In the last fifteen years there has been a rapid increase in the activity of foreign banks in
several developing economies. Although, foreign bank entry occurred in many developing countries,
its pattern was not uniform (IMF 2000). In Latin America as well as in the Central European (CE)
countries, the share of foreign banks in the first half of the 1990’s was well below 20 per cent and a
decade later the foreign banks controlled almost 75 per cent of total banking assets. By contrast, in
East Asia over the same period, the average share rose only from 3 to 7 per cent (Barth 2001). The
level of development of a country seems also not to be an obvious determinant explaining foreign
bank entries. In such countries as Egypt or Bangladesh, the foreign banks hold less than 10 per cent
of banking assets; on the other hand in Cambodgia, Czech Republic or Turkey more than 60 per cent
is in the foreign hands. The differences are also meaningful among the transition countries. In
Azerbaijan or Uzbekistan, the share of foreign banks is less than 5 per cent, whereas in such
countries as Hungary or Lithuania it amounts to almost 100 per cent. The discrepancies are also in
the developed countries. In Germany or United States, the foreign-controlled banks hold less than 10
per cent of assets, whereas in Luxemburg or New Zealand they hold more than 90 per cent.
A good financial system has been shown to be an essential ingredient for sustainable
economic growth (Levine 2005, World Bank 2001). The literature on foreign banking has also
shown that foreign bank participation can help develop a more efficient and robust financial system
(Claessens et al. 2001). Most evidences show that increased foreign banking is generally positively
correlated with the improvement of the efficiency of the domestic banking sectors and helps
strengthen countries’ financial systems. Especially, studies on the developing countries have shown
that these countries have benefited from this trend at most.1 Therefore, from the policy perspectives
it is important to know what determines a favourable environment that encourages cross-border
activity and entering foreign banks. Despite the recent trends in the banking internationalization, 28
per cent of developing countries still have foreign bank participation below 10 per cent and 60 per
cent of developing countries have below 50 per cent. Among these developing countries with the
foreign bank assets below 10 per cent, the transition countries constitute almost 20 per cent and 25
per cent of the sample with the foreign bank participation below 50 per cent (Van Horen 2006 and
EBRD). As the experience of some Central and Eastern European (CEE) transition countries has
shown the foreign bank participation has turned out to be inevitable to build stable and efficient
financial system. Hence, we would expect that in other developing and transition countries, the
entering the foreign banks might also turn out to be necessary in the near future.
At the same time, by permitting foreign banks to enter, the policy makers should take care
about how the foreign banks operate in the host markets. First, letting the foreign banks come in, the
host countries may open themselves up to economic fluctuations in the entrants’ home countries.
Moreover, the organizational form may affect the competitive structure of the local banking systems,
threatening profits and market share of domestic banks and affecting the price and quality of banking
services in the host country. And finally, the entry through de novo operation involves different
levels of parent bank responsibility and financial support. This can have implications not only for
parent bank but also for local regulators, who care about the stability of the host country, and for
local depositors who care about the safety of the savings. The recent experience of Argentina, where
some foreign banks decided not to recapitalize their foreign subsidiaries presents the best example
On the other hand, the literature on international banking comes up with some arguments in
favour of one entry mode versus another. While the empirical studies show that the entry of foreign
banks through cross-border mergers and acquisitions is positively correlated with the efficiency
improvements of the acquired banks, the entry of foreign banks through subsidiaries may promote
greater access to the financial services in the host countries, as in many countries, the foreign
subsidiaries have powers identical to those of domestic banks. Hence, although, the trade-off
between one entry mode versus another is by local regulators required, from the policy perspectives,
it is also important to know what determines a foreign bank’s choice of organizational form.
Today, the banking sectors of most transition countries are among the ones with the highest
share of foreign-controlled banking asset in the world. It ranges from 70 per cent in Poland to almost
100 per cent in Slovakia (Allen et al. 2006). The change in the share of foreign participation in
banking in these countries from the early transition years to the later ones is significant.
The pattern of the banking internationalization was also not uniform in these countries. At the
beginning of the transformation, foreign banks entered the region mainly as de novo operation.
Encouraged by the fast going economical and political reforms in the region and high economic
growth, the pressure to enter the CE region has increased. With the intention of gaining rapidly share
in the local market most foreign banks used mergers and acquisitions’ (M&As) entry mode instead
of de novo operation abroad.
Generally, banks are found to be attracted to markets abroad to exploit favourable financial
system environment and to take advantage of economic opportunities in those countries (Goldberg
and Saunders, 1981). However, the question arises, what the foreign bank managements saw in the
CE countries that in the middle of the 1990s experienced in an increase of foreign bank’s entrance?
Do the theorists from the developed countries find the acceptation of their thesis in the countries
characterizing negative real economic growth, high inflation, uncertainty with the political
institution and an underdeveloped banking sector? In this paper, we try to analyze the determinants
which in the light of high uncertainties in four countries: Poland, Czech Republic, Slovakia and
Hungary, contributed to the foreign bank entries into these markets.
Our decision on the choice of this sample has been driven by some variations between these
countries. On the one hand, these countries have experienced the most significant pattern of banking
internationalization among almost all transition countries; on the other hand, they represented
various policies toward foreign bank entries as well as started their transition processes with
different initial conditions. For this reason, in our opinion, these countries constitute the best testing
ground on determinants of foreign banking participation and entry modes chosen by foreign banks.
The literature comes up with various motives for foreign banks to go abroad. In addition, the
mode of entry or the organizational form chosen by foreign banks is not only an issue of their
strategy or mission, but also depends on the entry country’s conditions and environment. Despite the
profound changes in the banking sectors of the CE economies as well as growing number of
countries embracing foreign bank entries, there is still open debate about the determinants of
banking internationalization and its modes of entries. The empirical evidences presented in the
literature come mostly from the US and developed European countries. There has been little
empirical research in this field for the developing countries so far. With our study we present the
empirical evidence on the motivation and entry vehicles of foreign banks in the CE markets.
Our contribution with respect to previous literature is twofold. First, we consider a new and
wider set of explanatory variables than previous studies, verifying different hypothesis and relative
importance of economic factors in determining banks’ choice of whether and where to expand
abroad. Second, we use a unique sample of entry models of foreign banks entering the region. Our
framework permits us to examine the relation between the relative importance of the different
country’s factors and the chosen entry model by foreign banks in the CE region.
Our major finding is that the most important factors determining foreign bank entry into CE
countries were development of the financial system and the banking sector as well as the legal origin
of the home country. We also show that most of the entries occurred in the period of a poor creditor
rights protection. Furthermore, our results find that the size of economic growth rates differentials
between host and home markets, and finally the distance between the host country and the banking
headquarters were of great economic importance. We also show that determinants of bank
internationalization have changed within development of the financial systems. Finally, our findings
present that the economic determinants had also an impact on the decision of organization form of
the foreign banks in the CE local banking markets.
The remaining of the paper is organized as follows. In the next section we present a short
overview of problems encountered by the transition from planned economy to the market economy
in the four CE countries. The third section presents the literature review about determinants related
to our main hypothesis of the banks’ expansion abroad. At the end of this section we present also the
results of the few empirical papers on foreign banking in the transition countries. In the next section,
we present the variables based on previous empirical research, which we have applied in our
regressions. In a subsection we develop also our main hypothesis related to the economic
determinants and the decision about the entry mode of the foreign banks into the CE local banking
markets. In the fifth section we present the model which investigates the incentives of foreign banks
for entering CE countries in the last decade, the period of enormous uncertainties and economic
transformation. The next section describes the results and compares them with other ones from
developed countries. Finally, the last section of the paper concludes.
2. Banking sector in early transition process
All the CE countries in our study followed the socialist financial system model, which was
designed to support the central planning economic system. Despite the centralization of financial
functions the state directed credit allocation with scant regard for repayment capacity, using the
national bank and state banks to channel funds to state owned enterprises
As a consequence of political changes in the year 1989 the creation of an effective financial
was a priority for the new governments in the CE countries. The aim was to implement a market-
oriented economy and thus fundamental changes were needed in the financial system. So the
banking industry was one of the first economic sectors, which underwent a fundamental
Hungary was the leader among the CE countries in the banking reforms. The government began the
banking reforms even before the political changes. In the early 1980s the Hungarian government
permitted a number of foreign banks to set up operations, even though these banks competed with
state-owned banks in the areas of foreign exchange and trade-related transactions. The centralized
mono-banking system was replaced by a two-tier banking system as National Bank of Hungary
assumed the role of central bank in 1987. The new central bank was charged with pursuing monetary
policy, including exchange rate policy, and was made responsible for the supervision of the banking
sector. The second tier consisted of the specialty banks, newly created commercial banks, and the
few already operating foreign banks (Hasan and Marton 2003).
In Poland the reform of the banking system started in 1987, when the government allowed for
creation of the joint-stock banks, yet they were still owned by the state. Two years later a new
banking law was introduced, which created a two-tier banking system in Poland.
In all the CE countries as a process of creating a two-tier banking system the commercial and retail
operation was divested from the activity of national banks and transferred to new commercial banks.
In Hungary the government set up three new state-owned banks from the National Bank of Hungary,
in Poland nine banks were created out of the National Bank of Poland, while in the Czechoslovakia
through divestment form the State Bank of Czechoslovakia four banks were established. These
medium sized state-owned banks inherited segments of the old network and staff of the national
banks, household deposits and loan portfolio comprising mainly of credits granted to the state
enterprises of unknown quality. They supplemented the already existing large state-owned specialty
banks. Those specialty banks existed separately from the central bank and performed specific
functions on behalf of the government in the planned economies. A state savings bank with an
extensive branch network was responsible for collecting household deposits, although most savings
was forced and done by the state. A foreign trade bank handled all transactions involving foreign
currency. An agricultural bank provided short-term financing to the agricultural sector. A
construction bank funded long-term capital projects and infrastructure development (Bonin and
Table 1 presents the representatives of each specialization group in a particular
Although three to nine new state-owned banks were set up through the divestment from
central banks, yet the banking industry remained fragmented as the three to four specialist banks still
dominated the emerging banking system. However, already in the first year of the transformation,
new banks started to operate in transition countries. The entry requirements policy of the newly
central banks and the licensing procedure for the de novo banks was very lenient at that time. The
principal motivation was to increase the competition of the four large banks, which were considered
too inertial and ineffective. The number of de novo banks was very impressive at this time. In
Hungary six new banks were established, in Poland 20 new banks and 13 new banks in
Czechoslovakia in 1990. Of these, three were foreign owned in Hungary, five in Poland and four in
However, this huge expansion in de novo domestic private banks later caused serious problems for
the financial system. Most of those domestic banks were in general undercapitalized and placed an
additional unwanted burden on an underdeveloped regulatory structure. In addition, some of them
have been set up either by state enterprises or by local governments in order to provide soft lending
to them. Hence, the features of banking system at the beginning of transformation were structural
segmentation, high concentration of the assets caused by few large and medium sized state-owned
banks, and an increasing number of small domestic private banks (Bonin, Hasan and Wachtel 2005).
