The effect of foreign bank presence on banking

competition in Europe.

Alex Kloosterman

June December 2011

Abstract

This thesis examines the impact of foreign bank presence on banking competition in domestic
banking markets in developed and transition economies. The focus of this analysis is Europe
during the period 1996-2002 for the developed economies and 1996-2006 for transition
economies. Banking competition is measured by using the Panzar and Rosse H-statistic. This
thesis finds robust empirical evidence that an increase in foreign bank presence enhances
banking competition in both developed and transition host economies in Europe. However, no
evidence is found that increase in competition in transition economies is smaller than for
developed economies.

JEL Classification: D4, E44, G21

Keywords: Bank competition, foreign bank presence, European banking

Master Thesis Finance

Supervisor: prof. dr. S.R.G. Ongena
Second reader: prof. dr. H.M. Prast

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 The effect of foreign bank presence on banking
competition in Europe.

Author:
Alex Kloosterman
Tilburg University
Email: A.P.J.Kloosterman@uvt.nl
ANR: 225235

Tilburg University
Department of Finance
PO Box 90153, NL 5000 LE Tilburg, the Netherlands

Supervisor:
prof. dr. S.R.G. Ongena
European Banking Center - Tilburg University

Department of Finance
PO Box 90153, NL 5000 LE Tilburg, the Netherlands
Telephone: +31 13 466 2417, Fax: +31 13 466 2875
Secretary: +31 13 466 8367
Email: steven.ongena@uvt.nl
www.tilburguniversity.edu/webwijs/show/?uid=steven.ongena

Year of graduation: 2012

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Preface

I would like to thank my supervisor prof. dr. S.R.G. Ongena for his valuable feedback and
guidance during the writing of this master thesis. I also want to thank a colleague student,
Dirk Geraedts, for correcting my drafts and help. A special thanks goes to my girlfriend Lieke
van Ekert for her patience, support and correcting the final version of this paper. Last, but
certainly not least, I want to thank my parents for their endless love and support and giving
me the opportunity to finish this study.

February, 2012

Alex Kloosterman

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Table of contents

PREFACE............................................................................................................................................... 3
TABLE OF CONTENTS ...................................................................................................................... 4
1. INTRODUCTION ........................................................................................................................ 5
2. LITERATURE .............................................................................................................................. 6
3. FOREIGN BANK ENTRY AND BANK COMPETITION.................................................... 11

3.1 Measuring foreign bank presence ......................................................................................................... 11

3.2 Measuring bank competition ................................................................................................................ 12
3.2.1 Concentration ratios .......................................................................................................................... 13
3.2.2 Direct measures of competition ........................................................................................................ 15

4. DATA .......................................................................................................................................... 17

4.1 BANKSCOPE data .................................................................................................................................. 17

4.2 Macroeconomic and other data ............................................................................................................ 19

5. METHODOLOGY ..................................................................................................................... 20

5.1 Determining Panzar and Rosse H-statistic ............................................................................................. 21

5.2 The model ............................................................................................................................................. 23
5.3 Summary statistics ................................................................................................................................ 24

6. EMPIRICAL RESULTS ............................................................................................................ 30

6.1 Relationship foreign bank presence and banking competition in developed host economies ............... 30
6.2 Relationship foreign bank presence and banking competition in transition economies ........................ 33
6.3 Foreign bank presence-competition link with the use of other data ..................................................... 36
6.4 Robustness results ................................................................................................................................ 37

7. CONCLUSION ........................................................................................................................... 41
REFERENCES .................................................................................................................................... 43
APPENDIX ......................................................................................................................................... 46

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1. Introduction

In recent decades, governments have become more willing to liberalize their financial markets
and abolish restrictions on foreign bank entry. This willingness proceeds on the premise that
the gains from foreign bank entry outweigh the losses. As a result, financial institutions have
become more international. This can be seen by institutions establishing foreign subsidiaries
and branches or taking over established foreign institutions. Especially banking sectors in
transition and emerging market economies experience a strong increase of foreign bank entry.
The impact of foreign bank entry on the domestic banking markets is an important
issue for both policy makers and academics. Advocates of foreign bank entry argue that
foreign bank presence for example boost innovation of new banking products and services,
transfer good know-how and other skills (particularly in emerging banking markets), improve
the efficiency of productive resources allocation (which promotes economic growth), and
enhances the banking competition in domestic markets (Dages et al., 2000; Liuhto et al.,
2006). On the other hand, opponents argue that foreign banks gain economic power since they
obtain control of the allocation of credit (fear of foreign control), and "cherry-pick" highly
profitable (low default risk) borrowers, forcing domestic banks to focus on borrowers with
higher risks and become less profitable, efficient and competitive (Dages et al., 2000; Liuhto
et al., 2006; Weller. 2000).
As can be seen by the previous examples, the literature and empirical evidence have
not reached consensus on the foreign bank presencecompetition link. The purpose of this
thesis is to fill this gap in the literature. It is not the first to study the relationship between
foreign bank presence and bank competition. However, this thesis is different in measuring
banking competition. Other papers reasonably assumed that due to increased competition the
net interest margins and spreads decreased or they used a structural approach to describe the
banking competition in the market. By using this structural approach, concentration ratios
take a central position in order to describe the market structure. The most used examples of
structural approach measures are the k-bank concentration ratio and Herfindahl-Hirschman
Index. Nonetheless, these measures would not suffice in this thesis as foreign banks entering
the market would affect the concentration ratio and the variable of foreign presence. As a
result a non-structural approach is used to measure competition. By measuring competition
through the non-structural approach, competition is independent of concentration. The most
used examples of non-structural approach measures are the Panzar-Rosse, Iwata, and
Bresnahan models.
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 A recent paper which studied the foreign presence-competition link and measured
competition through a non-structural approach is the paper of Jeon et al. (2011). This article
examines the impact of foreign bank presence on the competitive structure of domestic
banking sectors in host emerging economies in Asia and Latin America during the period
19972008 by using the Panzar-Rosse H-statistic. The model used in this thesis is comparable
with the paper of Jeon et al. (2011). However, this thesis extends the work of Jeon et al.
(2011) for developed and transition host countries in Europe. A reason to choose specifically
for Europe is the fact that European banking markets were undergoing unique changes caused
by the establishment of the economic and monetary union (EMU) and deregulation of
financial services in the time period used for this thesis (1996 2006).
The results of this thesis indicate a robust positive link between foreign bank presence
and competition in both developed and transition host economies with the use of fixed time
and country effects. This positive foreign bank presence-competition link in developed host
economies seems to be larger for commercial banks only than for all banks. Further results
show significant relations between bank capitalization (positive) and bank profitability
(negative) and bank competition in developed host economies. For transition host economies,
bank capitalization (positive) and stock market capital (positive) have a significant
relationship with bank competition.
The remainder of this paper is as follows. Section 2 provides an overview of related
literature. In section 3, the measurement of both foreign bank presence and banking
competition is discussed. Section 4 contains the description and elaborates on the data used in
this thesis, followed by the discussion of the empirical model used in section 5. The main
results of this thesis are presented in section 6 and the conclusions are presented in section 7.

2. Literature

One of several papers that studied the strong increase of foreign bank presence in domestic
banking markets is the paper of Claeys et al (2006). They find that the market share of foreign
banks in Eastern Europe has reached 55% in 2003. Additional research done by Clarke et al.
(2001) and Crystal et al. (2002) finds that in Latin America, Hungary, Czech Republic and
Poland, foreign banks hold more than half of total banking assets. In other emerging
economies such as Asia, Africa, the Middle East and the Former Soviet Union, foreign bank
entry is also increasing but at a slower pace (Clarke et al., 2001).

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 The question arises whether this increase in foreign bank presence is a positive
development for domestic banking markets. Numerous authors addressed the potential
benefits of foreign bank entry in the domestic markets. The main arguments in favor of
foreign bank entry are defined by Dages et al. (2000) and Liuhto et al. (2006). One argument
is that foreign banks can introduce new services and innovating products to the local banking
market. Domestic banks are forced to go with these innovations if they want to retain their
competitive position. In turn, this leads to an overall introduction of new banking technology
and financial innovations in the banking market. Another argument is that foreign banks have
expertise and experience of other financial activities and can encourage the consolidation of
the banking system which leads to economies of scale in the banking market. Foreign banks
also have the ability to attract business from customers to the host country that would
otherwise have gone to banks in other countries. Further, assuming that the entrants are more
advanced than the domestic banks1, foreign banks could transfer good banking practice,
know-how, financial regulation, accounting, transparency, supervision and supervisory skills
and attract direct foreign investments. These spillover effects may improve the functioning of
the financials system which allow for a more efficient allocation of productive resources. This
in turn fosters economic growth (Levine, 2004).
Other possible benefits, not defined by the above authors, are that foreign entry eases
financial constraints without harming economic growth prospects. This is especially the case
in developing countries whose companies often lack access to alternative sources of finance
as evidence showed by Bruno and Hauswald (2009). In addition, Giannetti and Ongena
(2008) show that foreign banks make bank-firm relationships more stable as they are less
inclined to end relationships with their customers than their domestic counterparts. Further,
they find that newly foreign entered banks establish new relationships with younger and
growing firms. The last argument in favor of foreign bank entry, and the most important one
for this thesis, is that entry of foreign banks results in better conditions for competition as
foreign banks become potential competitors for local banks.
Nevertheless, the magnitude of most of these gains from foreign presence for the
domestic banking systems depends on the economic development of the host country.
Claessens et al. (2001) study the effect and extent of foreign bank presence in domestic
banking markets across the world. They find that the gains of foreign bank entry are the

1
Crystal et al. (2002) show that foreign banks entering Latin America are predominantly advanced banks from
Europe and North America.

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greatest in developing countries. Another finding of this paper is that foreign banks have
higher profits than domestic banks in developing countries. This could suggest that banks
which enter a market of a developing country are indeed more advanced or attract more
foreign investments than their domestic counterparts, like Dages et al. (2000) and Liuhto et al.
(2006) suggested. This paper also provides empirical evidence that a large foreign ownership
share of banks is associated with a reduction in profitability and margins of domestically
owned banks (in most countries). This suggests that foreign presence results in an increase in
competition in the domestic banking market. An additional interesting finding is that the
number of foreign bank entrants is more important than their market share. This implies that
the impact of foreign bank entry on local bank competition is felt immediately upon entry
rather than after foreign banks gained substantial market share.
The model used by Claessens et al. (2001) is further developed by Hermes et al.
(2004). In their paper they investigate the short-term effects of foreign bank entry on the
behavior of the domestic banking sector and the relationship between foreign bank presence
and the performance of the domestic banking market in the host country. Like Claessens et al.
(2001) they hypothesize that these effects are dependent on the level of economic
development of the host country. Their study shows that at lower levels of economic
development, foreign bank entry is generally associated with higher costs and margins for
domestic banks. These higher costs are the result of implementing new banking techniques
and practices (spillovers from foreign banks). These higher margins imply that the banking
markets in less developed economies are less competitive. In countries with higher levels of
economic development the effects appear to be less clear. However, they find some evidence
that at higher levels of development spillovers are inferior and due to competitive pressure of
foreign banks, costs and margins of domestic banks decrease.
Also important to mention are the negative consequences of foreign banks entering a
domestic market on the host country. Dages et al. (2000) and Liuhto et al. (2006) summarize
the main arguments against foreign bank presence. One of these arguments is the fear of
foreign control. By entering the market, foreign banks gain control of the allocation of credit
which gives them substantial economic power. Also the difference in objectives between
foreign banks and the host country's government can be an issue. The objectives of foreign
banks could be more focused on promoting exports from the home country or on supporting
projects undertaken by home country firms rather than focusing on the host country. The
regulatory differences can be an issue as well. For example, if the land of origin of the
foreign bank has weak bank supervision, this may lead to deficient banking in the host

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country. Overall, the regulatory differences could lead to loss of control for the supervisors of
the host country. Another argument against foreign entry is that banks may incur costs since
they have to compete with large international banks that have better reputations. In addition,
foreign banks generally concentrate on multinational firms, which results in local
entrepreneurs having less access to financial services (Stiglitz, 1993). According to Gormley
(2010), this is the result of high costs for foreign banks to acquire information about local
firms. Therefore foreign banks only lend to the most profitable firms. Weller (2000) shows
that multinational banks entering the Polish market resulted in lower credit supply among
Polish banks. This could suggest that foreign bank presence only increases the competition
between banks in the top-level customer segment or that this "cherry-picking" forces domestic
banks to focus on borrowers with higher risks and become less profitable, efficient and
competitive.
A paper that examines the competitive effects of bank entry is one by Gande et al.
(1999). They study the effect of foreign entry on the corporate debt underwriting market,
where they focus particularly on underwriter spreads, ex-ante yields, and market
concentration. The results show that underwriter spreads and ex-ante yields have declined
significantly with a bank entry which suggests an increase in competition. Regarding the
concentration ratio their paper finds evidence that indicates that bank entry tends to decrease
market concentration. This decline in market concentration is associated with an increase in
competition in the market2.
In addition, several authors discussed the competitive effect of different entry modes.
When a domestic banking market opens up foreign banks can either enter through acquisitions
of domestic banks or by a greenfield/de novo investment. Entry through acquisitions leaves
the number of banks constant. However, entry via a greenfield/de novo entry increases the
number of banks operating in the market. Claeys et al. (2006) and Van Tassel et al. (2005)
examined how different entry modes of foreign banks affect competition in a liberalized
banking market. Both papers with different approaches imply that greenfield entry leads to
more competition. Peria et al. (2004) study how foreign participation impact bank spreads.
Banks entering through a de novo investment tend to have lower interest rate spreads than that
of banks entering through the acquisition of a host country bank. In addition, they find that

2
The Structure-Conduct-Performance (SCP) Hypothesis associate a higher bank concentration ratio in the
market with a decrease in banking competition (i.e. in more concentrated markets banks collude more which
makes them less competitive).

