The existing literature ignores the effects of potential foreign entry on domestic banks in the process of financial liberalization. Empirical investigation of these effects is rare in practice due to the difficulties in observation and identification. Upon accession to the WTO, the China government committed to an opening timetable for the local-currency transactions. This timetable s an ideal setting to examine whether the potential entry of foreign banks has pro-competitive effects on the domestic banking market. Our empirical results show that domestic banks lower their interest margins in response to potential competition, and accordingly their before-tax profits decline. This signifies that efficiency gains in the banking sector also arise from potential foreign entry.

Ben Li

Jie Mao

English

Research Papers in Economics

     
 
 
  
  
Volume 29, Issue 1 
  
The effect of potential foreign entry in the banking sector 
  
 
 
Jie Mao  
School of Economics and Management, Tsinghua 
University 
Ben Li  
Department of Economics, University of Colorado at 
Boulder
Abstract 
The existing literature ignores the effects of potential foreign entry on domestic banks in the process of financial 
liberalization. Empirical investigation of these effects is rare in practice due to the difficulties in observation and 
identification. Upon accession to the WTO, the China government committed to an opening timetable for the local-
currency transactions. This timetable s an ideal setting to examine whether the potential entry of foreign banks has 
pro-competitive effects on the domestic banking market. Our empirical results show that domestic banks lower their 
interest margins in response to potential competition, and accordingly their before-tax profits decline. This signifies that 
efficiency gains in the banking sector also arise from potential foreign entry.
We thank Stijn Claessens and Paolo Coccorese for their helpful comments. 
Citation: Jie Mao and Ben Li, (2009) ''The effect of potential foreign entry in the banking sector'', Economics Bulletin, Vol. 29 no.1 pp. 141-
149. 
Submitted: Dec 09 2008.   Published: February 19, 2009. 
 
      
 
1. Introduction 
The existing literature documents that the entry of foreign banks causes efficiency 
improvements in the banking sector of host countries (e.g., Claessens, Demirgüç-Kunt, 
and Huizinga, 2001).
1  However, it remains unclear whether potential entry of 
foreign banks has a similar effect.   
Whether potential entry matters is a controversial topic in the theoretical literature 
on industrial organization, and it ultimately boils down to an empirical question. 
Capturing something merely potential is an empirical challenge; only a few papers 
have succeeded, primarily by ingeniously finding relevant real-world contexts. For 
instance, Bergman and Rudholm (2003) with regard to the Swedish pharmaceutical 
market, and Goolsbee and Syverson (2008) concerning the U.S. airline market. 
The opening timetable for foreign entry into the Chinese banking sector, to which 
China committed upon its accession to the World Trade Organization (WTO), 
provides a suitable setting in which to investigate the potential-entry effect. Using this 
setting, we empirically identify the impact of foreign banks on domestic banks 
through potential competition. 
 
2. Backdrop 
Before accession to the WTO in 2001, foreign banks in China were allowed only to 
engage in limited foreign-exchange transactions with multinational enterprises in 
particular regions. As a result, foreign banks played no more than a peripheral role. In 
accordance with the commitments made by the Chinese government, all types of 
foreign-exchange transactions in China were immediately opened to foreign banks 
upon China’s accession to the WTO in 2001, while local-currency transactions were 
derestricted step by step: four to seven cities per year from 2001 to 2005, and all 
remaining cities in 2006. As shown by the timetable in Figure 1, domestic banks faced 
competition from foreign banks in foreign-exchange business immediately, but did 
not face foreign competitors in local-currency business until the cities where they 
were located were opened up. During this grace period, the threat imposed by foreign 
banks was potential in nature. 
The potential threat was credible and substantial. Foreign banks indeed entered 
into Chinese cities to commence local-currency business when restrictions were 
removed. At the end of 2003, 84 out of the 191 foreign banks in China held 
local-currency licenses. Having modern banking technology and high-quality 
management, foreign banks quickly achieved large shares in the banking market. For 
instance, foreign banks issued more than 40% of new local-currency loans in 
Shanghai during the first 11 months of 2006 (Xu and Lin, 2007). History of other 
transition economies also indicated the forthcoming keen competition at that time: in 
the 1990s, foreign banks provided more credit to the private sector than domestic 
banks in all central and eastern European countries except Slovenia (Naaborg, 
                                                 
1 For the references on the effects of banking deregulation, see Freeman (2002) and Wall (2004).   
1 
  
Scholtens, de Haan, Bol, and de Haas, 2004). 
 