Given the poor banking supervisory environment caused by poor accounting and financial
information, weak off-side surveillance capacity and the lack of experience with on-site
examinations, it was bound to lead to problems in the banking industry. The benevolent licensing
policy, combined with inexperienced and still weak banking supervision, caused the new private
domestic banks to take on rather unsound development strategies. In addition, the absence of
effective legal and institutional supervision also invited fraudulent behaviour by the managements of
these banks. As a consequence the new domestic banks started to have liquidity problem in very
short term. Also the former specialist banks get into trouble as they inherited a loan portfolio from
the past in which credit was granted not on commercial terms. In addition, those banks were still the
primary lending vehicle and quasi fiscal financing, usually for loss-making state-owned enterprises
that had to be either privatized or closed. The number of non-performing loans increased
significantly as the structural problems of the real economy increased caused by the ongoing
transition process in CE countries (Bonin and Wachtel 2003). Once the compliance of supervision
provision requirement was enforced, the quality of loan portfolios became apparent. As a
consequence several large state-owned banks reported huge losses and the equity adequacy ratios
were below the requirement of the banking supervision.
In Hungary, at the end of 1992, 15–28 per cent of the credits extended were nonperforming
loans and were primarily borrowed by the state-owned enterprises during the pre-1989 era (Hasan
and Marton 2003). The situation quickly became unsustainable as failing financial institutions turned
for bailout to the National Bank of Hungary. As a result the newly established national bank was in
jeopardy and the Hungarian government had to step in through a series of costly loan consolidation
programs beginning in 1992 (Várhegyi 1994, 1995, Balassa 1996). The government objective of the
bailout programs was the cleaning-up of the books of the state-owned banks, which would permit a
sell of to foreign strategic investors. The cost of the program approached close to 10 per cent of
Poland was the most successful in dealing with the bad debt crisis. The success is attributable to the
design of the recapitalization program, which provided the least incentive for moral hazard. In
addition, the central bank encouraged the buyout of troubled banks by foreign strategic investors. As
a consequence, the costs of bad debt bank crisis were below 1.5 per cent of GDP and were the lowest
among the transition economies.
In Czechoslovakian a Consolidation Bank was established as a vehicle for the takeover of the
accumulated bad loans till 1991. The bank was created to take nonperforming loans from the balance
sheets of the largest state-owned banks, and the clean-up of the books of other banks in the periods
both before and after the division of Czechoslovakia (Dědek, 2001). The overall costs of the
Consolidation Bank are estimated to have reached more than 7 per cent of GDP. Nevertheless the
creation of the Consolidation Bank did not solve the problem of the banking sector and the Czech
National Bank had to intervene in the affairs of eight banks by 1996. In 1997 classified credits
reached already 32 per cent of the total banking credits in Czech Republic (Dědek, 2001). Finally the
problem was resolved through a postponed privatization of the largest banks. However, the estimates
indicate that the final cost of bank bailout in the Czech Republic may have approached 30 per cent of
GDP as compared to just 1.5 per cent in Poland or 10 per cent in Hungary.
The growing problem of bad debt was the tiger for the postponed bank privatization in all the
transition countries. In most of these countries the privatization of state-owned banks started in the
beginning of the 1990’s, yet foreign banks were entitled only to minority shares whereas controlling
stakes remained with the state treasury. However, as the problem of bad debt increased, the
government was more likely to sell controlling shares in the state owned banks to foreign strategic
investors. The governments in transition countries were in addition encouraged by privatizations
revenues as they started with the privatization of state owned banks. Thus, at the end foreign bank
made their entrance into transition countries mainly through rescuing the ailing domestic banking
In opposition to the other transition countries, in Hungary bank privatization policy from the
beginning of was aimed at selling controlling shares in state-owned banks to foreign investors.
Although the privatization required prior an initial recapitalization of the banks so that the
combination of current net worth and franchise value would attract a foreign investor. As a
consequence the Hungarian government engaged in multiple recapitalizations of its domestic banks
caused by the poor quality of loan portfolios. Thus, the government was able to attract foreign
investors and thus signal credibly the end to bailouts of these banks (Hasan and Marton 2003). At the
end of 1997, four of Hungary’s five large state-owned banks had been sold to foreign owners and by
the end 2006 the share of foreign banks was 63 per cent of total assets.
The Polish experience indicates the danger in combining the resolution of bad loans with
bank responsibility for enterprise restructuring. The main instrument used to restructure bad loans
was debt to equity swaps. Hence, weak banks with no expertise in restructuring large companies
ended up taking ownership stakes in their weak clients. Therefore bank credit was provided regularly
to ailing enterprises and no meaningful enterprise restructuring was promoted banks (Gray and Holle
1996). Poland’s program strengthened, rather than cut off the ties between weak banks and their
undesirable clients and, thus, postponed painful restructuring of ailing enterprises (Bonin and Leven
In addition, in Poland the government presented an inconsistent policy toward foreign banks. In
1993 the government attracted the first strategic foreign investor for two of the nine midsized
commercial banks, yet only minority shareholding was allowed. Thus, foreign institutions controlled
only 2.1 per cent of Polish banking assets at the end of 1994. The National Bank of Poland however
enabled foreign bank entry at the beginning as de novo operation and later through either the buyout
of failing banks or their nonperforming credit portfolio. At the same time the government arranged a
large bank merger, in which the three of the nine midsized commercial banks were merged with one
of the state savings bank to form the second largest financial group in Poland. However, the
persisting inefficiency of Polish banking system caused the government to change their attitude
toward foreign investors. So in 1997 foreign bank were allowed to take control in the initial
privatization of the state-owned banks. Since then significant strides have been made and foreign
strategic investors took control in some of the largest commercial banks. In 2004 the government
sold 30 per cent of shares in the country’s largest retail bank PKO BP through the Warsaw Stock
Exchange. It was the last state-owned commercial bank and therefore the government decided to
retain a majority stake in it. Yet, at the end of 2006, 75 per cent of total bank assets were controlled
by foreign capital.
In the Czech Republic bank privatization took place twice. In 1992 the government of the
Czechoslovakia conducted a voucher privatization transferring the shares to individual investors and
investment funds in exchange for vouchers. Three of the four large commercial banks participated in
voucher privatization, yet these banks participated on both sides of privatization as they also
sponsored the largest investment funds. As a result, Czech banks took ownership stakes in their
voucher-privatized clients, some of which continued to be loss making, while the state retained a
controlling ownership stake in the large banks. Consequently, voucher privatization in the Czech
Republic strengthened the relationship between banks and clients and left bank governance held
hostage to the legacies of the past. Thus, the privatization of the Czech banks was to little avail
because soft lending practices continued. As a consequence these banks accumulated bad debts,
which have been later transferred to the Consolidation Bank.
In Czech Republic the second round of privatization occurred from 1998 to 2001, when the
government sold holding in three major banks. Until than no Czech bank was sold to a foreign
investor. Those three banks accounted for 38 per cent of assets. Since then the proportion of foreign
owned bank assets soared to 96 per cent in 2006.
All these four transition countries took place in the enlargement process of the EU and are
members of the EU since May, 2004. Consequently they had to adapt the Second European Banking
Directive and the Single European Passport, which eliminated the last market-entry barriers into
their banking sector. Although in all the countries the deregulation of the banking sector could be
observed since 1997.
Concluding, the increasing foreign bank presence since the 1990s is one of the most striking
developments in the banking system in the transition economies. On average, foreign-owned banks
account for more two thirds of total bank assets in most transition economies at the end of 2006. The
percentage of assets in banks with majority foreign ownership in these countries ranges from 22 per
cent in Slovenia to 99 per cent in Estonia. By contrast, in EU-15, only Luxemburg and Great Britain
had more than 50 per cent of its banking sector controlled by foreign interests in 2005 (Allen,
Bartilloro and Kowalewski, 2006). Thus, banking sectors in transition countries differ significantly
from their counterparts in developing as well as from emerging market countries by the unusual high
percentage of assets held by foreign banks.
3. Literature Review
In the last decades various studies have been conducted that investigated the motivation and
location choice of banks abroad4.
The classical hypothesis (Aliber, 1984) is that banks follow their customers abroad, being
afraid of losing them once they have established relationships with banks operating in other
countries. According to the defensive expansion hypothesis, banks’ expansion enables them to retain
information on their customers.
Multinational banking hypotheses relating to the servicing and following their clients generally find
empirical support. Nigh et al. (1986) presented in their study of US banks’ overseas expansion that
the major determinant was to respond to the financial needs of US firms abroad. Their study implies
that US banks do not lead, but follow the US business sectors. Goldberg and Saunders (1980)
analyzed the factors affecting the expansion of US banks into UK, concluding that US trade is
significantly conducive to the growth of US banks in UK, while the Eurodollar interest rate and the
exchange rate are not significant factors. In a later study Goldberg and Saunders (1981) examine on
the contrary the growth of foreign banks in the US. They results provided evidence that the direct
investment made by foreign firms into the market was a significant positive determinant of growth
of foreign banks’ market share in the US. Hultman and McGee (1989) and Grosse and Goldberg
(1991) also provided results that foreign banks entered the US market to service the international
trade and direct investment needs of their home-country clients. In a recent study similar results were
presented by Magri et al. (2005) in a study on entry decisions and activity levels of foreign banks
operating in Italy. The authors report that trade influences both entry decision and activity levels of
foreign banks. However, they found also that the relative profitability of banking activity in Italy
strongly influences both entry decisions and activity levels. As a consequence the observed
correlation in several studies between proxies for foreign investment trade and the structure of a
foreign market complicates the conclusions on motivation. Thus, the motivation of bank to move
abroad may be explained by the need to follow its clients and equally by the lure of a potentially
significant new market.
The importance of new market opportunities in attracting foreign banks has been emphasized
by the eclectic theory of direct investment (Dunning, 1977). The theory was extended by Gray
(1981) to explain multinational banking. In this theory multinatinalization of banks is contingent
upon location-specific factors and ownership-specific factors.
The location-specific factors are the size and competition in the foreign market, presence of entry
restriction and other regulations. Foreign market size has been found to be a significant driver of
multinational banking by Terrell (1979) and Goldberg and Grosse (1994). While, Goldberg and
Johnson (1990) provides some support for relative lack of competition or high relative profitability
as causal factors. In contrast Nigh, Cho and Krishnan (1986) did not found that local market
opportunity to have a significant effect. In their study they analyzed the role of location-specific
factors in foreign involvement of the US banks.
