DF635

Proceedings of the Fifth Middle East Conference on Global Business, Economics, Finance and
Banking (ME16Dubai October Conference) ISBN: 978-1-943579-27-3.

Dubai-UAE. 14-16 October, 2016. Paper ID: DF635
The Impact of Bank Internationalization on Indian Economy

Massand Ajay B.,
Research Scholar,
School of Management,
National Institute of Technology Karnataka (NITK), India.
E-mail: saiajay785@nitk.edu.in
Gopalakrishna B. V.,
School of Management,
National Institute of Technology Karnataka (NITK), India.
E-mail: bvgopala@nitk.ac.in
Abstract
The study investigates the impact of foreign banks’ penetration on the performance of
domestic banks in India. The study also analyse the impact of foreign direct investment into
Indian domestic banks. The study uses financial data by forming a panel data set of 44 Indian
commercial banks for the period of 1999 to 2014. The study finds positive effects of bank
internationalization on the performance of domestic commercial banks in India. Foreign
banks bring competition in the Indian banking sector. Foreign banks make Indian commercial
banks more profitable in spite of dampening margins, they reduce costs, and improve asset
quality of Indian commercial banks. To seek the benefits of competition from the foreign
banks, RBI and Government of India should allow more offices of foreign banks and should
raise the limit of bank FDI in India.
Key Words: bank internationalization; foreign banks; bank FDI; Indian commercial banks;
bank performance
JEL Classification : F21, F23, G21
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www.globalbizresearch.org
1. Introduction
Entry of foreign banks into host banking market which is known as Bank
Internationalization is being followed rapidly across developing and developed economies of
the world. The widely accepted reasons for bank Internationalization are – the liberalization
of financial systems and formation of international organizations like World Trade
Organization (WTO) and International Monetary Fund (IMF) that have contributed towards
the establishment of foreign banks (Kim and Pant, 2010; Gormely, 2010) and the
development of sophisticated technology and communication system that made it easy to
monitor foreign banks by home country regulator (Berger et al. 2003). According to Global
Financial Stability Report (IMF, 2014) the increased cross country banking claims and
transactional statistics have touched half of the global GDP in 2007 which indicates the level
of bank internationalization in recent times. Another fact representing increased bank
internationalization is – asset share of foreign banks in the host banking market, especially in
the developing economies. In developing countries like Czech Republic, the share of bank
assets held by foreign banks was 10 percent in 1990 and 84 percent in 2011; in Hungary, the
figures were 10 percent in 1990 and 85 percent in 2011; while in Argentina, it was 10 percent
in 1990 and 48 percent in 2004; in Mexico, it raised from a mere 2 percent in 1990 to 82
percent in 2004; and in Croatia, it was 4 percent in 1997 and 92 percent in 2011 (IMF, 2013).
Foreign banks have captured 20 percent of the entire asset share in Organization for
Economic Cooperation and Development (OECD) nations and, on an average, 50 percent in
emerging and developing countries (Claessens and Horen, 2012). Thus, the penetration of
foreign banks into the host nations has been rapid which raised concerns among the
economists over the intention of entry of foreign banks and their impact on the host banking
sector. This study makes an attempt to analyze this concerns of Indian economist and
empirically tests the impact of foreign banks entry on the performance of the domestic banks.
The development of foreign banks, apart from fetching more capital, brings competition
in the market (Barajas et al., 2000; Claessens et al., 2001; Jeon et al., 2011; Lee et al., 2012;
Mulyaningsih et al., 2015) that leads to an efficient banking sector (Claessens et al., 2001;
Unite and Sullivan, 2003; Lehner and Schnitzer, 2008). However, the profit of domestic
commercial banks have enhanced in some developing countries after the entry of foreign
banks. Based on these results, a few studies argue that actual competition in the host counties
decreases with the entry of foreign banks (Sathye, 2003; Hermes and Lensink, 2004 and
Ghosh, 2012). Moreover, foreign banks charge low interest margin in the host economies
(Ghosh, 2012) that makes them earn more profits and perform better than their domestic
counterparts (Sabi, 1996; Chen and Liao, 2011; Claessens and Horen, 2012). Thus, there is a
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mixed response in the literature over the impact of foreign banks entry on the performance of
domestic banks.
India had liberalised its banking sector to achieve high competition, profitability, and
efficiency of domestic banks (Government of India, 1991). Though the foreign banks could
not capture high asset share (See Figure 1) due to Indian government’s restrictive policy, the
magnitude of impact of foreign banks on the performance of domestic banks is high (Kalluru
and Bhat, 2009; Gormely, 2010; Ghosh, 2012). In terms of physical presence, foreign banks
have almost fifty percent share according to the number of commercial banks by the end of
2014 in India (See Figure 2). Moreover, it is the mere entry of foreign banks and not the asset
share which alerts domestic banks (Claessens et al., 2001). In India, the impact of entry of
foreign banks demonstrates the reduction in the efficiency gap among the public and the
private banks (Bhaumik and Dimova, 2004). However, the study by Sathey (2003) indicates
that competition could not be achieved in Indian banking sector due to its restrictive policy
regarding foreign banks entry. Thus, the present study investigates the impact of entry of
foreign banks on the performance of Indian banks in terms of competition, profitability, and
efficiency.
Although the first foreign bank was established in India in the year 1853, however, the
presence of foreign banks is recognized after the financial liberalization in 1991. The
Narasimham Committee suggested GOI to liberalize for more foreign banks along with full
scale financial sector reforms to enhance competition and institute level playing field for them
in India. Hence, the Indian banking sector became exposed to greater foreign banks’ entry in
diverse geographical locations and various regions of Indian territory began to receive their
maiden foreign bank. Foreign banks’ entry took a leap when India became a founder member
of the WTO in 1995. Honoring the agreement, Indian government liberalized further for
existing and new foreign banks’ entry; For instance, initially five branches including ATMs
(Automated Teller Machine) were taken on board, eight in 1995, and then twelve in 1998
were permitted. RBI stuck typically to twelve branches till 2006 but later, heightened the
number above twelve branches excluding ATMs (Gormely, 2010). The Indian banking sector
was further liberalized for foreign banks in a phased manner with the discussion paper
published by RBI “Roadmap for the presence of foreign banks in India” in 2005 and the
second phase was implemented in 2013 in place of 2009, the main cause being the Global
financial crisis. The recent discussion paper “Banking Structure in India - The Way Forward”
(2013), published by RBI, set a reminder tone considering foreign banks’ entry in enhancing
domestic competition and efficiency.
According to Consolidated FDI Policy 2015 published by the Department of Industrial
Promotion and Policy (DIPP), only one mode of presence is allowed for foreign banks in
India. It could be as a branch mode, a wholly-owned subsidiary (WOS) mode or a
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representative office mode of presence. Moreover, foreign capital is permitted in Indian