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higher foreign bank presence leads to cost reductions for all banks operating in the market.
The findings of Fries et al. (2005) are similar. They studied the cost efficiency of banks in
Eastern European Countries.
Since banks are functioning as financial intermediaries their role is crucial in financial
systems. The question arises whether competition in the banking sector is as important as in
other sectors, and more importantly, is it "safe" to increase the competition in this essential
sector? Competition from a static point of view increases welfare of a country given that
competition reduces prices and increases the quantity supplied by the market. Also from a
dynamic point of view there can be argued that competition increases the standard of living as
competition increases the incentives for firms to be more innovative. Although economic
theory predicts that innovation should decline with competition, empirical evidence of Aghion
et al. (2002) finds the opposite. However, both economists and policy makers are convinced
that competition in the banking sector differs from other sectors3.
Several economists addressed the relationship between banking competition and the
financial stability. One of the papers that study this relationship between competition and
stability is Allen et al. (2004). They considered a variety of models to show the relationship
between competition and financial stability. Due to the complexity involved, there is a wide
range of possibilities concerning the relationship between competition and financial stability.
Their results imply that competition can increase financial stability but it might also that
competition affect financial stability in a negative way.
Foreign entry also has the ability to affect financial stability. Foreign banks can
improve the financial system with spreading new risk management methods, banking practice,
know-how, financial regulation, etc. described by Dages et al. (2000) and Liuhto et al. (2006).
With these improvements, foreign banks can increase the stability of the financial system.
However, foreign banks can also create new sources of banking fragility such as increasing
market influence and moral hazard (Minda, 2007).
According to the discussed literature in this section, the foreign presence-competition
link is positive. Nonetheless, most papers focused on emerging economies and not on
developed host countries. Therefore the first hypothesis discussed in this thesis is:

H1: Foreign bank presence enhances banking competition in developed host countries in
Europe.

3
These difference are briefly discussed in paragraph 3.2

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In addition, this thesis tests whether this foreign bank presence-competition link is also
positive for transition host countries and is smaller than for developed host countries. Like the
results of Weller (2000) illustrate, I expected that in less developed banking markets the
banking markets are less competitive. The second hypothesis then is:

H2: Foreign bank presence enhances banking competition in transition host countries and the
effect is smaller than for developed host countries in Europe.

3. Foreign bank entry and bank competition

This section discusses different methods for measuring foreign bank presence and bank
competition. Paragraph 3.1 starts with different methods to measure foreign bank presence
followed by the different methods of determining bank competition in paragraph 3.2.

3.1 Measuring foreign bank presence

Research done by Claessens et al. (2001) is one of the most wide-ranging empirical studies on
foreign bank presence. They investigated empirically how foreign presence affects the
operation of domestic banks. Their data consists of 7,900 bank observations over the period
1988 1995 from 80 countries worldwide. Although comprehensive data is used, it does not
allow for a distinction between wholesale versus retail banking markets. They are aware of
the fact that foreign entry generally takes place in the wholesale banking market. However,
they refute this missing data by arguing that foreign bank presence at the wholesale level has
an impact on the retail level as well. The paper lacks another distinction. Foreign entry can
either go by a greenfield/de novo investment or through acquisition of a domestic bank. These
two types of entry may have different consequences but are not included in the data. Their
paper measures foreign bank presence in the number of foreign-owned banks and the ratio of
total assets owned by foreign banks.
The data used in the paper of Jeon et al. (2011), although less bank observations
(5,114), is more extensive. In their paper they examine the impact of foreign bank entry on
competition in the domestic banking sectors in emerging host countries. Their study focuses
on Asia and Latin America during the period of 1997-2008 where they were able to provide
empirical evidence that an increase in foreign bank presence enhances competition in the host

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countries' banking sectors4. In addition, the authors find that this foreign bank presence and
banking competition is associated with a spillover effect from banks to their domestic
counterparts. This effect becomes stronger when foreign banks enter through a de novo
investment than through M&A acquisition. Their paper also uses foreign bank presence in
number of foreign-owned banks and the ratio of total assets owned by foreign banks.
Foreign presence is used in various other papers. Like the papers of Claessens et al.
(2001) and Jeon et al. (2011), almost all of it use a ratio of foreign-owned assets over total
assets or the total number of foreign-owned banks. Banks are labeled foreign if at least 50
percent of the shares are foreign-owned. Obviously, this +50 percent ownership gives
foreigners the control of the bank's operations.

3.2 Measuring bank competition

Bank competition is a fundamental issue and has been numerously discussed in academic
literature. Nonetheless, measuring bank competition is a difficult and complex problem. The
problem arises from the specialty of banks functioning as financial intermediaries. The
general argument in favor of competition in terms of allocation efficiency and cost
minimization does apply to the banking sector. But due to the presence of various market
failures the functioning of competition is distorted. Therefore, the standard competitive
paradigms are not always appropriate for the banking sector. Additionally, the government
intervention and various bank regulations to reduce the negative effects of banking
competition disturb the functioning of competition even more.
Even though measuring bank competition is complex, empirical study on bank
competition has made significant progress. Despite this progress there still is no consensus of
measuring bank competition. Bank competition measures can be divided into two groups;
structural measures and non-structural measures. In the structural approach, concentration
ratios take a central position in order to describe the market structure (k-bank concentration
ratio, Herfindahl-Hirschman index). This structural approach forges a direct link between
concentration and competition. By measuring competition through the non-structural
approach, competition is independent of concentration (Panzar and Rosse, Iwata, and
Bresnahan model). Although there are dozen ways of measuring competition in both the

4
Foreign presence is measured in both the number of banks and in terms of total assets. Banking competition is
measured with the Panzar-Rosse H-statistic.

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structural and non-structural approach, only the most common measures for competition are
discussed in this thesis.

3.2.1 Concentration ratios

In the banking literature, bank spreads (the difference between lending and deposits rates) and
interest margins (interest income minus interest expenses relative to the bank's interest-
earning assets) are frequently used as indicators of banking competition. Higher margins are
often interpreted as a lack of competition in the banking sector. However, indicators like
interest rate spreads also reflect other factors such as the probability of default of the
borrower. This makes these indicators less suitable as a competition measure. In addition,
profitability of the banking system is a poor indicator since it is influenced by country's
macro-performance and stability, the degree and form of taxation, judicial systems, and bank
specific factors, such as risk preferences (Claessens et al., 2003). Due to these shortcomings, a
form of concentration ratio is often used to measure bank competition. These concentration
rates have the advantage that they have the ability to capture structural features of the market
and are able to reflect changes in the market as a result of entry, exit, and mergers and
acquisitions. The structure of concentration ratios can either be discrete or cumulative.
Discrete measures, like the k bank concentration ratio, are simple and only require easy access
data. Critics of discrete measures maintain the view that every bank in the market influences
the market behavior (i.e. smaller banks in the market might force larger banks to become
more competitive) and not only the largest ones like discrete measures suggests. However,
supporters of discrete measures maintain the view that a small number of banks is very
unlikely to be influenced by the total number of banks in the market. Calculations based on
the entire banking system of a country would therefore be unnecessarily large-scale.
As mentioned, one of the most used discrete measures of concentration is the k-bank
concentration ratio. This ratio is the cumulative market share of the k largest banks in the
sector, and takes the form:
(3.1)
In which is the concentration ratio of the k largest banks and is the market share of the
individual large bank i. Given that there are no certain rules for the determination of k (the
number of banks included in the concentration ratio index), the bank concentration ratio is
determined arbitrarily. This ratio approaches unity if the k banks included in the calculation
make up the entire banking sector and approaches zero if an infinite number of banks in the

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sector is equally sized and the k banks chosen is comparatively small relatively to the total
number of banks in the sector.
A general used cumulative measure of concentration is the Herfindahl-Hirschman
index (HHI). This competition measure is often called the full-information index as it is able
to capture features of the entire distribution of bank sizes (Bikker et al., 2000). The
Herfindahl-Hirschman index takes the form:
(3.2)
In which HHI is the Herfindahl-Hirschman index and is the square of bank sizes measured
as market shares of all banks in the sector. As can be seen, the HHI (3.2) stresses the
importance of larger banks by assigning them a greater weight than smaller banks. Once more
the index reaches unity/one if banks included in the calculation make up the entire banking
sector or in the case of a monopoly. The HHI reaches its lowest value when all banks in the
sector are of equal size or when the number of banks in the market increases.
Marfels (1971) and Dickson (1981) discussed several other concentration indicators
based on their weighting schemes. Bikker et al. (2000) summarized these weighting schemes
in four classes. The first two classes are already discussed: (1) unity to top k banks and zero to
the remaining banks (k bank concentration ratio) and (2) banks market shares are used as
their own weights (HHI). The other two classes are: (3) the rankings of the individual banks
are used as weights (Hall - Tideman index (HTI) and the Rosenbluth index (RI)) and (4) each
market share is weighted by the negative of its logarithm (the entropy measure (E)). For more
information on these different weight schemes and measures of concentration, see Bikker et
al. (2000).
A competition measure in the same field but not described in the literature by Bikker
et al. (2000) and Bikker et al. (2002) is the Boone-indicator. This indicator (Boone, 2004) is
based on the conception that banks with lower marginal costs (more efficient banks) gain
higher market shares or profits. In addition, these gains become larger if the banking
competition is fiercer. The Boone-indicator is estimated as follows:
(3.3)
where stands for market share, for marginal costs, and is a vector of control
variables of bank i. The Boone-indicator is denoted as the coefficient .
In summary, the difference between the k-bank concentration ratio and the HHI is that
the HHI takes the market shares of all banks into account rather than the arbitrarily chosen k
largest banks. In addition, the HHI uses the banks' market share as their own weight which

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gives larger banks a greater weight than smaller banks. As a result both, in the United States
and Europe, the HHI plays a significant role in the enforcement of antitrust laws in banking
and is used as a benchmark to evaluate other concentration indices. The difference between
the HHI, concentration ratios and the Boone-indicator is that the latter takes into account the
reallocation effect. The HHI and concentration ratio are unable to take this effect into account,
since both indices increase once market shares are reallocated to larger, more efficient firms.
Although concentration ratios are widely used in the literature, they also have their
flaws. A shortcoming of using concentration ratios is that they fail to measure accurately the
distribution of power among the top firms. Also the Boone-indicator has it shortcomings, by
assuming that banks generally pass on gains from efficiency to its customers (Leuvenstein et
al., 2007). This is, however, not always the case and could therefore result in biased results. In
the last three pages of the Appendix the HHI and the 3-bank concentration ratio are compared
using Zipf's law.