Recent studies presented a new approach to multinational banking and market structures. In those
studies banks may use economic crises and distortions in the banking industry in order to enter a
foreign market. Peek and Rosengren (2000) found evidence that as a result of liberalizations and of
the worsening conditions in domestic markets, foreign banks expanded in several Latin American
countries. Consistent with this result Guille´n and Tschoegl (2000) found that Spanish banks have
increased their ownership in Argentina’s banks during the economic crisis of the last decade.
However, Engwall et al. (2001) found that foreign banks lost market share in Sweden during the
Scandinavian banking crisis there in the early 1990s. On the other hand, at the same time they found
that foreign banks increased their market share in Norway. As we see the empirical results do not
present a clear picture on market structure, yet it seems that foreign banks may use a domestic crisis
in order to increase their market share in the market.
The ownership-specific factors emphasis that banks become multinational in order to employ their
domestic strengths in foreign markets at low marginal cost and thus leverage those strengths. Such
advantages can take many forms, including large scale of operation, low cost of capital, unique
business processes or banking technology, skilled personnel and banks’ reputation (Nigh 1986;
Tschoegl 1987). Among bank-specific characteristics, size has been found to affect mainly the
patterns of foreign direct investment. Ball and Tschoegl (1982) provided evidence that the larger
banks are much more international than smaller ones.
Consistent with this result Focarelli and Pozzolo (2001) have shown that banks with foreign
shareholdings are on average larger and have headquarters in countries with a more developed and
efficient banking market. However, Berger et al. (1995) argue that larger banks have generally larger
and more internationally diversified customers, and therefore these banks have more incentives to
follow their clients when they operate abroad. If it is the case than large foreign banks would rather
follow their multinational clients than have been encouraged by their comparative advantage. In
addition, several studies have documented that foreign owned banks are not as profitable as their
domestic peers. Seth (1992) and Nolle (1995) found that foreign owned banks were not as profitable
as domestically owned banks, based on aggregate profits. DeYoung and Nolle (1996) use a profit-
efficiency model and conclude that foreign-owned banks were less profit-efficient because of their
reliance on purchased funds. Molyneux et al. (1997) applying a simultaneous equations framework
concludes that the profitability of foreign owned banks was mainly related to capital ratios,
commercial and industrial loan growth and asset portfolio composition.
Although, the presence of higher demand profit opportunities in the market of destination of the
investment seems likely to be an obvious determinant of the location choice of multinational banks,
the empirical studies are more equivocal on location-specific factors and ownership-specific factors
as motives for banks to go abroad.
Apart from leveraging existing advantages, following clients or seeking attractive markets
overseas, there are other determinants of bank expansion abroad. In the opinion of Focarelli and
Pozzolo (2001) bank internationalization depends on other factors besides the degree of economic
integration among countries. As an example Claessens et al. (2000) analyze foreign presence across
80 countries from 1988-95, and find that foreign banks are attracted to markets with low taxes and a
high per capita income. Although, the regulatory restrictions have been found to significantly affect
the pattern of bank investment abroad. Miller and Parkhe (1998) presented that US banks prefer to
expand in countries where capital requirements are less stringent and taxes are lower. Consistent
with this result, Nigh et al. (1986) and Goldberg and Johnson (1990) present that restrictions on the
entry of foreign investors significantly reduce the degree of internationalization of a country’s
banking market. According to Boot (1999) governments may wish to have the largest banks in their
countries to be domestically owned. Thus, we would expect that in high concentrated markets as the
CE are, the entry of foreign banks is more difficult. In this case a single acquisition of the former
state owned banks would imply the loss of a significant market share to the advantage of foreign
The literature on the restructuring and development of the financial sector in transition
economies is abundant. However, the empirical literature on banking in transition countries
concentrates mainly on the impact of foreign bank entry on banking efficiency. Yildirim and
Philippatos (2002) find that foreign banks in transition countries are more cost efficient but less
profit efficient relative to domestic banks. Hasan and Marton (2003) and Fries and Taci (2003)
demonstrate that the entry of more efficient foreign banks creates an environment that forces the
entire banking system in transition countries to become more efficient, both directly and indirectly.
Buch (2000) compares interest rate spreads in Hungary, Poland and the Czech Republic from 1995
to 1999. She finds evidence confirming the hypothesis that foreign banks create a more competitive
market environment in transition economies, but only after they have attained sufficient aggregate
market share. The results were conformed to Zajc (2002), who reported for six European transition
countries that foreign bank entry reduces net interest income and profit, and increases costs of
domestic banks. While, Bonin et al. (2003) examine the performance of banks in eleven transition
countries and show that majority foreign ownership is associated with improved bank efficiency.
On the contrary, Green et al. (2002) estimate the efficiency of domestic and foreign banks in Central
and Eastern Europe (CEE) in terms of economies of scale and scope. They find that foreign banks
are not really different from domestic banks and that bank ownership is not an important factor in
reducing bank costs. There results were in oppostition to Claessens et al. (2001), who reported that
foreign banks in CEE countries tend to have lower overhead costs and loan loss provisions and
higher profits than domestic banks.
Fries and Taci (2005) presented that costs are lower in those transition countries where foreign
owned banks have a large share of assets. While, de Hass and van Lelyveld (2003) argued that the
increase in foreign banks have contributed to credit stability in CEE by keeping up credit supply
during crisis periods, while domestic banks reduced theirs. Although their results also show that the
privatisation of domestic banking systems in CEE as such has not led to immediate positive stability
effects. They have shown that banks that are sold to foreign strategic investors do not change
immediately into more efficient banks. Additionally, they presented that the country conditions
matter for foreign bank growth, as they have reported a significant negative relationship between
home country economic growth and host country credit by foreign bank subsidiaries. Related results
were provided by Bonin et al. (2005) in a study on the impact of bank privatization in transition
countries. They have reported that state-owned banks are the least efficient and foreign de novo
banks are the most efficient of all bank types in transition countries. However, they found also that
domestic banks have a local advantage against foreign banks in pursuing fee for service business.
The effects of foreign ownership on bank efficiency have been also examined in a few
country specific studies. For Hungary, Hasan and Marton (2003) find that relatively more efficient
foreign banks created an environment that forced the entire banking system to become more efficient
in the years 1993 to 1998. Nikiel and Opiela (2002) find that foreign banks servicing foreigners and
business customers are more cost-efficient but less profit-efficient than other banks in Poland from
1997 to 2000. For Czech Republic and Poland, Weill (2003) reported that foreign owned banks were
significantly more efficient than domestically owned banks in 1997. On contrary, Matousek and Taci
(2002) observed greater efficiency in private banks in the Czech Republic for the period 1993–1998,
yet they did not found any evidence of greater efficiency of foreign owned banks in their study.
Although these single country studies provide mainly a positive relation between foreign ownership
and bank performance, yet the results are not always convincing.
Finally, Naaborg et al. (2003) present that the three largest banks in most European transition
economy are in foreign hands. However, banks from non-European countries are almost absent in
the transition countries. In addition, they report that there is a relatively strong presence in some of
the European transition economies of foreign banks from neighbouring countries.
While the empirical evidence confirms the follower relationship hypothesis, the importance
of local market opportunities requires deeper investigation. So far little research has been undertaken
in order to examine the relation between foreign bank expansion and economic and structural
characteristics of host countries. In particular, a variable measuring profit opportunities usually
mentioned in the theory is either omitted in empirical studies, because of limited data availability, or
found to be non-significant.
In addition, the validity of the foreign bank motivation and entry modes has not been yet
established for the transition countries due to the modest attention given to their empirical
verification. Our study tries to fill the existing gap in the multinational banking literature building
our study upon previous empirical work. We focus on this aspect arguing that transition countries are
an interesting testing ground for theories on multinational banking. In 1990s, the economy and
financial market were characterized by lack of competition and close regulation. The situation
changed in the 1990s due to political transformation, when the financial markets were liberalized
and competition in the market increased. As a consequence, the transition economy and thus the
banking sector offered several profit opportunities to be exploited by foreign banks. Yet, it is still
unclear which motives for foreign banks had been the leading in the decision to go into one of the
4. Economic determinants contributing to FDI in CE banking sectors
As have been shown in the previous section, there are various theories explaining the motives
for banks to go abroad. In this section, we review the determinants that have been provided by the
literature as the motivation of foreign banking and present the proxies we have included in our
regressions. Our main goal of this paper is to provide an answer, which determinants have been the
leading ones for foreign banks, in their decisions to open a subsidiary in one of the CE countries.
However, we have decided to organize those determinants into four major groups. Each of the group
represents a different hypothesis providing an explanation on the motives behind foreign bank
expansion into one of the CE country. In addition, we hope this way to be able to establish the
relationship between the motivation and the model of entry chosen by the foreign banks. We review
the determinants of entry modes of foreign banks in more detail in the sub-section below. Given the
above considerations, we present the following four hypotheses to be tested.
Hypothesis 1: The foreign bank involvement is positively related to client’s presence in
the CE country
Hypothesis 2: The foreign bank involvement is positively related to market opportunities
in the CE country
Hypothesis 3: The foreign bank involvement is positively related to low efficiency of
domestic banks in the CE country.
Hypothesis 4: The foreign bank involvement is positively related to favourable
regulations in the CE country.
As have been already mentioned in the past the pattern of foreign bank expansion has been
dominated by the follower relationship. Under this hypothesis banks decided to expand in order to
provide services to their home country clients in countries abroad. At the same time those banks
operating abroad have gained a growing understanding of foreign markets and have increased the
range of their operation and services. Thus, we believe that the pattern of foreign bank has some
characteristic that are peculiar to the banking industry, yet the choice of expanding abroad depends
on a wider range than just one single factor. Therefore our hypotheses should be seen with great
caution as the variables presenting them may be significant simultaneous and it is difficult to asses,
which of them may be more important on a stand alone basis.
Our first measure controls for the first hypothesis to be tested, which have been shown in
many previous studies as an important motivation for foreign bank expansion. As a proxy for the
follower hypothesis we use as proxy the stock of direct investments excluding financial industry into
one of the countries in the CE from the country of origin of the foreign bank. The variable non-
financial FDI was expressed as ratio to the domestic country GDP. We employ it as a lagged one
measure as the rationale is that home banks will follow their customers abroad so that they can
provide services for them in the foreign operations. Thus, we expected that there is a positive
relationship between foreign direct investments and the expansion of banks abroad. A strong positive
relationship has been reported in the studies of Nigh et al. (1986) and Goldberg and Johnson (1990).
