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How does Financial Openness Affect Bank Risk and Bank Profit Efficiency?

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By Dr Yun Luo and Professor Glauco De Vita, Centre for Business in Society

In a recently published paper [1], researchers from the Centre for Business in Society (CBiS) and the Faculty of Business and Law at Coventry University, investigate the interrelationship between financial openness, bank risk and bank profit efficiency using a cross-country sample of 2,007 commercial banks from 140 countries over the period 1999-2011. Although various individual links among these three variables have already been examined in previous literature, no previous study has investigated the intricate causal relationships among the three variables jointly in an international sample of bank-level data.

The empirical analysis focuses on establishing whether the effect of financial openness (capital and equity market openness) on both bank risk and profit efficiency occurs directly or through each of the two bank characteristics, efficiency and risk respectively. Methodologically, the potential reverse (Granger) causality between profit efficiency and risk is investigated first, using a dynamic simultaneous model via System Generalised Methods-of-Moments (SYS-GMM) estimation. Next, the role of bank risk on bank profit efficiency is estimated using stochastic frontier analysis, thus allowing estimates of efficiency to be influenced directly by a number of explanatory variables including different measures of risk and financial openness.

At the theoretical level, several propositions exist in the literature with regard to both the direct and indirect effects (positive and negative) of financial openness on bank profit efficiency, as well as the role that bank risk may play in relation to each of the above variables. However, to date, no single study has examined the importance of bank risk in investigating the effect of financial openness on bank profit efficiency or the impact of financial openness on both bank risk and profit efficiency by distinguishing between its direct influence and the effect that occurs through each of the two bank characteristics (efficiency and risk, respectively).

The main results of this study indicate that: (a) Financial openness reduces bank profit efficiency directly, not through changes in bank risk; (b) Bank risk reduces bank profit efficiency irrespective of financial openness; (c) Financial openness increases bank risk indirectly through the decreased bank profit efficiency.

Overall, it can be concluded that financial openness has a negative effect both in terms of bank risk and profit efficiency. The negative effect of financial openness on profit efficiency can be attributed to implicit costs, such as consolidation of banking operations, restructuring of bank portfolios, lack of risk management skills, and poor lending decisions, all of which may undermine bank profits and, in turn, induce banks to greater risk-taking. Yet, caution should be exercised in taking this evidence to signify that the overall net effect of financial openness on the banking sector is harmful since there are potential benefits associated with financial openness owing to greater financial development that may counterbalance the specific negative effects uncovered by this study.

These findings can be said to contribute to both a better understanding of how financial openness affects the efficient operation of banks as well as bank risk, and our knowledge of the channels through which the direct and indirect effects of financial openness are transmitted.

The policy implications flowing from these findings call for greater prudential regulation and supervision aimed at addressing the trade-off between financial liberalisation and risk. More stringent capital requirements and monitoring could go a long way toward limiting bankers’ propensity to higher risk-taking, while institutional reforms might create more effective incentives for productive investment opportunities to emerge from financial openness.

References

[1] Yun Luo, Sailesh Tanna, Glauco De Vita (2016). Financial openness, risk and bank efficiency: Cross-country evidence. Journal of Financial Stability 24, 132-148.

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