Nankai Business Review International

Location strategies of multinational banking under risk and asymmetric information

Jin Zhang Jun Shan Susheng Wang

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Article information:
To cite this document:
Jin Zhang Jun Shan Susheng Wang, (2013),"Location strategies of multinational banking under risk and
asymmetric information", Nankai Business Review International, Vol. 4 Iss 2 pp. 130 - 146
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NBRI
4,2

Location strategies of
multinational banking under risk
and asymmetric information

130

Jin Zhang and Jun Shan

Received 7 October 2012

Revised 10 January 2013
Accepted 20 February 2013

The Research Center for Corporate Governance, Nankai University,

Tianjin, China, and

Susheng Wang
Department of Economics, Hong Kong University of Science and Technology,
Hong Kong, China
Abstract
Purpose Inspired by the recent opening up of the Chinese banking market and by the ensuing
location strategies adopted by foreign banks, the purpose of this paper is to develop an empirical
analysis on location strategies. The paper enriches the existing literature by including many important
realistic aspects, some of which have never been analyzed in theory before, especially for firms
entering an unfamiliar and risky foreign market.
Design/methodology/approach The authors carried out an empirical study on foreign banks
entry to the newly opened up Chinese banking market and modelled location strategies of foreign
banks in China as a conditional logit problem, in which the dependent variable is the market chosen by
an investor. To investigate the determinants of foreign banks location choices in China, the authors
collected data of foreign banks entries into China during 1980-2006.
Findings The main empirical results are: asymmetric information, firm size and entry sequence are
significant determinants of foreign banks location strategies.
Originality/value The paper presents a new set of results.
Keywords China, Banks, Market entry, Multinational companies, Financial markets, Location strategy,
Economic risk, Asymmetric information, Firm size, Entry sequence
Paper type Research paper

1. Introduction
With todays fast paced globalization, the level of international financial activity is
expanding at an extraordinary rate. It has been a recent global phenomenon for many
multinational banks from developed economies to enter emerging markets, where
they quickly expand their businesses. How do multinational banks locate themselves
strategically when they enter a new market? Inspired by the recent opening up of the
Chinese banking market and by the observed location strategies adopted by foreign
banks in China, we contribute to the literature by providing an empirical analysis with
rich features.
Nankai Business Review
International
Vol. 4 No. 2, 2013
pp. 130-146
q Emerald Group Publishing Limited
2040-8749
DOI 10.1108/20408741311323335

The authors gratefully acknowledge support from the National Natural Science Foundation of
China under No. 71102048; Humanities and Social Science Research Funds of Ministry of
Education of China under No.10YJC630200 and No.11YJC790271; and the Fundamental Research
Funds for the Central Universities under No. NKZXB1115.

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Spatial competition has attracted many researchers since Hotelling (1929) published
his most celebrated paper[1]. Various modifications and extensions to the original model
have introduced alternative cost structures (DAspremont et al., 1979; Economides, 1986),
examined circular and two-dimensional markets (Salop, 1979; Tabuchi, 1994; Veendorp
and Majee, 1995), markets with non-uniform customer distributions (Tabuchi and
Thisse, 1995), and markets with multiple equilibria (Eaton and Lipsey, 1975;
De Palma et al., 1987). With the intention of explaining bank location strategies in a
foreign market, our empirical model has included many realistic features. Some of the
features which are particularly important for those in a new foreign banking market
have never been discussed in the existing literature on location strategies.
Since 2007, the Chinese banking market has been completely opened up. This market
today is one of the largest banking markets in the world. The total bank assets relative to
the gross domestic product (GDP) is also among the highest in the world. Chinas sustained
growth and long-term potential attract many foreign banks. However, for a researcher,
China posts a challenge since its market has many special features. By restricting to
discrete locations, our model allows a rich set of features, including heterogeneous
demand, asymmetric information and first-mover advantage. With rich features, our
regression model is fit for a study on the strategic entry of foreign banks to the Chinese
banking market. Our main empirical finding is that asymmetric information, firm size and
entry sequence are significant determinants of foreign banks location strategies.
The rest of this paper proceeds as follows. Section 2 presents a literature review on
location strategies of foreign banks. Section 3 presents our empirical analysis of foreign
banks entry into the Chinese banking market. Finally, Section 4 concludes the paper.
2. Literature review
In this section, we present a literature review on location strategies of foreign banks.
Because we focus on five factors in our empirical analysis: heterogeneous demand,
economic risk, asymmetric information, firm size, and sequential entry, we sort the
literature accordingly.
First, consistent with heterogeneous demand, one special feature of China is that its
market is highly regionalized. The nature of industries, customer needs and banking
conditions differ greatly by region. Highly different growth rates across regions result
in a very uneven income distribution, so that income in coastal areas is markedly
higher than that in inland regions. Indeed, the existing literature indicates that a firm
has a tendency to locate its outlets in high-demand regions. For example, Goldberg et al.
(1989) find that the level of international financial activity is positively related to per
capital income, the level of imports and the number of corporate headquarters across
US states. Yamori (1998) shows that Japanese banks choose their locations based on
local banking opportunities in the host countries. Following Anderson et al. (1997),
Montes-Rojas (2008) also shows that banks have a tendency to concentrate in rich
regions. Our theory implies this behavior under certainty.
Second, on the follow-the-clients strategy, Nigh et al. (1986) show that US foreign
direct investment (FDI) in a foreign country has a positive effect on US banking
activity in the host country, which is the so-called follow-the-clients strategy. But, local
market opportunities have no significant effects on US banks location choices. For less
developed countries, Sabi (1988) finds that market size, US FDI and economic growth
in the host country significantly affect US banking activity in the host country.

