If the absolute distance between source j and host i is large and the average (absolute) institutional distance of potential other source countries is small, i.e., source j has a competitive disadvantage in host country i, then the value of the institutional competitive
advantage variable will be high. If the specific source country is close to the host country, but the competitor countries are institutionally far, i.e., the reversed situation occurs, then the value of the competitive advantage variable will be low. In other words, a lower (higher) value indicates an institutional competitive (dis-)advantage of a bank in source country j with regards to entry in host country i. For our sample, the institutional competitive advantage variable InstCompAdvijt has a value between 0.01 and 2.72.
To construct our institutional competitive advantage variable we use the governance indicators of Kaufmann, Kraay and Mastruzzi (KKM, 2005). These measures have often been used in the literature, including in studies on the impact of institutional quality on the location of FDI in general and FDI in banking in particular (Stein and Daude, 2004 and Galindo, Micco and Serra, 2003). The KKM-indicators measure six dimensions: (1) voice and accountability, (2) political instability and violence, (3) government effectiveness, (4) regulatory quality, (5) rule of law and (6) control of corruption. For each dimension, indexes range from -2.5 to 2.5 with higher values indicating a better institutional environment. The measures are currently collected on an annual basis, but for earlier period only on a bi-annual basis. Countries’ KKM scores vary considerably over time, with changes over the sample period varying between -2.6 and 1.6. Our standard institutional competitive advantage measure uses the simple average of these six governance indicators.6
Figure 1 shows the relevance of using a relative rather than absolute measure of institutional differences. The figure plots at the time of entry the institutional quality in the host country of the foreign bank against the institutional quality of the foreign bank source country (the country in which the foreign owner is headquartered), where institutional quality is the simple average of the six governance indicators. If entry decision would be driven by absolute differences in institutional quality, i.e., source country banks would seek out those host countries that in absolute terms are the closest,
6 Although taking averages can hide certain indicator-specific effects on foreign bank entry, we believe this possibility to be limited as correlations between the six indicators are very high, ranging from 0.60 to 0.96. Nevertheless, using each of the six specific indicators lead to qualitatively similar results.