They have found a positive relationship between the US banks foreign activities and the size of US
foreign direct investments abroad.
Another common assumption in the empirical literature is that a well developed financial
market may attract foreign banks due to external agglomeration economies (Davis 1992,
Kindleberger 1974). The rationale behind is that investors consider whether to invest in foreign
banking, the size and structure of the particular financial system is likely to be one of the factors they
take into account. Thus, Konopielko (1997) formulated a hypothesis that with the economic
development of other countries the significance of the follow the client rationale for foreign entry in
banking will diminish and subsequently be replaced by search for client’s behaviour, which presents
our second hypothesis in our paper.
This claim was supported by Dopico and Wilcox (2002) who argued that the size of the host
country’s banking market is one of the significant determinants of foreign expansion. They found
that foreign banks are more pervasive in countries where banking is more profitable and where the
banking sector is smaller relative to GDP. In order to control for these characteristics, we considered
size of the financial sector and the banking sector, whereas the profit opportunities present our next
hypothesis and the proxies will be described later. In our study the size of the domestic banking
market of one of the CE countries is a location-specific determinant of foreign bank expansion.
We employ liquid liabilities, which are defined as the ratio of liquid liabilities of the financial system
to GDP. We consider this variable, as it is usual in the finance literature, as a proxy of financial
depth since it represents the size of the formal financial intermediary sector. The implicit assumption
is that the size of the financial system is positively related to the foreign bank entry. Including liquid
liabilities to GDP might also control for the effects of financial system underdevelopment that differ
systematically by income levels across countries.
In this study, similar to the study of Grosse and Goldberg (1991), the size of the banking
market is proxied by the deposits held by the domestic banks to GDP. This variable allows us to see
whether smaller and less developed domestic banking sectors attract more foreign banking. In theory
the larger the domestic banking market, the greater the number of potential customers. This would
suggest that there should be a large number of foreign banks willing to invest in large markets in
order to take advantage of the market’s potential. In our study we expect a positive relation between
the size of the banking market and the number of foreign banks. Especially in case of Poland, which
is the biggest country in the region, we anticipate to report a positive relation of foreign presense and
the size of the banking market.
Steinherr and Huveneers (1994) provided evidence that foreign banking was less common in
countries where a smaller number of domestic banks dominated banking. They argued that greater
concentration limited the choices available to borrowers, forced domestic firms into relationships
with the dominant banks and stunted the development of an arms-length lending market. In such a
market, even though banking might be profitable, foreign banks might be unable to enter. We test for
this by including a five-bank concentration ratio in our model specifications and expect a negative
relationship with foreign banking entry.
Market capitalization and turnover ratio
Demirgüç–Kunt and Levine (1996) documented that in different countries the extent of stock
market development highly correlates with the development of banks and other financial institutions.
We use the value of domestic equities on domestic exchanges divided by GDP to measure the
development of the stock market. In addition, we use the values of equities traded to GDP, which
reflect the activity of stock markets in transition countries. The total value traded ratio is frequently
used to gauge market liquidity because it measures market trading relative to economic activity. On
one side, we would expect significant positive relationship between the development of banking
sector and capital markets in transition countries. On the other side, the more active and developed
the capital market, the greater the competition with the banking industry. Thus, we may also assume
a negative relation between stock market development and activity and foreign bank entry.
Net interest margin and overhead costs
In order to test the importance of market opportunities in the transition countries we employ
two different variables. To test whether the overall profitability of banking in the host country
influenced foreign banking, we include a profitability measure – a net interest margin (Claessens et
al. 2001, Dopico and Wilcox 2002). High net interest margins in the CEE countries in comparison to
other developed countries have been observed in the past (Allen et al., 2006). However, Lensink and
Hermes (2004) find that in developing countries, foreign entry is associated with shrinking margins.
Similar results were previously reported by Claessens et al. (2001), who demonstrated that for most
countries higher foreign ownership is associated with a reduction of costs and net interest margins
for domestically owned banks. Those results were confirmed recently by Allen et al. (2006) in a
study on the EU-25 financial system. The authors have shown a gradually decline of the interest
margins in the CEE region over the last decade and the convergence towards the levels reported in
the developed countries.
Another source of motivation to expand abroad can be the foreign banks’ efficiency relative
to that of the domestic banks. According to Tschoegl (1987), high overhead costs, low efficiency of
management and the cost of capital can increase the likelihood of foreign bank expansion into the
market. In the Czech Republic and Poland foreign owned banks were more efficient than domestic
owned banks and this was not due to scale differences or the structure of activities (Weill 2003),
which would confirm our hypothesis. Therefore, to estimate and control for inefficient domestic
banks, we include the measures of overhead costs.
We will use this two variables in order to test our third hypothesis that foreign banks expand
into those markets, where are the highest profit opportunities and the lowest efficiency of banks. We
expect that foreign banks entering the market will see an opportunity to export their knowledge,
which will give them a competitive advantage in the domestic banking markets. Thus, we assume
that the foreign banks are probably the most efficient in their home market. The combination of high
profit opportunities and the inefficiency of the domestic banks provide the motivation for the third
hypothesis on foreign bank expansion into the CE countries. Therefore we expected that those two
variables will have a positive effect on the foreign entry into the region.
Legal origin, creditor rights and banking regulations
According to Goldberg and Saunders (1980) international expansion may be affected by both
economic and regulatory factors. In a series of influential papers La Porta et al. (1997, 1998) stress
that the cross-country differences in the legal environment and their enforcement may influence the
financial structure. Rajan and Zingales (1998) argue that bank-based financial structure prevails and
is more effective in countries with weak legal systems and poor infrastructures. While, Darby (1986)
presents that the rate of growth by particular parent countries may be stimulated by home country
regulation that reduces domestic profitability. To examine this issue, we follow La Porta et al.
(1997) and consider institutional factors that measure the quality of the legal environment both
overall and specifically for creditors.
We used the data on the legal origin from the La Porta et al. (1997, 1998) studies, the countries were
classified into five legal origin groups. With respect to legal origin, La Porta et al. (1997) distinguish
first between common law and civil law countries. The civil law comes from Roman law and relies
heavily on legal scholars to formulate its rules, whereas the common law originates from English
law and relies on judges to resolve disputes. It is common to further distinguish between French,
German and Scandinavian civil law countries. In addition, we separately control for the legal origin
of the transition economies were the legal system represents currently a combination between the
French and German civil law.
La Porta et al. (1997, 1998, 2000) argue that common law countries protect both shareholders and
creditors the most. More specifically, La Porta et al. (1998) show that countries based on the English
tradition have laws that emphasize the rights of creditors to a greater degree than the French,
German, and Scandinavian countries. French civil law countries give the weakest protection to
creditors, whereas German and Scandinavian civil law countries are somewhere in between. La Porta
et al. (1998) also examine enforcement quality. Countries with a French legal heritage have the
lowest quality of law enforcement, while countries with German and Scandinavian legal traditions
tend to be the best at enforcing contracts. In our study the variable English Legal Origin equals one
if the country has an English legal tradition and zero otherwise. Similarly, French Legal Origin,
German Legal Origin, Scandinavian Legal Origin and Socialist Legal Origin take on appropriate
values of one and zero for each country.
Legal and regulatory systems that facilitate the repossession of collateral and that grant
creditors a clear say in reorganization decisions are likely to encourage the development of banks.
As shown by La Porta et al. (1997) greater creditor right is positively associated with financial
institutions development. Thus, reforms improving creditor protection may attract foreign bank entry
into the transition countries. In terms of the specific indicators, we follow Pistor et al. (1999, 2000)
who modify the index of La Porta et al. (1997) by excluding one and including two additional
variables, referring the index to the problems of transition countries. In our analysis, the index ranges
from zero to five and aggregates creditor rights.
The creditor rights variable is described in La Porta et al. (1998) and Pistor (1999). We expect that
those countries with the legal systems that assign strong rights to creditor are more likely to support
the growth of banks including those of foreign origin.
Aliber (1984) and Hultman and McGee (1989) noted that a host country’s regulatory
environment affect foreign banking. Using the Barth et al. (2001) analysis of commercial bank
regulations, we construct an aggregate index of regulatory restrictions on bank activities in
securities, insurance, and real estate markets and restrictions on bank ownership of non-financial
firms. This measure of regulatory restrictions on bank activities gauges bank power and therefore
allow us to test whether restrictions on the range of permissible banking activities affected foreign
banking. Therefore, we anticipated a negative relation between foreign bank entry and regulatory
restriction on bank activities.
Economic growth and inflation
Weller and Scher (2001) claimed that the real economic growth and the level of development
of domestic banking determine foreign banks’ presence in the host countries. In order to control for
economic growth we include a variable representing difference in economic growth between host
and home country of the foreign bank. We expect to find a positive correlation between the
difference in economic growth rate and the presence of foreign banks.
A series of recent papers have addressed the study of the long-run influence of inflation on
growth and financial system development (Barro 1995). The main findings of this body of empirical
literature may be summarized as follows. First, inflation has a negative temporary impact upon long-
term growth rates. This effect is significant and generates a permanent reduction in the level of per
capita income. Second, inflation not only reduces the level of investment but also the efficiency with
which productive factors are used.
Exchange rate and corporate tax rate
To consider long-term economic conditions of the countries in our study, we include two
additional variables. The first is the change in foreign exchange rates of the currency of the domestic
country against the Euro currency. We use the exchange rate towards Euro as most of the foreign
banks stem from the Euro area. We will test whether fluctuations in the value of the host countries’
currencies affect the level of foreign investment in banking in CE countries.
Operating a banks subsidiary abroad will involve substantial flow of foreign currencies. A
depreciation of domestic currency may motivate foreigners to acquire the control of domestic bank.
In addition, when the host countries’ currencies depreciate, foreign banks may reduce their
repatriated income and increase their reinvestment in the host countries, as they may want to avoid
exchange rate losses. On the other hand, when the host countries’ currencies appreciate with respect
to foreign banks currencies, capital flows is expected to decrease as it becomes more expensive for
foreign investors to invest in one of the CE countries. Such a negative relation has been reported by
Goldberg and Saunders (1981) and Froot and Stein (1991).
Our second variable is the level of corporate tax in the CE countries. In the literature overseas
bank expansion is also frequently attributed to the variations in tax treatment of banks in different
countries. Thus, taxes may influence the level of foreign direct investment in banking in the region.
