Does the organizational form of foreign banks matter for bank profitability?

Msc International Business & Management – International Financial Management

Does the organizational form of foreign banks matter for bank profitability?

Evidence from four Latin American countries

September 29 2009 Xiangpeng Zeng

S1624873

Supervisor: dr. N. Brunia

Does the organizational form of foreign banks matter for bank profitability? Evidence from four Latin American countries

By

Xiangpeng Zeng September 29 2009 Student-number: 1624873 e-mail: Zeng.x@hotmail.com

University of Groningen Faculty of economics and business Msc International Business & Management Specialization International Financial Management

Uppsala University Faculty of business studies Msc Business & Economics

First supervisor: dr. N. Brunia

ABSTRACT

The aim of this thesis is to study if the organizational forms of foreign banks have an influence on their profitability. Using the data for 183 banks in four Latin American countries- Argentina, Brazil, Chile and Uruguay, my results show that there is a significant difference between profitability of foreign banks and profitability of domestic banks. I also find that the subsidiaries of foreign banks have a higher profitability than the branches of foreign banks. Furthermore, I examine the determinants of profitability of banks and I especially examine that if organizational form of foreign banks is one determinant of profitability of the banks. The regression results show that being the subsidiaries of foreign banks has a positive and marginally significant influence on the return on assets. Being the branches of foreign banks has a negative and marginally significant association with the return on assets. Finally, organization forms of foreign banks do not have any significant impact on the return of equity.

Key words: organizational form, branch, subsidiary, domestic banks, profitability.

TABLE OF CONTENTS

1. INTRODUCTION………. 4

2. ORGANIZATIONAL FORM OF FOREIGN BANKS ………. . 7

2.1 How foreign banks present in host countries ………. 7

2.2 Difference between branches and subsidiaries of foreign banks……… 8

3. LITERATURE REVIEW AND HYPOTHESIS ………... 10

3.1 Domestic banks’ performance VS foreign banks’ performance ……… 10

3.2 Performance of subsidiaries of foreign banks VS performance of branches of foreign banks ………... 12

3.3 Hypotheses ……….. 13

3.4 Determinants of profitability of banks ……….. .. 15

4. DATA AND RESEARCH METHODOLOGY ………... 16

4.1 The selection process of data ………... 16

4.2 Variables ………... 18

4.2.1 Bank-specific profitability determinants ……….. 18

4.2.2 Macroeconomic-specific profitability determinants ……… 23

4.3 Research Methodology ……….. 25

5. EMPIRICAL RESULT AND DISCUSSION ………. 27

5.1 The profitability of foreign banks VS the profitability of domestic banks …... 27

5.2 The profitability of branches of foreign banks VS the profitability of subsidiaries of foreign banks ………... 30

5.3 The determinants of profitability of banks ………... 31

5.3.1 The determinants of the return on assets of banks ………... 31

5.3.2 The determinants of the return on equity of banks ………. 34

6. CONCLUSION ………... 35

7. REFERENCE………. 36

8. APPENDIX……….. 41

1. INTRODUCTION

The 1990s witnessed a dramatic increase of foreign participation in emerging markets’ banking systems.

Latin American countries had the most striking changes, with foreign presence rising from less than 20% at the end of 1991 to more than 50% at the end of 2001 (Moguillansky et al, 2004)

. Macroeconomic stability and economic reforms, especially in capital markets, and the financial liberalization in Latin America, created attractive conditions for foreign banks, which were looking for economies of scale and worldwide growth (Moguillansky et al, 2004).

The presence of foreign banks competing alongside domestic banks triggers the question of whether there is a difference in performance between these two categories. Previous studies (Goldberg, 1981;

Houpt, 1980; Seth, 1992) have attempted to answer this question in the context of developed countries, especially in the U.S. and EU countries. Generally, their empirical results show that local banks perform better than foreign banks. For developing economies, the literature is filling in quickly with such studies (Buch, 1997; Claessens et al, 2001; Green et al, 2003). The empirical results from these studies are rather conflicting with some researches indicating that domestic banks outperform foreign banks and others demonstrate an opposite result.

Foreign banks can mainly adopt four organizational forms in host countries, which are: representative office, agent, branch and subsidiary

(Goldberg, 1992; Clarke et al, 2003). In this thesis, I will focus on branches and subsidiaries of foreign banks, since only these two organizational forms can present full immersion in a host country and gain most of the potential benefits (and risks) from entry into host countries (Clarke et al, 2003). A branch is an integral part of the parent bank. It may provide a full range of banking services and operates on the basis of the parent bank's full capital base. In contrast, a subsidiary is an independent legal entity in which the foreign parent bank has majority ownership (Havrylchyk & Jurzyk, 2006). Branches and subsidiaries have different governance structures between the parent banks and the overseas subunits, different strategic orientations as well as supervision authorities. Researchers find that only the appropriate fit between the environment and the organization structure can lead to the good performance of one organization (Khandwalla, 1977; Ansoff, 1974;

Duncan, 1972; Galbraith, 1973). Earlier studies also show that the effectiveness of investment is highly dependent on firms’ strategic orientation (Guisinger, 1985; Contractor, 1990). Furthermore, when dealing with different supervision authorities, foreign banks have different operation cost which will

1

Foreign presence is measured by ratio of the foreign banks’ assets to the total banking assets.

2

The difference among representative office, branch and subsidiary will be explained in detail in the following part of

this article.

influence their financial performance. Thus, I expect that the organizational form will play a role in the performance of foreign banks.

The organizational form of foreign banks at least matters for the managers of foreign banks and local regulators in host countries, since branches and subsidiaries typically involve different levels of parent bank responsibility and financial support. A subsidiary is an independent legal entity and a branch is an integral part of parent banks. Under most circumstances, parent banks are taking care of the liabilities for their branches. This not only matters for the parent banks, but also matters for the local regulators, since local regulators should keep the stability of financial market in host countries. Moreover, different organizational forms of foreign banks perform differently in host countries. The result of this paper indicates that subsidiaries perform better than branches of foreign banks in four developing countries, which provides managers of parent banks with directions in cases when they have to choose between these two organizational forms without any restriction

.

The current literature does not take organizational form’s influence on the performance of foreign banks into consideration. The main reason is the difficulty in getting data of branches of foreign banks. Since a branch is not an independent legal entity, it usually does not have its individual annual report (Goldberg, 1992). A few studies (Williams, 1998; DeYoung & Nolle, 1996; Peek et al, 1999) compare the performance of the subsidiary of foreign banks with that of domestic banks in developed countries and find that subsidiaries of foreign banks are less profitable. However, they ignore the performance of branches of foreign banks because of the non-availability of data. Moreover, they only focus on the foreign banks in developed countries. Hence, which organizational form of foreign banks performs better in developing countries still remains a puzzle.