domestic banks with a cap of 74 percent in private sector banks and 20 percent in public
sector banks (see Figure 5 and Figure 6). There were 44 foreign banks present with 332
branches from diverse twenty five home nations till 2014 which constitute 50 percent of
bank-share and less than 1 percent of branch share (see Figure 2 and 3). However, in spite of
minimal branch share, foreign banks were able to capture 7 percent (average) asset share of
total bank assets in India (see Figure 1) that suggests the presence of foreign banks does
matter.
The objective of the present research is topical and timely due to many reasons. Firstly, it
has been a silver jubilee for step-wise liberalization of Indian Economy and financial markets.
Secondly, Indian banking sector is flooded with foreign capital because the domestic
scheduled commercial banks in India have huge foreign capital in their balance sheet (as 74
percent and 20 percent foreign capital is allowed in Indian private and public sector banks
respectively – see Figures 10 and 11). Thirdly, almost half of the scheduled commercial banks
operating in India are foreign owned (44 foreign owned + 46 state owned). Fourthly, by
considering domestic banks of a single country “India” in our panel data set removes any
chance of existence of heteroscedasticity that occurs among countries in cross-country panel
data set (Claessens and Horen, 2014). Fifthly, there is a lack of empirical literature examining
the issue in the Indian context. Hence, the present study considers this as a crucial issue to be
explored. This study aims to contribute to the existing literature by adding to the study on
emerging Indian banking market. It uses bank FDI data in the Indian context and also
includes financial crisis period from 2008 to 2010.
The research paper is organized as follows – part 2 reviews the present relevant literature,
part 3 deals with methodology and data collection, part 4 discusses findings and results, and
part 5 concludes.
2. Review of Literature
Most of the studies dealing with the issue of change in performance of domestic banks
due to foreign banks’ entry are based on developed countries (Mcfadden, 1994; Denizer,
1999; Barajas et. al., 2000) or are cross-national by nature (Terrell, 1986; Claessens et al.,
2001; Hermes and Lensink, 2004; Lee, et al., 2011; Claessens and Horen, 2014). However,
there are contemporary studies on Asian countries and emerging markets such as –
Mulyaningsih et al. (2015) on Indonesian banks; Lee and Hsieh (2014) on the Asian
banking sector; Seo et al. (2013) on the Chinese banking sector; Jeon et al. (2011) on
emerging Asian and Latin American countries, and Wu et al. (2007) on Chinese banking
sector. Thus, the present study investigates the said issue in the Indian context and contributes
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to the current trends of academics. Moreover, the various studies highlighting the positive and
negative impact of foreign banks entry are also discussed.
The extensive cross-national study on foreign banks covering 7900 banks in 80 countries
for the time period of 1988 to 1995, conducted by Claessens et al. (2001) revealed that the
presence of foreign banks reduces the margins and profitability of domestic banks. But
according to Hermes and Lensink (2004), the impact of entry of foreign banks depends on the
status of financial development of the host country and the presence of foreign banks in low
levels of financial development pulls up the costs and margins of domestic banks, whereas the
same pushes the costs and margins of domestic banks down in a higher level of financial
development. Lee et al. (2011) supported financial development of the host nations. They
analysed panel data using Generalized Method of Moment (GMM) model in which they
considered 795 banks in 39 countries for the period of 1999 to 2006 and concluded that lower
level of development of the host nation has the positive effects of entry of foreign banks on
the income, profit, and cost of domestic banks. Terrell (1986) found that dampening of
margins, profitability, and cost of domestic banks are associated with the entry of foreign
banks in 14 developed host nations. However, these studies did not control bank and banking
industry specific variables.
Another comprehensive study by Berger and Hannan (1998) researched on the impact of
cost efficiency to over 5000 banks with the high market concertation. The study established
that more concentrated markets demonstrate lower cost efficiency. Thus, competition could
be improved through new foreign entrants than horizontal merger. There are cross countries
studies on foreign banks’ entry that compares the performance of foreign banks with the
domestic commercial banks in the host nations. Chen and Liao (2011) empirically tested
various effects of home and host country variables on foreign banks from 70 countries in the
period of 1992-2006 and found foreign banks more profitable than domestic banks in the
countries whose banking sector is less competitive. Claessens and Horen (2012) used balance
sheet data from many developing countries including India in the period 1999-2006 and found
that there are several determinants of foreign banks’ profitability, like the level of
development, size and monopoly power of the bank, and culture and regulatory distance
between home and host country. The study claimed that foreign banks from high income
county entering into host country that is relatively weak in regulation perform better than
domestic banks. Thus, the effect of foreign banks’ entry differs from country to country as a
host. According to Claessens and Horan (2014) that considered 5324 banks in 137 nations
from 1995 to 2009, documented different effects based on the host and home countries
relationships which tends to create heterogeneity in the sample. Thus, our study is focused on
a single country “India” as the host to study on the effect of foreign banks.
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There are studies on individual developed or developing nations but they have mixed
responses over the impact and behaviour of foreign banks in the host nation. To begin with,
Barajas et al. (2000) developed a semi-annual panel data for the Colombian financial sector
and studied the impact of liberalization on the banking sector. The results indicated that it
enhances competition, drops intermediation cost, and refines loan quality. Denizer (1999)
studied the issue in the context of Turkey and found that entry of foreign banks deteriorates
margin, profits, and overhead cost of domestic banks. Sabi (1996) found that foreign banks in
Hungary are more profitable than domestic banks. McFadden (1994) examined the issue in
case of Australia and found improvised operation of domestic banks. Studies available in
developing countries like Peria and Mody (2004) evaluated the impact of foreign banks on
domestic banks in Latin America and found a reduction in costs and spreads of domestic
banks due to increase in competition. Jeon et al. (2011) used panel data for developing
countries of Latin America and Asia from 1997 to 2008 and found that foreign banks enhance
competition in the host emerging markets with their spillover effects.
Unite and Sullivan (2003) studied the effect of foreign banks’ entry in Philippines and
found that foreign competition compels domestic banks to be efficient by reducing their
margins and profitability. Seo et al. (2013) studied the impact of foreign banks on Chinese
domestic banks from 1999 to 2008 and claimed that even though the entry of foreign banks
boost competition and efficiency in the Chinese banking market, it affects profits of domestic
banks negatively. Mulyaningsih et al. (2015) found that the entry of foreign banks in the form
of de novo banks has increased competition and has captured 45 percent of the banking
market by 2010 in Indonesia. The study on Chinese banking sector by Wu et al. (2007) found
that ROA of domestic banks having foreign capital in their balance sheet is lower than the
domestic banks without having foreign capital. Lehner and Schnitzer (2008) found positive
effects due to competition from foreign banks in the host banking market.
A few studies on Indian banking sector have contradictory results. Kalluru and Bhat
(2009) followed Claessens et al. (2001) model to find out the impact of foreign banks on
public sector banks from 1996-2007 in India. The study revealed that foreign banks improve
the profitability and overhead expenses of public sector banks. However, the study further
claimed that it deteriorates asset quality of public sector banks. Gormley (2010) found that
foreign banks lend only to a few profitable firms that results in declining of domestic lending
in India. The study by Ghosh (2012) that examined the impact of foreign banks’ entry from
1996-2007, considered both public as well as private banks in India. It discovered that the
presence of foreign banks boosts the profitability and improves asset quality of domestic
banks. However, it reduces the spreads. Ghosh (2012) did not find any sign of improved
efficiency of domestic banks in India due to the foreign bank's entry. Mohan (2013) discussed
the scenario of foreign banks in India by highlighting the view of World Bank’s global
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development financial report of 2008. It praised foreign banks for their spill over effects like
innovative products, risk management techniques, cross-border services, and quality of
service delivery. However, it did not accept foreign banks for their contribution to improvised
financial services, improvised efficiency of domestic banks, and simplification of credit
constraints to the manufacturing sector in India.
We learnt from the above extensive review of literature that the liberalization of the entry
of foreign banks was intended to improve upon the efficiency and productivity of domestic
banks. A few studies found the negative impact and the rest found positive effects of foreign
banks on the host economy. Most of the studies have highlighted about the spill over effects
of foreign banks like bringing new technology and accessing to financial services that
improve the quality and delivery of services. For example, in Czech Republic foreign banks
initiated ATM facility and reached out in remote areas before domestic banks do. Foreign
banks come up with a variety of innovative financial products in terms of technology in
domestic market and encourage domestic banks to follow them. In order to retain the asset
share, domestic banks improve the quality of their services and reduce the delivery time of
banking services. Thus, domestic banks gradually train their employees effectively and hire
highly qualified and experienced employees. The entire process improves the standard of
banking in the home country.
3. Methodology and Data
3.1 Model
The present study investigates the impact of the presence of foreign banks on the
domestic banks’ businesses in India. Claessans et al. (2001) is a very extensive empirical
study first of its kind covering so many countries that has been widely accepted and followed
by many authors. Thus, we also use Claessens’ (2001) model to measure the impact of foreign
banks entry into India. The study is backed by the theoretical concept shown in equation (i)
related with accounting equation that represents that Profit of banks depends on their Interest
Income (II) and other income (OI) subtracted by overhead expense (OD) and loan loss
provision (LP). Change in any of the equation components results in change in the profit. The
theory assumes that for any change in foreign bank share (in terms of foreign capital or
number of foreign banks or the number of foreign banks’ offices or asset share of foreign
banks) marks a change in the domestic bank’s profits. The change occurred due to a change in
the behaviour of domestic bank’s strategy, to compete with foreign banks, by changing any of
the explanatory variable in (i) for a bank.
P = II + OI - OD - LP (i)
P= Profit of Banks, II=Interest Income, OI=Other Income, OD=Overhead expense, LP=Loan