The corporate tax regime in use may therefore determine whether or not a country is an attractive
location for a foreign bank to establish a subsidiary. At the same time the foreign entry can be a
response to moves by the host country to attract foreign banks by offering more favourable tax
treatment than the bank’s home country or in order to increase competition in the financial services
The geographic differences between the home and host nations may proxy not only the
geographical, but also the cultural distance between countries. Given the importance of information
about customers as well as of knowledge of outlet markets in banking, we expected a negative
relationship between distance and foreign entry. In addition, in several studies the geographical
distance has been applied in the literature as a proxy for the degree of economic integration (Ball and
Tschoegl 1982, Grosse and Goldberg 1991).
We measure the geographic difference using the distance between banks host and home country. A
negative relationship may indicate that the difficulty of operating a subsidiary in a foreign country
grows as geographical and cultural differences increase. Focarelli and Pozzolo (2001) have reported
that the distance increases the probability of market entry by acquiring shares in a foreign bank.
While, Magri et al. (2005) presented that the likelihood of operating a foreign bank in Italy diminish
as geographical and cultural differences increased.
Finally, following Magri et al. (2005) we introduced also a dummy in the estimates to
identify countries belonging to the EU. We assume that EU banks should have an advantage to other
foreign banks due to lower entry barriers and extended the activities that are permitted to undertake
under the EU Directive. Therefore we expected the variable to exert a positive effect, which has been
reported in Italy by Magri et al. (2005).
4.1 Economic determinants and the entry modes of foreign banks
In principle, the factors affecting the decision about entry into the CE countries may vary with
the mode of entry chosen by a bank. Since such determinants as high net interest margin or great
economic development may promote one form of entry, the others as tax relieves or high
concentration of the banking sector may influence positively the other formal structures. Hence, an
organizational form is not an arbitrary formality but rather a function of foreign bank’s strategy and
scope of its activities willing to provide in the host country. In addition, foreign bank must take into
constitute an economic environment existing both in home and host countries. The legal form chosen
by a foreign bank is also of great substantive importance from another reason. It may under certain
circumstances have effect on the stability of both home and host banking sectors. The first one may
be affected by a failure or great losses of a parent’s bank institution in a host country. From the point
of view of a host country, the regulations promoting particular modes of entry may prevent country
from a crisis or at least attenuate their effects (Tschoegl 2003).
The regulatory environment of the CE countries has changed over time. Furthermore, it was also
different among the countries themselves. In principle, the foreign banks could enter the CE
countries either by acquiring or merging with a domestic bank or through de novo operation. We
distinguish among the operational forms a subsidiary or branch of a parent company, as well as a
representative office of a bank. Since bank’s representative office can not provide any financial
services in a host country, we do not consider them in our analysis.
A branch is defined as an integral part of the parent organization and in our opinion it constitutes
the highest level of foreign banking penetration in a host country. The branch shares a parent’s credit
rating, lends and trades on the parent’s full capital base. Thus, it may have substantial advantage in a
host country banking market. However, a branch may go insolvent if its parent goes bankrupt or
other way around. Thus, this mode of entry requires a careful supervision of both home and host
country’s authorities. The Polish banking law allowed the foreign banks to enter via branches since
1989. The licensing policy was also very liberal at that time. The only requirement to be fulfilled by
a foreign bank to set up a branch was an agreement with the National Bank of Poland. However,
despite that, Poland did not experience in wave of branches. The situation has not changed
significantly until now. One of the reasons was that the Polish National Bank was not willing to
allow foreign banks to operate as branches easily.
The situation looked differently in Hungary. The Hungarian regulatory authorities abolished the
entry via branch until the 1997 and even after the implementation of the Second Banking Act
Amendment in 1997, which provided a possibility to establish a branch by a foreign institution, this
form effectively qualified as subsidiaries in terms of capital requirements and operations (Kiraly et
al. 1999). Although, the operation activities via branches are allowed, the country has not
experienced any opening of branches till 2004.
In the Czech and Slovak Republics the situation looked very similar to Poland. The banking laws
from their beginning allowed foreign banks to set up branches assumed they received a formal
approval from the host national central bank.
Since the accession into the EU, the member states has been granted a “single passport”, which
assumes that all credit institutions authorized in an EU country would be able to establish branches
or supply cross-border financial services in the other countries of the EU without further
authorization, provided that a bank was authorized to provide such services in the home state
Table 2 shows that branch has been very rare mode of penetrating CE banking markets
comparing with other European countries despite any specific restrictions (excluding Hungary) per
se imposed by the regulatory authorities on this organizational form. One reason for that could be
that branches are very sensitive to the location-specific risk (Tschoegl 2003). Hence, in the course of
instable political and economic situation, the parent banks preferred to choose other organizational
forms, which could put them in the more secured position and did not require risking their
reputations once the expectations of great economic development would not have been met. Wengel
(1995) has proved it empirically concluding that the parent tends to send branches to wealthier
countries, while the less sophisticated forms to the developing ones. On the other hand, setting up a
branch of foreign bank should be justified by sufficient activities in the area for which a branch
offers an advantage (Heinkel and Levi 1992). Therefore, many studies on international banking
argue that branches are not attracted by great profit opportunities and hence they do not state in the
direct competition with other legal forms (Miller and Parkhe 1998). In the US, Heinkel and Levi
(1992) found that setting up a branch was positively correlated with the development of the domestic
money and capital markets, in which the foreign branches participate allocating the deposits of their
customers collected in the home market. Hence, we may assume that the development of the capital
markets in the CE countries as well as better creditor rights may positively affect the inflow of
branches into this region.
A subsidiary is a separate legal entity incorporated in the host country, mostly acted as wholly-
owned subsidiary company of a parent bank and often it is engaged in a broader range of financial
services than branches. Since the beginning of transformation the subsidiaries were the most
frequent forms of entering the CE banking markets. Heinkel and Levi (1992) point out that
subsidiaries differ from other forms of banking operations and thus respond differently to various
factors. First, they operate in the different area of competition than other legal forms. Second, the
parent bank has different motivations on establishing it. In the CE the history of subsidiaries can be
divided into two periods. The first, early 1990s when the subsidiaries were set up and second, the
middle of 90s when the privatization process began. The motivations of entry through this type of
organizational form have also changed across time. In the early of 1990s, the major motive driving
an establishment of a subsidiary was to provide high-quality services to these companies which had
invested in or traded with the CE countries as well as their foreign employees on the spot (Majnoni
et al. 2003). Thus, these subsidiaries were mostly engaged in the wholesale and corporate banking,
especially depositing, trade and exchange foreign operations. The best examples are Commerzbank
in Hungary (1993) and Czech Republic (1991), Bank of America (1990) and Citibank (1991) in
Poland. It should be also mentioned that many of these banks were motivated to enter by the tax
relieves which were very common practice at that time in CE countries. Unlike branches which are
subject to the home country’s regulations and tax and accounting standards, this could be an
additional motivation for setting up a subsidiary.
In the middle of 1990s, during the time of the major bank privatisations, the motivations behind
setting up a subsidiary changed. In this period foreign banks noticed an opportunity of acquiring
large domestic universal banks. Some of them acquired subsidiaries and even merged them with
already existing operation or branches. Apart from it in this period many subsidiaries of the foreign
banking institutions began to operate, especially in consumer finance sector as Porsche Bank, Opel
Bank, Fiat Bank or Sygma Bank.
Following the above argumentation, we would argue that the establishment of branches and
subsidiaries would be motivated by different factors and that they do not stay in direct competition to
As mentioned already, the most common mode of penetrating the CE banking markets which
became in the middle of 1990s was an acquisition of the existing banks. The entry through M&As
was the quickest and the simplest mode of establishing presence in the CE countries. Mostly, it took
place during the privatization process when the governments offered share in the domestic banks in
order to save them or in exchange for the takeover of bad portfolios. This process lasted till the
entrance of the CE countries into the EU. One reason for that were the administration restrictions
imposed by the governments on the acquisition of majority stakes by foreign institutions. In the
Czech Republic, for example, the acquisition of majority stakes to the strategic investors was
abolished. Thus, foreign investors were able to buy only minority interests in the domestic banks in
the first years (Bonin and Wachtel 1999). The Hungarian banking law, on the other hand, required
an agreement of President of the National Bank on acquisition of stakes in a domestic bank above 10
per cent. However, it represented the most liberal licensing policy and the privatization process with
the possibility of acquisition of majority later on. In Poland, the government started to sell majority
shares of the state-owned banks to foreign investors at the end of the 1990s (NBP 2001).
Tschoegl (2003) point out that the type of an organizational form chosen by foreign banks to
expand, is often closely connected with its strategy. He argues that the conditions which drew
foreign banks to enter developing countries erode over time and then some will have to withdraw
their local operations. Therefore, he distinguishes among others two types of banks’ strategies. First,
prospectors who enter via wholly-owned subsidiaries or joint-ventures in order to engage in
exploratory foray. Second, restructures who acquired large domestic banks in privatization process
and treat their investments rather as long-term commitment. Tschoegl (2003) also argues that as
foreign banks have no comparative advantage in retail banking vis-à-vis host country banks in the
long-run perspective, the acquisition of the domestic banks can be the only possible method to get in
this business and remain in it for certain, at least, medium term. In this sense, this mode of entry
gave the entering foreign banks much greater comparative advantage as setting up a branch or
Tables 3 and 4 show the number of foreign bank entries into the CE countries in breakdown by
entry modes and entering countries during the period 1994-2004. As it can be seen, the M&As have
been the most favourite entry mode of the foreign banks into CE markets during the last years.
[Table 3] and [Table 4]
The high number of the yearly entries by M&As can be a result of the banking regulations and
restrictions imposed by the governments in the CE countries on acquisition of majority stakes in the
domestic banks and as well as other forms of entry. In the course of relaxing the restrictions, the
same foreign banks could further increase their stakes in the domestic banks. An entry via subsidiary
was the second most common mode of internationalization into the CE banking markets and
dominated over the other methods mostly at the beginning and middle 1990s.
Table 3 shows also that Poland had the highest number of foreign bank entries. However, as we
compare the assets of the foreign banks between individual banking sectors presented in the table 4,
we can observe that the Czech Republic and Slovakia are among the CE countries with the highest
share of the banking assets in the hands of the foreign banks. Furthermore, Table 5 shows that
foreign bank entries came mainly from the neighbours countries of the CE countries.
5. Data and Methodology
This section describes our data set and the two econometric methods that we use to assess the
economic determinants of foreign bank expansion into the four CE countries. First, we employ
Poisson regression with our sample for the four CE countries and the OECD countries over the
1994–2004 period. Second, in order to evaluate the economic determinants and the entry mode of a
foreign bank into the CE market we use a bivariate probit model using our sample over the 1994–
2004 period. In our study we concentrate only on the OECD countries as almost all foreign banks
operating in the CE region were from the OECD member countries. All variables employed in our
analysis are presented in the Appendix.