My thesis fills in this research gap by investigating the impact of specific organizational forms of foreign banks on their financial performance -profitability- in four Latin American countries, which are Brazil, Chile, Argentina and Uruguay. My thesis focuses on the Latin America, since foreign banks in Latin America have a quite high market share and have attracted less academic attention. Table 1 shows that the literature about foreign banks in Central Eastern European countries is richer than that in Latin America. The reasons for choosing these four countries are as follows: firstly, my thesis focuses on developing countries and these four countries are marked as such according to the standard of The World Bank (World Bank, 2009). Secondly, branches and subsidiaries are two popular organizational

3

Sometimes, the government in host countries has some restrictions about organizational form of foreign banks for legal

and regulatory considerations.

forms in these four countries (Cerutti et al, 2007). This therefore facilitates the analysis of the different organizational forms on banks’ profitability. Finally, the activities of foreign banks in these countries are well documented, and thus, the data I need are more easily available.

Furthermore, in this paper I do not only identify if there are profitability differences between domestic and foreign banks in four developing countries, but I also examine if there are profitability differences between branches and subsidiaries of foreign banks. Moreover, I study the determinants of profitability of banks; especially, I want to examine if the organizational form of foreign banks is a significant determinant of the banks’ profitability.

The research question I aim to answer in order to investigate the aforementioned issues in this thesis is:

Does the organizational form of foreign banks have an influence on the profitability of foreign banks in host countries?

In order to answer this research question, three sub-questions need to be answered. They are as follows:

(1) Are there differences between the profitability of domestic and foreign banks in host countries?

(2) Are there differences between the profitability of branches and subsidiaries of foreign banks in host countries?

(3) What are the determinants of profitability of banks?

The empirical result of my thesis shows that there are significant profitability differences between

foreign banks and domestic banks as well as between subsidiaries of foreign banks and branches of

foreign banks. Furthermore, the organizational form of foreign banks is a significant determinant of one

of the two profitability measurements I employ, i.e. of the return on assets, but not of the return on

equity. This thesis represents one of the first attempts at analyzing whether the organizational form

matters for foreign banks’ performance in developing economies. My contribution to the literature is

twofold. Firstly, I account for the differential implications of organizational forms of foreign banks on

their performance. Secondly, I identify the organizational form of foreign banks to be the determinant of

profitability (the return on assets) of banks, which supplements the current literature about determinants

of banks’ profitability.

2. ORGANIZATIONAL FORM OF FOREIGN BANKS

2.1 How foreign banks present in host countries

There are a number of organizational forms that foreign banks can adopt when entering a host country.

Goldberg (1992) notes that the representative office is the most limited, but the easiest organizational form to establish. These offices do not take deposits or make loans. In general, foreign banks establish overseas representative offices to test the possibility of further involvement in a host country.

Agencies may make commercial and industrial loans, but they cannot make consumer loans. They also cannot accept deposits. They are allowed to maintain credit balances that are similar to deposits;

however, payments are rarely made from these accounts (Goldberg, 1992). Because both the agency and the representative office cannot present full immersion in a host country, most of the potential benefits (and risks) of foreign entry into developing countries will come from two other organizational forms.

A branch is an integral part of a parent bank which means it can draw upon the parent bank's capital base, and can offer a wider range of services than agencies or representative offices (Clarke et al, 2003).

Parent banks and their branches have common legal entity. Furthermore, branches are supervised by the legal authority in home countries and are, generally, wholesale oriented.

Subsidiaries can offer a broader range of financial services than branches, and in many countries, they are regulated in the same way as domestic banks by legal authority in host countries. A subsidiary of foreign banks is an independent legal entity and makes their loan based on their own capitalization.

Moreover, subsidiaries are more retail oriented (Clarke et al, 2003). The above part is a short

introduction of the organizational forms of foreign banks, a detailed explanation of the differences

between branches and subsidiaries is presented below.

2.2 Differences between branches and subsidiaries of foreign banks

Firstly, the governance structure between parent banks and their subunits is different. I will use resource dependency theory of management to explain governance structure between parent banks and subunits. The resource dependency theory indicates that power is based on the control of resources, which are considered strategic within the organization (Pfeffer & Salancik, 1977a; Mudambi & Navarra, 2004). Strategic resource is the resource that is very important to the organization and is scarce. Power, in the management literature, has been based on the basic notion that ‘power is the ability to get others to do something that they would not otherwise do’ (Dahl, 1957) and that the successful exercise of power requires it to be based on a set of ‘legitimating principles’ that are specific to the organization (Weber, 1968). Resource dependence theory proposes that the organizations lacking in resources will seek to establish relationships with others in order to obtain needed resources. Resource dependence theory predicts that if one organization has more resources which are strategic to other organizations, this organization will have more control on other organizations.

The relationship between parent banks and branches is more centralized. Centralization means that decision is mainly made by the headquarter (Fisman et al, 2002). Adequate capital is a strategic resource for a bank to run their business. The capitalization of a branch is fully based on the parent banks’ capital base. Moreover, a branch is not an independent legal entity. The legal status of a branch implies that it has no ownership rights over its tangible assets (Mudamb & Pedersen 2007). So, branch needs its parent banks’ legal status and capital to establish and conduct its operations. Parent banks have great control on their overseas branches. A branch can only carry on the policy and decision made by parent banks and get very limited decision rights. On the other hand, the governance structure between subsidiary and parent banks is more decentralized. Decentralization means delegating decision-making authority down to the lower levels in an organization (Fisman et al, 2002). A Subsidiary is an independent legal entity and do not always make their loan based on the parent bank’s capitalization and they can raise their capital from local stock market (Goldberg et al, 2005). Therefore, subsidiaries depend less on their parent banks and have more freedom to make their own decisions.

Secondly, branches and subsidiaries have different strategic orientation. The international strategy of a

branch is more globally integrated. The global integration is used by the multinational companies to

maximize their company-wide effectiveness by coordinating their overall global efforts to a relatively

narrow band of activities in different locations (Hout et al, 1982; Brock & Siscovick, 2007). Branches

of foreign banks concentrate on segments such as wholesale and investment banking, which are

typically underdeveloped in the host countries (Cerutti et al, 2007). Branches emphasize on the integration with their parent banks. Comparing to branches, subsidiaries are more locally responsive.

