Effects of Foreign Bank Entry on Domestic Banking

Abstract

Introduction

During the last one and a half decade, the Indian Banking system has witnessed many changes such as institutional changes, regulatory changes as well as technical changes. These years have also witnesses an increased presence of foreign bank operations in India. During the year 2001, foreign banks occupied about 42% of the total banks and controlled more than 8% of the total assets of India’s banking system (RBI). Among other things the increase in foreign bank operations was due to the fact that since the early 1990s the Indian Government had started implementing financial sector reforms which allowed foreign banks to set up branches and domestic banks to be privatized, that were earlier regulated.

A number of questions are raised due to the increased presence of foreign banks, about their effects on the domestic banking sector. On the positive side, foreign banks entry makes domestic banks less fragile and less prone to crisis, it encourages adoption of best practices in the domestic banking system and stabilizes overall credit market in emerging economies, since domestic banks are highly sensitive to local conditions. On the negative side, foreign banks take the best credits and leave the worst for domestic banks and they tend to increase lending in good times and provide less in bad times. This study aims at empirically evaluating the effect of foreign banks presence on the operations of domestic banks in India, particularly on public sector banks. The selection of only public sector banks for the study is motivated by two reasons:

Prior to 1992, public sector banks operation were heavily regulated than the other domestic banks which resulted in low profitability and low efficiency ; the subsequent banking reforms were aimed at improving their profitability and efficiency by inducing competition and practicing deregulation policies. Allowing more foreign operations was one of them.

Public sector banks were allowed to control more than 70% of the total assets, deposits and branches of the Indian Banking system. The econometric analysis is based on the bank level data for 27 public sector banks for the period 1996-2007. And investigate how foreign bank entry will influence operations of the Indian public sector banks.

This paper presents a review of literature on the effects of foreign bank entry on domestic bank operations. It also explains the methodology employed and the database. Subsequently it presents the empirical results. Finally the paper gives the conclusion.

Review of Literature

In literature, several studies have examined the issue of the effects of foreign bank entry on the domestic financial institutions, markets and the economy as a whole. In the brief literature survey there is a focus on the effects of the foreign bank entry on the domestic banking industry. Several studies have mentioned the potential benefits as well as the costs associated with foreign bank entry for domestic banks.

As far as the arguments on the benefits of foreign bank entry are concerned, studies by a number of researchers have highlighted the advantages of foreign bank entry. The advantages are:

The presence of foreign banks creates a greater competition in the home country that stimulates the domestic banks to reduce their costs, improve efficiency and increase the diversity of financial services.

Since domestic banks have to retain their market share in the presence of the foreign banks, they are pressurized to improve the quality of their services by putting an end to the old style of banking operations.

Foreign bank entry may lead to spill-over effects. To begin with, foreign banks come with new financial services and modern technology, because of their expertise in those areas, and which are new to the domestic banks. The introduction of these services and technologies may stimulate the domestic banks to also come up with such new services for improving the efficiency of financial intermediation.

Foreign banks may also help to improve the management of domestic banks by participating in the stream of takeover or joint venture practices. This may directly or indirectly contribute to help managerial efficiency.

Foreign bank entry may also lead to the development of the domestic banks’ supervisory and legal framework, as these banks may demand improved system of regulation and supervision from the regulatory authorities.

Foreign banks presence may also reduce political influence on the domestic banks since the latter may demand operational freedom to be able to compete with the former.

The presence of foreign banks may also increase the quality of human capital in the domestic banking system either by importing high skilled labor or by training the local employees. More clearly, to start a business either by setting up a new branch or by acquiring an existing domestic bank, a foreign bank requires quality personnel in the domestic country. To meet their needs they may either go for importing highly skilled managers or they may go for training local people. Therefore, this increase in quality of available human capital for the domestic banks will improve the efficiency of the domestic banks as well.

All these effects may lead to more efficient domestic banking practices, which may in turn lead to reduced costs.

