Foreign Entry and the Mexican Banking System, 1997-2007

In recent years, governments around the world have been opening up their banking systems to foreign competition with the expectation of making them more efficient, stable, and resilient to shocks. Academics and policymakers have therefore been exploring the effects of foreign bank entry from both a theoretical and an empirical point of view. Most studies conclude that foreign entry increases the contestability of markets, thereby reducing administrative costs, lowering net interest margins (NIMs), and driving down bank rates of return. Nevertheless, as Clarke and others note, much of what we know comes from cross-country studies that are heavily weighted toward developed economies.¹ This is particularly crucial because the impact of foreign entry may vary with the level of economic development.²

The literature to date on foreign bank entry in developing economies does not provide a consensus set of results. There is some evidence that foreign entry increases social welfare. Clarke, Cull, and Martínez Pería find that enterprises in countries with high levels of foreign bank participation tend to rank interest rates and access to long-term loans as lesser constraints on their operations and growth than do enterprises in countries with low levels of foreign bank participation.³ Martínez Pería and Mody, analyzing a group of Latin American cases in a pooled time-series cross-sectional framework, find that foreign banks charge lower interest rate spreads than domestically owned banks.⁴ They also find that foreign bank entry is associated with an overall increase in administrative efficiency and a decrease in interest spreads, suggesting that foreign entry spurred competition. Denizer obtains similar results in a study of Turkey: foreign entry reduced domestic bank overhead expenses, as well as bank profitability.⁵ Unite and Sullivan find that foreign entry was associated with declines in interest rate spreads, overhead expenses, and profits in the Philippines, but the effect was confined to domestic banks that had been tied to business groups.⁶ Kasekende and Sebudde report that foreign banks in Uganda have better internal control mechanisms than domestic banks in terms of judging the quality of borrowers.⁷

Not all the evidence points in the same direction, however. Havrylchyk finds that foreign banks in Poland are more efficient than domestic banks, but then shows that the efficiency gains are all located in so-called greenfield banks: domestic banks that are acquired by foreign banks do not become more efficient.⁸ Cardim de Carvalho finds no differences between foreign and domestic banks in Brazil in terms of credit allocation or technical efficiency.⁹ Indeed, technical progress in online banking and automation in Brazil has been introduced more aggressively by domestically owned banks. Claessens, Demirguç-Kunt, and Huizinga find that foreign banks operating in developing economies have higher overhead expenses, charge higher interest margins, and earn higher rates of return than domestic banks.¹⁰

Foreign banks may also be less willing to extend credit on the basis of "soft knowledge" about firms than domestically owned banks. Studies of Argentina and Pakistan suggest that foreign entry may therefore give larger firms even greater advantages by exacerbating problems of differential access to capital.¹¹ The finding that foreign banks eschew soft-knowledge lending is supported by multicountry studies that use panel data techniques. Detragiache, Tressel, and Gupta report that foreign entry in a panel of poor economies is associated with a net reduction in total lending to the private sector: foreign banks appear to have skimmed off the best credit risks, leaving domestic banks with a pool of weaker borrowers from which to select.¹² A related body of research suggests that foreign banks represent a trade-off for a developing country. Galindo, Micco, and Powell develop a model and present evidence indicating that foreign banks may be less susceptible to funding shocks than domestic banks because they can tap capital from their home institutions, but at the same time foreign banks are more reactive to shocks that affect expected returns.¹³ That is, they may be more fickle than domestic lenders, leading to greater banking system instability...