The impact of foreign bank penetration on the domestic banking sector: new evidence from China

Abstract

This study proposes a foreign bank branch networks index (FBBNI) to capture bank-level exposure to competition from foreign banks in terms of geographical proximity. The index takes account of the rapidly expanding branch networks of both foreign and domestic banks in China. Based on data from a sample of three types of Chinese commercial banks from 2002 to 2011, we find that exposure to the branch networks of foreign banks is associated with improved profitability at domestic banks, higher efficiency, and increased non-interest income, consistent with knowledge transfer from foreign banks. These relationships are most pronounced for joint-stock domestic banks presumably because their ownership structure fosters knowledge transfer.

Keywords:

• foreign exposure
• bank performance
• Chinese banking

JEL Classifications:

• G2
• G21
• G28

Acknowledgements

The authors are grateful, for their helpful comments and advice, to two anonymous referees, Angelica Gonzalez, Zhenyu Wu (discussant), and participants at the 3rd Conference on Chinese Capital Markets at University of Edinburgh Business School, July 2013.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. In 2006, the ‘Big Five’ were officially relabelled as ‘large-scale commercial banks’ from ‘wholly state-owned commercial banks’ to reflect the result of ownership diversification. BOCOM is much larger than the JSCBs, and its shares are spread among different state-owned entities. Therefore, in 2006, the CBRC redefined it as a SOCB and it joined the other four big state-owned banks (the Big Four) to become the Big Five. For consistency, we treat BOCOM as a SOCB rather than a JSCB throughout the period.

2. The Asian Development Bank was the first foreign financial institution to purchase an interest in a Chinese domestic bank when in 1996 it purchased a 3.3% stake in the China Everbright Bank for $1.9 m (Berger, Hasan, and Zhou 2009).

3. For example, on 17 June 2005, the Bank of America (BOA) invested $3.0 billion in a 9% stake of the China Construction Bank and in August 2011, BOA sold half of its China Construction Bank holding for $8.3 billion, making an after-tax profit of about $3.3 billion in five years (Protess 2011).

4. For instance, foreign banks are still not allowed to offer automobile financing.

5. At the end of 2006, the CBRC imposed a prudent supervision measure on foreign banks. It requires that foreign banks must be locally incorporated as legal entities before they offer a full range of banking services to Chinese citizens.

6. The cross-sectional maximums per year are not the preferred benchmark since they vary over time. In order to reflect changes in the number of foreign bank branches at the city level over time, we use the panel total maximum as a constant benchmark.

7. We thank a reviewer for raising this point.

8. Due to their relatively small size and shorter history, this study only includes seven major RCBs. During the past few years, the RCBs have gradually shifted away from a policy-driven, rural-oriented business model to a market-oriented urban-focused operational model, and they have also started to compete directly with other commercial banks, especially the CCBs. Therefore, we classify the RCBs within the CCB category.

9. In order to minimise the potential omitted-variables problem, we also include the squared terms of the control variables in the models. There is little evidence of non-linear effects, and so these results are not tabulated.

10. Ferri (2009) argues that CCBs have a strong local focus and that their performance is related to the banks' locations. Therefore, as a robustness check, we re-estimate the main regressions by controlling for the levels of regional economic development in the sub-samples of CCBs. We include the real GDP growth of the province in which the head office of a CCB is located in the models. The results are not materially different from those for the models which do not control for regional economic growth. They are available on request.

11. The results of OLS estimation also show a similar level of economic significance.

12. Although the Chinese government has gradually liberalised interest rates over last two decades, the banks' interest rates are still semi-controlled by the Central Bank. Feyzioglu (2009) argues that the large interest margin given by the managed interest-rate system is one of main reasons for the high profitability of Chinese banks.

13. The market share of foreign banks accounts for only around 2% over the sample period, indicating that the extent of foreign bank penetration is relatively limited.