Location
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131

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132

They find that financial services tend to be exported along with goods. Goldberg and
Johnson (1990) find that per capita GDP, which may represent a host countrys banking
opportunities, FDI and US trade are significant influential factors affecting US banks
location choices. Brealey and Kaplanis (1996) conduct a cross-country analysis of
location choices of foreign banks. They also find a significant relationship between
bank locations, trade and FDI. Yamori (1998) also finds that FDI in manufacturing is
an important determinant in Japanese banks location choices. For foreign banks in
the USA, Esperanca and Gulamhussen (2001) find that multinational banks not only
follow corporate customers but also non-corporate customers from the home country.
For Italian banks, Mutinelli and Piscitello (2001) show that international banking
experience, the need to follow pre-existing customers and positive externalities offered
by international financial centers are important factors affecting a foreign banks
location choices. For German banks in emerging markets, Wezel (2004) further finds
that non-banking FDI has a strong pull effect on banking FDI flows, but per capita
GDP and trade linkages are insignificant in attracting foreign banks. In contrast,
Kolstad and Villanger (2008) recently find that foreign investors in the financial
industry appear indifferent to political economy conditions and per capita GDP in the
host country and trade activity between the host and home countries. Instead, they find
that FDI in finance is robustly linked to FDI in manufacturing.
Third, on the effect of risk, Wezel (2004) pays particular attention to risk since risk
is an important feature of emerging markets. He finds that a highly developed financial
market and a low country risk attract FDI flows in banking. His finding is consistent
with our finding in that risk is an important factor in choosing bank locations since
location is a long-term plan. For foreign banks from OECD countries in Italy, Magri et al.
(2005) further find that the host countrys risk, economic integration, profitable
opportunities and country size have a significant impact on location decisions.
Fourth, on the effect of asymmetric information, DellAriccia et al. (1999) and
Marquez (2002) indicate that potential entrant banks face an adverse-selection
problem stemming from their inability to distinguish new borrowers from old
borrowers who have been rejected by other banks. DellAriccia et al. (1999) show that
such asymmetric information gives so much advantage to the incumbents that two
banks in Bertrand equilibrium can effectively block entry for all others. In contrast,
Marquez (2002) argues that, in places of high growth, high turnover can erode an
incumbents information advantage, thus reducing the adverse-selection effect and
permitting entry. Burdisso and DAmato (1999) show that, for a developing country
like Argentina, after the banking industry is opened up to competition, a banks
degree of concentration (as measured by the banks market share) turns out to be
very low in the most populated areas, while the opposite is true in less developed
areas. Also, Berger and Dick (2007) show that early entrants appear to perform badly
due to a lack of experience, knowledge and connections in a new banking market.
Van Horen (2007) also finds that banks from developing countries are more likely
to invest in small developing countries with weak institutions, where banks from
developed countries are reluctant to go. We interpret the results in the last two papers
as due to asymmetric information, since banks from developing countries are likely to
understand a developing market better. With much evidence on the importance
of asymmetric information in location choices, our analysis takes into account
asymmetric information as a potential factor in location strategies.

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Finally, on the first-mover advantage, Berger and Dick (2007) find an advantage in
market share for early entrants.
3. Empirical analysis
3.1 Foreign banks in China: some stylized facts
Foreign bank entry in China. Since Japan Bank of International Corporation established
a representative office in Beijing in 1980 and Nanyang Commercial Bank (Hong Kong)
established a bank branch in Shenzhen in 1981, foreign banks have become an integral
part of Chinas banking market. Following Chinas rapid economic growth and gradual
entry into the world market, in the last 20 years, foreign banks have been
enthusiastically establishing their presence in China. As of the end of 2006, 223 foreign
banks from 42 countries and regions have established 242 representative offices and
312 bank institutions, including branches, sub-branches and wholly-foreign-owned banks
in China. Figure 1 shows the trend of foreign bank entry in China from 1980 to 2006.
Against the background of the gradual opening-up policy, China has taken several
steps to open up its banking sector to foreign competition since the early 1980s. Before
1985, banks were only allowed to establish bank branches and bank subsidiaries in five
special economic zones in coastal areas, including Shenzhen, Xiamen, Zhuhai, Shantou
and Hainan province, together with two major cities, Beijing and Shanghai. Over time,
the Chinese Government gradually relaxed the geographical restriction on foreign banks
so that more and more major cities were opened up for foreign banks. Eventually in 1994,
the geographic limitation was completely phased out. Since then, foreign banks have
been allowed to do foreign currency-based businesses nationwide. When China joined
the World Trade Organization (WTO) in December 2006, China started to grant
permission to foreign banks to conduct local currency-based (yuan-based) businesses.
Moreover, to support the development of the countrys underdeveloped hinterland,
China has been granting priorities to foreign banks that would expand into the western,
central and north-eastern territories. By the end of 2006, more than 70 branches and
subsidiaries were opened in these regions.
Activities of foreign banks in China. Although the market share of foreign banks
in China stayed at a low level of around 2 per cent until 2006 in terms of total assets,
550

