Are Foreign Banks Bad for Development Even If They Are Efficient? Evidence from the Indian Banking Industry

Abstract

Most papers on banking focus on profitability and cost efficiency as measures of performance. In doing so, these papers ignore the fact that, unlike in the manufacturing and services sector industries, the long term viability of a bank depends more on its ability to assess credit worthiness of potential borrowers and provide credit, than on static measures of financial performance. At the same time, the political economy of economic growth and economic reforms cannot overlook the impact of ownership and reforms on credit infusion, which is a major determinant of economic growth. Specifically, there is widespread belief that while foreign banks are perhaps more efficient and profitable than domestic banks in emerging markets, these banks are content to ‘cherry pick’ and limit disbursal of loans. Using bank-level data from India, for six years (1995-96 to 2000-01), we show that given a favourable atmosphere involving economic reforms and banking sector liberalisation, as well as time needed to overcome the informational disadvantages vis a vis the domestic banks, foreign banks are willing to be aggressive in credit markets of emerging economies. The policy implication of our paper is that it provides a strong rationale for policy initiatives that encourages entry of foreign banks into emerging markets and the expansion of their activities in these economies.