3.2.2 Direct measures of competition

As been previously discussed, banking competition can also be measured through the non-
structural approach. One measure that uses this approach is the model developed and
expanded by Panzar and Rosse (1977; 1987). This methodology determines the competitive
behavior of banks on properties of a reduced-form (based on cross-section data) revenue
equation at the bank or market level. Their model uses a test statistic H which, under certain
assumptions, can be used as a competitive measure of banks. These assumptions are: the
number of banks needs to be endogenous to the model (long-run equilibrium); the
performance of banks needs to be influenced by the actions of other market participants; and
the model assumes a price elasticity of demand greater than unity/one. By maximizing the
profits both at the bank and industry level, the equilibrium output and the equilibrium number
of banks can be obtained. First, a bank maximizes it profits by equalizing its marginal
revenues with its marginal costs and takes the form5:
(3.4)
where is the revenue of bank i and are the costs of bank i (the apostrophe refers to
marginal), is the output of bank i, is the number of banks, is a vector of m factor input
prices of bank i. and represent a vector of exogenous variables that shift the bank's
revenue function and cost function. Secondly, if the market is in equilibrium the number of

5
The derivations of (3.4) - (3.6) are based on the paper of Bikker et al. (2000) and Bikker et al. (2002)

Page 15 of 57
banks is constant and each firm produces its profit maximizing quantity the zero profit
constraint holds on the market level:
(3.5)
Where the variables marked with an asterisk (*) represent equilibrium values. Panzar and
Rosse (1987) measure market power by the extent to which a change in factor input prices
( ) is reflected in the equilibrium revenues ( ) earned by bank i. The competitive
measure, H-statistic, is then defined as the sum of the elasticities of the reduced-form
revenues with respect to the banks input prices:

(3.6)

Panzar and Rosse (1987) investigated four commonly employed models for an industrial
market. The first market model investigated describes monopoly. Panzar and Rosse (1987),
proved that under monopoly, an increase in input prices will increase marginal costs since
firms do not have the incentive to charge this price increase to the consumer. As a result, this
reduces the equilibrium output and subsequently reduces the revenues. For a monopolistic
market the H will therefore be zero or negative. The other two models are monopolistic
competition (0 < H < 1) and perfect competition (H = 1). Under perfect competition the H-
statistic is equal to 1 because an increase in input prices raises both the revenues and the
marginal costs by the same amount. The H of this last model is not restricted. Panzar and
Rosse show (1987) that strategic interactions among a fixed number of banks may result in
positive values of H. In a perfect collusion oligopoly, the values of H are zero or negative,
similar to the monopoly model.
Advantages of the Panzar and Rosse model is the use of bank-level data, the difference
in production function per bank, and it allows to study the difference between type (foreign
and domestic) and size of banks. A small drawback of the model is the assumption that the
banking industry is in long-run equilibrium6. In addition, Bikker et al. (2009) find that a
positive value of the Panzar and Rosse H-statistic is not consistent with any form of imperfect
competition and a negative value can occur under various conditions even in short- run or
long-run competition. Concluding, Bikker et al. (2009) find that the Panzar and Rosse H-
statistic is less informative than literature suggests and therefore recommend the Bresnahan-
Lau approach. However, the Breshnahan-Lau approach is much harder to derive and
empirical evidence of the accuracy of this Bresnahan-Lau approach is scarce.

6
Whether the banking industry is in long-run equilibrium can be tested. More information on this test in section
5

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 An alternative non-structural way for measuring competition in the banking sector is
to compute direct measures of market power. A frequently used measure of market power is
the Lerner Index. This index is defined as the difference between output prices and marginal
costs divided by the output price. The advantage of the Lerner Index with respect to the
Panzar and Rosse H-statistic is that it is not a long-run equilibrium measure of bank
competition. As a result, the Lerner Index can be calculated at each point in time. However,
the Lerner Index also has its flaws such as the difficulty to directly observe prices and
marginal costs, and the lending rates should be adjusted for default risk (Beck, 2008).

4. Data

As described in the previous section, a measure for banking competition can be computed in
several ways. To determine the competition in the host countries and see whether there is a
relation with foreign bank presence, this thesis uses the Panzar and Rosse H-statistic. None of
the described measures of competition are perfect. Since the Panzar and Rosse H-statistic is
one of the most practical methods, the data needed is relatively easy accessible and could be
used in combination with variables for foreign presence, it is the most suitable measure for
bank competition for this thesis.
In this section, the data used for determining the Panzar and Rosse H-statistic and the
data for the final models for developed and transition host country economies are discussed.
The majority of the data used is provided by Bureau van Dijk - BANKSCOPE7. This database
contains balance sheet data, income and expenses and other financial data of a large number
of banks across the world. This section starts with the clarification of data used from
BANKSCOPE in paragraph 4.1. Other data used in this paper are discussed in paragraph 4.2
which continues with a description of the macroeconomic data from the World Bank.

4.1 BANKSCOPE data

To determine a possible link between foreign bank presence and banking competition in a
host country, bank-level data is needed to construct the Panzar and Rosse H-statistic. This
bank-level data is collected from the database of Bureau van Dijk - BANKSCOPE for the
years 1996-2002 for developed economies and 1996-2006 for transition economies. In this
thesis a distinction is made between all banks in the host country and commercial banks only

7
Data downloaded in June 2011

Page 17 of 57
for developed host countries. This distinction is made since there are different natures and
business scopes of different bank types which conduct business in different areas of
specialization. Hence, by using all banks in the host country to see whether there is a
relationship between foreign bank presence and banking competition in a host country could
create a potential bias in the results. Therefore, in this thesis, a dataset is also used with
commercial banks only. This choice is made because the core business of commercial banks
is to maximize their profits with interest revenues. These interest revenues are used in the
Panzar and Rosse H-statistic as a measure of banking competition. The construction of the
Panzar and Rosse H-statistic is further discussed in section 4.
Before collecting the data from Bureau van Dijk BANKSCOPE, a system needs to
be constructed to prevent double-counting of the available banks in the database. This is
needed as Bureau van Dijk BANKSCOPE reports both balance sheet data at the
consolidated and unconsolidated levels. To avoid this double-counting and avoid
overestimating the assets, only one of these two levels can be used. However, this is not the
best option since some banks only report consolidated statements or only unconsolidated
statements. Deleting one of these two definitions would therefore result in loss of data. By
using a variable that ranks banks in a country by their assets limits duplications. In
BANKSCOPE, this variable is CTRYRANK (country rank) and refers to the last available
year in BANKSCOPE. Banks with no ranking are dropped from the sample.
The first sample, consisting of all banks in developed economies, starts with 10,289
banks in Europe sorted on Western and Eastern Europe in BANKSCOPE. This results in
72,023 bank observations for 46 different countries in Europe. Turkey and Russia are dropped
from the sample as these countries are Europe-Asia countries and this paper focuses mainly
on Europe. The actual sample used is smaller, than the amount of bank observations as
mentioned above, as a result of the application of other selection criteria. One of these
selection criteria is to remove countries with less than 30 bank-year observations8. This
minimum is needed because a significant amount of observations is needed to estimate the
country's Panzar and Rosse H-statistic. Other criteria include dropping observations with
missing values for interest revenues, personnel expenses, and capital expenditures.
The second sample, of commercial banks in developed economies, starts with 3,755
(26,285 bank observations) banks in Europe. Again, Turkey and Russia and bank observations

8
Claessens et al. (2003) used a minimum of 50 bank-year observations. However, a minimum of 30 bank-year
observations should suffice.

Page 18 of 57
with too many missing variables are deleted from the sample. For this sample, the selection
criteria of a minimum amount of bank observations are more tolerant. The amount of 30
bank-year observations is reduced to an average of 20 bank-year observations per country.
This is done because using 30 bank-year observations would exclude too many countries from
the sample resulting in too little observations for the final model as described in section 5.
Note that any results from these data could have a potential selection bias due to this
minimum requirement of 20 bank-year observations.
The final sample of developed host countries consists of many bank observations
without a rank. Therefore almost half of the observations are deleted. As a result 38,500
observations in 45 different countries are left in the sample of all banks. For the sample of
commercial banks there are 10,920 observations left. The final sample for determining the
Panzar and Rosse H-statistic in developed economies consists of 10,914 observations in 8
different countries for all banks. For commercial banks there are only 2,128 observations.
The last sample is that of transition host countries in Europe. This data is computed
with the available data on foreign bank presence from the European Bank for Reconstruction
and Development9. This sample starts with 704 banks (7,744 observations). After deleting
countries with no rank and missing values for interest revenues, personnel expenses, and
capital expenditures there are 1,498 observations left divided over 18 different countries.

4.2 Macroeconomic and other data

Besides the dependent variable, the Panzar and Rosse H-statistic, an independent variable for
foreign presence is needed to forge a link between foreign bank presence and bank
competition. Several variables can be used to indicate the foreign bank presence in a country.
A common used variable is the number of foreign banks in comparison with all banks in a
country or the total assets of foreign banks over the total assets of all banks in a country.
BANKSCOPE provides this data, but it is only available for the current/last year and
BANKSCOPE does not provide any ownership history. As a result this thesis had to depend
on data from other authors. This thesis uses the dataset collected by Micco et al. (2004)10 for
the Inter-American Development Bank11. They used the share of foreign-owned assets over

9
More information on this data in section 4.2
10
Dataset can be downloaded at http://www.iadb.org/res/files/data_app_mpy.xls
11
Dataset can be downloaded at: http://www.ebrd.com/pages/research/economics/data/macro.shtml#structural or
the older (but more extensive) version used in this paper: www.econ.washington.edu/user/thornj/sci08.xls

Page 19 of 57
total assets of all banks in developed countries to define foreign presence. Data for transition
economies on foreign presence are more accessible. The European Bank for Reconstruction
and Development computed a dataset with foreign bank presence in Europe both in terms of
assets and number of banks.
Other data used from other authors are the 3-bank concentration ratios. These ratios
are computed by Micco et al. (2004) and the 3-bank concentration ratio from the 'Financial
Structure' dataset of Beck (2008). These ratios are not used in one of the models, but rather
serve as reference material. By comparing these variables, which are all computed with the
same method, the data used in different papers can to some extent be compared. As can be
seen in table XIII in the Appendix the concentration ratios of Micco et al. (2004) and Beck
(2008) are highly correlated. However, the concentration ratios calculated with data collected
for this thesis are not correlated. This means that data used in this thesis is notably different
than that from those two papers mentioned above. More information on the used
concentration ratios is discussed in section 5.
Additional data used from Beck (2008) are the financial environment factors that are
able to capture the financial development of the host country. These factors are stock market
total value (total value traded shares) as a ratio of GDP, stock market capitalization (total
value of shares) as a ratio of GDP, and stock market turnover ratio. In the final model as
described in paragraph 5.2 also macroeconomic data are used. These data such as country's
GDP and GDP growth are collected from the World Bank data base. More information on the
used or named variables is described table XII in the Appendix.

5. Methodology

In this section the model used to test the relationship between foreign entry and banking
competition is further discussed. This is done by a two-step approach. Before the final model
is discussed, the dependent variable (the Panzar and Rosse H-statistic), needs to be defined.
The model for determining the Panzar and Rosse H-statistic is discussed in paragraph 5.1. The
next paragraph continues with the final model used to test the relationship between foreign
entry and bank competition. The summary statistics for the banking competition for both the
developed and transition host countries' economies and the foreign presence are discussed in
paragraph 5.3.

Page 20 of 57
5.1 Determining Panzar and Rosse H-statistic

As described in paragraph 3.2.2, a direct measure of competition is the Panzar and Rosse H-
statistic. This paper uses one of two models defined by Bikker and Haaf (2002). The first
model is the reduced-form revenue equation:

(5.1)

Where i indexes banks and t indexes time (years), IR is the ratio of total interest revenue12 to
total assets, IE is the ratio of annual interest expenses to total assets, PE is ratio of personnel
expenses to total assets, and PCE is the ratio of physical capital expenditure and other
expenses to total assets. Control variables in this equation are BCF, bank specific factors.
These bank specific factors are additional variables which theoretically derive from equation
5.1 and reflect risk, costs and sizes of banks. Bank specific variables used in this equation are:
banks equity to total assets, the ratio of net loans to total assets, and total assets. is an
individual bank effect, and is a random disturbance term. The control variable used by
Jeon et al. (2011), other income, is not used in this model as there are too many missing
observations. The Panzar and Rosse H-statistic is estimated as the sum of elasticities of
revenue with respect to the input prices. In the notation of equation 5.1 the Panzar and Rosse
H-statistic is given by .
However, we can assume that the competitive structure of the banking industry in
Europe changed significantly over time in the period used in this thesis13. These changes were
the result of deregulation of banking services, more advanced information technology, and the
internationalization of domestic financial markets. Due to these changes it is assumed that the
long-term equilibrium shifts slowly over time. To account for these market dynamics Bikker
and Haaf (2002) described a continuous-time curve. This model is the same as the normal
reduced-form revenue equation (equation 5.1), but the elasticities of H are multiplied by
. The time-varying Panzar and Rosse H-statistic is estimated by using a nonlinear
least squares and bank-level panel data. The model takes the form (5.2):

12
Only interest revenue is used rather than the total revenues since it's the core business of credit firms. Based on
Moleneux (1994)
13
Especially, from 1993 onwards when the European Union was formally developed.