There have been a number of arguments on the costs associated with the entry of foreign banks. These have been sided by a number of researchers like Stiglitz (1193), Peek and Rosengren (2000), etc. These studies point towards the following points:

Cost reductions may occur only in the long run, since banks need to invest first in introducing new services, improving the quality of existing services, adopting new management techniques and upgrading their staff

The presence of foreign banks will weaken the domestic banks due to increased competition, the domestic banks will have to compete with large international banks

The presence of foreign banks will diminish the ability of the domestic regulatory authorities to influence the banking sector as well as the economy, since foreign banks are less sensitive to their desires

The presence of foreign banks may also make domestic banks more vulnerable to adverse foreign shocks

The presence of foreign banks may also lead to neglect of the financial needs of the local entrepreneurs, since foreign banks usually concentrate on the multinational firms.

As far as the empirical evidence with respect to the effects of foreign bank entry on domestic bank operations is concerned, it is quite limited and rather mixed.A study using a large sample of 80 countries was conducted. The study showed that the increased presence of foreign banks is associated with reduction in profitability, non-interest income and overall expenses of domestic banks, besides revealing the positive efficiency effects on domestic words. A study by Denizer (2000) where he examined the effect of foreign bank entry on Turkey’s domestic banks, showed that met interest margins, return on assets and overhead expenses of domestic banks decreased after foreign bank entry. The study concluded that even though the foreign banks had a market share in the range of 3.5-5%, they put much pressure on the domestic banks. A study on the Columbian banking system found that foreign bank entry increases competition, deteriorates loan quality and increases intermediation spreads of domestic banks. A study involving 14 developed countries, 8 of which allow foreign bank entry, found that foreign bank entry is associated with lower interest margins, lower pre-tax profits and lower operating costs. Another study examining the impact of foreign banks in Hungary found no evidence to support that foreign bank entry improves performance of domestic banks. A study of the impact of foreign bank entry on the Polish banking sector found that foreign bank entry brought greater competition that led to the Polish banks lowering the total credit supply to the economy, thereby affecting the business environment of the country.

A study reviewing the banking systems of East Asian countries with respect to the effects of foreign bank entry, found that, in Korea, foreign banks compete with the domestic banks and they are not interested in sharing their risk management techniques with the Koreans. The study, in general also observed that foreign banks seem to ‘cherry pick’ the best credit and leave the worst for the domestic banks and are likely to increase lending in good times but decrease it in bad times. Chantapong (2005) examined the performance of domestic and foreign banks in Thailand after the East Asian financial crisis. The study found that profitability of foreign banks is much higher than domestic banks, and the improved competition with greater foreign bank entry provided advantages to domestic banks in technological and managerial adjustments. Using a sample of 48 countries, a study found that the effect of the foreign bank entry depends on the economic development in the host country. At the lower level of economic development, the study found that foreign bank entry is generally associated with higher costs and higher net interest margins, while at higher level of economic development foreign bank entry is negatively associated with costs, profits and net interest margins of domestic banks. A study examined the performance of foreign and domestic banks in the UK and found that domestic banks perform better than the foreign banks in terms of higher net interest margin, higher pre-tax profits and lower loan loss provisions. The study concluded that foreign banks operating in a developed country may not have much impact over domestic bank operations because of certain explicit or implicit barrier such as organizational diseconomies of operating or maintaining an institution from a distance, difference in language, etc. A study by Peria and Mody (2003) analyzed the impact of foreign bank participation on bank spread in Latin America and found that foreign bank entry is associated with higher competition, lower costs and lower spreads.

The above literature review reveals the following research gaps:

The empirical findings of these studies disclose rather inconclusive or mixed findings as some of the studies reveal the positive effects and some find negative or indifferent effects of foreign bank entry on domestic activities

The majority of the studies concentrate on banking systems of the developed countries such as the US and Europe, where the effect may differ

Such studies in emerging countries like India are rare; infact not even a single study exists with respect to the Indian banking system. Therefore, the present paper attempts to deal with this issue in depth. The findings may have policy implications for regulatory authorities on allowing more foreign bank operations in India.

