies (AEs).Also, the study covers the widest possible range of nations for the
period 1998–2013.
From the perspective of development finance, in LICs and to an extent in EMs, there are
significant informational asymmetries that increase the cost of acquiring soft information by
foreign banks, on the basis of which a large share of potential borrowers are identified. Thus, the
understanding the implication of banking sector globalization on host nations bank performance
is important for the development of the domestic banking industry. From the host nation’s
policymakers point of view, economic success of any nation intrinsically hinges on the tradeoff
between external policy choices and their internal consequences. One such external policy
choice, very relevant in LICs and EMs, is the extent of banking sector openness. Hence, in
guiding economic policy, the findings of the analysis will shed light on regulatory measures for
central bankers and governments, but also for adequate risk management by banks.
The benefits and costs of banking sector globalization have been hotly debated in the media,
policy forums, and academic conferences. Arguments in favor of opening a nation’s banking
sector to foreign ownership are made under several premises. First, some contend that a foreign
bank presence increases the amount of funding available to domestic projects by facilitating
inflows of capital. Such a presence may also increase the stability of available lending to the host
nation by diversifying funding bases, and hence increasing the overall supply of domestic credit.
Secondly, others argue that foreign banks improve the quality, pricing, and availability of
financial services, both directly as providers of such enhanced services and indirectly through
competition with domestic financial institutions. Thirdly, foreign bank presence is said to
improve financial system infrastructure – including accounting, transparency, and financial
regulation – and stimulate the increased presence of supporting agents such as ratings agencies,
auditors, and credit bureaus. Also their presence might enhance the ability of regulatory
institutions to measure and manage risk effectively. Foreign banks are backed by their parent
banks, so may be perceived as safer than domestic counterparts, especially in times of economic
crisis. Last but not least, foreign banks may be less susceptible to political pressures and less
inclined to lend to connected parties. These force simply positive economic effects of a foreign
bank presence in a host nation.
In rebuttal to these points those opposed to foreign bank participation argue that because foreign
banks have weaker ties with host markets and have more alternative business opportunities than
domestic banks, they are more likely to be fickle lender. There is also the potential that they
could import shocks from their home countries. Other economists have argued that foreign-
owned banks will in fact decrease the stability of bank credit provision by withdrawing more
rapidly from local markets in the face of a crisis either in the host or home country.

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Yet others argue that foreign banks “cherry pick” the most lucrative domestic markets or
customers, leaving the less competitive domestic institutions to serve other, riskier customers and
increasing the risk borne by domestic institutions. Moreover, independent of the effect on
aggregate credit, the distribution of credit may be affected, resulting in redistribution and
potential crowding out of some segments of local borrowers. This may lead to rising income
inequality or higher rural–urban divide.
The effect of foreign banks on profits and costs in host markets are also theoretically debatable.
On the one hand, foreign bank presence might lead to higher profitability as foreign bank’s
technological edge is relatively strong, and these often internationally well-known banks might
also have lower costs of raising funding. The benefits of newer technology can spill-over to
domestic banks leading to higher profits for the entire banking industry. On the other hand,
foreign banks might be less profitable as they may not be strong enough to overcome
informational disadvantages. Their presence will also increase competition for domestic banks,
thereby reducing profits for all.
The second part of the paper comprises in the analyses of the banking profits and banking-sector
globalization trends and patterns.

As noted earlier, the author’s captured banking-sector performance by two measures, banks’
profits and cost efficiency. Bank profits are best measured by return on assets (ROA) –
commercial bank’s net after-tax income to total assets. ROA reflects the ability of a bank’s
management to generate profits from the bank’s assets. Thus, it indicates how effectively the
bank’s assets are managed to generate revenues. The author also measured profits by net interest