3. Data and Specification 
Our data are primarily extracted from the BANKSCOPE, which is both a widely-used 
data source in banking literature, and the most comprehensive micro-level database of 
Chinese banks available to academia. Our dataset includes 22 domestic commercial 
banks in China that accounted for the majority of total assets in the Chinese banking 
sector during the period 2000–2006.
2  
To maintain comparability with the study of actual foreign entry, we focus on the 
same dependent variables as Claessens et al. (2001). Net interest margin is the 
difference between interest income and interest paid out in lending activities, and it 
reflects the market power of a bank, as well as the efficiency it contributes to the 
economy. Higher margin signifies a lack of competition and thus lower efficiency. 
Non-interest income is the income from a bank’s non-lending business. Before-tax 
profit measures the profitability of a bank, overhead expenses represent the level of 
overhead costs, and loan-loss provisions refer to actual provisions for bad debts. 
Consistent with standard practice in the literature, all five variables are calculated as 
ratios over total assets. In addition, we incorporate bank-level control variables, 
including leverage (the ratio of equity to total assets) and default risk (the ratio of 
loan-loss provisions to loans) as well as regional GDP per capita and GDP growth 
rate.
3 Table 1 reports descriptive statistics for our dataset. 
The model is specified as   
=+' +' + ' + + + ijt jt it jt i t ijt y αδ PRE β B γ X μC ψT ε ,   (1) 
where  ijt y  is the variable of interest—including net interest margin, non-interest 
income, before-tax profit, overhead expenses, and loan-loss provisions—for domestic 
bank   in city  i j  at time  ,  is a vector of potential-threat indicators in city  t jt PRE
j  at time  ,  t it B  is a vector of bank-level control variables at time   which would 
be discussed later, 
t
jt X   is a vector of region-level control variables at time  ,   is 
a bank dummy, and   is a time dummy. The error term,
t i C
t T ijt ε , is assumed to satisfy 
classical assumptions. We employ the weighted-least-squares technique to estimate 
the model, with the weights being the inverse of the number of domestic banks in the 
given city and year. Observations are at the year-bank level. Notably, covariates of 
ijt y  that change over years but do not vary across firms would be absorbed by the 
time dummy. 
Potential-threat indicators are dummy variables that indicate the chronological 
distance between the year to which a given observation belongs and the year in which 
local-currency business in city  j  is opened to foreign banks; PRE = (PRE4, PRE3, 
PRE2, PRE1). PREn is equal to 1 if the city to which an observation belongs is n 
                                                 
2 Foreign banks in a few cities were allowed to do foreign-currency transactions before 2001, but they were not 
allowed to embark on local-currency transactions until the opening year stipulated in the official timetable. Thus, we 
also include the observations for 2000.  
3 Region-level variables are reported in or calculated based on the statistical yearbooks published by the Chinese 
government. Coccorese (2008) discusses the role of environmental variables on banks’ conducts. 
2 
  
years away from being opened.   
What PRE captures is the heterogeneity among cities caused by the varying 
chronological distance between the current year and the opening year. This effect will 
not be contaminated by a second effect so long as the second effect does not generate 
city-level heterogeneity. For example, consider that in 2003 city A is one year away 
from opening, while city B is two years away:  and 
. Suppose that another reform is undertaken in these two cities in 
2003. The heterogeneity caused by the chronological order—the effect of being one 
year away from opening—will be captured by the coefficient of PRE1; the effect of 
the contemporary reform will not affect this coefficient, because the reform does not 
differentiate these two cities, and thus it will be absorbed by the time dummy. Other 
reforms in China during the studied period proceeded on a nationwide basis, rather 
than following the timetable; therefore, the effects of other reforms would not 
confound the captured potential-entry effect.   
,2003 = (0,0,0,1) A PRE
,2003 = (0,0,1,0) B PRE
 