Methodology and Data

The empirical analysis aims at examining the effects of foreign bank entry on the operations of the public sector banks. To examine this issue, we first need variables that account for the presence of foreign banks in the country. The measure FB_SHARE, that is, the ratio of the number of foreign banks to the total number of banks in the country, reflects the intensity of the foreign banks’ presence.

Next, we need variables that reflect operations of public sector banks. The following variables are used to measure the income, profitability and costs of the public sector banks:

Net interest margin to total assets (NIM)

Non-interest income to total assets (NINTINC)

Profits before tax to total assets (PROF)

Overhead expenses to total assets (OVERHEAD)

Non-performing loans to total loans (NPL)

The first two ratios show the accounting value of the bank’s income. In order to reflect the profitability of the bank, PROF is considered. The last two ratios show the costs of banks in the form of entire overhead and bad loans. Changes in these variables may be associated with changes in the presence of foreign banks through competition and/or efficiency.

The model is defined as :

Δπit =α0+βΔ FB_SHAREt +ϒΔBSit +ΔδMEt + εit

where

πit is the dependent variable (e.g. NIM or PROF) of interest for bank i at time t;

FB_SHAREt is the share of the foreign banks at time t;

BSit is a set of bank-specific control variables for public sector bank I at time t;

MEt is a set of macroeconomic control variable at time t.

α,β,ϒ and δ are coefficients to be estimated

The above model is estimated by Ordinary Least Squares (OLS) method.

In order to capture the structural characteristics of the bank, we include the following bank-specific variables as control variables:

Capital: The ratio of book value of equity capital to total assets, which captures the strength of capital in the bank. It expected the higher the ratio, lower the need for external funding and therefore higher the profitability. On the other hand, holding large equity ratios either on a voluntary basis or as a result of regulation can be costly for banks. Therefore, the expected relationship between capital and dependent variables are unpredictable.

Deposits: The ratio of total deposits to total assets. Deposits are the main source of funds for banks. Higher the deposit ratio, higher is the availability of funds for the bank. If a bank is able to turn those deposits into earning assets, then the bank income will increase. On the other hand, holding large deposit ratios either on a voluntary basis or as a regulatory requirement (eg. Cash reserve ratio) can be costly for banks. Moreover, pressure of large deposit ratios may lead to indiscriminate bank lending which may result in high non-performing loans. Therefore, again, the expected relationship between deposits and our choice of dependent variables is unpredictable.

Liquidity: The ratio of non-interest earning assets (such as cash in hand, balances with the RBI and balances with other banks) to total assets. High liquidity ratios, either self-imposed for prudential reasons or as a result of regulation (eg. Reserve or liquidity requirements), impose a cost on banks since they have to give up holding higher-yielding assets. The kind of relationship this variable will have with our dependent variables depends on what extent the banks are able to transfer this opportunity cost to borrowers. Therefore, again this relationship is uncertain.

Overhead: The ratio of overhead expenses (such as payments to and provisions for employees) to total assets. It reflects employment as well as total amount of wages and salaries and is an indicator of the management’s ability to control personnel expenses. This variable is expected to have a negative impact on the bank’s income and profit variables because efficient bank management is expected to operate at lower costs.

In order to capture the macroeconomic environment in the country we also include the following macroeconomic variables as control variables:

GDP Growth: The annual growth rate of Gross Domestic Product (GDP). In the short run the level of economic development may play a role in determining the effects of foreign bank entry on the domestic banking system. This is because, less developed countries generally have under developed financial systems and lower levels of human capital. Therefore, there may be room for the improvement of domestic banking practices when foreign banks enter the market. This may have positive effects on the operations of domestic banks in the long run. However the short-run costs may increase and the lower the level of economic development, the greater the short run costs.