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margin (NIM) – the difference between bank’s interest income and interest expenses scaled by
total assets. Figs. 1 and 2 show the yearly averages of banks’ ROA and NIM, respectively, for
the entire sample of nations and also in EMs, LICs and AEs. Two interesting facts are revealed.
Bank profits are highest in LICs reflecting impediments to market competition. Secondly, banks
ROA were negative in AEs during 2008–2009 indicating these nations to be the origins of the
GFC. Cost efficiency is measured by banks overhead costs-to-assets ratio (OCA). It is defined as
operating costs such as administrative costs, wages and compensation to employees, advertising
expenses, property costs, exclusive of banks interest payments and taxes. Higher OCA reflects
more cost inefficiency. Fig. 3 presents the time series of the annual averages of OCA, again for
the entire sample of nations as well as in LICs, EMs and AEs. An ocular view reveals a clear
pattern. The banking industry is least cost efficient in LICs as one would expect, followed by that
in EMs while it is most cost efficient in AEs. A similar pattern is emerged in Fig. 4 that uses
banks cost-to-income ratio (CIR) as another measure of cost efficiency.
The author reached to two primary
reasons that drive foreign banks to
enter another country. The first
reason consists in the search of
higher profits and more
diversification opportunities.
Foreign banks from a given home
country have entered a host nation
either through extending branches
and subsidiaries of parent banks or
through mergers and acquisitions
with private banks in the host nation.
Secondly, governments of host
nations have increased the
accessibility of expanding services
for foreign banks. In some cases,
foreign bank entry into previously
restricted markets has occurred in
the aftermath of a crisis or political
upheaval.
Fig. 5 shows the yearly averages of
the percent of foreign banks to total
banks. A foreign bank is a bank
where 50% or more of its shares are
owned by foreigners. Across this time period of study LICs had on average the highest share of
foreign banks in their domestic banking industry, followed by that in EMs. Pervasive market
inefficiencies and outmoded banking practices that exist in LICs incentivize foreign banks to
enter these nations to reap higher profits, possibly outweighing informational disadvantages they
may face. A second measure is used to capture the extent of banking sector globalization – the

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ratio of loans from non-resident banks to GDP of a nation. Fig. 6 shows the annual average of
this measure. For most of the time period of analysis, AEs have the highest share of loans from
non-resident banks in their domestic markets, followed by that in EMs.
In the next section the author describes the data he chose for his model, and also the empirical
results that he obtained throughout the research.
The dataset comprises of a balanced panel of 169 countries spanning the period 1998–2013. The
greater country coverage yields statistically more reliable results on the effect of banking sector
globalization. Secondly, the larger sample allows examining whether different banking and
macroeconomic variables are more effective in countries at different levels of economic
development. Thirdly, time-series dimension of the data allows asking how these variables
change over time, converge across countries, or both. Fourthly, the panel dataset allows
analyzing the consequences of institutional reforms on banking sector globalization, thereby
avoiding some econometric concerns about cross-sectional work.
Bank profits are modeled as a function of banking-industry specific factors (Xj i,t), financial (Xk
i,t) and macroeconomic variables (Xl i,t) that are represented below:
πi,t = α + β0Xj i,t + β1Xk i,t + β2Xl i,t
The variables included in the model are explained as follows:
The banking-industry specific factors refer to capitalization, industry size, industry
structure, banks’ costs, bank diversification, and balance sheet structure.
The effect of capitalization on bank profits is ambiguous. Banks with higher capital-to-asset
ratios are considered relatively safer and less risky compared to institutions with lower capital
ratios. Furthermore, a large share of capital increases creditworthiness as bank capital acts as a
safety net in the case of adverse developments like potential bankruptcy. Banks with higher
capital-to-assets ratios normally have a reduced need for external funding, which again has a
positive effect on their. In addition, more capitalized banks have a high franchise value, so have
incentives to remain well capitalized and engage in prudent lending. In line with the
conventional risk–return hypothesis, there is an inverse relationship between capitalization and
profits. The author proxied capitalization by the ratio of total equity capital to total bank assets.
Regarding the industry size, larger size banking industry should reduce costs by reaping
economies of scale or scope. In fact, more diversification opportunities that come in a bigger
market should allow banks to maintain (or even increase) profits while lowering risk. On the
other hand, in large sized markets banks will face more competitive pressures. This compounded
with larger agency costs, and higher costs of monitoring more loans might lower bank profits.
Industry size is measured by total assets divided by GDP for each nation. This was also proxied
for banking sector’s overall level of development.
About the industry sector, profits are typically higher in a banking industry that is less
competitive. A small number of banks may be able to collude either implicitly or explicitly, or
exploit their market power independently, by paying lower rates on deposits, charging higher