loss Provision.
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To capture the entry of foreign banks, the variables used are the foreign bank's assets
normalized by total assets of all schedule banks, number of foreign banks to total banks
present in India, and foreign banks offices to total offices of banks in urban and metropolitan
areas. Here we introduce a new variable, FDI in Indian banking sector normalized by total
FDI into India that captures the impact of foreign capital inflow in the domestic banks along
with the capital inflow in foreign banks. In order to measure the change in the performance of
Indian domestic banks, the variables adopted are NIM (Net Interest Margin), ROA (Return on
Assets), ROE (Return on Equity), Overheads, NPA (Non-Performing Assets). The model for
the study is shown below (ii) and we consider all variables in first difference to estimate short
term relationships among variables.
𝑃𝑖𝑡 = 𝛽0 + 𝛽1 𝑆𝑡 + 𝛽2 𝐼𝑡 + 𝛽3 𝐵𝑡 + 𝛽4 𝑀𝑡 + ∈𝑖𝑡 (ii)
Where, 𝑃𝑖𝑡 represents the performance measurement of Indian domestic bank i in the year t
(i.e. NIM or ROA etc.), 𝑆𝑡 represents share of foreign banks in the year t (i.e. foreign banks
share in terms of assets/numbers/branches/bank FDI), 𝐼𝑡 represents individual bank control
variables at time t (i.e. CRAR or Liquidity), 𝐵𝑡 represents bank industry control variable at
time t (i.e. Concentration), 𝑀𝑡 represents macro-economic variables at time t (i.e. GDP
growth and Real interest rates differential). 𝛽0 is intercept and 𝛽1 , 𝛽2 , 𝛽3 , 𝛽4 are the
coefficients of explanatory variables.
3.2 Variables and Hypothesis Defined
The main intention of the study is to capture the effect of entry of foreign banks on the
performance of the Indian domestic banks. Thus, we adopt all the variables from the standard
literature measuring foreign banks entry and performance of the Indian domestic banks. The
various dependent and Independent variables are explained here.
3.3 Dependent Variables
NIM (Net Interest Margin) is a measure of bank competition which is calculated as
interest income subtracted by interest expense normalised by total assets. In general, as
competition increases, banks tend to narrow their margins, thus, NIM diminishes with the rise
in the number of players in the market. Hence, if domestic banks compete with the foreign
banks, the NIM should be condensed. The expected sign for NIM is negative. Barajas et al.,
(2000) and Seo et al., (2013) reported declining spreads of domestic banks. Hermes and
Lensink (2004) found a negative relationship between foreign banks entry and NIM in case of
lower developed nations, while a positive sign for developed nations. Indian studies Gosh
(2012) and Kalluru and Bhat (2009) also found dampening of margins for domestic banks.
However, they did not find statistically significant relationship.
H1: There is a negative relation between the net interest margin of domestic banks and
foreign banks share.
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NPA (Non-Performing Asset) is the asset which does not yield any return for the bank. It
can be calculated as substandard, doubtful, and loss loans adjusted for total advances. NPA of
domestic banks could be affected either way due to foreign banks’ penetration. If domestic
banks imitate high credit risk management techniques of foreign banks and improve their
skills for credit valuation or follow foreign banks by accepting only hard information to lend
(Gormley, 2010) that may improve asset quality of domestic banks. On the other hand, if
domestic banks increase lending to compete with foreign banks, they may end up with high
NPAs. Thus, the exact sign for NPA cannot be predicted. Barajas et al., (2000) found a
decline in NPAs of domestic banks due to foreign bank penetration. However, Indian studies
differ in their results. Gosh (2012) reported improvement in asset quality of domestic banks
whereas Kalluru and Bhat (2009) found an increase in NPAs of Indian public sector banks.
H2: Foreign banks share has a significant impact on asset quality of domestic banks.
Overhead (cost) is a measure of operating expense incurred by domestic banks
normalised by total assets. If domestic banks compete with foreign banks to retain their asset
share and spend more money, their overheads will raise. Thus, the expected sign is positive
for this variable. Barajas et. al. (2000) and Gosh (2012) found increase in overheads with
raising foreign banks share. Herms and Lensink (2004) found a positive relation for
developing countries whereas, negative relationship between overheads of domestic banks
and foreign banks’ share of financially developed countries.
H3: There is a negative relation between overheads of domestic banks and foreign banks
share.
ROA (Return on Asset) and ROE (Return on Equity) are the measures of profitability for
banks. ROA is the measure of overall profitability of banks which is calculated by profit
before tax normalised by total assets, and ROE represents the banks’ efficiency to generate
profits for its shareholders which is measured by net profit normalised by capital plus reserves
and surplus. Domestic banks may imitate technology used by foreign banks and train their
employees or hire skilled employees to compete with foreign banks, which raises overall
profitability and high return for their shareholders. Thus, domestic banks increase their
efficiency and get benefited by spill over effect of foreign banks. Hence, the positive
relationship should be expected. However, there are studies which found the negative
relationship, e.g. Claessens et al. (2001) and Unite and Sullivan (2003). Most of the studies,
including Indian studies, found a positive relationship. e.g. Ghosh (2012), Kalluru and Bhat
(2009) and Herms and Lensink (2004).
H4: There is a positive relationship between the profitability of domestic banks and
foreign banks share.
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3.4 Independent Variables