The locally responsiveness strategy requires the multinational companies to allow each subsidiary to organize itself to maximize its own effectiveness in the local competitive environment (Hout et al, 1982:

Brock & Siscovick, 2007). Subsidiaries of foreign banks are in direct competition with local commercial banks for retail clients. According to local clients’ preferences, subsidiaries select service and activities to meet local needs. The focus of the foreign subsidiary is to communicate with the local market (Goldberg et al, 2005).

Thirdly, branches and subsidiaries have different foreign involvement in the ownership of banks and different supervision authorities. The share of a branch of foreign banks is one hundred percent owned by its parent bank. Parent banks have majority share of its subsidiaries, but not one hundred percent.

Moreover, the prudential supervision of branches is the responsibility of the supervising authorities of home countries of foreign banks. For subsidiary, they are supervised by the authority in host countries (Clarke et al, 2003).

Last of all, branches and subsidiaries have different business orientations and capitalization. Branches are usually wholesale oriented and finance their own capital from their parent banks’ capital base.

Subsidiaries are retail oriented and make loan based on their own capitalization.

The above part gives an introduction on organizational forms of foreign banks and specific explanation

of differences between branches and subsidiaries of foreign banks. In the following part, I will review

the literature related to research questions and formulate the research hypotheses.

3. LITERATURE REVIEW AND HYPOTHESES

3.1 Domestic banks’ performance VS foreign banks’ performance

The research on the effect of foreign ownership on banks’ performance is quite extensive. Buch (1997) argues in his study that foreign investors from advanced countries bring state-of-the-art technology and human capital to domestic banks, as foreign banks use modern technology from and rely on the human capital of their parent banks, they should perform better than domestic-owned banks. Berger et al (2000) develop two useful hypotheses to predict and explain the different performances between foreign and domestic banks. The home field advantage hypothesis argues that domestic banks outperform foreign banks. They explain that this advantage could occur either as a result of organizational diseconomies in operating and monitoring a foreign bank from a distance or of cultural and market characteristic barriers that foreign banks are not aware of. The global advantage hypothesis states that foreign banks might benefit from competitive advantages relative to their domestic peers, which leads to a better performance. The main argument is that foreign banks from advanced countries can get better educated labor force with superior managerial skills, which has the ability to provide higher quality services.

Foreign banks can reduce costs by using advanced technologies associated with risk pricing, screening and monitoring. Moreover, they can also improve profits through superior risk management and diversification skills (Berger et al, 2000).

From table 1, one can see that the empirical results about performance differences between domestic banks and foreign banks in developing countries are quite conflicting. Crystal et al. (2002) and Yildirim

& Philippato (2007) provide empirical evidence for developing countries in favor of the home field

advantage hypothesis. However, Giovanni et al (2003) and Naaborg et al (2003) find that foreign banks

are more profitable than domestic banks and the global advantage hypothesis is a good explanation for

this result. Claessens et al (2001) prove both hypotheses in their research. Their study shows that

foreign banks outperform domestic banks in developing countries (global advantages), but the opposite

is the case in developed countries (home field advantage). Bonin et al. (2005) and Mian (2003) find no

significant evidence for either the home field advantage or the global advantage, since foreign

ownership does not matter for the performance of the banks in their studies.

Table 1 Literature about the performance of foreign and domestic banks.

Title of the article Authors Data Result Significant

difference?

Observations Countries Period

Has foreign bank entry led to sounder banks in Latin America?

Crystal,B. Gerard Dages, and Linda S. Goldberg Jennifer S.

67 banks 7 Latin American countries From

1995 through 2000

Domestic banks are more profitable than foreign banks

Not included in the research Efficiency of banks: recent

evidence from the Transition Economies of Europe,

1993-2000

Yildirim, H.

Semih and Philippatos, George C.

562 financial institutions

In 14 transition economies of Europe

From 1993 to 2000 Foreign banks are less profitable relative to domestic banks

Yes

The dynamics of foreign bank ownership:

evidence from Hungary

Giovanni Majnoni.

Rashmi Shankar.

And Éva Várhegyi

26 commercial banks

In Hungary From 1995 to 2000 Foreign banks are more profitable than domestic banks

Yes

How important are foreign banks in the financial development of European transition countries?

Ilko Naaborg . Bert Scholtens . Jakob De Haan . Hanneke Bol .and Ralph De Haas

947 observations

In 10 Central Eastern European Countries

From 1993 to 2000 Foreign banks have higher profitability than domestic banks in general

Not included in the research

How does foreign entry affect domestic banking markets?

Claessens S.

Demirguc-Kunt A.

And Huizinga H.

7900 bank observations

In 80 countries For the 1988-1995 period

Foreign banks have higher profit than domestic banks in

developing countries and foreign banks have lower profit in developed countries

Not included in the research

Bank performance, efficiency and ownership in transition countries

John P. Bonin . Iftekhar Hasan .and

Paul Wachtel .

225 banks In 11 Central Eastern European countries

From 1996 to 2000 Foreign banks is more profitable than domestic banks

No

Foreign, private domestic, and government Banks:

New evidence from Emerging Markets

Atif Mian Over 1,600 banks

In 100 emerging economies For the 1992-1999 period

There is no significant profitability difference between foreign banks and domestic banks

No

3.2 Performance of subsidiaries of foreign banks VS performance of branches of foreign banks

In recent years, scholars start to study the influence of entry mode of foreign banks on their performance. Foreign banks have two choices to enter an overseas market. One is Greenfield Investment (GI), the other one is Merger and Acquisition (M&A). Greenfield investment involves the establishment of a new institution from scratch, whereas a Merger and Acquisition implies the purchase of a local bank's shares or other form of capital (Vo Thi et al, 2008). Organizational form is represented by different organizational structures such as branches and subsidiaries. The major organizational form of a M&A entry of the bank is a subsidiary, since foreign banks buy a local bank which is an independent legal entity in host countries. In theory, a GI entry bank can establish either a branch or a subsidiary. However, if a foreign bank wants to use a subsidiary to compete directly with local banks in host countries, the cost of acquiring a local bank is lower than establishing a new subsidiary in host country, since acquiring a local bank can make this foreign bank get previous local banks’ network and existing clients (Lehner, 2008). Therefore, the major organizational form of GI entry banks is branches, in essence. From the current literature about the performance of GI entry banks and M&A entry banks, I can get some ideas about the performance of branches and subsidiaries of foreign banks.