Page 21 of 57
Again, where i indexes banks and t indexes time (years), IR is the ratio of total interest
revenue to total assets, IE is the ratio of annual interest expenses to total assets, PE is ratio of
personnel expenses to total assets, PCE is the ratio of physical capital expenditure and other
expenses to total assets. Note that if the Panzar and Rosse H-statistic is constant over
time. Time takes the value 1 for the first year and increases by one every year. Hence, 1996
takes value 1 and 2002 takes value 7. The control variables are similar to that of equation 5.1.
The Panzar and Rosse H-statistic is given by . Again, for a
monopolistic market the H will be zero or negative, for monopolistic competition the H will
be between zero and one. Hence, a higher Panzar and Rosse H-statistic is associated with
fiercer bank competition in the market.
As described in paragraph 3.2.2 the Panzar and Rosse H-statistic can be used as a
competitive measure of banks under certain assumptions. The most important assumption is
that the market is in long-run equilibrium. To examine whether the findings of equation 5.2
are in long-run equilibrium, is replaced with . The line of thought is
that bank returns are equalized across banks and that the return on equity (ROE) is
uncorrelated with bank input prices in equilibrium. The natural logarithm is needed to adjust
for negative values of ROE. This test takes the form:

(5.3)

To test whether the 0 a F-test is used. If rejected at 1% significance

level, the market is assumed not to be in equilibrium.

Page 22 of 57
5.2 The model

Now that the dependent variable is defined and tested, the empirical model to study the effect
of foreign bank presence on the competition in the domestic market can be formulated. Like
Jeon et al. (2011) competition is determined by four categories of variables: (1) the market
structure in the banking industry; (2) bank specific characteristics; (3) macroeconomic
environment factors; and (4) financial environment factors. Hence, the model is specified as
follows:

Where i indexes the country and t indexes time. The dependent variable is the
Panzar and Rosse time-varying H-statistic obtained by estimating equation 5.2 in the previous
paragraph. Foreign presence is the share of foreign assets over the total assets of all banks in a
country as described in the data section or the total number of foreign banks over the total
banks in the host countries. The bank concentration is a measure for the market structure in
the banking industry. In this thesis several concentration ratios are computed with the data
used in this paper such as the 3-bank/5-bank concentration ratios and the Herfindahl-
Hirschman index. Similar to equations 5.1 and 5.2 some of the bank specific characteristics
are also used in this model. However, in equation 5.1 these variables are based on bank-level
data. Therefore, these variables need to be converted to national averages to be used in the
final model. The purpose of these bank specific characteristics is to proxy the strength of the
bank's balance sheet and the bank's financial constraints in the host country. Characteristics
used in this model are banks size, liquidity, profitability, capitalization and riskiness. The
countrys average of bank size is measured by the average total assets. Liquidity is measured
by the average net loans as a ratio of the total assets because loans are the least liquidity type
of asset. Therefore, banks with relatively high amounts of loans are illiquid. The average
profitability is calculated by the net interest income as a ratio of the total assets. There are
several methods to determine the risk of a bank. In this model, risk is the average loan loss
provision as a ratio of the net loans. This measures the risk because loan loss provision is a

Page 23 of 57
reservation for defaulted loans of customers. A bigger reservation implies that a bank is more
risky.
The financial environment factors are variables that are able to capture the financial
development of the host country. In this model the factors; total value of the stock market as a
ratio of the country's GDP, stock market turnover ratio, and stock market capitalization are
used. For the macroeconomic environment factors the country's GDP, GDP growth and
inflation rate are used.

5.3 Summary statistics

In this paragraph the summary statistics of the two most important variables, the Panzar and
Rosse time-varying H-statistic and the foreign presence, are discussed. First, the summary
statistics for the developed countries are discussed in paragraph 5.3.1. This paragraph starts
with the Panzar and Rosse time-varying H-statistic followed by the foreign presence in the
host countries. In the next paragraph 5.3.2, the summary statistics of the Panzar and Rosse
time-varying H-statistic and foreign presence for transition economies are discussed.

5.3.1 Summary statistics developed host countries

As mentioned in previous sections, this thesis made a distinction between all banks (i.e.
commercial banks, savings banks, cooperative banks, and bank holding companies etc.) and
commercial banks only. Table I shows the summary statistics of the time-varying Panzar and
Rosse H-statistic for developed host countries in Europe. Note that of the eight countries
described in section 3 only six countries remain. One of the countries that is dropped is
Ukraine due to unaccountable results with the time-varying Panzar and Rosse H-statistic. The
second country that is dropped is Denmark, as the market is not in a long-run equilibrium as
tested with equation 5.3 if using all banks. As can be seen in table I the data used are heavily
balanced. Hence, every country used is represented by seven years of observations (1996-
2002). The time variable in column (7) is as described in equation 5.2. Positive values
indicate that the banking competition increased in the used time period and negative values
indicate a decrease in banking competition in the used time period. Note that since some
banks operate in multiple countries, the measure of competition in a particular country reflects
the average level of competition on the markets where the banks of this country are settled. If
we look at the time-varying Panzar and Rosse H-statistic for all banks, it increased for most

Page 24 of 57
all countries in the used time period. Only the time-varying Panzar and Rosse H-statistic of
Switzerland decreases in that time period. In addition, Switzerland is one of the countries with
less banking competition than the other countries in the sample. This is also the case for
Luxembourg. The countries with the fiercest banking competition are Great Britain and
France. Great Britain is relatively close to perfect competition (H=1).
The results shown in table I for commercial banks are not significantly different.
France and Great Britain are still one of the countries with the highest banking competition
accompanied with Germany. Note that the countries chosen for commercial banks are
somewhat different than the countries chosen for the sample of all banks. Denmark is added
since by using only commercial banks in the equilibrium test (equation 5.3), the banking
market of Denmark is in equilibrium. However, the results of Denmark are unexpected. The
result as shown suggests that the market for commercial banks in Denmark is monopolistic.

Table I: Summary statistics time-varying Panzar and Rosse H-statistic for developed host countries
Ob Mean Max. 1996 2002 Time variable
Country Std. (2) Min. (3)
s (1) (4) (5) (6) (7)
All banks
Austria 7 0.1981 0.0073 0.1880 0.2084 0.1880 0.2084 0.0171
France 7 0.6033 0.0096 0.5900 0.6168 0.5900 0.6168 0.0074
Germany 7 0.3282 0.0180 0.3038 0.3538 0.3038 0.3538 0.0254
Great Britain 7 0.7897 0.0095 0.7766 0.8029 0.7766 0.8029 0.0056
Luxembourg 7 0.1453 0.0161 0.1239 0.1686 0.1239 0.1686 0.0514
Switzerland 7 0.1807 0.0106 0.1664 0.1958 0.1958 0.1664 -0.0271
Average 7 0.3742 0.2441 0.1239 0.8029 0.3630 0.3861 0.0133
Commercial banks
only
Austria 7 0.2626 0.0350 0.2165 0.3137 0.2165 0.3137 0.0618
Denmark 7 -0.8581 0.0484 -0.9269 -0.7923 -0.9269 -0.7923 -0.0261
France 7 0.5300 0.0133 0.5118 0.5487 0.5118 0.5487 0.0116
Germany 7 0.5230 0.0328 0.4585 0.5581 0.4585 0.5581 0.0180
Great Britain 7 0.5032 0.0065 0.4942 0.5122 0.4942 0.5122 0.0059
Luxembourg 7 0.2486 0.0181 0.2242 0.2744 0.2242 0.2744 0.0337
Switzerland 7 0.1588 0.0044 0.1528 0.1650 0.1650 0.1528 -0.0128
Average 7 0.1205 0.5191 -0.9269 0.5581 0.1545 0.2090 0.0050
Notes: Table I presents summary statistics on the time-varying Panzar and Rosse H-statistic for developed host
countries. Note that from the final sample as described in section 4, Ukraine and Denmark are dropped. The
time variable (7) is as described in equation 5.2. Denmark is added since with using only commercial banks
the market is in long- run equilibrium. More information of bank observations per country can be found in table
XIV in the Appendix.

Page 25 of 57
However, Bikker and Haaf (2002) and results of all banks in this thesis (not shown because
Denmark is not in long-run equilibrium for all banks) show that the banking market in
Denmark is as competitive as other developed host countries in Europe. The average (without
Denmark) of the Panzar and Rosse time-varying H-statistic is 0.1205 (0.3352), which is lower
than that of all banks. This suggests that the market for commercial banks is less competitive.
Worth of mentioning is that although Bikker and Haaf (2002) used a different time
period, the results shown in table I are compared with their significantly lower (less
competition). One reason for this difference could be the use of different data.
The foreign presence in the different developed host countries used in this thesis is
presented in table II. As described in section 4 this data comes from the paper of Micco et al.
(2004). The foreign bank presence increased in the period of 1996 - 2002 for all countries
from on average 14.8% to 21.2%. There are two countries of which the foreign presence
raised spectacular. The first country is Austria where the foreign assets over total assets
increase with approximately 30% from 1997 - 1998. The second country is Denmark where
this increase occurred in the later period 1999 - 2000. In this period, the foreign assets over
total assets increase with approximately 20%. In this same period the foreign presence in
Luxembourg also increased with a significant 12%. By looking at the averages of foreign
bank presence for the different countries, Luxembourg is the country with the far most foreign
bank presence with an average of almost 80% followed by Austria with almost 24%.

Table II: Foreign presence in developed host economies

Country 1996 1997 1998 1999 2000 2001 2002
Austria 0.0499 0.0634 0.3684 0.3668 0.2944 0.2681 0.2387
Denmark 0.0160 0.0172 0.0152 0.0155 0.2196 0.2005 0.2118
France 0.0621 0.0621 0.0800 0.0781 0.0436 0.0421 0.0360
Germany 0.0525 0.0484 0.0499 0.0495 0.0466 0.0340 0.0326
Great Britain 0.0703 0.0703 0.0826 0.0884 0.0821 0.0721 0.0653
Luxembourg 0.7651 0.7426 0.7433 0.7358 0.8574 0.8903 0.8485
Switzerland 0.0201 0.0207 0.0211 0.0212 0.0301 0.0565 0.0525
Average 0.1480 0.1464 0.1944 0.1936 0.2248 0.2234 0.2122
Notes: Table II presents the foreign presence ratio of Micco et al. (2004). This foreign presence represents the
share of foreign-owned assets over total assets of all banks in a country. Note that the data used in the paper of
Micco et al. (2004) are more extensive than the seven countries used above. Additional summary statistics of
this data can be found in table XV in the Appendix.

Page 26 of 57
5.3.2 Summary statistics transition host countries

In this paragraph the summary statistics of the transition host countries are discussed. For
transition host economies there has not been made a distinction between all banks and
commercial banks. Unfortunately this distinction was unable to be made as there would be too
little observations.
Table III shows the summary statistics of the time-varying Panzar and Rosse H-
statistic for transition host countries in Europe. None of the eighteen countries as described in
section 4 was deleted for not being in equilibrium or for other reasons. The data used for
transition host economies are less balanced than that of developed host countries.

Table III: Summary statistics time-varying Panzar and Rosse H-statistic transition host countries
Country Obs. Period PRH(fy) PRH(ly) Time-variable Mean Std.
0.2942 0.1123 -0.1376 0.1909 0.0636
Albania 8 1999-2006
-0.0010 -0.0018 0.2729 -0.0014 0.0004
Bosnia and Herzegovina 3 2004-2006
-0.8957 -0.6931 -0.0513 -0.7909 0.0758
Bulgaria 6 2001-2006
0.5419 0.6955 0.0277 0.6158 0.0517
Belarus 10 1997-2006
0.9448 1.0000 0.0059 0.9732 0.0190
Czech Republic 11 1996-2006
0.9662 0.8620 -0.0114 0.9132 0.0346
Estonia 11 1996-2006
0.0346 0.1092 0.1151 0.0656 0.0247
Croatia 11 1996-2006
0.1238 0.1305 0.0052 0.1271 0.0022
Hungary 11 1996-2006
0.3865 0.5451 0.0344 0.4617 0.0526
Lithuania 11 1996-2006
0.3135 0.3217 0.0026 0.3176 0.0027
Latvia 11 1996-2006
0.0161 0.1294 0.2085 0.0562 0.0372
Moldova 11 1996-2006
0.6221 0.6779 0.0215 0.6497 0.0221
Montenegro 5 2002-2006
0.1055 0.1350 0.0247 0.1197 0.0098
FYR Macedonia 11 1996-2006
0.7511 0.8184 0.0086 0.7843 0.0223
Poland 11 1996-2006
0.6077 0.6455 0.0067 0.6265 0.0127
Romania 10 1997-2006
0.1508 0.1700 0.0400 0.1602 0.0083
Serbia 4 2003-2006
0.5536 0.6208 0.0115 0.5866 0.0223
Slovenia 11 1996-2006
-0.3264 -0.2383 -0.0315 -0.2803 0.0292
Slovak Republic 11 1996-2006
0.0307 0.3098 0.0273
Average 9
Notes: Table III presents summary statistics on the time-varying Panzar and Rosse H-statistic for transition host
countries. The time-variable is as described in equation 5.2. PRH(fy) is the Panzar and Rosse H-statistic in the
first year of the period, PRH(ly) is for the last year in the period.

