Banking Sector Opening: Policy Questions And Lessons For Developing Countries

Leonardo Martinez-Diaz
Leonardo Martinez-Diaz Global Director - Sustainable Finance Center, World Resources Institute

February 15, 2007


After decades of zealously protecting their banking markets, in the 1990s many developing and transition economies began to scale down or eliminate barriers to foreign direct investment (FDI) in the banking sector. Today, policymakers in a second wave of countries are in the early stages of opening their banking sectors or are under considerable political pressure to do so. Indeed, banking sector opening has been making headlines in recent months: The issue was hotly debated by U.S. and Russian negotiators during World Trade Organization (WTO) accession talks in 2006, India’s government recently pledged greater opening of its banking sector by 2009, and the Chinese government has been selling significant equity stakes in some of the country’s largest banks to foreign investors. Even smaller and less integrated economies, such as Vietnam and Libya, are currently preparing strategies for opening their banking sectors to foreign capital and competition.

For developing country decision makers, this opening has raised urgent and complex policy questions. Banking sector opening can bring real benefits in the form of fresh capital, more competition, new financial products, and improved corporate governance, but it also can introduce new financial risks and vulnerabilities. This policy brief surveys the lessons and insights that developing country policymakers can draw from the academic literature and from the experiences of countries that have opened their banking sectors in the recent past.

The brief makes several recommendations. To ensure that foreign entry delivers the most benefits while introducing the least amount of risk, developing country policymakers should address the banking system’s structural problems—particularly high levels of concentration—before or in parallel with the opening. They should also diversify the mix of foreign entrants and the ownership structures of acquired domestic banks, set out a clear division of labor between home- and host-country bank regulators, and learn from the financial authorities of advanced economies how best to deal with the challenges posed by foreign entry.