Majnoni et al. (2003), is one of the first studies that take entry mode of foreign banks in Hungary from

1995 to 2000 into consideration. According to different entry modes, foreign banks have been grouped

into Greenfield banks and M&A banks. They compare profitability differences among Greenfield banks,

M&A banks and domestic banks and find that Greenfield banks are most profitable in the 3 banks

groups. The reason for this result is that Greenfield banks have a long-standing presence on the

Hungarian market and have built up a core clientele, particularly of large corporations. After studying

the Polish banking industry between 1997 and 2001 and 10 Central Eastern European countries between

1995 and 2002, Havrylchyk & Jurzyk (2006) conclude that Greenfield institutions are more efficient

than domestic banks. However, takeover banks do not outperform the domestic banks. Vo Thi et al

(2008) study the impact of specific entry mode of foreign banks on cost efficiency in Czech Republic,

Hungary, and Poland. Their results show that foreign banks are generally more cost efficient than

domestic banks. Further, they compare particular modes of entry of foreign banks and uncover that the

superior cost performance of foreign banks is mainly caused by Greenfield banks. There is no cost

difference between M&As and domestic banks. Finally, they compare Greenfield banks with M&A

banks and find that Greenfield banks perform better. This can be explained by the fact that GI banks are

of smaller size while M&A banks may suffer from diseconomies of scale due to their acquisitions of

large institutions.

The above literature shows that Greenfield banks outperform M&A banks, which suggest that branches of foreign banks may perform better than subsidiaries of a foreign bank. However, Greenfield banks do not equal branches. When a foreign bank has adequate capital and is efficient in screening potential borrowers, establishing a new subsidiary is a good choice, since a new subsidiary can better explore parent banks’ competitive advantages gained from other markets (Lehner, 2008). A branch is just the major organizational form of GI banks. Therefore, I still need to further compare the performance of branches with that of subsidiaries. In the following part, I will formulate research hypotheses according to the differences between a branch of a foreign bank and a subsidiary of a foreign bank.

3.3 Hypotheses

Studies of the relationship between the environment and the organization point to the notion of the appropriate fit between the environment and the organization structure (Khandwalla 1977; Ansoff 1974;

Duncan 1972; Galbraith 1973). The environments in these studies have been differentiated along the dimensions of stability, complexity, diversity, and hostility. The general notion appears to be that the more dynamic, complex, diverse, and hostile the environment is, the more uncertainty it creates for organizational members. Studies suggest that in an uncertain environment, an organization with low levels of centralization will have better financial performance (Lawrence & Lorsch 1967; Burns &

Stalker 1966). The environments mentioned in above studies mainly consist of economic environment and political environment (Lawrence & Lorsch 1967; Burns & Stalker 1966). In Latin America, neither economic environment nor social environment is stable (Blanco & Grier, 2009; Sáinz, 2006).

Subsidiaries of foreign banks have more autonomy to deal with the uncertainties of local environment, which could lead to better profitability than branches in Latin America.

Earlier studies have also suggested that the effectiveness of investment incentives is highly dependent

on firms’ strategic orientation (Guisinger, 1985; Contractor, 1990). Luo’s study (1999) examines the

underlying relationship between the type of international strategy (global, locally responsive, and

transnational) and subsidiary performance in the People's Republic of China. After controlling for

cultural, size, and equity effects, he finds that strategy type is important for the overall performance of

international expansion and the strategy combining local responsiveness and global integration can lead

to a better performance. Roth and Kendall (1990) compare the performance difference among the

companies with different strategic orientations. After investigating 147 business units, they find that the

return of investment of companies with locally responsive strategy is higher than the companies with

other strategic orientations. Brock and Siscovick (2007) investigate the linkage between strategy and effectiveness of a company. Based on the data including 259 multinational subsidiaries from Asia- Pacific area, they find that global strategy does not contribute to the effectiveness of a subsidiary of a multinational company. The reason is that the global strategy cannot make overseas subunits adapt their services or products very fast in order to meet local needs in an unstable local environment. Therefore, the locally responsive strategy would be a better choice in such an environment. The above literature suggests that a subsidiary of a foreign bank will be more profitable than a branch of a foreign bank in Latin America. However, branches also have their advantages compared with subsidiaries.

A branch is fully owned by its foreign parent bank while a subsidiary is not. Hasan and Marton (2000) classify banks in Hungry into different groups according to different levels of foreign involvement in bank ownership, they find that banks with higher foreign bank ownership involvement are associated with lower inefficiency. Choi and Hasan’s (2005) research also confirms this point. Their paper investigates the relationship between the involvement of foreign investors in the ownership structure and performance of banks including profitability and risk measures. Based on the banks in Korean commercial bank industry, they find that the extent of the foreign ownership level, not the mere existence of foreign ownership, has a significant positive relationship with the profitability of banks.

The explanation for this result is that banks with higher foreign share can obtain better technology and management from their foreign parent banks, which improve their profitability. Thus, a branch of a foreign bank may perform better than a subsidiary of a foreign bank, since branches have higher foreign involvement in their ownership.

Branches are supervised by the authorities in home countries. At the same time, they already

accumulated the experience on how to deal with legal authority in home countries, so they do not need

extra resources to deal with it. On the other hand, subsidiaries are regulated by legal authority in host

countries, and they need extra resources to deal with local requirements. Moreover, a branch raises its

capital from the parent bank while a subsidiary finances its capital by itself. Thus, the financing cost of

a branch is lower. Subsidiaries have higher cost for financing and dealing with supervision authorities,

which have a negative influence on their profitability.

The above literature review and analysis indicates that branches and subsidiaries have distinct advantages and disadvantages. For subsidiaries of foreign banks, foreign parent banks have the majority of the total shares and thus, control the subsidiary. Consequently, the subsidiaries also get parent banks’

technology and management skills quite easily. Moreover, retail oriented subsidiaries have larger network and can offer full range of services to the clients in the host countries. The revenue of subsidiaries can be expected to be higher than that of wholesale oriented branches with a narrow range of services. Higher revenue can compensate higher cost. Therefore, considering the importance of governance structure and business strategy to the financial performance of a bank, I expect that subsidiaries of foreign banks will have a higher profitability than branches of foreign banks.

Hypothesis 1. There are differences between the profitability of branches of foreign banks and the profitability of subsidiaries of foreign banks.

Hypothesis 2. Other factors being equal, subsidiaries of foreign banks will have higher profitability than branches of foreign banks.

