Banking Efficiency and Foreign Ownership in Transition: Is There Evidence of a Cream-Skimming Effect?

This paper revisits the issue of cost efficiency in the banking sector and the role of foreign ownership in European transition economies. The novelty of our approach is that we instrument for the decision of foreign investors to acquire domestic banks. This analysis allows us to evaluate the endogeneity bias that results from the so-called cream-skimming effect. Using a sample of 282 banks in 19 transition countries, we employ a two-stage instrumental variable approach. In the first stage, we estimate the probability of foreign acquisitions of domestic banks by implementing a panel probit model. In the second stage, the estimated propensity scores are used in the Battese and Coelli (1995) stochastic efficiency frontier specification. Although cost differences may also be caused by different product characteristics, our main finding is that the instrumental variable approach reveals that foreign ownership has a negative impact on cost efficiency. This observation indicates that in the transition countries studied the cream-skimming effect is significant, which implies that foreign investors tend to acquire the most cost efficient banks in the first place.