Page 27 of 57
Some countries catch the attention, such as Albania. In the period 1999-2006 the competition
decreased significantly. Next, Bosnia and Herzegovina and Bulgaria are the only countries in
the sample that tend to a monopolistic banking market. However, the negative time-variable
indicates that the competition in that market is increasing. Last, the results of Czech Republic
show that the market is almost perfectly competitive. This is in line with the results of Bikker
et al. (2008) who also find almost perfect banking competition in Czech Republic in the
period 1994-2004. Further, the overall results show that countries such as Estonia, Lithuania,
Poland, and Romania are countries with more banking competition. The opposite is true for
Albania, Bosnia and Herzegovina, Croatia, and Macedonia.
The average banking competition in Europe for transition host countries is relatively stable in
the period 1996-2006. In figure 1, the average competition of the eighteen countries used is
plotted over time. Looking at the overall competition in Europe, we see that the banking
competition in Europe for transition host countries decreased in the years 2000 and 2001.
Bikker et al. (2008) have found the same results in their paper. They ascribe this decrease in
competition to the introduction of the Euro. However, the countries used in that paper were all
EMU countries. Thus the decrease in competition for transition host countries in Europe could
be the result of the introduction of the Euro but this cannot be stated with certainty.

Transition All banks

0.4500
0.4000
0.3500
0.3000
Transition All banks
0.2500
0.2000
0.1500
0.1000
0.0500
0.0000
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Figure 1: The average Panzar and Ross H-statistic for transition host economies in the period 1996-2006.

In table XVI (Appendix) the foreign presence in the different transition host countries used in
this thesis is presented. As described in section 4 this data comes from the European Bank for
Reconstruction and Development. Foreign bank presence increased considerably in the period

Page 28 of 57
of 1996 - 2006 for all countries from on average 15% to 74%. Interesting to see is that in 2006
assets owned by foreign banks in countries such as, Albania, Bosnia and Herzegovina,
Estonia, Lithuania, Montenegro, and Slovak Republic were more than 90 percent. An
additional finding is that in Belarus the foreign bank presence stays relatively behind to other
transition countries in Europe. This could be the result of the communist history of Belarus.
In figure 2, the average foreign presence measured in both assets and number of banks
is plotted in the period 1996-2006. Interesting to see is that in the nineties foreign presence in
volume (number of banks) was relatively higher than foreign bank presence in number of
assets. Although the trend of increased foreign presence in number of banks continued, we see
that foreign presence in number of assets passes the foreign presence in number of banks.
This suggests that foreign banks are increasing their market share not by establishing foreign
subsidiaries and branches or taking over established foreign institutions, but instead by buying
more assets.

Foreign presence
Average assets vs average number of banks
Transition host economies
0.80
0.70
0.60
Foreing Presence

0.50 Foreign presence (assets)

0.40 Foreign presence (# banks)

0.30
0.20
0.10
0.00
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Figure 2: The average foreign presence measured in both in terms of assets and in number of banks in transition
economies.

Page 29 of 57
6. Empirical results

In this section the empirical results of the model in paragraph 5.2 of this thesis are presented.
Different regressions are used to determine the effect of foreign bank presence on the bank
competition. Again there has been made a distinction between all banks and commercial
banks only for developed host countries in Europe. The first paragraph of this section starts
with the relationship between foreign bank presence and banking competition in developed
economies. The next paragraph discusses the same relationship but this time for transition
host economies. Paragraph 6.3 tests the same relationship as in paragraph 6.2 but now with
data provided by my supervisor prof. dr. S.R.G. Ongena. The last paragraph 6.4 tests the
robustness of the results as presented in paragraphs 6.1 and 6.2.

6.1 Relationship foreign bank presence and banking competition in developed host
economies

To observe whether there is a relationship between foreign bank presence and bank
competition, the regression is used as described in section 4. The results of this regression can
be found in table IV. This table is presented below and shows that both OLS with and without
country and time effects are used to determine the effect of foreign bank presence on bank
competition. For all OLS regressions with country and time dummies fixed, effects are used.
To determine whether random or fixed effects should be used, a Hausman test is applied.
Note, to control for the banking market structure, concentration ratios are used that are
calculated with the data used in this thesis. This was the best option because the concentration
ratios calculated by Micco et al. (2004) and Beck (2008) are too much uncorrelated with the
data used in this thesis. By using these concentration ratios, the results could become biased.
Table IV presents the estimation results of equation 5.3 for all banks in column (1) and
(2), and those for commercial banks in column (3) and (4). As can be seen in this table there is
a negative relationship between foreign bank presence and bank competition in the period
1996 2002 for all banks with the use of an OLS regressions without country and year
effects. By using country and year effects, this negative relationship converts to a statistically
significant positive relationship. The estimates presented in column (1) imply that a 10%
increase in the share of total assets owned by foreign banks leads to a decrease of 0.0469 of
the Panzar and Rosse time-varying H-statistic. If we look at the commercial banks, this 10%

Page 30 of 57
increase in the share of total assets owned by foreign banks leads to a decrease of 0.0466 of
the Panzar and Rosse time-varying H-statistic in column (3). Again, the relationship between
foreign bank presence and the Panzar and Rosse time-varying H-statistic seems to be positive
with the use of country and year effects. Columns (2) and (4) imply that a 10% increase in the
share of total assets owned by foreign banks, leads to an increase in the Panzar and Rosse
time-varying H-statistic with 0.0044 and 0.0096 respectively. This positive result is consistent
with the results of Claessens et al. (2001) and Jeon et al. (2011) which studied the effects of
foreign presence on bank competition in emerging economies.
For all banks, although not statistically significant, the concentration ratio seems to
reduce banking competition. By using fixed country and year effects this reduction seems to
get less strong. This negative relationship is in line with the structure-conduct-performance
(SCP) paradigm. This predicts that there is an inverse relationship between bank
concentration and competition. Summarizing the SCP, in more concentrated markets, banks
are more willing to collude rather than to compete. Although this is stated in the SCP, other
papers like Claessens et al (2003) find no evidence that the competitiveness measure
negatively relates to banking system concentration.
Several bank-specific factors also seem to have a significant effect on banking
competition. First, the results show, although very small, a negative result of the bank size on
the host countries' banking competition. In addition, there is a positive significant relationship
between bank capitalization and banking competition. This indicates that banking competition
seems to be more intense in bank markets which are dominated by larger and more capitalized
banks for the European banking market. The opposite is true for Latin America and Asia as
the results shows of Jeon et al (2011). Secondly, there is a negative relationship between the
liquidity of the banks balance sheet for all regressions. Hence, the higher the liquidity rates,
the less efficient are the banks. This implies that banks which are operating less efficiently
have a negative effect on the banking competition in the host country. This result could be
expected since banks that are operating inefficiently are not eager to compete with other
banks. Profitability also has a negative, statistically significant, effect on banking competition
in the host country. This suggests that higher profits for banks lead to less competition as
suggested by Claessens et al (2001). Also riskiness affects the banking competition in the host
country. Although not statistically significant, it seems that more riskiness of the banks
contributes to the banking competition in a negative way. This suggests that in riskier banking
environments the competition becomes less intense. Worth noting is that Jeon et al. (2011)
found the same results for banks in Asia and Latin America.

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 Table IV: Effects of foreign bank presence on banking competition in developed economies, 1996 -2002
Dependent variable: time-varying Panzar and Rosse H-statistic
All banks Commercial banks
OLS (1) OLS (2) OLS (3) OLS (4)
Banking market structure
Foreign presence (Assets) -0.4695 *** 0.0439 * -0.4663 * 0.0958 ***
(.010) (.024) (.283) (.036)
Concentration ratio -0.0670 -0.0269 -0.1651 -0.0169
(.091) (.018) (.181) (.018)
Bank specific factors
Total assets -0.0000 *** -0.0000 -0.0000 -0.0000
(.000) (.000) (.000) (.000)
Capitalization 4.6295 *** 0.2800 -12.3433 *** 0.8364 ***
(1.552) (.254) (2.498) (.321)
Liquidity -0.8201 *** -0.0082 -0.8871 *** -0.0775
(.169) (.039) (.301) (0.052)
Profitability -13.7420 *** -4.5262 *** -3.8192 -7.5100 ***
(4.058) (.898) (9.485) (1.228)
Risk -3.4150 1.2328 -11.3390 -0.3180
(5.939) (.818) (12.142) (.881)
Macroeconomic environment
GDP 0.0000 *** 0.0000 0.0000 *** -0.0000
(.000) (.000) (.000) (.000)
GDP growth 0.0127 * 0.0004 0.0094 -0.0009
(.007) (.001) (.021) (.002)
Inflation 0.0084 0.0011 -0.0520 ** 0.0016
(.014) (.002) (.026) (.002)
Financial environment
Stock market turnover ratio -0.0132 0.0065 -0.1700 -0.0245 *
(.058) (.007) (.186) (.014)
Stock market capitalization -0.1274 *** -0.0071 -0.1646 -0.0191 *
(.040) (.007) (.114) (.010)
Stock market total value traded -0.0056 0.0036 0.1278 0.0090
(.045) (.007) (.151) (.012)
Dummies
Year dummies No Yes No Yes
Country dummies No Yes No Yes

Constant term 0.7457 *** 0.4297 *** 1.6270 *** 0.3512 ***
Observations 42 42 49 49
R-squared 0.945 0.7894 0.8360 0.8522
Notes: Table IV presents the effects of foreign bank presence on banking competition in developed economies,
1996 -2002. Standard errors are shown in the parentheses. * 10% significance level, ** 5% significance level,
and *** 1% significance level. As described in section 4, commercial banks have a larger dataset since Denmark
is added.

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The results shown in this table also imply that the macroeconomic environment of the host
country affects competition. The results indicate that countries with a higher GDP
(statistically significant) or GDP growth have more banking competition. Also the inflation in
the host country affects the competition. The overall results show a positive, not statistically
significant, effect which implies that countries with higher inflation rates have fiercer banking
competition.
Last, the financial environment also has its impact on banking competition. Although
not significant, the total value traded on the stock market has a positive coefficient. This
suggests that host countries with larger or more intensive stock markets have more banking
competition. In addition to the financial environment there are negative and statistically
significant coefficients on the stock market turnover ratio and stock market capitalization.
This implies that in larger host countries and countries which have a high level of non-finance
competition, the banking competition becomes less intense.

6.2 Relationship foreign bank presence and banking competition in transition

economies

Secondly is to show whether there is a relationship between foreign bank presence and
banking competition in transition economies. These results are shown in table V. Again both
OLS with and without country and year dummies are used to determine the effect of foreign
bank presence on bank competition. This table represents countries in transition, the other
main difference with table IV is that this time, there has not been made a distinction between
all banks and commercial banks. This distinction was hard to make since the amount of banks
in the transition economies are very small and the selection criteria as described in paragraph
4.1 made the sample even smaller. Note that the minimum bank observations criteria were not
met. Therefore, the results shown in this table could have biased results. Although I am aware
of this shortcoming, the results are still shown to show the difference between transition and
developed economies.
Table V represents the estimation results of equation 5.3 for transition economies in
Europe in the period of 1996-2006. Column (1) and column (2) present the results using OLS
with and without country and year effects with use of foreign assets over the total assets in the
host country as the foreign presence variable. Column (3) and column (4) present the same
but with the total of foreign banks over the total banks in the host country.