3.4 Determinants of profitability of banks

In this thesis, I also aim to examine if organizational form is one determinant of profitability of banks in

developing countries. Therefore, I will review the literature about the determinants of banks in this

subsection. In the current literature, the profitability is usually measured by the return on assets and the

return on equity and is expressed as a function of internal and external determinants. Internal

determinants are factors that are mainly influenced by a bank’s management decisions and policy

objectives. The external determinants are factors that reflect the economic and legal environment which

can influence the operation and performance of financial institutions (Athanasoglou et al, 2005). The

internal determinants include the factors such as level of liquidity, risk management, capital adequacy,

expenses management and bank size (Athanasoglou et al, 2005; Vo Thi & Vencappa, 2008). As to the

external determinants of bank profitability, it is further differentiated into different types. One type

describes the macroeconomic environment including inflation and interest rates. The other type

describes market characteristics which are market concentration, industry size and ownership status

(Athanasoglou et al, 2005). The empirical results about the determinants of bank profitability vary

significantly, since every study has its own datasets and environment.

4. DATA AND RESEARCH METHODOLOGY

4.1 The selection process of data

My final sample includes 183 banks in Argentina, Brazil, Chile and Uruguay from 2002 to 2004. Owing to the difficulty in obtaining the data from branches, I firstly check the data availability for branches from 2001 to 2008. The reason for starting from 2001 is that the initial penetration of foreign banks in Latin America has not been achieved before 2000. A period after initial penetration offers better opportunity to study the performance of foreign banks (Crystal et al, 2002). Moreover, I will study the determinants of profitability of banks. Current banks’ profitability is related to previous profitability and has an influence on the future profitability. Thus, I will conduct a panel data analysis, since panel data contain time series observations of a number of individuals and have greater capacity of capturing the complexity of human behavior than a single cross-section or time series data (Cheng, 2006)

. Previous literature about performance of banks also usually uses panel data analysis (Athanasoglou et al, 2005;

Vo Thi & Vencappa, 2008; Williams, 1998). Considering the branch as well as the time series data availability, I finally choose the period from 2002 to 2004, in which I can obtain a major amount of data for branches of foreign banks.

After choosing the period, I start to select the banks. Firstly, I select the commercial banks and government-owned banks for each year to make sure that I estimate the profitability based on a relatively homogeneous group of banks. Secondly, I select the banks that are present in these markets for these three years. After that, I classify the data into foreign banks and domestic banks. A bank is considered as a foreign bank if at least 51% of its capital is owned by foreign investors. Finally, I group foreign banks into branches and subsidiaries. After this process of selection, I get the data which is used in my thesis.

4

The Cheng’s (2006) research gives a detailed introduction of advantages of the panel data.

Table 2 The selection process of data

Stage Criterion of selection Number of banks in the

sample

1 Commercial banks and government-owned

banks by each year

213 banks

2 Presence for three years 194 banks

3 Foreign ownership 185 banks

4 Organizational form of foreign banks 183 banks

Table 3 The final number of banks in the research

Bank group Brazil Argentina Chile Uruguay

Domestic 45 36 9 4

Branch 5 6 5 7

Subsidiary 32 12 8 14

Total 82 54 22 25

The data for bank-specific variables is mainly obtained from the BankScope. My thesis focuses on the organizational form of foreign banks, so it is crucial to obtain the appropriate information on bank ownership and organizational form. BankScope does offer these two kinds of information for the year which is last updated, but it cannot offer historical information about ownership and organizational form. Therefore, I have to track the evolution in ownership of each bank and organizational form of foreign banks in the data all over the time. I use several sources including banks’ official publications, national central banks and newspapers to differentiate between foreign banks and domestic banks as well as between subsidiaries and branches. Furthermore, the data for macro-specific variables is from the World Development Indicators 2007 and national central banks.

Following the strategy of Bonin et al. (2005), Green et al. (2003), Havrylchyk & Jurzyk (2006), I use

unconsolidated statements when these are available, but rest on consolidated statements otherwise. The

unconsolidated format was the most widely used in the BankScope database. It is also in line with the

assumption that since the financial markets in the sample countries were underdeveloped, banking

accounted for the bulk of the financial sector (Green et al, 2003). Moreover, I use local accounting

standard data according to the availability of data.

4.2 Variables

I carefully select variables in my thesis in order to measure the profitability of foreign banks and identify the determinants of profitability of banks. Following the previous literature (Panayiotis et al, 2006; Athanasoglou et al, 2005), two variables are used to measure the profitability and these are the ratio of net income to assets ratio (ROA) and the ratio of net income to equity (ROE). In principal, the return on assets reflects the ability of a bank’s management to generate profits from the bank’s assets, although it may be biased due to off-balance sheet activities. The return on equity indicates the return to shareholders on their equity. In particular, it represents the net benefit the shareholders receive from investing their capital in the bank. The return on equity equals the return on assets times the total assets- to-equity ratio. The variables for the determinants of profitability of banks are classified into bank- specific variables and macroeconomic-specific variables.

4.2.1 Bank-specific profitability determinants

Liquidity risk: the ratio of loans to total assets (LA) is served as a proxy for liquidity risk. Liquidity risk is the inability of a bank to fund increases in assets and meet obligations as they come due without incurring unacceptable losses and is an important determinant of bank’s profitability (Athanasoglou et al, 2006). Liquidity risk indicates that a bank should hold assets with different levels of liquidity. The assets with different levels of liquidity demand different levels of return. Demirgüç-Kunt et al (2004) find that banks with high levels of liquid assets in cash and government securities may receive lower interest income than banks with less liquid assets. The loans market, especially credit to households and firms, is less liquid and has a greater expected return than other bank assets, such as government securities (Athanasoglou et al, 2006). Thus, when a bank has a high loans of assets, its liquidity risk is high, which demands higher profitability. I expect the ratio of loan to assets to have a positive relationship with profitability.

Credit risk: to proxy this variable, I use the loan-loss provisions to loans ratio (LOL). Loans are the

main source of income for a bank and changes in credit risk may reflect changes in the health of a

bank’s loan portfolio (Cooper et al, 2003). Duca & McLaughlin (1990) find that increased exposure to

credit risk is normally associated with decreased firms’ profitability. Miller & Noulas (1997) also find

that the higher the exposure to high-risk loans, the higher the accumulation of unpaid loans and the

lower the profitability. This suggests that profitability of a bank is related to the quality of loan, not to

the volume of loan. Thus, I expect the ratio of loan-loss provisions to loans to be negatively associated with profitability.

