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Location Decisions of Foreign Banks and Institutional Competitive Advantage - page 14 / 33

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institutional competitive advantage over a period, rather than to explain entry (the flow of new foreign banks) as a function of year by year changing circumstances.

Compared to other analyses, most of which are cross-sectional regressions, using first-differences means the number of possible control variables we need to include are more limited as fewer variables are time-varying. One variable we do include is the change in entry restrictions, the limits imposed on foreign bank entry, with a dummy equal to one if foreign bank entry is restricted, and zero otherwise, i.e., a more liberal regime.11 We also include the changes in the institutional quality of the host country, bilateral trade, source country dollar GDP, and source country dollar GDP per capita.12 The Appendix provides a complete description of all variables used.

Since the decision to enter is likely made before the year of entry and, as such, is based on the information available at that moment, we lag our independent variables by one year. This means that, since our main dependent variable is the change between 1996 and 2006, we use for the explanatory variables their changes between 1995 and 2005.13 This way we also further reduce the risks that foreign bank entry affects our independent variables. Our benchmark model becomes thus as follows:

dForpresenceij = α0 + α1dInstCompAdvij + α2dInstHosti + α3dEntryresti + α4dTrade + α5dGDPsource j + α6dGDPcapsource j + εij

11 There might also be (lack) of entry restrictions that are not host country-specific but rather specific to the source country-host country combination. For example, while entry may be unrestricted in principle, for some reasons banks from one country may not be allowed to enter another country. Or the opposite may be the case, for example because of a Free Trade Agreement banks from a specific source country are allowed to enter a specific host country, but other foreign banks are not allowed to do so. Furthermore, it could be that, using the argument of prudential oversight, regulators in host countries only allow entry of banks from certain source countries (e.g., countries with strong institutions) to enter. The first difference regression controls for these and other bilateral, fixed effects as longs as they are time-invariant.

12 Another useful indicator would be bilateral FDI flows, but data are not available. FDI flows are, however, highly correlated with trade flows, which are included in the model. Other potential explanatory variables considered in earlier analyses (mostly cross-sectional regressions), like the GDP of host country, financial depth of the host country, banking market structures, either have little time variation or may be endogenous to foreign bank entry. We therefore do not include these variables in the regression model (although doing so does not change our results qualitatively).

13 Except for the institutional competitive advantage variable based on KKM for which we, due to data limitations, use the change between 1996 and 2004.

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