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Location Decisions of Foreign Banks and Institutional Competitive Advantage - page 3 / 33

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1998). It helps explain why, for example, US as well as Spanish banks expand into Latin America as trade and FDI is relatively large between these groups of countries.

However, profit related to the direct provision of trade- and project-related finance to firms that have expanded across borders has arguably become a less important reason to establish a bank presence abroad. With technological advances and better communications, banks are increasingly able to provide many types of financial services across borders to firms’ foreign affiliates without needing to establish affiliates in foreign markets. Furthermore, firms can more and more obtain trade- and project-finance related services from local banks that have improved their capacities. Rather, it seems banks have been expanding abroad to seek new, local market opportunities and so increase profitability within an acceptable risk profile. Indeed, host and source country characteristics capturing profitability and risks in general, but not specifically related to trade and FDI, have been found to be important drivers of banks’ decision to enter a foreign market. Focarelli and Pozzolo (2000 and 2005), for example, find that banks prefer to have subsidiaries in countries where expected profits are larger because of higher expected economic growth and/or the prospect of benefiting from local banks’ inefficiencies. And Buch and DeLong (2004) find that information costs and regulations hold back cross-border bank merger activity as they reduce profitability.

The general FDI literature has highlighted, however, that the motivation of profit requires some further explanation. For a firm from a particular source country to enter a certain market and be profitable, there must be an advantage of that firm relative to local firms. In the FDI literature, the internalization theory has developed to explain why this may be the case. The theory asserts that firms expand abroad to exploit the knowledge advantage created within the firm. This concept of internal knowledge is very broad and includes technical, marketing and managerial know-how (see Casson, 1987). To benefit most of this internal knowledge advantage, firms are best off to invest in countries that are similar to those they are already familiar with (Buckley and Casson, 1991). For banks, the concept of internal knowledge has mostly been used with respect to informational issues. Banks can, for example, derive informational advantages from long- term bank-client relationships by allowing them to offer their customers financial services at better terms than other providers may (Rajan, 1992, and Petersen and Rajan,

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