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 Similar to the results of table IV, the variables of foreign presence and concentration
ratio differ in relationship between OLS regressions with and without country and year
effects. This could suggest there is a potential time trend in foreign presence and
concentration ratio or a difference in country characteristics. In comparison, the papers of
Claessens et al. (2001) and Jeon (2011) only used OLS with country and year effects as well.
Therefore, only the results of these regressions (columns 2 and 4) are discussed.
Again, all results of foreign presence are statistically significant. The estimations
column (2) implies that a 10% increase in the share of total assets owned by foreign banks
result in an increase in the Panzar and Rosse time-varying H-statistic of 0.0036. An increase
of 10% in total number of foreign banks over the total banks in the host country results in an
increase of 0.0037. This positive result is consistent with the results of Claessens et al. (2001)
and Jeon (2011) which also studied the effects on foreign presence in transition economies.
Comparing the results in both table IV and table V (all banks and with country and year
effects), the results imply that the effect on foreign bank presence in transition economies on
bank competition, although very small, is indeed smaller than that of host developed
countries. However, testing these coefficients by using dummies for developed countries and
multiply them with the foreign presence variable and use both variables in the regression, the
results show that difference in coefficients are not significantly different. Therefore, the
second hypothesis is partly rejected.
In host countries that are in transition, the concentration ratio as well has a statistically
significant negative impact on bank competition. As mentioned above, this is in line with the
structure-conduct-performance (SCP) paradigm that predicts that there is an inverse
relationship between bank concentration and competition.
The Several bank-specific factors that show the strength of the banks also seem to
have an effect on banking competition in transition economies. Although not significant, the
results show that bank size has a very small, negative effect on the host country's banking
competition. In addition there is a positive, significant relationship between capitalization and
bank competition. This indicates that banking competition seems to be more intense in bank
markets which are dominated by larger and more capitalized banks for the European banking
Market. This is in line with the findings of Leon et al. (2011), for emerging economies in
Latin America and Asia. Secondly, there is a negative relationship between the liquidity of
banks and competition. This implies that banks which operate less efficient have a negative
effect on the banking competition in the host country. Although the results are not statistically
significant the results of profitability (positive) are different from developed host countries.

Page 34 of 57
Riskiness (positive), not statistically significant, is the same as for developed economies in
table IV.

Table V: Effects of foreign bank presence on banking competition in transition economies, 1996 -2006
Dependent variable: time-varying Panzar and Rosse H-statistic
Banking market structure OLS (1) OLS (2) OLS (3) OLS (4)
Foreign presence (Assets) -0.2009 0.0360 *** - -
(.127) (.009) - -
Foreign presence (# Banks) - - -0.7076 *** 0.0375 *
- - (.201) (.018)
Concentration ratio 0.5970 *** -0.0705 *** 0.6018 *** -0.0840 ***
(.191) (.018) (.182) (.018)
Bank specific factors
Total assets 0.0000 -0.0000 0.0000 -0.0000
(.000) (.000) (.000) (.000)
Capitalization 0.4200 0.1723 ** 0.7005 -0.1660 *
(.896) (.080) (.854) (.082)
Liquidity 0.0865 -0.0189 -0.2175 -0.0312
(.407) (.030) (.402) (.032)
Profitability 0.2374 -0.1444 0.2502 0.0843
(2.807) (.210) (2.676) (.216)
Risk -0.6234 0.0371 -1.0464 0.0336
(1.063) (.063) (1.024) (.066)
Macroeconomic environment
GDP 0.0000 *** 0.0000 0.0000 *** 0.0000
(.000) (.000) (.000) (.000)
GDP growth 0.0001 -0.0001 0.0081 -0.0010
(.014) (.001) (.013) (.001)
Inflation 0.0031 -0.0000 0.0035 -0.0001
(.003) (.000) (.003) (.000)
Financial environment
Stock market turnover ratio 0.0081 0.0002 .0034 0.0003
(.210) (.000) (.202) (.001)
Stock market capitalization 1.6422 *** 0.0758 * 1.8724 *** 0.0929 *
(.630) (.043) (.689) (.045)
Stock market total value traded -0.6771 -0.0224 -0.3663 -0.0375
(.711) (.048) (.688) (.029)
Dummies
Year dummies No Yes No Yes
Country dummies No Yes No Yes

Constant term -0.2403 *** 0.3144 *** 0.0171 ** 0.4163 ***

Observations 130 130 130 130
R-squared 0.2236 0.5496 0.2794 0.0256
Notes: Table V presents the effects of foreign bank presence on banking competition in transition economies,
1996 -2006. Standard errors are shown in parentheses. * 10% significance level, ** 5% significance level, and
*** 1% significance level.

Page 35 of 57
The results also imply that the macroeconomic environment of the host country affects
competition. The results show that countries with a higher GDP or GDP growth have more
bank competition (although very small). Also the inflation in the host country affects the
competition. The results show a negative relationship which implies that countries with higher
inflation rates face less banking competition (the opposite is true for developed host
countries).
The financial environment shows some significant effects on the impact on banking
competition. Although not significant, the stock market turnover ratio has a positive effect on
the banking competition in the host country. Thus host countries' stock markets with intensive
trading on the stock market have fiercer banking competition. The positive, statistically
significant, relationship between stock market capitalization and banking competition
suggests that countries with larger stock markets have more banking competition. However,
host countries with more value traded on the stock market have lower banking competition.
As can be seen by comparing table IV and table V, the r-squared differs significantly.
For developed host countries (table IV) the r-squared is approximately 0.79 and 0.85. For host
countries in transition this is respectively 0.02 and 0.55. This suggests that the model used is
much more suitable for developed host countries than for host countries in transition in
Europe. In addition, showed by Jeon et al. (2011), this model is suitable for emerging host
countries in Latin America and Asia as well.

6.3 Foreign bank presence-competition link with the use of other data

For transition host countries more data was available for the variable foreign presence. Like
the data already used for developed host economies, the data of Micco et al. (2004) was also
available for transition economies. In addition, my supervisor prof. dr. S.R.G. Ongena was
kind enough to provide me with more data regarding foreign bank presence. These variables
are computed in the same way as that of assets. To show the amount of foreign presence, the
variables assets, loans, equity and interest income for foreign banks are shown as a ratio of the
total amount of assets, loans, equity and interest income.

Table VI: Effects of foreign bank presence on banking competition with other foreign presence
variables in transition economies, 1996 -2006

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Dependent variable: time-varying Panzar and Rosse H-statistic
No lagged factors Lagged factors
CR3 (1) HHI (2) CR3 (3) HHI (4)
Foreign Presence
1
Foreign Assets (Micco et al. 2004) 0.0663 *** 0.0690 *** 0.0641 *** 0.0714 ***
(.009) (.012) (.008) (.010)
2
Foreign Assets 0.0319 *** 0.0142 0.0331 *** 0.0364 ***
(.009) (.011) (.009) (.011)
3
Foreign Loans 0.0302 *** 0.0141 0.0336 *** 0.0381 ***
(.008) (.010) (.009) (.009)
4
Foreign Equity 0.0403 *** 0.0131 0.0406 *** 0.0418 ***
(.009) (.011) (.011) (.011)
5
Foreign Interest income 0.0304 *** 0.0125 0.0323 *** 0.0353 ***
(.009) (.010) (.009) (.011)
Dummies
Year dummies Yes Yes Yes Yes
Country dummies Yes Yes Yes Yes
Notes: Table VI presents the effects of foreign bank presence on banking competition with other foreign
presence variables in transition economies in the period 1996 -2006. The same model is used as in table IV and
table V. To save space only the foreign presence variables are shown. Standard errors are shown in parentheses.
* 10% significance level, ** 5% significance level, and *** 1% significance level. The number of observations
ranges between 62 and 92. The lagged factors are for robustness. This robustness test is further discussed in the
next paragraph. Variables 2-5 were provided by my supervisor prof. dr. S.R.G. Ongena.

In Table VI above, the summarized results of the model, as described in section 5 with the
other variables of foreign presence, are discussed. As can be seen, all regressions show a
positive (and almost all are statically significant) relationship between foreign bank presence
and banking competition. Again the results can be interpreted as follows: an increase of 10%
of, for example foreign owned equity, results in an increase in the Panzar and Rosse H-
statistic of 0.004 (column 1).

6.4 Robustness results

Further studied, is whether the main findings on the impact of foreign bank entry on bank
competition, obtained in paragraph 6.1 and 6.2, are robust. In this section, various tests are
used to see if modifications of the model result in different findings. One of these
modifications is to address for the possible endogeneity of the different bank-specific factors
(size, capitalization, liquidity, profitability, and risk) and the financial environment factors
(stock market turnover ratio, capitalization, and value traded) in equation 5.2 (I.e. banks could
change their policies or risk profiles in consequence of increasing banking competition in the

Page 37 of 57
market of the host country). Therefore, these factors are lagged with one period in the foreign
bank presence-bank competition equation. The results are presented in table VII.

Table VII: Effects of foreign bank presence on banking competition with lagged factors in
developed economies, 1996 -2002
Dependent variable: time-varying Panzar and Rosse H-statistic

All banks Commercial banks

Banking market structure
Foreign presence 0.0352 * 0.0383
(.021) (.030)
Dummies
Year dummies Yes Yes
Country dummies Yes Yes
Observations 36 42
Adjusted R-squared 0.8611 0.8890
Notes: Table VII presents the effects of foreign bank presence on banking competition with lagged factors in
developed economies in Europe, 1996 - 2002. The same model is used as in table IV and table V. To save space
only the foreign presence variables are shown. Standard errors are shown in parentheses. * 10% significance
level, ** 5% significance level, and *** 1% significance level.

The results shown in table VIII did not change significantly from that of table IV. Only the
significance level of the foreign presence for commercial banks changed. However, the results
still show a positive relationship between foreign bank presence and banking competition.
Another modification is the alternative measure of banking concentration in the host
country. In the model used in paragraph 6.1, the concentration ratio HHI was used, which is
defined as the square of bank sizes measured as market shares of all banks in the sector.
Alternatively, the CR3 (three largest banks) and the CR5 (five largest banks) are used. This
concentration ratio is defined as the sum of the market shares held by the three/five largest
banks in the host country. The results are shown in table VIII.

Table VIII: Effects of foreign bank presence on banking competition with other concentration ratios in
developed economies, 1996 -2002
Dependent variable: time-varying Panzar and Rosse H-statistic

Page 38 of 57
 All banks Commercial banks
CR3 CR5 CR3 CR5
Banking market structure
Foreign presence (assets) 0.0224 * 0.0176 0.2268 -0.1431
(.024) (.025) (.274) (.292)
Dummies
Year dummies Yes Yes Yes Yes
Country dummies Yes Yes Yes Yes
Observations 36 36 42 42
Adjusted R-squared 0.7752 0.7773 0.7826 0.7103
Notes: Table VIII presents the effects of foreign bank presence on banking competition with other concentration
ratios in developed economies in Europe, 1996 -2002. The same model is used as in table IV and table V. To save
space, only the foreign presence variable is shown. Standard errors are shown in parentheses. * 10%
significance level, ** 5% significance level, and *** 1% significance level.

Again, the results did not change significantly. The relationship between foreign bank
presence and competition stays positive. However, the results become less statistically
significant. Comparing the results in table VIII and table XVIII in the Appendix (this table
presents the results with all modifications put together), the relationship is robust, positive,
and overall statistically significant for all banks. The findings for commercial banks are not
robust.

Table IX: Effects of foreign bank presence on banking competition with lagged factors in
transition economies, 1996 -2006
Dependent variable: time-varying Panzar and Rosse H-statistic
Foreign presence
Foreign presence (# Banks)
Banking market structure (Assets)
Foreign presence 0.0381 *** 0.0197
(.010) (.020)
Dummies
Year dummies Yes Yes
Country dummies Yes Yes
Observations 123 123
R-squared 0.5064 0.4376
Notes: Table IX presents the effects of foreign bank presence on banking competition with lagged factors in
transition economies in Europe, 1996 -2006. The same model is used as in table IV and table V. To save space,
only the foreign presence variables are shown. Standard errors are shown in parentheses. * 10% significance
level, ** 5% significance level, and *** 1% significance level.

Page 39 of 57
These modifications are also made for the findings of the transition economies in table IX.
The first modification is that factors are lagged with one period in the foreign bank presence-
bank competition equation. Note that foreign presence is defined in two different variables.
Foreign presence as assets owned by foreign banks over the total assets in the host country
and the number (#) of banks that are foreign (+50% of their shares is owned by foreign
banks). In table IX above the results of this modification are presented.
The results show that the relationship of foreign presence measured as the number of
foreign banks over the total number of banks and competition is positive (not statistically
significant). Thus, the overall results did not change and still show a small positive effect of
foreign bank presence on the banking competition in the host transition economies.
The next modification is the alternative measure of banking concentration in the host
transition country. Alternatively, the CR3 and the CR5 are used. The results of these modified
models are shown in table X below.