As mentioned before, the study adopts four variables to present share of foreign banks.
i.e. BK_FDI (Foreign Direct Investment in Indian banking sector to total FDI inflow in India),
FB_A (foreign banks asset share to total banking asset), FB_N (number of foreign banks to
total commercial banks in India excluding RRBs), FB_O (foreign banks offices to total
offices of banks in India in urban and metropolitan cities). FB_N was used in Herms and
Lensink (2004), Kalluru and Bhat (2010), and Claessens et al. (2001). FB_A was not found
significant in Claessens et al. (2001), hence, many studies avoided this variable including
Indian study Kalluru and Bhat (2009). However, Ghosh (2012) used FB_A, FB_N, and FB_O
in case of India where all the variables were found statistically significant. Hence, the present
study considers all the three variables mentioned above along with BK_FDI which also
represents penetration of foreign banks as it is a long term investment in assets. Moreover, the
previous studies like Nigh et al. (1986), Yamori (1998), and Moshirian (2001) have used
BK_FDI variable as a proxy for the entry of foreign banks.
3.5 Control Variables
The study controls variables related to Individual bank specific, bank industry specific,
and macro-economic variables. Individual bank specific variables used are CRAR and
LIQDT. CRAR (Capital to risk weighted asset ratio) represents Tier I plus Tier II capital
requirement by risk weighted assets. It is the compliance by Individual banks in order to have
asset quality. LIQDT (Liquidity) represents liquidity position of individual banks that
includes Cash in hand, balance with RBI, balance with other banks, and call money. The
study adopts CONC as bank industry specific variable that represents the concentration of top
five banks in terms of deposits. It considers highest aggregate deposits of five banks as a part
of total deposits of all commercial banks in a particular year in India. As the bank's
performance could be influenced by macro-economic variables like economic growth, the
study adopts real GDP growth in the services sector and real interest rates as macro-economic
control variables.
All these variables are collected from RBI’s annual publications – Statistical Tables
related to Banks in India, Handbook of Statistics on the Indian Economy, and The Basic
Statistical Return of Scheduled Commercial Banks. The data on the real interest rate is
collected from World Bank database. The Panel data set has accounting data of 44 domestic
banks from 1999 to 2014. We exclude “Kotak Mahindra bank” and “Yes bank” due to lack of
data throughout the study period. The data for bank FDI is available from 2001 onwards that
makes the panel unbalanced. The study records 616 observations for each variable.
The summary statistics presented in Table 1 is consistent with the data presented by
Ghosh (2012). From Table 4, a positive correlation among bank FDI, foreign banks’ asset
share and foreign banks’ offices is observed. However, an unusual correlation is reported
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between the number of foreign banks’ share and offices share of foreign banks; this highly
negative correlation is mainly due to two reasons. First, throughout the study period, the
number of foreign banks have increased whereas, the number of domestic banks have
decreased due to consolidation among Indian banks. There have been around twenty mergers
or consolidation during the study period in Indian banking sector (read more in Goyal and
Joshi, 2011). The similar trend is seen in global economy (read more in Claessens and Van
Horen, 2014); second, the offices of domestic banks have increased more rapidly than foreign
banks’ offices due to the restricted entry limit for opening of foreign banks’ offices.
4. Empirical results
Based on the different explanatory variables measuring foreign banks’ share i.e. foreign
banks asset share, number of foreign banks share, foreign banks offices share, and bank FDI,
we form four different panels A, B, C, and D (see Table 3). The F statistics of all the panels
are statistically significant which indicate that our empirical model is appropriate and the
interpretation of its results make sense. In all the panels the control variables related to bank
specific, industry specific, and macroeconomic variables have been added. The overall results
indicate that foreign banks’ penetration improves competition in the market (H1), improves
asset quality (H2), reduces cost (H3), and raises profitability (H4). The results of the present
study is consistent with the results of the previous studies (see Table 4).
The surge of 10 percent bank FDI leads to drop of 3 percent net interest margin (Column
A-1), similarly, upsurge in 10 percent in foreign banks’ assets leads to drop in net interest
margin by 4 percent (Column B-1). Hence, negative margins represent an increase in
competition. The results of Panels A, B, and C that indicate the negative relation between
foreign banks penetration and net interest margin, are statistically significant. Thus, H1 is
accepted. All the studies in Table 4 got negative results but the results of both the Indian
studies Kalluru and Bhat (2009) and Ghosh (2012) are statistically not significant. In our
results, the result of Panel D of share of foreign banks’ offices is positively significant that
indicates the share in foreign banks’ offices does not add to competition which is due to
restricted entry limit on foreign offices in India (Kim and Pant, 2010; Ghosh, 2012). Hence,
RBI should allow more foreign bank offices to enhance competition in the banking space. As
Indian banking sector is less competitive due to its high NIM than an average NIM of all the
banks in the world (Mohan, 2006) it is argued that foreign banks’ entry tend to reduce NIM in
India. Chen and Liao (2011) found that foreign banks enter into less competitive market and
perform better than domestic commercial banks and Claessens and Horen (2012) provided
evidence that foreign banks entering from high income nations perform better than domestic
banks. This further adds more pressure on the domestic banks that leads to tough competition.
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It is evident from the column A-2, B-2, and D-2 that NPA declines with increase in
foreign banks’ share whereas column C-2 shows the opposite result in the case of increase in
number of foreign banks. The results of C-2 is consistent with the results of Kalluru and Bhat
(2009) for Indian study that considered only public sector banks in their data set. Lee et al.
(2011) is another study to use number of foreign banks’ share that did not find statistically
significant results for NPA. However, the results of column A-2, B-2, and D-2 are consistent
with Barajas et al. (2000), Hermes and Lensink (2004) and Ghosh (2012). Hence, we accept
H2.
In case of Overheads, Panel A and B reports negative relationship (column A-3 and
Column B-3), whereas the result in column C-3 is not significant and the result in Column D-
3 is less significant which confirms the foreign banks’ presence deteriorates cost of domestic
banks. Hence, H3 is accepted. Moreover, these results are consistent with most of the previous
studies (see Table 4). However, the result of Indian study Kalluru and Bhat (2009) shows
positive results that can be compared with our result in column C-3 considering only foreign
banks’ number as a dependent variable. We consider only number of foreign banks cannot