Inflation: The annual rate of inflation estimated using the GDP deflator. Inflation will raise both costs and revenues of banks. Higher inflation affects banks by making it difficult for banks to adjust their operating expenses with rising inflation. However, the effect of inflation on banks; performance depends on whether banks’ expenses rise faster than the revenues , which in turn depends on to what extent an economy is matured to predict the upcoming inflation. Therefore, the relationship between inflation and the choice of the dependent variables is uncertain.

Interest: The real rate of interest is defined as annual interest rate on government securities minus annual inflation. Higher interest rates are associated with higher interest margins, especially in developing countries, where demand deposits frequently pay zero or less than market rate of interest rates. On the other hand, higher interest rates also increase the cost of borrowing in the market. Therefore, again, the expected relationship with my choice of dependent variables is uncertain.

This study consists of a panel of 27 public sector banks with a total of 324 observations for the period 1996-2007. All the statistical data was obtained from the Annual Accounts Data of Scheduled Commercial Banks, Statistical Tables relating to Banks in India, reports on Trend and Progress of Banking in India, published by RBI.

Results and Discussion

The summary statistics of the selected banks are given in Table 1. Mean value of variables indicate that public sector banks, on an average, have around 3% of net interest income margin; about 2% of non interest income; about 1.77% of overhead expenses; about 2.15% of equity capital; around 84% of deposit sand about 10.73% of liquid assets to their total assets. Public sector banks on an average, get about 0.63% of returns on assets and some of the banks also experience negative returns. Public sector banks, on an average, have about 5.85% of non-performing loans in their total loans and some of the banks have very high non-performing loans. Mean value of foreign bank share indicates that the foreign banks account for more than 38% share in Indian banking system. The mean values of GDP growth, inflation and real value of interest indicate that the Indian economy annually, on an average, evidenced about 6.45% of growth in GDP, about 5.75% of inflation and about 4.4% of real interest rates, respectively. Standard deviation of variables indicated that there is a very slight variation in the dataset and it is slightly higher in case of non-performing loans to total loans, deposits total assets and foreign bank share.

Table 1: Summary Statistics

Variable

Mean

Std. Dev.

Min

Max

Net Interest Income/TA

2.962

0.532

0.519

4.278

Non Interest Income/TA

1.955

0.625

0.576

3.637

Overhead/TA

1.773

0.508

0.704

3.200

Return on Assets

0.626

0.864

-7.511

1.761

Non-performing Loans/TL

5.845

4.513

0.170

26.010

Foreign Banks Share

38.295

3.082

33.333

42.000

Capital/TA

2.158

2.987

0.035

13.427

Deposits/ TA

84.032

4.743

66.287

91.526

Liquidity/TA

10.734

3.703

4.342

24.361

GDP Growth

6.448

1.590

3.942

8.607

Inflation

5.749

2.165

3.166

9.684

Real Interest Rate

4.409

2.153

1.029

7.954

Note:

The OLS estimates of Equation (1) are presented in Table 2. To see if the specified model is valid we conduct diagnostics tests and the results are as follows: statistical significance of F-test is all the specifications support the overall significance of the model; failure to reject the null hypothesis of RESET supports that the model specification is adequate; and failure to reject the null hypothesis of White’s test reveals that residuals are white noise.

Table 2: Regression Results on Change in Foreign Bank Presence and change in Public Sector Bank Performance

Variable

Panel 1

Panel 2

Panel 3

Panel 4

Panel 5

Δ Net Interest Margin / TA

Δ Non Interest Income / TA

Δ Return on Assets

Δ Overhead / TA

Δ Non-Performing Loans / TL

Constant

ΔForeign Banks Share

ΔCapital /TA

ΔDeposits/TA

ΔLiquidity/TA

ΔOverhead/TA

ΔGDP Growth

ΔInflation

ΔReal Interest Rate

Adj R2

F-Statistic (p-value)