Capitalization: the ratio of equity to assets (EOA) is widely used as a key capital ratio to proxy the capitalization (Athanasoglou et al, 2006; Vo Thi & Vencappa, 2008; Berger, 1995b). Even though overall capitalization has been demonstrated to be important in explaining the performance of financial institutions, its impact on bank profitability is ambiguous. According to Berger (1995b), the lower ratio of equity to assets shows a relatively risky position, which makes banks to expect higher profit.

However, the higher levels of equity to assets would decrease the cost of external funding, resulting in a positive impact on profitability (Molyneux, 1993). Moreover, an increase in the equity to assets may reduce the expected costs of financial distress and bankruptcy, and thus, raise expected profit (Berger, 1995b). Therefore, I expect the ratio of equity to assets to have a positive relationship with profitability.

Bank size: I use the logarithm of banks’ assets (SIZE) to examine the possible relationship between bank size and profitability. Bank size is generally used to capture potential economies or diseconomies of scale in the banking sector. Since the dependent variables (ROA and ROE) of my model are deflated by total assets, it would be appropriate to log total assets before including them in the model (Athanasoglou et al, 2006; Vo Thi & Vencappa, 2008; Berger, 1995b). This variable controls for cost differences and product and risk diversification according to the size of the credit institution. When economies of scale can be achieved, the banks have lower cost, which can lead to higher profit (Goddard et al., 2004). On the other hand, risk diversification can result in lower return. Eichengreen and Gibson (2001) find that the effect of a growing bank’s size on profitability may be positive up to a certain limit. Beyond this point the effect of size could be negative due to the bureaucracy in decision making and other reasons. Hence, the expectation between size and profitability is unclear.

Management expense: the ratio of overhead costs to total assets (OVER) is used as a measurement of

management expense. This variable is used as a measurement of bank efficiency as it can capture cross

bank differences in organization and operation (Amor-Tapia, 2006). Different business systems, product

mixes, and asset allocations mean different overhead cost structures. The existing literature shows that

any reduction of expenses improves the efficiency and hence, increases the profitability of a financial

institution (Bourke, 1989). Moreover, Al-Haschimi (2007) finds that operating inefficiencies appear to

be the main determinants of high bank spreads in Sub-Saharan economies. Brock & Rojas Suarez (2000)

also find that administrative and other operating costs contribute to the prevalence of high spreads in

Latin American countries. Therefore, I expect the ratio of overhead cost to total assets to have a negative relationship with the profitability.

Management efficiency: the ratio of total earnings assets to total assets (EOR) is proxy for operation efficiency of a financial institution. The efficient management makes possibly more profits with the same resources (Amor-Tapia, 2006). Hence, a higher proportion of earning assets would be an indication of efficiency while a higher proportion of fixed and non-earning assets would be a sign of inefficiency. Earning assets include loans, deposits with banks, securities, and equity investments. Non- earning assets include cash, intangible fixed assets and accrual accounts (Amor-Tapia, 2006). I expect the ratio of total earning assets to total assets to have a positive influence on the profitability of banks.

Cost of financial intermediation: I use the ratio of net interest margin to total assets to measure the cost of financial intermediation. The cost of financial intermediation is the difference between the gross cost paid by a borrower to a bank and the net return received by a depositor (Brock and Suarez, 2000).

High net interest margins have usually been associated with inefficiency (Saunders & Schumacher, 2000). Low deposit rates represent unattractive returns for maintaining deposit accounts and hence, discouraging savings. On the other hand, high loan rates increase the cost of the funds and reduce the demand for the loan, decreasing the profitability of a bank. Therefore, I expect the relationship between the ratio of net interest income to total assets and profitability to be negative.

Foreign ownership: I use a dummy variable to identify the impact of foreign ownership on profitability.

The dummy (FOREIGN) equals one when a bank is controlled by a foreign investor, and dummy equals zero when a bank is a domestic bank.

Organization form of foreign banks: I use two dummy variables to identify the impact of

organizational form of foreign banks on profitability. The dummy (subsidiary) equals one when a bank

is a subsidiary of foreign banks, and dummy equals zero when a bank is not. Moreover, the dummy

(branch) equals one when a bank is a branch of foreign banks, otherwise it equals 0.

4.2.2 Macroeconomic-specific profitability determinants

Three macroeconomic variables including real interest rate (RIR), inflation rate (IR) and annual growth rate of GDP (GDP) are used to measure macroeconomic conditions of host countries. Bank profitability is sensitive to macroeconomic conditions. Generally, higher economic growth encourages banks to lend more and permits them to charge higher margins, as well as improving the quality of their asset (Neely et al, 2000). Previous research (Neely et al, 2000; Bikker & Hu, 2002) already proved that economic growth can improve the profitability of the banking sector, so I expect the GDP to have a positive impact on profitability.

As for other macroeconomic variables, the expectation is unclear. High inflation rate means that banks usually charge higher loan interest rate which can have a positive influence on profitability of the banks.

However, it is the case only if the inflation rates can be anticipated and banks can adjust their interest rate on time. Otherwise, it is possible that bank’s costs increase faster than its revenue, which results in lower profit. Similar analysis can be applied to the real interest rate. Higher real interest rate makes banks to entail higher loan interests, and increases the profitability of banks. On the other hand, higher real interest rate can also reduce the demand for capital, which has a negative impact on the profitability of banks. Therefore, the expectations of the relationship between the inflation rate, the real interest rate and profitability are unclear.

Table 4 summarizes the variables I use and their definitions. Table 4 also shows expected relationship

between independent variables and the dependent variables as well as the sources of the data. Table 5

shows the descriptive statistics of the variables used in this thesis. Moreover, table 6 demonstrates the

correlation between different variables.