provide broad picture especially when the results of other variables develop negative
relationship with Overheads.
The results of profitability are mixed. On one hand, Column A-4, A-5, D-4 and D-5
suggest inclining profitability due to foreign bank penetration, on the other hand, column C-4
and C-5 show opposite results. This indicate that enhancement in number of foreign banks has
adverse effect on profitability of domestic banks but the enhancement in number of offices of
foreign banks and foreign investment in domestic banks bring more profitability to domestic
banks. The results of previous studies Claessens et al. (2001), Unite and Sullivan, Wu et al.
(2007) and Lee et al. (2011) support the decline in the profitability of domestic banks.
However, the results of the Indian studies Kalluru and Bhat (2009) and Ghosh (2012) found
increasing profitability of domestic banks in spite of decline in the margins which reveals that
domestic banks in India have adopted high technology and utilized it properly to raise their
profits. Indian commercial banks are already into other businesses like investment banking,
selling of mutual funds and insurance products etc. However, the commercial banks are also
allowed to invest by RBI. Considering all these facts regarding increased banking scope for
Indian banks, we accept H4. Moreover, the results of the study are for short term period that
can change over the long run.
In general, foreign banks’ presence raise efficiency of domestic banks with improving
profitability and reducing overhead cost for them. Seo et al. (2013) uses a variable
representing efficiency and claims enhancement in the efficiency of Chinese banks due to
foreign banks’ entry. However, Ghosh (2012) considers efficiency variable in case of Indian
12
banking sector that does not claim for efficiency improvement due to having mixed results for
different variables.
The results of Control variables are in line with the general expectations. CRAR evidence
to raise margins and profitability while controls in the reduction of overheads and NPAs
which is the main objective of holding capital for adjusting risk (see Table 3). The results also
evidence that proper liquidity utilization enhance margins and holding high liquidity enhance
costs. If the bank concentration remains high, the NPAs and overhead cost increases which is
clearly observed from results (Table 3) in the case of Indian domestic banks. The growth in
macroeconomic variables service sector and real interest rates result in boosting competition
that reduce profitability but raise overheads. We also control for Crisis period as it may affect
the performance of banks. The results of crisis dummy variables are diverse that could be due
to the selection of wrong dummies. However, we interpret the results considering highly
significant variables, crisis leads to high NPAs (column A-2) and overheads (column B-3)
that shrink margins (column C-2) and operating profits (column D-4). However, it increases
return on equity that could be a short term phenomena due to stock-market crash which leads
to lower the share value that represents major reduction in market capitalization. If the
reported reduction in capital is proportionately higher than the reduction in banks’ net profit,
it tends to shows high ROE.
The above results suggest that Indian domestic banks have raised their profits in spite of
reduction in their margins that could be due to decline in overhead costs. Thus, the efficiency
of domestic banks is increased due to foreign banks penetration. Sophisticated technology is
an important factor for efficiency enhancement (IMF, 2000). The reasons could be the
adaptation of high technology and usage of innovative sophisticated financial products by
Indian domestic banks that are considered as spill over effects of foreign banks. There are
sufficient examples prevailing in the history of Indian banking sector e.g. first ATM in India
was introduced by HSBC (Hong Kong and Shanghai Banking Corporation) in 1987 while
Citibank and Standard Chartered banks have introduced credit card and credit card with photo
respectively (Kim and Pant, 2010). The concepts of Car loan and Home loan are believed to
be adopted from foreign banks in India. Today, there are over 0.18 million ATMs (on site +
off site) and 21.4 million outstanding credit cards in India (RBI). Moreover, foreign banks
typically charge lower interest rates as compared to domestic banks in India (Ghosh, 2012)
that further leads to reduction in the margin of domestic banks to compete with foreign banks.
As evidenced from results that foreign banks improve asset quality of domestic banks. This is
due to Indian domestic banks learned high credit risk management techniques from foreign
banks and lend on hard information avoiding opaque information firms (Gormely, 2010).
Thus, there is an improvement in the performance of Indian domestic banks due to foreign
banks’ presence.
13
5. Conclusion
The liberalization has invited many foreign banks and foreign capital into the Indian
economy. However, at the time of liberalization of Indian economy the aim set for the entry
of foreign banks, is yet to be tested. This study makes an attempt to measure the impact of
foreign banks entry and bank FDI inflow on the performance of the domestic banks. Using
the accounting data of 44 domestic banks, the present study uses a panel data model for the
period of 1999 to 2014 and investigates the above objectives. The study considers four
measures of foreign banks’ share -- foreign banks numbers share, their offices share, their
asset share and foreign direct investment in the Indian banking sector. The study finds that
foreign bank's outreach has positive effects on the performance of domestic banks business.
The entry allows more competition and enhances efficiency of domestic banks by raising their
profitability and reducing overheads. The presence of foreign banks improves asset quality of
domestic banks, which is believed to be due to transfer of high credit risk management
techniques of foreign banks. Thus, the spill over effects of foreign banks are clearly visible in
the Indian banking sector with the use of high technology and improvised banking facilities.
Thus, the study suggests policy makers to provide more scope for bank FDI and ease the entry
limit for foreign banks offices in India.
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16
Figure 1: Asset share by foreign banks in India (in percentage from 1999 to 2014)
.088 .088
.084 .084
.080 .080
.076 .076
.072 .072
.068 .068
.064 .064
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Source Statistical Tables relating to banks in India published by RBI
Figure 2: Number of foreign banks in India (in percentage from 1999 to 2014)
.52 .52
.48 .48
.44 .44
.40 .40
.36 .36
.32 .32
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Figure 3: Foreign banks’ offices in India (in percentage from 1999 to 2014)
.0104 .0104
.0100 .0100
.0096 .0096
.0092 .0092
.0088 .0088
.0084 .0084
.0080 .0080
.0076 .0076
.0072 .0072
.0068 .0068
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
17
Figure 4: Share of Bank FDI inflow to the total FDI flow in India (in percentage from
2001 to 2013)
BK_FDI
.07 .07
.06 .06
.05 .05
.04 .04
.03 .03
.02 .02
.01 .01
.00 .00
99 00 01 02 03 04 05 06 07 08 09 10 11 12 13
Source RBI (through Right to Information)
Figure 5: Foreign Investment in Private Banks in India1 (as on March 2014)
80.0 72.1 69.3 71.9