4. Results 
The results are reported in Table 2. Column (1) shows a substantial decline in net 
interest margin when domestic banks face potential entry by foreign banks. All four 
PRE-coefficients are statistically significant at conventional levels. The average 
coefficient is −0.415. Considering that the average of net interest margin is 2.034, we 
find that an average bank will lower its margin by approximately 20% (0.415/2.034≈
0.204).
4 Lower margin suggests that domestic banks adjust their loan pricing in order 
to retain existing clients or to increase market share.   
The positive correlation between net interest margin and overhead expenses is 
consistent with the findings by Claessens et al. (2001). One intuitive interpretation is 
that banks pass the burden stemming from potential entry to depositors and borrowers. 
The positive correlation between net interest margin and default risk signifies the 
tradeoff faced by domestic banks. Higher default risk causes banks to raise interest 
rate and thus margin rises; at the same time, higher interest rate results in higher 
default risk because of adverse selection (Stiglitz and Weiss, 1981). 
Column (2) reports an increase in non-interest income on the eve of opening 
(coefficient=0.148, s.e.=0.055). This effect is significant only when time gets close to 
the opening. A natural explanation is that banks strengthen their non-lending business 
in response to their future foreign competitors, who have already been more 
developed and experienced in non-lending business. An alternative explanation is that 
domestic banks charge higher service fees in their non-lending business. The former 
explanation is more likely to apply, in that the effect of potential entry is, if not 
pro-competitive, at least not counter-competitive in theory. Furthermore, the positive 
coefficient of overhead expenses in Column (2), though only significant at the 10% 
level, also lends support to the former explanation, because non-lending business 
usually involves additional staff training and equipment purchases. 
                                                 
4 It is noteworthy that each of the PREs is exclusive of the others; hence, the coefficients of PREs are not additive. 
3 
  
The effect of potential foreign entry on before-tax profit is reported in Column (3). 
All four PREs have negative coefficients, and the first three depress profit 
significantly, suggesting that the decrease in net interest margin is still nontrivial even 
though it is partially offset by the increase in non-interest income. 
Column (4) reveals weak evidence that domestic banks raise overhead expenses 
in response to potential foreign entry. Sachs and Woo (2003) mention that domestic 
banking technologies may be improved when the entry of foreign banks makes 
advanced banking technologies available. In our case, overhead expenses increase 
even prior to actual entry of foreign banks. Our results imply that the technology 
improvement is not only attributable to spillover, but also to voluntary 
self-development, since spillover is absent prior to actual foreign entry. The positive 
coefficient of regional GDP per capita also supports this technology explanation, 
because the rise in overhead expenses is higher in richer regions; in other words, the 
banks located where economic performances are not good would be less likely to 
incur the additional expenses to improve their technologies.   
The effect of potential foreign entry on loan-loss provisions is unclear, as shown 
by Column (5). In fact, the total effect of potential entry on loan-loss provisions is 
theoretically ambiguous. On the one hand, domestic banks may become more 
cautious at launching loans in the periods prior to opening; thus, the quality of loans 
rises. On the other hand, future availability of loans provided by foreign banks may 
encourage local firms with low risk to postpone borrowing from domestic banks. 
Finally, as expected, default risk is shown to be close associated with loan-loss 
provisions. 
 
5. Conclusion 
In addition to the known foreign-entry effect, this paper finds another channel through 
which derestricting the domestic banking sector improves social efficiency. The net 
interest margin and before-tax profit of domestic banks decline in response to the 
potential threat imposed by foreign banks in the process of banking liberalization. We 
also find weak evidence that potential entry causes the non-interest income and 
overhead expenses of domestic banks to rise, which is possibly because of 
technological improvements in non-lending business. As a result, the benefits of 
opening the banking sector are stronger than conventionally expected. 
 
References 
Bergman, M. A. and N. Rudholm (2003) “The Relative Importance of Actual and 
Potential Competition: Empirical Evidence from the Pharmaceuticals Market” 
Journal of Industrial Economics 51(4), 455-467. 
Coccorese, P. (2008) “Bank competition and regional differences” Economics Letters 
101, 13-16. 
Claessens, S., A. Demirgüç-Kunt, and H. Huizinga (2001) “How does Foreign Entry 
Affect Domestic Banking Markets?” Journal of Banking and Finance 25, 
4 
  