In our paper we evaluate the economic determinants of foreign bank entries and its entry
modes into the four local banking markets in CE. In order to analyze those markets we use yearly
data on countries and banks in the four CE countries, namely the Czech Republic, Hungary, Poland,
Slovakia for the period 1994-2004. These countries have shown widely different policies towards the
mode of foreign bank entry as we have presented above.
Our final sample contains 110 cross-border entries either by M&A or through setting up a
branch or subsidiary by a OECD foreign bank in one of the host countries. We established those
transactions using public information as national and international press coverage and compared it
with the list of foreign banks compiled by national bank supervisors.
In our study we define a foreign bank entry as to be followed by three forms: entry by setting up
a branch, subsidiary or/and via M&A.
We define a subsidiary or branch as a organisational form that received a domestic license or
approval by domestic bank supervisory institution. The transformations of the already existing
foreign banks, i.e. the transformations of branches into subsidiaries or vice versa are not considered
as entry and therefore are not included in our analysis. We argue that they can be driven by other
market determinants, which might not be observable for the non-existing foreign banks.
We define the entry through M&A as an acquisition of minimum of 5 per cent shares in a
domestic bank by a foreign banking institution as well as merger of domestic and foreign operation
in a host country. In our paper we are interested only in the horizontal foreign entry, which are
assumed to offer a broad potential for cost and profit efficiency improvements. Other types of
transactions, such as government owned banks or other financial institutions acquiring an bank are
excluded because they may be motivated by a different set of considerations. Moreover, our analysis
does not include mergers or acquisitions of the domestic banks with other domestic banks.
5.2 Poisson regression
In order to analyze entry decisions into the CE countries, we consider the number of entries
of foreign banks at time t into Poland, Hungary, Czech Republic and Slovak in breakdown by a
country of origin, conditioning on the specific groups of the regressors such as host-country
characteristics, physic relationship between host and home country and potential determinants of
entering. In contrast to other analysis, we are not strongly interested in the characteristics of banks
entering the CE countries as this area has been covered by many researchers whose work can also be
applicable to the four countries in our study.5 Hence, we are mainly interested in answering the
a) How much did the host-country characteristics and in particularly macroeconomic conditions
matter in the entrance process of foreign banks into CE? Which of them did the foreign banks
consider to be the most important?
b) How much did the host-country banking regulations influence the number of foreign entries?
c) Which of the suggested in the section 2 determinants of banking internationalization did the
foreign banks mostly follow deciding on entry the CE countries?
Accordingly, we estimate the following choice model:
where y = number of entering banks from country i into country h at time t and Y1ht, Y2ht, Y3ht,… Y29ht
have independent Poisson distribution with parameters
h = host countries (Hungary, Poland, Czech Republic, Slovak)
i = entries from the sample (OECD countries) defined together as home countries
K ht = a vector of variables specific to the host country
H hit = a vector of variables specific for the relationship between host country and home country
B it = a vector of variables specific for the home countries
We estimate a model with a Poisson specification controlling for some unobserved country-
and time-specific effects clustering the standard errors on the home country’s levels. Hence, our
error term has one or two components depending on the specification: µiht= εiht+αh or µiht= εiht+αh+θt.
We believe that a Poisson regression is the most appropriate specification of our model for
several reasons. First, most empirical studies analyzing entries of foreign banks and their activities in
the host countries use Ordinary Least Squares (OLS) as estimation methodology. However, it has
been shown that omitting the countries which do not participate in the foreign banking may lead to
inconsistent estimate parameters because of loosing information excluded from the sample. In such
cases, OLS estimates are biased towards zero (Greene 2000). Moreover, employing the OLS
regressions where the dependent variable is a count variable seems to be inappropriate as one should
explicitly account for this type of dependent variables and use the estimation techniques designed for
it (Maddala 1985). On the other hand, the non-linear methods allow us to take advantage of the
larger number of observations and reduce the biasness. It is very useful particularly, when one
investigates foreign bank entries into CE in the time-series context, where the number of individual
foreign entries is small or zero. In the cases, where there is preponderance of zero or small values
and the dependent variable is of discrete nature, we can improve on the least squares with a model
that account for these characteristics (Greene 2000).
Moreover, most studies examining the determinants of banking internationalization use due
to data unavailability either time-series or cross-section structure of the data. Both are faced to some
drawbacks, which do not allow us to take all results unambiguous. Since the cross-section studies
ignore the time-series dimension of the data which may result in the biasness of the estimates due to
omitting the country-specific effects, the time-series studies, on the other hand, besides their
attractive characteristics, suffer from the lack of availability of good-quality and sufficient length of
the data needed for the purpose of the time-series analysis.
The new panel data techniques enable us to control for these shortcomings. They allow us to
take advantage of the time dimension of the data as well as to estimate common relationships across
countries. By introducing the country dummy variables we allow for controlling for the effects of
those omitted variables that are specific either to individual CE country or are specific to each time-
period. In each regression, we test for their jointly significance.
At the end we show that our results are robust testing for significance of other explanatory
variables used in the literature examining banking internationalization.
As far as the determinants of the entry modes are concerned, we use a bivariate seemingly
unrelated probit specification. Unlike the other studies, we control explicitly for the correlation
between particular entry modes and test whether any organizational form stayed in direct
competition with others.
5.3 Bivariate Probit Regression
In our study we are also interested in the relation between economic determinants and entry
modes of foreign banks into the CE countries. In particular, we are interested in changes between the
determinants affecting particular organizational forms among the CE countries. Since the decisions
about particular mode of entry might be correlated at time t within a home country, we have chosen
a seemingly unrelated bivariate probit estimation (SURB), where the dependent variable is of the
binominal discrete nature either one or zero. Thus, the model takes a form:
where Yiht equals one when an entry via a particular form (M&A, branch or subsidiary) from country
i into country h occurs at time t versus an entry through another form from country i into country h
occurs at time t, otherwise zero.
As the equations are estimated simultaneously, we allow for the error terms to be correlated between
the entry modes. The other vectors are the same as defined in the first specification.
This section presents the results of the Poisson regression and of the bivariate probit
regression. First, we present the descriptive statistics for our sample. Second, we discuss the results
of the Poisson regressions and we present the outcome of our robustness analysis. Finally, we show
the results of our panel analysis using the bivariate probit estimations.
6.1 Descriptive statistics
Table 6 – 9 provides summary statistics of our sample of OECD countries. Table 6 shows the
data representing economic characteristic of the 30 OECD countries in the period 1994-2004. In
addition, the table show the economic characteristics of those countries with no foreign direct
investment in CE, as well of those countries with foreign bank entry into the CE.
In Table 7 we show the economic characteristics splitting the OECD countries sample using
our CE host countries: Poland, Hungary, Czech Republic and Slovakia.
Similar, as in Table 6 we divided also the sample in countries with foreign entry into CE and
not. Table 8 presents the economic characteristics of those OECD countries without any foreign
direct investment in the financial services in the CE region.
While, Table 9 shows the economic characteristic of the OECD countries with operation in
the the CE region.
6.2 Poisson regression results
This section presents our Poisson regression results. In Table 10 we present the results for
foreign bank entry into the CE countries. We regress the dependent variable first against country
economic determinants and then progressively add our additional control variables. Table 6 shows
the results with a different set of independent variables in regressions (1) – (4). The Poisson
regressions reveal that some of our economic determinants may have a positive and statistical
significant impact on the entry decision of foreign banks into the CE countries.
In the regression (1) of the 1276 observations in the sample we lost 64 observations due to
the missing data on overheads in the home countries. In the regression (2)-(4) we lost additionally
261 observations because we missed some data on non-financial FDIs for Hungary. In all four
specifications we included dummies with respect to the host country in order to control for the
effects of those omitted characteristics which are specific to the individual CE countries. We test
also if those effects are significant and can explain the variations in the foreign banking between
these countries. Additionally, in regression (3) we added a time-effect and test if the determinants of
entering into CE have changed across time.
In the regression (1), the coefficients of two of three country-characteristics variables are
significantly different from zero. As expected, the tax rate is negatively correlated with the expected
number of foreign banks’ entries into CE countries, although, it seems not to be economic significant
in the regression. The reason might be that this variable may capture two opposite effects: (a) the
higher tax rate may discourage foreign banks to enter, especially by entry modes falling under the
local taxation; (b) the higher tax rate may encourage foreign entrants to choose particular entry
modes which gave a possibility to foreign banks to be exempted from local taxation or could
repatriate their profits to the parent banks.
As expected, the exchange rate shows a negative correlation with the expected number of
entries of foreign banks into CE and is highly significant. The negative sign of this variable may
indicate that with the depreciation of the foreign currency, the foreign banks started searching for
possibilities for great profits which occurred in the CE markets. The positive correlation between
inflation and the expected number of the foreign banks entering into CE was surprising. Yet, taking
into account that high inflation rates in the CE countries were associated with high net interest
margins, this variable may capture the effect of great profit opportunities on the CE banking markets
rather than its negative impact on the economy. This result is also consistent with other findings of
the literature on this topic. For example, Demirgüc-Kunt (1998) et al. find that inflation is associated
with higher realized interest margins and thus higher profitability of banks, especially in the
developing countries. This finding they explain by the fact that in developing countries demand
deposits frequently pay zero or below market interest rates. On the hand, in the period of high
inflation when the entries of most foreign banks occurred, the monetary policy targets of the CE
countries were already set and the specific measures to achieve them were identified.
The measure capturing the differences in the economic development between home and host
country turned out, on the other hand, not to be statistically significant, although it has an expected a
negative coefficient. It indicates that the higher the growth rate of the host country in comparison
with the home country, the higher the expected number of foreign banks entering the CE countries.
The size of the banking sector and financial sector appear to be statistical significant. Since
the bank deposits are positively correlated with the expected number of bank entries, consistent with
the hypothesis, the larger domestic banking sector, the greater number of potential clients and thus
better prospects for great profits. The second variable measuring the level of intermediation of a
country has a negative correlation with the banking internationalization into CE. We interpret this as
evidence that with the greater development of the financial sectors of the CE countries, it exists a
wider range of financial products and services outside a banking sector, and thus lower demand on
traditional banking products.
The coefficient of the concentration level of the banking sector is economically significant
and shows a negative correlation with the expected number of entering banks. Consistent with our
hypothesis, the result indicates that high concentration of the banking markets hinders new entries of
The net interest margin is negatively correlated with the expected number of entries of the
foreign banks. The impact of this variable remains also statistically significant. The low interest
income of the banking sector suggested high potential of the credit markets in the CE countries and
thus great profit opportunities from the retail and wholesale banking for the new entrants.