Table X: Effects of foreign bank presence on banking competition with other concentration ratios in
transition economies, 1996 -2006

Dependent variable: time-varying Panzar and Rosse H-statistic

Foreign presence (Assets) Foreign presence (# Banks)
CR3 CR5 CR3 CR5
Banking market structure
Foreign presence 0.0330 *** 0.0276 *** 0.0387 ** 0.0287
(.007) (.011) (.017) (.019)
Dummies
Year dummies Yes Yes Yes Yes
Country dummies Yes Yes Yes Yes
Observations 121 118 121 119
R-squared 0.6398 0.4499 0.5844 0.4303
Notes: Table X presents the effects of foreign bank presence on banking competition with other concentration
ratios in transition economies, 1996 -2006. The same model is used as in table IV and table V. To save space,
only the foreign presence variables are shown. Standard errors are shown in parentheses. * 10% significance
level, ** 5% significance level, and *** 1% significance level.

The results are different than those of table IX. These results show that the findings of foreign
presence measured as the number of foreign banks over the total number of banks are slightly
robust. All other results are robust as well. The relationships presented still show a small
positive effect of foreign bank presence on the banking competition in the host transition
economies. By putting all modifications together, we get the results as shown in table XIX in

Page 40 of 57
the Appendix. Again, these results show that foreign bank presence as measured with the
number of foreign banks is not robust. Therefore the results are considered not robust.

7. Conclusion

In recent decades, governments have become more willing to liberalize their financial markets
and abolish restrictions of foreign bank entry. This willingness proceeds on the premise that
the gains from foreign bank entry outweigh the possible losses. As a result, financial
institutions have become more internationally which have resulted in more M&A's between
domestic and foreign banks and establishment of new foreign subsidiaries in the host country.
Especially banking sectors in transition market economies experience a strong increase of
foreign bank entry in the period 1996-2006. In developed economies, this increase is less
visible and for the larger economies in Europe such as Great Britain, France and Germany, the
foreign bank presence even decreased in the period 1996-2002.
This thesis contributes to the existing literature on how foreign bank presence affects
the banking competition in the host country Most papers used a structural approach to
describe the banking competition in a host country. With this structural approach
concentration ratios take a central position in order to describe the market structure and the
banking competition. However, these measures would not suffice since foreign banks entering
the market would affect both the concentration ratio and the variable of foreign presence. To
avoid this, another measure of competition which not includes any form of concentration ratio
is used. Therefore, in this thesis the Panzar and Rosse time-varying H-statistic is used as
described in the paper of Bikker and Haaf (2001). As stated above this measure is from the
non-structural approach where competition is independent of concentration.
For the determination of the Panzar and Rosse time-varying H-statistic bank-level data
from BANKSCOPE for European countries are used. In this thesis, both the relationship
between foreign presence and banking competition for developed and transition economies
are studied. For developed economies, seven Western-European countries in the period of
1996-2002 are used. For the transition economies this sample is larger with eighteen East-
European countries in the period of 1996-2006. For developed economies the Panzar and
Rosse time-varying H-statistic met the minimum requirement of thirty bank-level
observations per year per country for all banks. For commercial banks this requirement
adjusted to twenty bank-level observations. With the transition country economies no

Page 41 of 57
minimum bank-level observation requirement were made since none of these countries has
more than thirty banks in the period (1996-2006).
With this data, the relationship between foreign bank presence and banking
competition in the developed host country is positive for all banks and commercial banks only
with the use of fixed time and country effects. This positive link seems to be larger for
commercial banks. Further, the results show significant effects between bank capitalization
(positive) and bank profitability (negative) and banking competition in the developed host
countries.
This foreign presence competition link is also positive for transition host countries.
Only the results for foreign presence, measured in foreign owned assets, are robust. Further,
the results show significant effects between bank capitalization (positive) and banking
competition in the developed host countries. In addition, the financial environment such as the
stock market capitalization has a positive, statistically significant, relation with bank
competition.
Comparing the results between foreign presence in developed host countries and host
countries in transition, the results imply that the effect of foreign bank presence in developed
economies on bank competition, although very small, is larger than that of host countries in
transition. This result was expected since I believed that the competition in transition host
economies was smaller than for developed host economies. However, tests show that the
coefficients were not statistically different form each other. Therefore, this difference in
competition cannot be stated with certainty.
Recommendations for future research are to study the effect of foreign presence with
different entry modes by foreign banks. Also the use of foreign presence as the number of
foreign banks over the total number of banks for developed countries could be a valuable
addition to this research. In closing, with more extensive data the effects of foreign presence
on banking competition could be ascribed to different bank types and sizes or only in the top-
level customer segment as Weller (2000) suggested.

Page 42 of 57
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Appendix

Page 46 of 57
 Table XI: Summary of different papers
Authors Objective Variables Panel Methodology Sources Results
Dummies for foreign
greenfield and M&A,
Bank
foreign bank share, Their model predicts that
Study how different entry observations of BANKSCOPE data
bank share of foreign competition is stronger if
modes (greenfield and ten Eastern base maintained
greenfield, bank share market entry occurs through a
Claeys et al. (2006) mergers & acquisition) European Regression analyses by
of foreign M&A, the age greenfield investment and
affect interest rate of countries in the Fith/IBCA/Bureau
of the bank after M&A therefore domestic banks'
loans. period 1995- van Dijk
or greenfield, and interest rates are lower.
2003
country specific
variables.
The research results show that
Bank
Estimate empirically the Number of foreign foreign banks entry affects
observations of
short-term effects of banks as percentage of negatively domestic banks
ten Eastern
foreign banks entry on total banks, share of revenues. Foreign banks entry
Liuhto et al. (2006) European Regression analyses BANKSCOPE
bank performance in the foreign banks' assets, can also raise the overhead
countries in the
Central and Eastern and country specific costs of the local banks and
period 1995-
European (CEE) Countries. variables. increase competition in the host
2001
country in short run.
Investigate how net
Bank Their results show that foreign
interest margins, Profitability indicators
observations of banks have higher profits than
overhead, taxes paid, and of banks, foreign bank
Claessens et al. (2001) 80 countries in Regression analyses BANKSCOPE domestic banks in developing
profitability differ share, and country
the period countries and the opposite in
between foreign and specific variables.
1988-1995 developed countries.
domestic banks
The share of foreign
bank assets in total Their investigation shows that
Investigates the short- Same as Data set related to
banking sector assets, at lower levels of economic
term effects of foreign Claessens et al. Beck, et al. (2000),
number of foreign development foreign bank entry
Hermes et al. (2004) bank entry on the But in the and data uses by
banks, Profitability is generally associated with
behavior of the domestic period 1990- Claessens et al.
indicators of banks and higher costs and margins for
banking sector. 1996 (2001)
country specific domestic banks.
variables.

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 Table XII: Variable definitions and data sources
Variable Definition Source
Panzar and Rosse H-statistic
IR Total interest revenue to total assets BANKSCOPE
IE Ratio of annual interest expenses to total assets BANKSCOPE
PE Ratio of personnel expenses to total assets BANKSCOPE
PCE Ratio of physical capital expenditure and other expenses to total BANKSCOPE
assets
ROE Return on equity BANKSCOPE
Panzar and Rosse H-statistic Time-curved Panzar and Rosse H-statistic derived from the data Authors' own calculation based on
of all banks in the host country BANKSCOPE data
Banking market structure
Foreign bank presence (assets) Ratio of assets owned by foreign (commercial) banks to the total Micco et al. (2004), and European Bank
(commercial) bank assets in the host country for Reconstruction and Development
Foreign bank presence (# banks) Ratio of the number of foreign banks to the total number of European Bank for Reconstruction and
banks in the host country Development
Foreign bank presence (other) Ratio of total assets, total equity, total interest income, and total Micco et al. (2004), and prof. dr. S.R.G.
loans held by foreign-owned banks Ongena
Concentration ratio Concentration level measured by the 3-bank (CR3) and 5-bank Authors' own calculation based on
(CR5) concentration ratio in the host banking sector BANKSCOPE data
HHI Concentration level measured by the Herfindahl-Hirschman Authors' own calculation based on
Index in the host banking sector BANKSCOPE data

Page 48 of 57
 Table XII: Variable definitions and data sources (continued)
Bank specific factors
Size Average bank size, measured by bank total assets BANKSCOPE
Liquidity Average bank net loans to total assets BANKSCOPE
Profitability Average bank interest income to total assets BANKSCOPE
Risk Average bank loan loss provision divided by net loans BANKSCOPE
Capitalization Average bank capitalization, measured by the ratio of equity to BANKSCOPE
total assets
Macroeconomic Environment
GDP Gross domestic product of the host country World Bank data
GDP growth Real gross domestic product growth of host country World Bank data
Inflation Inflation rate World Bank data
Financial environment
Stock market turnover ratio Ratio of the value of total shares traded to average real market capitalization Financial Structure dataset Beck (2008)
Stock market traded Total shares traded on the stock market exchange to GDP Financial Structure dataset Beck (2008)
Stock market capitalization Value of listed shares to GDP Financial Structure dataset Beck (2008)

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 Table XIII: Correlation matrix different concentration ratios
c3m c3b cr3 cr5 cr3c cr5c
c3m 1
c3b 0.7556 1
cr3 0.4604 0.3924 1
cr5 0.3977 0.3215 0.9804 1
cr3c 0.2993 0.5155 0.1749 0.0546 1
cr5c 0.2619 0.4801 0.2284 0.1275 0.9479 1
Notes: c3m: 3-bank concentration ratio Micco et al. (2004), c3b: 3-bank concentration ratio Beck (2008), cr3
and cr5 are concentration ratios as calculated with data used in this thesis for all banks. Concentration ratios
cr3c and cr5c are the concentration ratios as calculated with the data used in this thesis for commercial banks.

Table XIV: Number of observations of banks per country-year

1996 1997 1998 1999 2000 2001 2002
All banks
Austria 30 35 79 88 99 110 123
Denmark 35 39 40 41 41 44 45
France 71 74 77 78 82 91 91
Germany 908 969 1,023 1,069 1,164 1,225 1,262
Luxembourg 34 36 39 40 45 47 47
Switzerland 125 137 142 153 157 181 216
United Kingdom 43 45 49 58 65 67 70
Commercial Banks only
Austria 11 16 17 20 23 27 29
Denmark 67 77 77 81 82 89 90
France 54 61 65 68 77 80 82
Germany 21 23 23 23 22 25 23
Luxembourg 45 47 49 48 50 52 56
Switzerland 18 19 21 24 27 28 29
United Kingdom 31 32 36 36 41 43 43

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Table XV: Additional summary statistics foreign presence developed host countries, 1996-2002
Mean Std Min Max
0.2356 0.1313 0.0499 0.3684
Austria
0.0994 0.1042 0.0152 0.2196
Denmark
0.0577 0.0176 0.0360 0.0800
France
0.0447 0.0080 0.0326 0.0525
Germany
Great Britain 0.0758 0.0084 0.0653 0.0884
0.7975 0.0653 0.7358 0.8903
Luxembourg
0.0317 0.0159 0.0201 0.0565
Switzerland