RESET (p-value)

White test (p-value)

Note:

The results indicate that the foreign bank entry is significantly associated with an increase in public sector bank profitability (Panel 3), overhead expenses (Panel 4) and non-performing loans (Panel 5). Foreign bank entry seems to have negative effects on net interest margin and non-interest income of public sector banks. However the results do not reveal any statistically significant relationship of net interest margin and non-interest income with foreign bank entry. The results imply that foreign bank entry is associated with greater profitability in public sector banks. This high profitability may be due to increasing competitive conditions in the banking industry with increasing presence of foreign banks. The high overhead expenses may reflect managerial inefficiency and stubborn organizational structures. More clearly, public sector banks feel much pressure from the re-structuring of the entire financial system due to foreign bank entry and increasing competition. This increase in competition forces public sector banks to upgrade their inferior personnel skills to compete with technologically advanced and service efficient foreign banks in order to retain their market share. For this, the public sector banks need to invest in training their managers, which results in increasing overhead expenses. Higher overhead expenses may also be due to the payment of higher salaries on par with the foreign banks to employ skilled managerial personnel. In the long run, foreign bank entry may enable public sector banks to reduce costs as they incorporate many superior practices of foreign banks and foreign banks may force public sector banks to give up their protected ‘quiet life’ and may stimulate them to reach cost-efficiency. The higher non-performing loan may be due to the fact that foreign banks usually lend more to multinational firms and neglect small entrepreneurs and priority sectors. With government intervention, public sector banks lend to these neglected sectors at low interest rates or subsidized interest rates which not only decreases the interest income of public sector banks, but also results in higher default rates since these sectors are less developed and more vulnerable to seasonal factors.

Turning to control variables, capital and deposits are positively associated to profitability. Liquidity is negatively associated to the net interest margin, non-interest income, profitability and overhead expenses. Overhead expenses are positively associated to net interest margin and negatively associated to profitability. We interpret these results to mean that higher capital and deposits will increase profitability of public sector banks. Other factors remaining constant, holding higher liquidity may adversely affect the bank’s income and profitability since the assets lie idle in the form of required reserves. Interestingly, we find that higher liquidity reduces overhead expenses of public sector banks. A higher overhead expense increases net interest income. This may be due to the fact that higher provisions and salaries to bank personnel stimulate and motivate employees to use their abilities efficiently in collecting deposits and keeping them in high return loan portfolios and they may also follow standard monitoring practices which help the banks to improve their interest margins.

Turning to macroeconomic control variables, growth rate of the economy is positively associated to the net interest margin and overhead expenses and negatively associated with non interest income. Inflation is positively associated with the profitability and the overhead expenses and the rate of interest is positively associated to the non-performing loans. These results indicate that during economic prosperity, banks may get numerous opportunities to increase their interest incomes and increasing incomes with rising economy will also put pressure on overhead expenses. Moreover, contrary to the earlier studies, we find that as the economy grows, costs of banks increase and incomes decline, as evidenced by increasing overhead expenses and decreasing non- interest income. It is also evidenced with negative sign in the profitability equation; although it is not statistically significant. The result implies that there is much room for public sector banks to improve their profitability and efficiency and the entry of foreign banks increases the costs of public sector banks. Further, a higher inflation not only leads to higher profits but also to more overhead expenses; higher interest rates lead to more default loans

Conclusion

This paper investigates the effect of foreign bank entry on the operations of public sector banks in India. The empirical results reveal that foreign bank entry usually increases competition in the banking industry as is evidenced by increasing profitability of banks. The increased competition seems to be deteriorating the loan quality as evidenced by increasing default loans. Foreign bank entry also increases the overhead expenses of public sector banks. Besides foreign bank presence is negatively associated with net interest margins and non-interest income of public sector banks, even though the relationship is statistically weak. Therefore, the empirical results, in general, suggest that foreign bank entry in the Indian banking system adversely affects the operations of public sector banks.