Table 4 Variable definitions and sources of the data

Variables Measure Notation Expected

Effect

Sources of the

data Dependent

variable

Profitability Net income/

assets

ROA BankScope,

National central banks, official website of the banks, professional journals and newspaper Net income/

equity

ROE In d ep en d en t v a ri a b le s B a n k -s p ec if ic v a ri a b le s

Liquidity Risk Loans/assets LA positive

Capitalization Equity/asses EOA positive

Bank size Log (assets) SIZE unclear

Credit risk loan-loss provisions to loans

LOL negative

Management expense

Operating expenses/

assets

OVER negative

Cost of financial intermediation

Net interest income/ assets

NIM positive

Management efficiency

Earning assets/assets

EOR positive

Ownership Binary dummy

variable equal to one for foreign banks

FOREIGN unclear

Organizational form

Binary dummy variable equal to one for subsidiary

SUBSIDIARY unclear

Organizational form

Binary dummy variable equal to one for branch

BRANCH unclear

M a c ro -s p ec if ic

v a r ia b le s

Inflation rate Current period inflation rate (consumer prices)

IR unclear World

Development Indicators Real interest rate Real interest 2007

rate

RIR unclear

annual growth rate of GDP

Real GDP growth

GDP positive

Table 5 Descriptive statistics of the variables

Variables Mean

Standard

Error Median

Standard Deviation

Sample

Variance Kurtosis Skewness Range Minimum Maximum

LA 0.418 0.011 0.389 0.246 0.061 -0.760 0.307 0.997 0.000 0.997

OVER 0.081 0.004 0.058 0.093 0.009 35.837 5.003 0.897 0.001 0.898

EOR 0.853 0.005 0.875 0.112 0.013 7.947 -2.183 0.835 0.165 1.000

SIZE 2.633 0.036 2.548 0.833 0.694 -0.421 0.229 4.261 0.704 4.965

ROE -0.034 0.030 0.098 0.714 0.509 43.803 -3.963 13.068 -8.093 4.975

EOA 0.194 0.007 0.138 0.174 0.030 5.437 2.146 1.340 -0.348 0.992

NIM 0.070 0.005 0.052 0.122 0.015 90.862 -4.943 2.408 -1.743 0.665

ROA -0.005 0.004 0.012 0.096 0.009 28.852 -4.481 1.144 -0.856 0.288

LOL 0.112 0.046 0.016 1.076 1.157 213.656 12.186 27.126 -7.626 19.500

IR 0.110 0.003 0.085 0.067 0.005 -0.047 0.776 0.248 0.011 0.259

RIR 0.289 0.010 0.343 0.228 0.052 -0.603 0.248 0.863 -0.022 0.840

GDP 0.024 0.003 0.022 0.063 0,004 0.293 -0.967 0.229 -0.110 0.118

SUBSIDIARY 0.361 0.021 0.000 0.481 0.231 -1.667 0.582 1.000 0.000 1.000

BRACH 0.120 0.014 0.000 0.326 0.106 3.498 2.342 1.000 0.000 1.000

FOREIGN 0.481 0.021 0.000 0.500 0.250 -2.001 0.077 1.000 0.000 1.000

Table 6 Correlation matrix of variables

LA OVER EOR SIZE ROE EOA NIM ROA LOL IR RIR GDP SUB BRA FOR

LA 1,000

OVER 0.115 1.000

EOR 0.204 -0.070 1,000

SIZE

-

0.111 -0.381 0,051 1.000 ROE

-

0.038 -0.130 0,038 0.049 1.000 EOA

-

0.058 0.176 -0.044

-

0.548 0.030 1.000

NIM 0.155 0,298 0.084

-

0.201 0.161 0.161 1.000

ROA 0.030 -0,197 0.050 0.128 0.658 -0.063 0.054 1.000

LOL

-

0.107 0,056 0.003

- 0.050

-

0.055 0.069 0.012

-

0.112 1.000 IR

-

0.102 0,240 -0.120

- 0.227

-

0.216 0.106 0.049

-

0.294 0.073 1.000

RIR 0.055 0,065 0.079 0.041

-

0.050 -0.100 0.137 0.027

-

0.023 0.185 1.000 GDP

-

0.028 -0,164 0.107 0.102 0.228 -0.038

-

0.121 0.308

-

0.142 -0.684 -0.437 1.000

SUB 0.185 0,034 -0.106 0.075

-

0.028 -0.010

- 0.088

- 0.005

-

0.053 -0.029 0.130

- 0.010 1.000 BRA

-

0.148 -0,055 -0.109

- 0.145

-

0.030 0.219

- 0.045

-

0.121 0.172 0.008 -0.038

-

0.009 -0.278 1.000

FOR 0.082 -0,004 -0.173

- 0.022

-

0.046 0.132

- 0.114

-

0.084 0.061 -0.022 0.101

-

0.016 0.780 0.384 1.000

4.3 Research Methodology

In order to answer the first and the second sub-question of this thesis, I use the average profitability to represent the profitability of each bank group, since the average value can represent the whole series and conveys general idea of the whole group (Hardy et al, 1988). In the statistics, mean, median and mode are used as the average value of the group. When the data in the sample is normally distributed, the mean is the most widely used type of the average value.

The previous researchers also use mean value to identify the profitability difference in different bank groups (Havrylchyk & Jurzyk, 2006; Claessens et al, 2001).When sample data is not normally distributed, the median is a better measure than the mean, since the median is less sensitive to extreme scores (Lehmann, 1951). The mode is the value that occurs the most frequently in a data set and makes sense for the nominal data (Lehmann, 1951).

Based on the above analysis, I firstly examine the distribution of data in each sample, and then choose the method of comparison. Histogram figure and Jarque-Bera are applied to check the distribution of the data, as they are the most common ways to check the normal distribution of the data (Aldrich, 2005). I use the mean value to represent the average profitability of banks when the data of my sample is normally distributed. An Independent-Sample T test is applied to study the mean profitability difference between foreign banks and domestic banks as well as between branches and subsidiaries of foreign banks. On the other hand, the median is used when the sample data is not normally distributed. Mann-Whitney U test is adopted to identify the profitability difference of different bank groups. Mann-Whitney U test is used to determine if a difference exists between two groups and is ideally dependent on random selection of subjects into their respective group (Herrnstein et al, 1976). Moreover, I also compare the average profitability among different bank groups for each year and each country to see if the profitability difference is caused by a certain country or a certain year.

As for studying the determinants of profitability, I will conduct a regression analysis. Least squares methods on fixed or random effects models are mostly widely used in the literature about the profitability of banks, since it is powerful and easily calculated (Havrylchyk & Jurzyk, 2006;

Athanasoglou et al, 2005). The fixed effects model allows the partial regression coefficients to be

common across cross-sectional units, but the intercepts in the regression model are taken to be

distinct among individual banks. A random effect model assumes that a common mean value for

the intercept exists and the cross-sectional differences in the intercept values of each bank are

reflected in the error term (Poole & Greenland S, 1999). I choose the random effect. The reason for this choice is primarily driven by the data. If I use the fixed effect in my estimation, the ownership dummy and organizational form dummy take the same value for the same bank across the whole period, which results in a singular matrix of explanatory variables. The singular matrix of variables means that the value of the determinant of that matrix becomes zero and it cannot be inverted. The reason for this singular matrix is that a linear combination of the vectors of dummies gives rise to the intercept vector. As the explanatory variable matrix cannot be inverted, it is impossible to estimate coefficients. Moreover, random effects can take into account both bank-specific and time effects. Therefore, random effects are used in my estimations.