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 Table XVI: Foreign presence in transition host countries
Country 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Foreign presence (assets)
Albania 0.14 0.19 0.35 0.41 0.46 0.47 0.93 0.92 0.91
Bosnia and Herzegovina 0.02 0.04 0.02 0.04 0.22 0.65 0.77 0.80 0.81 0.91 0.94
Bulgaria 0.33 0.43 0.75 0.73 0.75 0.83 0.82 0.75 0.80
Belarus 0.01 0.01 0.02 0.03 0.04 0.08 0.08 0.20 0.20 0.16 0.15
Czech Republic 0.19 0.23 0.26 0.38 0.65 0.89 0.86 0.86 0.85 0.84 0.85
Estonia 0.02 0.29 0.90 0.90 0.97 0.98 0.98 0.98 0.98 0.99 0.99
Croatia 0.01 0.03 0.07 0.40 0.84 0.89 0.90 0.91 0.86 0.91 0.91
Hungary 0.46 0.61 0.59 0.62 0.67 0.67 0.85 0.84 0.63 0.83 0.83
Lithuania 0.28 0.41 0.51 0.37 0.55 0.78 0.96 0.96 0.91 0.92 0.92
Latvia 0.52 0.71 0.79 0.74 0.74 0.65 0.43 0.53 0.49 0.58 0.63
Moldova 0.22 0.34 0.40 0.35 0.37 0.35 0.34 0.20 0.23
Montenegro 0.17 0.24 0.31 0.88 0.92
FYR Macedonia 0.09 0.12 0.11 0.12 0.53 0.51 0.44 0.47 0.47 0.51 0.53
Poland 0.14 0.16 0.17 0.49 0.73 0.72 0.71 0.72 0.71 0.74 0.74
14
Romania 0.12 0.15 0.44 0.47 0.51 0.53 0.55 0.59 0.59 0.88
Serbia 0.00 0.01 0.01 0.00 0.01 0.13 0.27 0.38 0.38 0.66 0.79
Slovenia 0.05 0.05 0.05 0.05 0.15 0.15 0.17 0.19 0.20 0.23 0.30
Slovak Republic 0.13 0.19 0.24 0.24 0.43 0.78 0.84 0.96 0.97 0.97 0.97
Average 0.15 0.21 0.27 0.34 0.50 0.58 0.58 0.62 0.64 0.70 0.74
Foreign presence (# banks)
Albania 0.38 0.33 0.80 0.85 0.92 0.92 0.92 0.87 0.88 0.88 0.82
Bosnia and Herzegovina 0.12 0.17 0.17 0.15 0.25 0.41 0.53 0.51 0.52 0.61 0.69
Bulgaria 0.07 0.25 0.50 0.65 0.71 0.74 0.76 0.71 0.69 0.68 0.72
Belarus 0.05 0.05 0.05 0.11 0.19 0.31 0.43 0.57 0.59 0.60 0.60
Czech Republic 0.43 0.48 0.56 0.64 0.65 0.68 0.70 0.74 0.74 0.75 0.76
Estonia 0.27 0.33 0.50 0.43 0.57 0.57 0.57 0.57 0.67 0.77 0.86
Croatia 0.07 0.11 0.17 0.25 0.49 0.56 0.50 0.46 0.41 0.38 0.45
Hungary 0.62 0.67 0.64 0.67 0.79 0.78 0.74 0.76 0.71 0.71 0.70
Lithuania 0.25 0.33 0.42 0.31 0.46 0.46 0.50 0.54 0.50 0.50 0.55
Latvia 0.53 0.50 0.50 0.50 0.55 0.48 0.43 0.43 0.39 0.39 0.54
Moldova 0.00 0.00 0.30 0.50 0.55 0.34 0.63 0.56 0.56 0.41 0.40
Montenegro 0.30 0.30 0.30 0.70 0.80
FYR Macedonia 0.23 0.23 0.25 0.22 0.32 0.38 0.35 0.38 0.38 0.40 0.42
Poland 0.31 0.35 0.37 0.51 0.63 0.67 0.76 0.79 0.77 0.82 0.83
Romania 0.32 0.39 0.44 0.56 0.64 0.73 0.77 0.70 0.72 0.73 0.84
Serbia 0.03 0.03 0.03 0.04 0.04 0.15 0.24 0.34 0.26 0.43 0.59
Slovenia 0.11 0.12 0.10 0.16 0.21 0.21 0.27 0.27 0.32 0.36 0.40
Slovak Republic 0.48 0.45 0.37 0.40 0.57 0.57 0.75 0.76 0.76 0.70 0.67
Average 0.25 0.28 0.36 0.41 0.50 0.53 0.56 0.57 0.56 0.60 0.65

14
1.51 changed to 0.15

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Table XVII: Additional summary statistics foreign presence in transition host countries
Foreign presence (assets) Mean Std. Min. Max.
Albania 0.532 0.312 0.144 0.933
Bosnia and Herzegovina 0.474 0.399 0.019 0.940
Bulgaria 0.686 0.181 0.325 0.827
Belarus 0.090 0.075 0.007 0.204
Czech Republic 0.625 0.293 0.190 0.891
Estonia 0.815 0.335 0.016 0.994
Croatia 0.613 0.399 0.009 0.912
Hungary 0.690 0.127 0.462 0.850
Lithuania 0.687 0.266 0.280 0.961
Latvia 0.618 0.120 0.428 0.791
Moldova 0.311 0.073 0.196 0.398
Montenegro 0.502 0.365 0.169 0.919
FYR Macedonia 0.356 0.197 0.094 0.534
Poland 0.549 0.260 0.144 0.743
Romania 0.482 0.220 0.115 0.879
Serbia 0.239 0.284 0.002 0.787
Slovenia 0.145 0.084 0.049 0.295
Slovak Republic 0.611 0.362 0.127 0.973

Foreign presence (# banks) Mean Std. Min. Max.

Albania 0.779 0.214 0.333 0.923
Bosnia and Herzegovina 0.374 0.207 0.122 0.688
Bulgaria 0.590 0.227 0.071 0.765
Belarus 0.324 0.240 0.053 0.600
Czech Republic 0.649 0.113 0.434 0.757
Estonia 0.555 0.174 0.267 0.857
Croatia 0.350 0.171 0.069 0.558
Hungary 0.708 0.056 0.619 0.786
Lithuania 0.438 0.099 0.250 0.545
Latvia 0.477 0.056 0.391 0.545
Moldova 0.387 0.216 0.000 0.625
Montenegro 0.480 0.249 0.300 0.800
FYR Macedonia 0.323 0.078 0.217 0.421
Poland 0.619 0.201 0.309 0.828
Romania 0.622 0.169 0.323 0.839
Serbia 0.197 0.193 0.028 0.595
Slovenia 0.231 0.103 0.100 0.400
Slovak Republic 0.589 0.148 0.370 0.762

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 Table XVIII: Effects of foreign bank presence on banking competition with other concentration
ratios and lagged factors in developed economies, 1996 -2002

Dependent variable: time-varying Panzar and Rosse H-statistic

All banks Commercial banks
CR3 CR5 CR3 CR5
Banking market structure
Foreign presence 0.0468 * 0.0478 * 0.0561 * 0.0638 **
(.021) (.022) (.030) (.029)
Dummies
Year dummies Yes Yes Yes Yes
Country dummies Yes Yes Yes Yes
Observations 36 36 42 42
Adjusted R-squared 0.8615 0.8595 0.8841 0.8912
Notes: Table XVIII Effects of foreign bank presence on banking competition with other concentration ratios and
lagged factors in developed economies, 1996 -2002. The same model is used as in table IV and table V. To save
space only the foreign presence variables are shown. Standard errors are shown in parentheses. * 10%
significance level, ** 5% significance level, and *** 1% significance level.

Table XIX: Effects of foreign bank presence on banking competition with other concentration ratios
and lagged factors in transition economies, 1996 -2006

Dependent variable: time-varying Panzar and Rosse H-statistic

Foreign presence (Assets) Foreign presence (# Banks)
CR3 CR5 CR3 CR5
Banking market structure
Foreign presence 0.0373*** 0.0271** 0.0210 -0.0011***
(.009) (.011) (.020) (.020)
Dummies
Year dummies Yes Yes Yes Yes
Country dummies Yes Yes Yes Yes
Observations 119 116 119 116
R-squared 0.6049 0.4383 0.5346 0.3962
Notes: Effects of foreign bank presence on banking competition with other concentration ratios and lagged
factors in transition economies, 1996 -2006. The same model is used as in table IV and table V. To save space
only the foreign presence variables are shown. Standard errors are shown in parentheses. * 10% significance
level, ** 5% significance level, and *** 1% significance level.

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In several academic papers it is shown that the distribution of firm sizes follow Pareto's law.
This law states that size and rank of a firm are related by:
Equation A.1
When the exponent reaches one ( = 1), then equation A.1 is identified as Zipf's law. This
relationship was original used for explaining the distribution of city and country sizes.
However, some authors have shown that this law can also be used on firm level and that
differs per industrial sectors. The size of the firms is computed in terms of total assets, sales ,
income and employees. Schaeck et al. (2008) argues that the degree of deviation of are
related to the degree of interaction between firms in a sector. By interaction they mean
competition, cooperation or collusion between firms. Therefore, observing could provide
useful insights in the market structure and competition in a sector.
The Zipf exponent can be obtained by rewriting equation A.1 with a log-transformation:
Equation A.2
The slope of can be obtained by an OLS regression. Using this regression for banks, a
higher implies a lower dispersion of extreme bank sizes and higher bank concentration. In
figure 3, the largest 250 observations in terms of log of the banks size are plotted against the
log of the rank. As can be seen they follow almost perfectly the slope of -1 (Zipf's law).

5
Log of the rank

0
8 10 12 14
Log of the bank size

Figure 3: Log of the bank size is plotted against log of the rank for the 250 largest (in assets) banks in Europe.

In table XX below, the coefficients obtained, R-squares, number of banks and different
concentration ratios are presented for different countries in Europe. The values of are

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obtained by using the time periods (to increase the sample size) and for firm size, total assets
are used.

Table XX: The estimated Zipf slope coefficients ()

Country Period Observations R-squared SE 3-K HHI
Austria 1996-2002 645 0.944 0.006 0.647 0.014 0.279
Denmark 1996-2002 415 0.950 0.007 0.583 0.688 0.187
France 1996-2002 1479 0.829 0.007 0.609 0.218 0.033
Germany 1996-2002 8973 0.899 0.003 0.748 0.432 0.082
Great Britain 1996-2002 1038 0.859 0.006 0.488 0.649 0.168
Luxembourg 1996-2002 482 0.823 0.012 0.572 0.388 0.088
Switzerland 1996-2002 1788 0.924 0.004 0.564 0.810 0.549

Albania 1999-2006 60 0.815 0.032 0.511 1.000 0.390

Bosnia and Herzegovina 2004-2006 204 0.886 0.018 0.714 0.710 0.190
Bulgaria 2001-2006 198 0.870 0.015 0.550 0.550 0.130
Belarus 1997-2006 107 0.886 0.019 0.886 0.860 0.410
Czech Republic 1996-2006 283 0.802 0.015 0.499 0.730 0.180
Estonia 1996-2006 78 0.758 0.028 0.443 0.980 0.840
Croatia 1996-2006 362 0.919 0.009 0.580 0.560 0.140
Hungary 1996-2006 327 0.698 0.015 0.400 0.530 0.170
Lithuania 1996-2006 91 0.800 0.027 0.515 0.730 0.220
Latvia 1996-2006 150 0.800 0.020 0.496 0.600 0.140
Moldova 1996-2006 77 0.921 0.024 0.704 0.580 0.160
Montenegro 2002-2006 36 0.903 0.043 0.783 0.870 0.450
FYR Macedonia 1996-2006 133 0.923 0.017 0.685 0.730 0.240
Poland 1996-2006 301 0.882 0.011 0.507 0.440 0.100
Romania 1997-2006 221 0.849 0.014 0.486 0.590 0.160
Serbia 2003-2006 187 0.908 0.014 0.599 0.440 0.090
Slovenia 1996-2006 184 0.839 0.020 0.628 0.590 0.190
Slovak Republic 1996-2006 175 0.797 0.020 0.535 0.720 0.190
Notes: Table XX presents the estimated Zipf slope coefficients, , with their respective standard errors and R-
squares. The values reported for the concentration indices 3-K and HHI are the values for the last year in the
given period.

As can be seen, Zipf's has a wide range of values from 0.400 (Hungary) to 0.886 (Belarus).
Also the values of the HHI from 0.033 (France) to 0.840 (Estonia) and the 3-bank
concentration ratio from to 0.014 (Austria) to 1.00 (Albania) differ significantly per country.
This illustrates that the different indices vary widely in both values and range and fail to reach
consensus on the most concentrated and least concentrated markets. Based on the results of
table XX, both indices are evenly inefficient.

Page 56 of 57
To decide which of these concentration indices is more suitable, Schaeck et al. (2008)
performed two other tests. First they show the elasticity of different concentration indices as a
function of with different sample sizes. The results show that HHI is the most suitable index
to distinguish between small differences in the bank size distribution when it follows a Pareto
law for both small (n=100) and large (n=500) samples. However, HHI is less adequate when
needed to compare sample concentration measures that have different values of . In this case
the 3-bank concentration ratio would be more suitable. For smaller values ( < 0.5) of in
large samples there is not much difference between the 3-bank concentration ratio and HHI.
The second test shows the elasticity of the different concentration indices as a function of
sample size for systems with different Zipf exponents ( = 1 and = 0.3). The results show
that for = 1 the 3-bank concentration ratio is preferred However, for = 0.3 HHI is the most
sensitive and therefore the best index.
As the sample used in this thesis has an average (median) of 0.589 (0.572) both the first and
second test show that HHI is the most suitable concentration ratio for this paper.

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