70.0
60.0 52.6 52.4 51.4
in percentage
44.7 46.9
50.0 40.0 39.8 38.7
34.7 36.9
40.0 28.9 28.6 26.0
30.0 21.8
16.9
20.0 12.1
10.0 0.0
0.0
Name of Private banks
18
Figure 6: Foreign Investment in Public Sector Banks1 (as on March 2014)
20.0
17.2
18.0 16.1
16.0
in percentage
14.0 11.9 12.0

12.0 10.5 10.0
9.1 8.6
10.0 8.2 7.7
8.0 6.7 6.6 6.0
6.0 4.4
3.1 3.2 3.2
4.0 2.2 2.4 2.0
2.0 0.7 0.0 1.0
0.0 0.0 0.1 0.0
0.0
Bharatiya Mahila Bank…
Oriental Bank of…
State Bank of Bikaner &…

Allahabad Bank
Dena Bank
Syndicate Bank
Andhra Bank
UCO Bank
Bank of Baroda
Canara Bank
Bank of Maharashtra
Indian Bank
State Bank of India

Corporation Bank
Vijaya Bank
Punjab & Sind Bank
United Bank of India

Bank of India
IDBI Bank Limited
State Bank of Mysore

State Bank of Patiala
Indian Overseas Bank
State Bank of Travancore

Punjab National Bank
Central Bank of India
Union Bank of India
State Bank of Hyderabad