Based on the above discussion, I adopt the Ordinary Least Square method with random effects to make regression analysis. Furthermore, I follow the White test process to prevent heteroskedasticity, which is in line with the choice of the most recent literature (Athanasoglou et al, 2005; Vo Thi & Vencappa, 2008). A model including foreign dummy, branch dummy and subsidiary causes singular matrix problem, thus, my models only include one organizational form dummy each time. The research models of my thesis are as follows:

(1) ROA = β

+ β

LA + β

OVER + β

EOR + β

SIZE + β

EOA + β

NIM + β

LOL β

IR+ β

RIR + β

GDP + β

FOREIGN + β

SUBSIDIARY

(2) ROA = β

+ β

LA + β

OVER + β

EOR + β

SIZE + β

EOA + β

NIM + β

LOL β

IR+ β

RIR + β

GDP + β

FOREIGN + β

BRANCH

(3) ROE = β

+ β

LA + β

OVER + β

EOR + β

SIZE + β

EOA + β

NIM + β

LOL β

IR+ β

RIR + β

GDP + β

FOREIGN + β

SUBSIDIARY

(4) ROE = β

+ β

LA + β

OVER + β

EOR + β

SIZE + β

EOA + β

NIM + β

LOL

β

IR+ β

RIR + β

GDP + β

FOREIGN + β

BRANCH.

5. EMPIRICAL RESULT AND DISCUSSION

5.1 The profitability of foreign banks VS the profitability of domestic banks

Table 7 shows the distribution of data and method I use to compare the profitability difference between foreign banks and domestic banks as well as between branches and subsidiaries of foreign banks. Table 8 indicates which bank group has higher average profitability and whether the difference of profitability is significant. From the whole sample, I can see that the domestic banks have a higher average profitability than foreign banks and this difference is significant.

After that, I examine if this result holds for every year and every country. The domestic banks still

have higher average profitability for each year and the significance of difference also holds,

except of the return on equity in 2004. In four Latin American countries, Uruguay is the only

country where foreign banks have higher profitability with an insignificant difference. For the

other three countries, the result of comparison of profitability is in line with the result from the

whole sample. These results show that the profit efficiency of domestic banks lasts all over time

and holds in most of the countries in the sample, therefore, I conclude that domestic banks have a

higher profitability than foreign banks in general, which supports the home field advantages

hypothesis in the literature review.

Table 7 The distribution of data and method

Data Profitability Are data

normally distributed?

Method to compare

All ROA No Mann-Whitney U

ROE No Mann-Whitney U

2002 ROA No Mann-Whitney U

ROE No Mann-Whitney U

2003 ROA No Mann-Whitney U

ROE No Mann-Whitney U

2004 ROA No Mann-Whitney U

ROE No Mann-Whitney U

Brazil ROA No Mann-Whitney U

ROE No Mann-Whitney U

Argentina ROA No Mann-Whitney U

ROE No Mann-Whitney U

Chile ROA No Mann-Whitney U

ROE Yes Independent-Sample T test

Uruguay ROA No Mann-Whitney U

ROE No Mann-Whitney U

5

the histogram figure of each sample is given in appendix

Table 8 profitability difference between domestic banks and foreign banks as well as branches and subsidiaries

Data Foreign VS Domestic Subsidiary VS Branch

ROA ROE ROA ROE

All significant difference? Yes Yes Yes Yes

bank group with higher profitability? Domestic Domestic Subsidiary Subsidiary

2002 significant difference? Yes No Yes No

bank group with higher profitability? Domestic Domestic Subsidiary Subsidiary

2003 significant difference? Yes Yes No No

bank group with higher profitability? Domestic Domestic Subsidiary Subsidiary

2004 significant difference? Yes Yes Yes Yes

bank group with higher profitability? Domestic Domestic Subsidiary Subsidiary

Brazil significant difference? Yes Yes No Yes

bank group with higher profitability? Domestic Domestic Subsidiary Subsidiary

Argentina significant difference? Yes Yes No No

bank group with higher profitability? Domestic Domestic Subsidiary Subsidiary

Chile significant difference? Yes Yes Yes No

bank group with higher profitability? Domestic Domestic Subsidiary Subsidiary

Uruguay significant difference? No No No No

bank group with higher profitability? Foreign Foreign Branch Branch

6

The specific test results are given in the table 11,12,13 in the appendix

5.2 The profitability of branches of foreign banks VS the profitability of subsidiaries of foreign banks

The result form the whole sample shows that there is a significant difference of profitability between subsidiaries of foreign banks and branches of foreign banks; and subsidiaries have higher average profitability. For each year, the profitability of subsidiaries is still higher, but the significance of the difference varies according to different years. In 2002, the return on equity of branches is insignificantly different from that of subsidiaries. In 2003, there is no significant difference in the return on assets and the return on equity between these two organizational forms.

In four Latin American countries, Uruguay is the only one country where branches of foreign

banks have higher average profitability with an insignificant difference. In Brazil, the difference

of the return on assets between branches and subsidiaries is insignificant. There is no significant

difference of profitability in Argentina. In Chile, the difference of the return on equity is

insignificant. The above result shows that the average profitability of subsidiaries of foreign

banks is significantly higher than that of branches of foreign banks, which meets the hypothesis in

this thesis. Uruguay is a special case in my sample, since the result is different from other

countries. The banking crisis during the sample period contributes to this result. In this banking

crisis, cash-strapped Argentineans begin withdrawing their deposits from Uruguay, which makes

domestic banks in Uruguay run into severe liquidity shortage (Plaza & Sirtaine, 2005). This

liquidity shortage decreases the profitability of the local banks. On the other hand, the foreign

banks in Uruguay have been the great beneficiaries of the “flight-to-quality” during the crisis and,

no major consolidation or downsizing has taken place among these banks (Plaza & Sirtaine,

2005). The major organizational form of foreign banks in Uruguay is branches. Branches of

foreign banks select their service carefully and adopt conservative strategy of investment, making

them perform better than subsidiaries of foreign banks which are deeply involved into the local

banking system (Plaza & Sirtaine, 2005).