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Location Decisions of Foreign Banks and Institutional Competitive Advantage - page 4 / 33

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1994). More generally, banks’ advantages derive in large part from their ability to process information efficiently because of greater use of technology, specialized skills (e.g., risk management), scale, etc. These advantages will depend in part on the information and business environment the bank already is working in.

In terms of explaining why and how banks expand abroad, the internalization theory would suggest that, depending on the familiarity of the bank with a certain environment in the source country, it can be a source of strength in terms of engaging in cross-border entry in another country. The empirical prediction would be that banks enter countries with a similar level of information quality and, more generally, with a similar institutional environment. For example, other things equal, a bank that is used to work in a very transparent country without corruption, would find it easier to operate in a not opaque and low corruption country. Vice-versa, a bank that is used to work in an opaque institutional environment, might be able to operate well in a country which is also opaque. This hypothesis is supported by Galindo, Micco and Serra (2003), who find that foreign bank penetration is greater between source and host countries that are legally and institutionally similar. This suggests that banks’ internalization advantages play a role in entry decisions.

We build on these papers, but argue that the internalization motive alone cannot explain a bank’s entry into a particular country. This argument implicitly assumes that the location decision of an individual bank is made independent of the location decisions made by other, competing banks that are also expanding their business abroad. When a bank decides to expand its business abroad, however, its choice of location is not just dependent on the bank’s own advantage (and on issues such as bilateral trade and FDI flows), but also on the competitive advantage that the investing bank has over not only banks already present (local and foreign) but also over other foreign banks that are potential entrants. In other words, for a bank from a particular source country to enter a certain market, there must be a competitive advantage of that bank relative to local banks as well as relative to other foreign banks that can also enter. At the same time, the internalization hypothesis suggests that a bank can derive advantages from its ability to work within a certain institutional environment. Combining the competitive advantage requirement and the internalization hypothesis therefore implies that the institutional

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