Name of Public Sector Banks

1
Foreign investment into Indian banking sector includes FDI, FII, NRI investment, ECB etc. The
consolidated limit to invest into private Indian banks is 74 percent and in public sector bank in 20
percent.
Table: 1 Summary Statistics
Variables Mean S.D. No. of Definition
Observations
NIM 0.0282 0.0065 616 Interest earned – Interest expended/ Total Asset
NPA 0.0271 0.0297 616 Non-performing assets/ Total Advances
OVHD 0.0208 0.0058 616 Operating expense/ Total Asset
ROA 0.0093 0.0054 616 Net Profit/ Total Asset
ROE 0.1516 0.0958 616 Net Profit/ Capital + Surplus
BK_FDI 0.0229 0.0198 616 FDI inflow into banking/ Total FDI inflow into India
FB_A 0.0728 0.0062 616 Foreign banks’ asset/ Total Asset
FB_N 0.4047 0.0488 616 Number of Foreign banks/ Total schedule commercial
banks excluding RRBs
FB_O 0.0091 0.0010 616 Foreign bank’s offices / Total schedule commercial banks
offices in urban and metropolitan excluding RRBs
CRAR 0.1305 0.0363 616 Tier I + Tier II capital / Risk weighted Assets
LIQDT 0.0881 0.0465 616 Cash in hand + balance with RBI + balance with other
banks + Call money
CONC 0.3939 0.0164 616 Top five banks’ deposits / Total bank deposits
RIR 0.0499 0.0246 616 Real Interest rates growth
SERGW 0.0845 0.0177 616 Growth of service component of GDP (Constant price)
19
Table: 2 Correlation of major variables
BK_FDI FB_N FB_A FB_O NIM NPA OVHD ROE ROA

BK_FDI 1.0000
FB_N -0.4387 1.0000
FB_A 0.3612 -0.3625 1.0000
FB_O 0.0634 -0.8582 0.2384 1.0000
NIM -0.0416 -0.1366 -0.1143 0.2056 1.0000
NPA -0.3008 -0.1134 -0.0734 0.3933 -0.0078 1.0000
OVHD -0.0933 -0.2208 -0.0253 0.3665 0.4618 0.4349 1.0000
ROE -0.0272 -0.1013 0.0389 0.1207 0.2955 -0.1653 -0.1819 1.0000
ROA 0.0271 -0.0549 0.0179 0.0252 0.4180 -0.2993 -0.2072 0.7809 1.0000
20
Table 3: Foreign Bank penetration and domestic bank performance
Panel A P anel B
NIM NPA OVHD ROA ROE NIM NPA OVHD ROA ROE
(A-1) (A-2) (A-3) (A-4) (A-5) (B-1) (B-2) (B-3) (B-4) (B-5)
-0.0312* -0.1328** -0.0345** 0.0279* 0.4878*

BK_FDI
(-1.8189) (-2.3634) (-2.3121) (1.8641) (1.8454)
-0.4227*** -0.6398** -0.3216*** -0.0229 -0.2007

FB_A
(-6.0811) (-2.1928) (-5.1760) (-0.3888) (-0.1859)
0.0467*** -0.112*** 0.0016 0.04118* 0.0206 0.0440*** -0.2103*** -0.0106* 0.0472*** 0.1876*
CRAR
(6.4208) (-4.7049) (0.2657) (6.4835) (0.1842) (-6.0811) (-7.3309) (-1.7424) (8.1303) (1.7673)
0.0186*** 0.0047 0.0111** 0.0008 -0.0510 0.0199*** 0.0291 0.0145*** -0.0019 -0.0253
LIQDT
(3.2179) (0.2500) (2.2100) (0.1755) (-0.5721) (3.7574) (1.3035) (3.0626) (-0.4408) (-0.3067)
0.1526*** 0.5946*** 0.1252*** 0.0317 0.8997** 0.0463*** 0.2501*** 0.0427*** 0.0078 0.2688
CONC
(5.7873) (6.8832) (5.4608) (1.3799) (2.2148) (3.0594) (3.9344) (3.1554) (0.6084) (1.1418)
-0.0007 0.0106*** 0.0006 0.0009 0.0399*** 0.0023** 0.0070 0.0025*** 0.0013 0.0376**
CRISIS
(-0.9216) (4.0183) (0.8926) (1.4038) (3.2147) (2.1476) (1.5085) (2.6208) (1.4633) (2.1864)
0.0211 -0.547*** -0.0011 -0.0207 -0.7107** 0.0352** -0.2149*** 0.0244* -0.0153 -0.4743**
SERGW
(0.9444) (-7.4557) (-0.0596) (-1.0577) (2.0583) (2.3383) (-3.3944) (1.8110) (-1.1935) (-2.025)
-0.0671*** 0.0840 -0.0060 0.0106 0.3282 0.0396** 0.5258*** 0.0876*** 0.0139 0.5135**
RIR
(-4.0196) (1.5360) (-0.415) (0.7279) (1.2763) (2.3786) (7.5143) (5.9884) (0.9862) (1.9835)
-0.0374*** -0.1535** -0.0291*** -0.0080 -0.1755 0.0277*** -0.0090 0.0204*** 0.0022 0.0431
c
(-3.7705) (-4.7162) (-3.3757) (-0.9259) (-1.1463) (3.8668) (-0.2997) (3.1849) (0.7144) (0.3869)
adj R2 0.1658 0.4435 0.1406 0.0804 0.0464 0.1649 0.4190 0.1887 0.0947 0.0278
F-statistics 17.2229*** 65.962*** 14.346*** 8.1386*** 4.9744*** 19.6005*** 67.3947*** 22.910*** 10.8548*** 3.7016***
(pvalue) (0) (0) (0) (0) (0) (0) (0) (0) (0) (0)
Panel C Panel D
21
NIM NPA OVHD ROA ROE NIM NPA OVHD ROA ROE
(C-1) (C-2) (C-3) (C-4) (C-5) (D-1) (D-2) (D-3) (D-4) (D-5)
-0.0162* 0.2689*** 0.0072 -0.0244*** -0.3368***