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rates on loans and fees, and earn higher pro- fits. Larger banks also benefit from economies of
scale. Highly concentrated markets are therefore inherently more profitable. Industry structure is
measured by bank concentration ratios, assets of the assets of three largest commercial banks as a
share of total commercial bank assets in a country.
Regarding the liquidity risk, banks with a higher share of more liquid assets are perceived to
have a safer asset portfolio and hence earn lower profits. This is measured by Liquid Assets to
Deposits and Short Term Funding. The share of liquid assets reflects the bank’s ability to convert
deposit liabilities into income earning assets, which, to a certain extent, also reflects a bank’s
operating efficiency.
Banks’ costs reflect the efficiency of bank’s management. Costs are measured by the ratio of
non-interest expenses to total assets (OCA). A reduction in costs, driven by improved managerial
efficiency, is expected to increase profitability.
Bank diversification comprises in earning streams that can be decomposed into two components:
interest and non-interest incomes.
Regarding the balance sheet structure, a larger proportion of deposits should, increase
profitability as they constitute a more stable and cheaper funding compared to borrowed funds.
The financial factors refer to market risk, financial development and economic
development.
Market risk captures the probability of default of a country’s banking system. Again following
risk–return trade-off, higher risks should lead to more profits. This is measured by bank-z score
that compares the buffer of a country’s banking system (capitalization and returns) with the
volatility of those returns, i.e., sum of ROA and equity capital-to-assets divided by standard
deviation of (ROA).
Regarding the financial development, the sample of countries is marked by wide variation in the
maturity of their overall financial markets. As stock markets develop, better availability of
information increases the potential pool of borrowers, making it easier for banks to identify and
monitor them. This raises the volume of business for banks, making higher margins possible.
The level of economic development reflects differences in banking technology, the mix of
banking opportunities, and any other aspects of banking regulations omitted in other variables.
This is measured by real GDP per capita.
The macroeconomic fundamentals refer to the real GDP, inflation, and interest rate.
Higher economic growth implies both lower probabilities of individual and corporate default and
an easier access to credit.
An inflation rate fully anticipated by the bank’s management implies that banks can
appropriately adjust interest rates in order to increase their revenues faster than their costs and
thus acquire higher economic profits.

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Higher rates typically foster profitability. This may reflect the fact that demand deposits
frequently pay zero or below market rates, while higher real interest rates increases the
borrower’s repayment rates.
The results for emerging markets, low income countries, and advanced economies proved the
theories that support the actual research.
In EMs, and even more so in LICs foreign banks may be able to realize high interest margins
because they are exempt from credit allocation regulations and other restrictions which are a net
burden on margins. Furthermore, pervasive market inefficiencies and outmoded banking
practices that exist in these countries could allow foreign banks to reap higher profits than
domestic banks, outweighing the information disadvantages they possibly may face. However, in
AEs, banking markets tend to be more competitive with more sophisticated participants. So, any
technical advantages they may have in these markets are not enough to overcome the
informational disadvantages they face relative to domestic banks.
In EMs increase in banking sector globalization is positively significant in affecting profits,
when using the share of loans from non-resident banks-to-GDP. This positive coefficient
captures the technological spill-overs from foreign banks to the entire host nation’s banking
industry. In contrast to this, in LICs, the coefficient is negatively significant. This suggests first
that foreign banks face substantial information bottlenecks, and secondly their presence raises
competitive pressures, thereby reducing profits for the overall industry. Gleaning at the results
for AEs, a higher share of non-resident bank loans has a negatively significant on ROA. This
negative coefficient implies in AEs spill-overs are less important since the technological gap
between domestic and foreign banks is smaller with the banking industry being already
competitive.
From a development finance point of view, the negative effect of banking sector globalization on
bank profits for the entire sample of nations should not be interpreted as evidence supporting
more protectionist policies toward foreign banks. Rather they capture increased competition that
is generated by opening up the domestic banking sector. More importantly it reflects
informational disadvantages that foreign banks face that cannot be overcome by their
technological edge. This is especially relevant in LICs. From a policy perspective, this calls for
banking regulatory authorities like central banks in LICs to implement policies to ameliorate
informational asymmetries, especially when it is based on soft information, as is often the case
when dealing with small firms.
The main conclusion of the article is that, it is imperative to sustain economic growth in host
nations for their banking industry to sustain profits and remain cost efficient.

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