The variable measuring the legal and regulatory structure of the CE banking markets, the
bank freedom index has, as expected, a negative sign, although it is insignificant. Possibly it is
because all CE countries were considered by foreign institutions to have similar regulatory structure
and other country-characteristics and location specific factors played a decisive role in an entry
process into a particular country.
On the other hand, the variable capturing the effects of the improvement in the creditor rights
is significant and negatively correlated with the expected number of banks entering the CE countries.
The reason could be that most of the foreign bank entries occurred in a period of poor creditor rights
The difference in the efficiency of the banking markets seemed not to be a driving factor to
an entry of foreign banks into CE countries although it indicates a negative sign. It means that the
higher the inefficiency of the banking market relative to the home market, the higher probability of
an entry. Possibly it is a result of opposite effects of this variable on an entry. Once more inefficient
banking markets may encourage M&A entries consistent with the hypothesis that foreign investors
may use their expertise in order to restructure inefficient banks, the inefficient banking markets may,
on the other hand, discourage greenfield investments.
The results of the regression provide also evidence that the law of origin of the entering
country is of great economic importance. The legal origin variables are significant even at the one
percentage significance level. This result is also consistent with other findings in the literature that
foreign banks are more willing to locate their operations in the countries which share the same legal
origin (Galindo et al. 2002).
Conditioning our regression on the dummy if a country belongs to the EU or not, we can see
that joining the EU exerts a negative effect on the number of entries of foreign banks into CE
countries. It is also statistically significant. This negative impact is possibly because of the fact that
since joining the EU creates many new opportunities, the banking markets of the CE countries had
been already penetrated by the foreign banks leaving the new entrants a limited room to step in.
Finally, consistent with other literature, our result shows that the distance between home and
host country is economic important in determining an entry decision. In the regression the variable is
statistically significant even at the one percentage level. The negative correlation with the foreign
banking suggests that banks from neighbouring countries were more expected to enter the CE’s
As a goodness of fit measure we perform Pearson test which in each specification was highly
insignificant suggesting that our data are indeed Poisson distributed (the results are not reported
The regression (2) reports the estimates of the specification that includes non-financial FDIs
(lag), testing the hypothesis that the foreign banks were motivated to enter the CE countries by
following their customers and providing them their services on site. Although the coefficient of this
variable appears in the regression as insignificant, it has an expected positive sign. The inclusion of
the inflow of non-financial FDIs has resulted in some changes in the significance of the coefficients
as well as has changed the sign of one of the variables. We see that the estimate of the exchange rate
becomes positive, as we would expect, however insignificant. Possibly, because two different effects
may appear. In the (1) regression the exchange rate was significant at the one percentage level
because since we did not control for other motives of foreign banks’ entries into CE than motives
driven by great profit opportunities, the appreciation of the local currencies encouraged the foreign
entrants willing to take advantage from the strong currency. However, as we include the non-
financial FDIs and take into consideration the fact that depreciation of the currency creates great
prices for the foreign investors, many foreign banks followed the FDIs in the period of great
depreciation of the local currencies.
The insignificance of the concentration level of the banking sectors of the CE countries as
determinant of number of foreign bank entries can be explained possibly by two offsetting effects:
(a) the higher concentration level of the banking sector could have a negative effect on the number
of entries of foreign banks where the established retail and wholesale structure was desired; (b) the
higher concentration level could indicate under-banked and under-serviced markets and thus could
exert positive effects on foreign banks following their clients.
The economic significance of the differences in the growth rates between host and home
country after inclusion of the volume of the FDIs in the non-financial sector we interpret as the
evidence that the countries, which suffered from low economic growth were more expected to
search for the opportunities in the CE countries.
In the (2) regression the variable measuring the regulatory structure of the banking markets in
the CE countries becomes an important determinant of entry of the foreign banks into these
countries. We think that this is due to the fact that dummies with respect to the country of entry
remain jointly insignificant (compare regression (1), (2), (3) and (4)) rather than due to inclusion of
the non-financial FDIs. The reason might be that since the omitted characteristics between the CE
countries disappear, the entry into that country was more probable that imposed lower restrictions
on foreign banks’ entries.
Regression (3) presents the results of the regression after the inclusion of the time-specific
effects. We see that the results do not differ strongly from the ones of the regression (2). Interesting
is, however, the improvement of the significance level of the non-financial FDIs, which may suggest
that the foreign banks followed their customers entering the CE countries only at a certain point of
time. In order to test for it, we include in the next regression an interactive term. The parameter
estimates for three interactive terms are negative and highly significant suggesting that the “follow
the customer hypothesis” was not realized at the eve of the EU accession of the CE countries. The
parameter estimate for the non-financial FDIs on its own is, however, positive and highly significant.
It may indicate that the foreign banks followed their customers only at the beginning of the transition
process. We can also see that after inclusion of the interactive terms, two variables have changed
their significance. The exchange rate becomes significant at the one percentage significance level but
the net interest margin looses its economic significance. It may indicate that the foreign banks
following their customers could benefit also from the great depreciation of the currencies of the CE
countries. The insignificance of the net interest margin may suggest that retail and wholesale
banking activities gained an importance in the course of time. Finally, the results suggest that the
determinants motivating the foreign banks to enter the CE countries have changed across time.
6.2.1 Robustness analysis
We next conduct a number of robustness tests. We test for the significance of other explanatory
variables, which may explain foreign banking entry and have been also presented in the literature.
Additionally, we check whether our results are robust to different econometric techniques. We begin
our robustness analysis with the regression (1) and include new control variables. In the regression
(6), we estimated our model with the ordered logit and in the regression (7) with Tobit. The
empirical literature points out some advantageous of these two econometric techniques for the type
of observations which we use in the regression. The results of new estimation are reported in the
Table 11. The results show that none of the covariates is significant even at 10 percentage level and
their inclusion does not affect our previous results.
The national income per capita is used as a measure of a host country’s purchasing power and
thus demand for the banking services. The coefficient of this variable is negative and insignificant.
This is possibly because of the two offset effects. The measure of the country risk, as before, is
highly insignificant although shows a positive sign. It is consistent with the hypothesis the higher the
index (lower a country risk), the higher expected number of foreign banks entries. The coefficient for
the stock market as expected is positive suggesting that the foreign banks entries are positively
correlated with the stock market development. However, the variable is statistically insignificant.
Thus, we include instead the stock market capitalization and also this time the coefficient was
positive, yet insignificant. Finally, we included a measure of the size of country proxied by the
population of the host country. The coefficient of this variable was positive, but again insignificant.
6.3 Results of Bivariate Probit Regression
In the Table 12 we present results from a simple univariate probit estimation conducted on
the pooled data where we compare the coefficients for all types of entry modes. Each equation from
the previous regression (2) is estimated separately. The error terms are clustered on the home
To analyze the inferences in greater detail, we compare further the coefficients on
determinants affecting the presence of branches with respect to M&As and subsidiaries as well as
subsidiaries with respect to branches. This gives us a picture of comparative influences of the
different factors on the choice of entry mode. Moreover, by considering what interdependencies
between the banking forms are consistent with the empirical literature, the model shows how
different forms of banking activity compete or complement one another and what pattern of
competition or complementation between banking forms created the banking structure of the CE
countries. Unlike other studies on this presented in the literature, we employ the model which
directly control for it. The results are shown in Table 13.
In Table 14 we examine further the subsidiaries versus M&As, as these modes dominated in the
entrance process of foreign banks into CE. Moreover, as their activities could overlap to some extent
we feel that these forms could compete with each other in some areas. Moreover, in Table 14 in the
regression (2) and (3) we included also non-financial FDIs, although the literature on international
banking treats the trade variable and non-financial FDIs exchangeable as proxies for “follow the
customer hypothesis”. However, we follow Miller and Parkhe’s (1998) approach who argue that
since the bilateral trade can be positively correlated with different modes of entry, the non-financial
FDIs could explain the foreign entries through subsidiaries. We present in Table 14 in the regression
(3) the results of the regression with the country effect in order to examine if any unobserved and
omitted characteristics of the countries may explain additionally the differences in foreign bank
entries between the countries.
The results in Table 12 show that none of the entry modes stays in direct competition. It
might suggest that the foreign banks had different motives to establish their presence in the CE
markets. Hence, the organizational forms chosen by the foreign institutions could be considered as
complementary rather than as substitutes as suggesting the analysis from the developed countries
(Heinkel and Levi 1992). Moreover, the results may partly explain why the banking sectors in the
CE countries are overbanked but underserviced (Heinz 2004, OENB 2002, Bonin et al. 1998 ). It
may suggest that the level of the banking services were the same among the organizational forms of
In the regression (1) in Table 12, the coefficients of country characteristics variables are in
most cases significantly different from zero. Reversely than our previous results, the tax rate appears
in the regression highly economic significant suggesting that it has an impact on bank’s
organizational form. The signs of the coefficients show, however, different signs. The positive sign
of the coefficient for branch regression indicates that since branches have an advantage in shifting
profits across borders, they were more likely in countries with the higher tax rates. This finding is in
line with the results presented in the literature (Cerulti et al. 2005). The other organizational forms
since they fall under the local tax regime, they were more likely in countries with lower corporate
tax rates. The variable proxy the risk of a country suggests interesting implications. It appears
significant only in two regressions, although of opposite signs. As we have expected and in line with
previous findings, branches were less likely in countries with high country risk as they are
considered to be the most sensitive to the local country conditions. Hence, the coefficient in a
regression where a branch is our dependent variable has a positive sign. In case of regression when a
subsidiary is a dependent variable, the country risk seems not to be economic important, although it
also shows a positive sign. The sign of the coefficient of the M&A regression is significantly
different from zero but opposite to the regressions with subsidiaries and branches it has a negative
sign. An explanation for that might be that many M&As’ deals occurred following the economic
crises in the host countries since these events provided great opportunities for favourable transaction
in terms of acquiring local banks.
The size of the banking sector and financial structure suggest very interesting implications.