5 
 
891-911. 
Freeman, D. G. (2002) “Did state bank branching deregulation produce large growth 
effects?” Economics Letters 75(3), 383-389. 
Goolsbee, A. and C. Syverson (2008) “How Do Incumbents Respond to the Threat of 
Entry? Evidence from the Major Airlines” Quarterly Journal of Economics 
123(4), 1611-1633.   
Naaborg, I., B. Scholtens, J. de Haan, H. Bol, and R. de Haas (2004) “How Important 
are Foreign Banks in the Financial Development of European Transition 
Countries?” Journal of Emerging Market Finance 3, 99-123. 
Sachs, J. D. and W. T. Woo (2003) “China’s Economic Growth after WTO 
Membership” Journal of Chinese and Business Studies 1(1), 1-31. 
Stiglitz, J. E. and A. Weiss (1981) “Credit Rationing in Markets with Imperfect 
Information” American Economic Review 71(3), 393-410. 
Wall, H. J. (2004) “Entrepreneurship and the deregulation of banking” Economics 
Letters 82(3), 333-339. 
Xu, L. and C.-T. Lin (2007) “Can Chinese Banks Compete after Accession to WTO?” 
Journal of Asian Economics 18, 883-903. Table 1   
Descriptive Statistics 
 Mean  Std.  Dev.  Min  Max 
Net  interest  margin    2.034 0.499 0.948 4.161 
Non-interest income  0.278  0.293  -0.020  1.475 
Before-tax  income  0.737 0.313 0.194 1.691 
Overhead  expenses  1.055 0.223 0.586 1.793 
Loan-loss  provisions  0.483 0.310 0.033 2.467 
Leverage 3.753  2.492  -11.7  8.767 
Default  risk  0.905 0.544 0.061 4.048 
Regional GDP per capita (1,000 Yuan)  27.91  13.70  5.54  55.04 
Regional growth rate of GDP (%)  12.28  1.45  8.99  15.35 
Notes: Bank-level variables are extracted from the BANKSCOPE. Regional variables are reported in or calculated 
based on the statistical yearbooks published by the Chinese government. Table 2   
Potential-entry Effects of Foreign Banks 
  (1) (2) (3) (4) (5) 
 
Net Interest 
Margin 
Non-interest 
Income 
Before-Tax
Profit 
Overhead 
Expenses 
Loan-loss 
Provisions 
PRE4 -0.577***  0.081  -0.520**  0.161  0.029 
 (0.211)  (0.107)  (0.218)  (0.112)  (0.053) 
PRE3 -0.499***  0.105  -0.395**  0.127*  -0.031 
  (0.155) (0.076) (0.162) (0.072) (0.052) 
PRE2 -0.280**  0.091  -0.223*  -0.006  -0.021 
  (0.117) (0.064) (0.127) (0.069) (0.041) 
PRE1 -0.304**  0.148***  -0.136  0.026  -0.044 
  (0.136) (0.055) (0.129) (0.061) (0.040) 
Leverage 0.000  0.011  0.016  0.008  -0.003 
 (0.016)  (0.010)  (0.021)  (0.011)  (0.005) 
Overhead expenses  1.338***  0.209*  0.403*    0.121 
 (0.227)  (0.121)  (0.212)    (0.085) 
Default risk  0.502***  -0.087*  -0.083  0.006  0.566*** 
  (0.081) (0.044) (0.063) (0.051) (0.031) 
Regional GDP per capita  -0.005  -0.002  -0.002  0.020***  -0.001 
  (0.010) (0.009) (0.013) (0.006) (0.005) 
Regional Growth rate of GDP  -0.012  -0.004  -0.003  0.038  0.011 
  (0.037) (0.019) (0.038) (0.024) (0.013) 
Constant 0.571  0.045  0.007  -0.239  -0.173 
  (0.709) (0.544) (0.796) (0.529) (0.295) 
Joint Sig. Test of PREs    2.74**  2.03  2.17*  2.50*  1.01 
R
2 0.93 0.91 0.70 0.81 0.98 
Observations 105  105  105  105  105 
Notes: Robust standard errors in parentheses. * significant at 10%; ** significant at 5%; *** significant at 1% 2001 2006 2005 2004 2003 2002
- Open up foreign-exchange transactions in all the cities.
- Open up local-currency transactions in Shanghai, 
Shenzhen, Tianjin, and Dalian (4 cities)
Open up local-currency transactions in 
Guangzhou, Qingdao, Zhuhai, Nanjing, and 
Wuhan (5 cities)
Open up local-currency transactions in Shantou, 
Ningbo, Harbin, Changchun, Lanzhou, Yinchuan, and 
Nanning (7 cities)
Open up local-currency transactions in Kunming, 
Beijing, Xiamen, Xian, and Shenyang (5 cities)
Open up local-currency transactions in Jinan, 
Fuzhou, Chengdu, and Chongqing (4 cities)
Remove all geographical restrictions
Figure 1
Opening Timetable for Foreign Banks 
into the Chinese Banking Sector

Bank competition and regional differences”

Can Chinese Banks Compete after Accession to WTO?”

Credit Rationing in

Did state bank branching deregulation produce large growth effects?”

Entrepreneurship and the deregulation of banking”

How Do Incumbents Respond to the Threat of Entry? Evidence from the Major Airlines”

How does Foreign Entry Affect Domestic Banking Markets?”

How Important are Foreign Banks in the Financial Development of European Transition Countries?”

The Relative Importance of Actual and Potential Competition: Empirical Evidence from the Pharmaceuticals Market”

The effect of potential foreign entry in the banking sector

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The effect of potential foreign entry in the banking sector

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