FB_N
(-1.9255) (8.1565) (0.9707) (-3.5365) (-2.6534)
1.8354*** -7.1980*** 0.7247* 0.9259** 14.0691*

FB_O
(3.7843) (-3.6184) (1.6695) (2.2929) (1.9048)
0.0433*** -0.1994*** -0.0104* 0.0462*** 0.1737 0.0443*** -0.2117*** -0.0105* 0.0473*** 0.1899*
CRAR
(6.1755) (-7.2605) (-1.6696) (8.0216) (1.6433) (6.3728) (-7.4236) (-1.7023) (8.1877) (1.7940)
0.0200*** 0.0152 0.0136*** -0.0008 -0.0096 0.0194*** 0.0273 0.0140*** -0.0019 -0.0244
LIQDT
(3.6642) (0.7108) (2.8111) (-0.1936) (-0.1174) (3.5899) (1.2346) (2.9067) (-0.434) (-0.2973)
0.0333** 0.3890*** 0.0434*** -0.0056 0.0847 0.0270* 0.3023*** 0.0335** 4.94E-05 0.1519
CONC
(2.0582) (6.1421) (3.0178) (-0.4231) (0.3474) (1.7037) (4.6356) (2.3585) (0.0037) (0.6275)
-0.0031*** 0.0037 -0.0012* 0.0006 0.0294*** -0.0026*** -0.0016 -0.0012** -0.0012** 0.0367***
CRISIS
(-4.1995) (1.2949) (-1.8847) (1.1207) (2.6485) (-3.6340) (-0.5612) (0.0976) (2.0030) (3.3537)
-0.0045 0.2214*** 0.0272 -0.0573*** -1.0501*** -0.0111 -0.1000 0.0015 0.0012** -0.7413***
SERGW
(-0.2180) (2.7033) (1.4670) (-3.3383) (-3.3303) (-0.6328) (-1.3812) (0.0976) (2.0030) (-2.7558)
-0.0311** 0.5478*** 0.0424*** -0.0002 0.3352 -0.0530*** 0.5435*** 0.0277** -0.0331** 0.2604
RIR
(-2.2531) (10.1328) (3.4586) (-0.0216) (1.6107) (-3.4744) (8.6774) (2.0330) (-2.2547) (1.1197)
0.0167* -0.2576*** -0.0034 0.0202*** 0.2979** -0.0028 -0.0186 -0.0003 -0.033** -0.0199
c
(1.8435) (-7.2552) (-0.4282) (2.7205) (2.1794) (-0.4459) (-0.7146) (-0.0656) (-2.2547) (-0.2053)
Adj R2 0.1226 0.4639 0.1566 0.1115 0.0382 0.1365 0.42088 0.1590 0.1017 0.0332
F-statistics 14.1558*** 82.4806 18.491*** 12.8252 4.7422*** 15.8926*** 69.4196*** 18.80667 11.6691*** 4.2353***
(p-value) (0) (0) (0) (0) (0) (0) (0) (0) (0) (0.0001)
Note: *** represent significant level at 1%, ** represent significant level at 5%, * represent significant level at 10%.
22
Table 4: Comparison of the results of present study with the previous studies
Author NIM NPA OVHD ROA

Barajas et al. (2000) Negative Negative Negative
Claessens et al. (2001) Negative Negative Negative
Unite and Sullivan (2003) Negative Negative Negative
Hermes and Lensink (2004)2 Negative Negative Negative Positive
Wu et al. (2007) Negative
Kalluru and Bhat (2009) Negative* Positive Positive Positive
Lee et al. (2011)2 Negative Positive* Negative Negative
Chen and Liao (2011) Positive
Ghosh (2012) Negative* Negative Negative Positive
Seo et al. (2013) Negative
Present study Negative Negative Negative Positive
*results are statistically not significant
23

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Proceedings of the Fifth Middle East Conference on Global Business, Economics, Finance and

Banking (ME16Dubai October Conference) ISBN: 978-1-943579-27-3.

The Impact of Bank Internationalization on Indian Economy

representative office mode of presence. Moreover, foreign capital is permitted in Indian

P= Profit of Banks, II=Interest Income, OI=Other Income, OD=Overhead expense, LP=Loan

𝑃𝑖𝑡 = 𝛽0 + 𝛽1 𝑆𝑡 + 𝛽2 𝐼𝑡 + 𝛽3 𝐵𝑡 + 𝛽4 𝑀𝑡 + ∈𝑖𝑡 (ii)

3.4 Independent Variables

Figure 5: Foreign Investment in Private Banks in India1 (as on March 2014)

80.0 72.1 69.3 71.9

Name of Private banks

Source Statistical Tables relating to banks in India published by RBI

Figure 6: Foreign Investment in Public Sector Banks1 (as on March 2014)

14.0 11.9 12.0

Oriental Bank of…

State Bank of Bikaner &…

State Bank of India

United Bank of India

IDBI Bank Limited

State Bank of Mysore

State Bank of Travancore

Union Bank of India

State Bank of Hyderabad

Source Statistical Tables relating to banks in India published by RBI

Table: 2 Correlation of major variables

BK_FDI FB_N FB_A FB_O NIM NPA OVHD ROE ROA

-0.0312* -0.1328** -0.0345** 0.0279* 0.4878*

-0.4227*** -0.6398** -0.3216*** -0.0229 -0.2007

-0.0162* 0.2689*** 0.0072 -0.0244*** -0.3368***

1.8354*** -7.1980*** 0.7247* 0.9259** 14.0691*

Author NIM NPA OVHD ROA

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-0.0312* -0.1328 -0.0345 0.0279* 0.4878*

-0.4227* -0.6398 -0.3216*** -0.0229 -0.2007

-0.0162* 0.2689* 0.0072 -0.0244* -0.3368***

1.8354* -7.1980* 0.7247* 0.9259** 14.0691*