The last decade has seen many foreign banks enter other markets, especially in developing countries, to provide a broad range of financial services locally. This has been driven by domestic deregulation, including the removal of entry barriers, technological advances, increased financial integration, and more generally heightened globalization. As for other foreign investors, individual banks have to weigh the costs and risks of going abroad against the opportunities at home and against other modalities to provide services across borders without establishing a presence, such as through cross-border lending. Furthermore, foreign banks have many markets to choose from when establishing a presence abroad. This leads to the question what factors drive the decision of a bank from a specific country to go abroad and establish presence in a specific country.
In this paper, we investigate the role of institutional competitive advantage in driving the decision of banks from specific countries to enter specific countries. Using a large sample of source and host countries over the last two decades, we examine whether banks seek out those countries where their institutional competitive advantage provides them with an advantage over other, competitor banks. We develop a measure of institutional competitive advantage for each source-host country pair based on third-party assessments of countries’ institutional environments. Using a first-difference model and controlling for time-varying factors, we find that institutional competitive advantage is an important factor in driving foreign banks’ location decisions.
Our finding relates to the general literature on the determinants of foreign bank entry. Banks engage in foreign entry presumably to increase profitability, within an acceptable risk profile. Several factors have been identified affecting this return versus risk consideration. Traditionally, the decision of banks to go abroad has been considered to be closely tied to the internationalization of non-financial firms through trade and FDI. In other words, banks follow their customers to provide them with financial services abroad, especially trade and project finance, and thereby increase their businesses and profitability. Empirical studies have shown that FDI in banking is indeed correlated with the amount of bilateral trade and other forms of FDI between source and host countries (Grosse and Goldberg, 1991, Brealey and Kaplanis, 1996, Williams, 1998, and Yamori,