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Location Decisions of Foreign Banks and Institutional Competitive Advantage - page 5 / 33





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difference between host and source country taking into account the institutional differences between host and all competitor source countries matters for foreign bank entry from a specific source country into a specific host country.

The impact of this concept of institutional competitive advantage on location attractiveness has not been studied before for any type of foreign investment. In order to test its empirical validity for the specific case of foreign bank entry, we construct a database covering banks in almost all countries, their ownership and, if majority foreign- owned, the source country of the owner, at each point in time during 1995-2006. We next construct a bilateral measure of a bank’s institutional competitive advantage which relates to the source country and the specific host institutional environment as well as to the competitor source countries’ institutional environments. Together, this allows us to test whether a bank’s better knowledge about a certain business environment compared to its competitors is a determining factor in decisions to enter a certain market relative to other markets.

Using a first difference approach, we find that when the quality of institutions in the source country is close to that of the host country relative to how close the competitors’ institutional qualities are on average to that of the same host country, a bank is more likely to enter. In other words, it is a bank’s ability to better work in a certain institutional environment relative to its competitors, which makes it enter a certain market. We also find that being close in institutional quality to the specific host country relative to competitor banks matters more than just being close. We confirm earlier findings that higher institutional quality and lower entry barriers in the host country lead to more entry. Furthermore, more trade between host and source country leads to more entry. We also find evidence of some supply effects in that economic development in the source country matters for outward investments.

Our results help explain foreign bank entry, but also have some more general lessons. First, while the term competitive advantage is often used in analyses of FDI and countries’ general prospects, few studies have tried to apply this concept empirically. The fact that competitive advantage related to institutional environment can be an important driving factor in entry decisions of foreign banks may also apply to other types of FDI, such as in high-technology or other institutional-sensitive services. As such, our


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