Financial development matters mostly in foreign bank entries via branches and subsidiaries. In case
of regression where a M&A deal is our dependent variable only the coefficient of bank deposits is
positive and significantly different from zero. The result may confirm that as most M&As
transactions were driven by potential opportunities in the retail and wholesale banking, the
inheritance of the important clients were of great importance. On the other hand, the result might
suggest that foreign banks acquiring or merging with the domestic banks were more oriented
towards servicing large institutional and corporate clients, whom they inherited with the portfolios of
the domestic banks. The results for a branch regression are of totally different nature. The negative
signs of both coefficients may be explained by the fact that at the beginning the branches of foreign
banks entered in the early stage of countries’ development being driven by the privatisation
processes of enterprises, which partly took place via stock exchanges. Most branches of the foreign
institutions were involved in a big portion of these transactions rendering investment banking
services. With the development of the stock markets as well as growth of the private sector, the
branches of the foreign banks extended the scope of their activities offering variety of products
related to the money and capital markets. Thus, controlling also for the stock market capitalization,
the coefficient of this variable is highly significant and exerts a positive sign. This result supports
Heinkel and Levi’s (1992) hypothesis that setting up a branch of a foreign bank should be justified
by sufficient activities in the area for which a branch offers an advantage. The regression for
subsidiaries shows however different results. The signs are exactly reverse than the signs of the
coefficients of the M&As’ regression and are significantly different from zero. The positive sign of
the liquid liabilities suggests that with the development of the financial sectors the new opportunities
for subsidiaries of the foreign banks emerged. The stock market capitalization appears in the
regression as insignificant. Thus, it seems that the stock market activity did not determine the set up
of subsidiaries by a foreign banks in a local banking market. The negative sign of the coefficient for
the M&A regression may again confirm the entering foreign banks in the period following the
financial crises, where the activity of the stock markets tends to decline.
The variable measuring the concentration level of the banking sector shows in two cases
positive signs and in case of the M&A regression a negative sign. Besides the subsidiary regression
where the variable is statistically insignificant, the other coefficients are highly economic significant.
The positive sign of the coefficient for the branch regression might be explained by a different scope
of activities, mostly in investment and corporate banking, rendered by this form of the foreign
institutions. They have not stayed in the direct competition to the ones serviced by the local banks.
Higher concentration of the banking sector meant the dominance of several local institutions in the
credit market. Such a structure of the banking markets gave other foreign institutions the possibility
to gain their shares in other fields. It might be especially true for the developing economies, where
the markets are unsaturated and the development of the financial sectors forces other financial
products and services to be strongly desired. Another picture presents the regression in which a
M&A deal is considered to be our dependent variable. The coefficient of the concentration level with
a negative sign may suggest that in the markets where the local banks enhance their market power,
the states banks were less willing to sell their stakes for foreign institutions.
Many foreign institutions entered the CE banking markets in order to provide their home
clients with the services on site. In the beginning the banks restricted their activities to trade services.
The positive and significant variable for the subsidiary regression may indicate that mostly
subsidiaries were the modes of entry chosen by foreign banks to service their clients. The
insignificance of the coefficient of the M&A regression may suggest on different types of clients
followed. Since subsidiaries might follow multinational companies, entries of foreign banks through
M&A of the local banks could and hence might indicate that they might service larger companies.
The coefficient of the trade variable for the branch regression shows as expected a negative sign and
it is insignificant.
Interesting implications suggest the variable measuring the distance between the parent bank
and its presence in the home country. Although, the coefficients from all three regressions show a
negative sign, as expected, only for branch specification, it is significant. The result is not surprising
as most of the entries through M&As and subsidiaries occurred among European banks, all CE
countries can be considered to be of comparable distance.
The first conclusion that we can draw with regard to the banking regulations for all three
regressions is that higher banking regulations hinder the foreign banks’ entries. However, only in the
regression (1) for branches and (3) for M&As, the coefficients of the variable are highly significant
from zero. The reason is that the branches and M&As were the organizational forms which were
regulated differently among the CE countries. The results of the influence of the creditor rights
confirm our findings from the first regression.
The coefficients of the net interest margin present the same signs for all the regression
specifications, yet it differ in their statistical significance. The negative sign of the net interest
income may indicate increasing competition. Increasing competition may explain why we observe
the statistical significance of the coefficient for a M&A regression. Thus, this method of entry may
be preferred foreign banks with the aim to reach a strong position in the local markets in a short
The literature on the international banking refers very often to the income per capita as a
variable measuring a host countries’ purchasing power and thus demand for the financial services
(Buch and Lapp 1998, Buch 2000, Sagari 1992, Yamori 1998) and largely find a positive relation to
foreign banking assets or FDIs. Our result however indicates that the impact of this variable depends
on type of the organizational form chosen by a foreign institution. We find that the branches were
more likely in the wealthier countries once M&A in the poorer. For the subsidiary regression, the
income per capita seems not to have an explanatory power.
The difference in the growth rates between home and host countries indicates that the lower
the difference (the higher the growth rate of the host country), the higher the probability of an entry
into a host country. The result is valid for all regressions, although the coefficients for the branch
and M&A regressions are not statistically significant.
Table 13 analyses the differences in a greater detail by an econometric comparison of the
presence of branches in respect to subsidiaries and M&As, while Table 14 show the comparison of
subsidiaries in respect to M&As.
As we can see from the Table 13, the examination of the branches with respect to subsidiaries
and M&As supports that the branches do not stay in any direct competition to other banks’
organizational forms in the CE countries. The results fully reflect the findings from the simple probit
regression presented in the Table 12. The one difference is the insignificance of the bank freedom
coefficient in the branch regression versus M&As one. The reason might be due to two offsetting
effects: (a) the branches were more likely in countries with lower regulations on branches; (b) in
countries where the higher regulations on branches applied, the foreign banks chose an entry via
The regressions in Table 14 confronting the subsidiaries versus M&As indicate, on the other
hand, more interesting implications. Already the result of Wald test suggests on some correlation
between M&As and subsidiaries. This comes from the significance of the coefficient of trade in case
we confront the entries through M&As with subsidiaries. Once we consider them separately, the
coefficient of this variable in the M&A regression seems to appear as economically unimportant.
This could suggest that subsidiaries of foreign banks could compete with the acquired local banks
for some clients, possibly larger multinational companies. After the inclusion of the non-financial
FDIs, we see that this variable is significant only in the M&A regression suggesting that since the
acquirers were large international banks, they could also follow large clients engaged in various
investments in the CE markets. We can also see that inclusion of the FDIs modify slightly our results
in regression (3) supporting the results of Miller and Parkhe (1998) that different forms of entry are
positively correlated with following specific clients. Moreover, the result suggests that since the
M&As and subsidiaries of foreign banks competed to the some extent, they reacted similarly to some
The results in Table 14 regression (3) seem to reflect the results from regression (2), however
the bank freedom index and country risk variables became insignificant for both M&A and
subsidiaries regressions. This may support our previous finding that controlling for the omitted
country characteristics and location specific factors, the differences between the CE countries in
terms of banking regulations and country risk do not explain different modes of entries chosen by
In the last decade we have witnessed a great influx of foreign banks into the CE countries.
The share of foreign bank assets rose from below 20 per cent to almost 80 per cent in all these
countries. We assume that the foreign banking in the CE will continue to expand, albeit at a slower
The literature on international banking has identified several factors that influence the
location choice of foreign banks. With this paper we add to this literature twofold: first, by
examining the determinants of banks’ choice – whether and where to expand abroad and second, by
determinants of organisational form chosen by foreign banks. Our empirical results show that
macroeconomic and institutional determinants influenced significantly a foreign bank’s decision to
expand the CE countries. We find that the foreign institutions were mostly attracted by large
potential of the CE banking markets and low degree of their financial sophistication. This finding
stays on the contrary to the results from the developed countries, where the foreign banks are more
likely to expand the countries with a high level of financial and banking system development.
According to these studies, only such markets offer more efficient banking product opportunities.
Our results do not support this view. They rather suggest that less developed financial systems offer
a wider range of possibilities for foreign banks to achieve great profits. Moreover, we show that in
the beginning of the transition process, many foreign banks decided to enter the CE markets simply
by following their clients. In the course of financial development occurring in the CE countries, the
new opportunities emerged and bank’s “follow the customer“ behaviour has been replaced by a
search for client’s behaviour. We also find that most foreign banks entries occurred in the poor
creditor rights protection. However, the legal origin of the home country was of great economic
importance. We show that common law countries as well as countries with German and French law
traditions were the most likely to enter the CE banking markets than other legal families. Finally, in
line with other studies, our results suggest that most banks stem from the European countries. This is
confirmed by a negative and significant coefficient of the distance between a host country and a
foreign bank’s headquarter.
We also looked on the modes of foreign bank entry and its relationship to the economic
determinants. We find that the choice of organizational form of a foreign bank depend strongly on
the economic characteristics of the host country. Moreover, consistent with previous studies, we
show that the decision on mode of entry is determined by a scope of activities a foreign bank is
going to render in a host country as well as by a type of client followed.
Our results are important from a research point of view. They expand the previous literature
on different economic factors encouraging foreign bank entries. They introduce a wider set of
explanatory variables than previous studies on this topic. They also shed a light how different factors
influence various organizational forms of entries, thus fitting in the growing literature on the role of
foreign banks in the host countries’ financial systems.
The results are also important from the policy perspectives. For one, they show that high
level of financial sophistication and strong creditors’ rights protection are not a necessary
prerequisite to attract foreign banks. Since the foreign banks have been shown to have a beneficial
influence on domestic financial systems, it seems to be good news, especially for developing and
other transition countries whose financial systems are poorly developed and the access to the
financial services is constrained. Furthermore, since the behaviour of foreign banks changes with the
development of financial systems, this suggests different implications for the supervisory authorities.
Replacing the foreign banks’ behaviour by “searching for clients’ behaviour” might encourage
foreign banks to take on excessive risks which might cause important consequences for the stability
of the host countries’ financial systems and thus might require specific policy responses.
Finally, our results suggest further agenda for research. One area for further research would
be to investigate the impact of mode of entry and organizational form on foreign bank behaviour in
the developing countries in more detail. Can the fact that the various organizational forms react
differently on the location-specific factors be explained by different behaviour of these banks in the
host countries? If yes, in what activities they engage in. Would it be true that foreign banks entering
through cross-border mergers and acquisitions are more oriented towards large retail and wholesale
clients neglecting lending to small businesses? The findings from the developed countries suggest
so. Additionally, the results from the developed countries suggest that subsidiaries of foreign banks
are more likely to engage in the retail and small-business lending and hence promoting greater
access to the financial services. The picture of the CE countries, however, shows that many
subsidiaries of foreign banks operate in the niche business providing such services as car loans or
mortgages. Thus, the scope of the activities of the foreign subsidiaries in the developing countries
requires a deeper investigation. And finally, does a lack of branches have any consequences on the
development of the financial systems in the CE countries? Several studies indicate that banking
sectors of the transition countries are overbanked but underserviced. It would be interesting to find
out the reasons for this.
Related to this, it would be interesting to look at banks’ determinants in the decision process
of whether to enter through de novo operation or cross-border mergers and acquisitions. Since the
behaviour of foreign banks may vary in the financial distress, the regulators should monitor what
banks are likely to choose subsidiaries rather than branches as an entry mode into a host country.
None of these areas has yet much been studied for developing countries.