Location
strategies

133

Number of business outlets

500
450
400
350
300
250
200
150
100

Number of banks

50
0
1980

1985

1990

1995

2000

2005

Figure 1.
Number of foreign banks
and their business outlets
in China

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134

the total value of foreign banks total assets has been increasing steadily from the early
1990s, as shown in Figure 2. Besides the traditional businesses such as taking in
deposits, making loans, clearing and insurance, foreign banks are encouraged to engage
in derivatives tradings, QFII custodian businesses, personal wealth management,
offshore banking services and electronic banking, etc. The business scope of foreign
banks has been increasingly diversified and expanded. By the end of 2006, foreign
banks total assets amounted to US$11,882 million, with total deposits of
US$39,700 million and loans of US$61,600 million.
3.2 Data, model, and variables
Data description. To investigate the determinants of foreign banks location choices in
China, we collect data of foreign banks entries into China during 1980-2006. There
were 223 banks from 42 countries that entered the Chinese market during that period
with a total of 554 business entities (bank outlets) including branches, sub-branches,
wholly-foreign-owned banks and representative offices. To identify sample banks
and collect the necessary information on these banks, we retrieve data from a number
of sources, including Bankscope and Chinese Almanac of Finance and Banking
(various years). Data about provinces where the banks have chosen to locate are
collected from China Statistical Yearbook and Chinese Provincial Statistical
Yearbooks. The full sample consists of a total of 552 observations. There were
15 provinces and municipalities in China where foreign banks established their
presence by the end of 2006. We divide these places into three markets according to
their average population density from 1980 to 2006. We will describe the grouping
rule later. Table I presents the grouping of the 15 provinces and municipalities.
120,000
100,000

Total assets

80,000
60,000
40,000
20,000

Figure 2.
Total assets
of foreign banks

Table I.
Grouping of provinces
and municipalities

0
1993

1995

1997

1999

2001

2003

Group

Provinces and municipalities

Market1

Fujian, Hainan, Heilongjiang, Hubei, Liaoning,

Shaanxi, Sichuan, Yunnan
Guangdong, Jiangsu, Shandong, Zhejiang
Beijing, Shanghai, Tianjin

Market2
Market3
Total

2005

2007

Number of observations
76
142
334
552

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Table II shows the distribution of location choices and the origins of foreign banks in
China in the full sample.
The regression model. We group locations into three markets based on population
density. We model location decisions of foreign banks in China as a conditional logit
problem, in which the dependent variable is the market chosen by an investor. According
to McFadden (1974), logit choice probabilities can be derived from individual utility
maximization. We assume that each bank chooses a market to set up its new business
outlet for profit maximization. The underlying profit is determined by a set of
individual-specific variables, i.e. the banks characteristics at the time when it decides to
establish a new outlet, together with a set of alternative-specific variables representing
characteristics of the alternative markets. The profit for investor i in market m is:

pim z im g x i b m 1im ;

Location
strategies

135

where zim contains alternative-specific variables for alternative market m and investor
i, and vector g captures effects of the alternative-specific variables; xi consists of
individual-specific variables, and bm contains coefficients for the effects on alternative
market m relative to the base alternative market.A bank chooses market m if pim is
Location choice
Bank origin
New
North
South
Year establishments Market1 Market2 Market3 Asia Europe America America Oceania Africa
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Total

1
5
4
3
5
11
11
6
3
6
8
13
25
35
27
36
31
27
15
20
7
8
16
25
45
75
84
552

0
0
0
0
0
5
4
0
1
2
2
2
4
4
3
7
8
4
0
0
2
0
0
1
4
8
15
76

0
1
1
0
3
3
4
3
1
1
1
1
9
12
9
6
6
4
2
3
0
2
5
3
14
22
26
142

1
4
3
3
2
3
3
3
1
3
5
10
12
19
15
23
17
19
13
17
5
6
11
21
27
45
43
334

1
2
1
1
4
6
5
3
2
1
3
7
18
22
15
26
18
11
4
8
5
4
13
17
33
39
51
320

2
2
2
1
4
4
3

1
1
1
2
1

5
4
3
5
8
9
8
10
10
11
7
2
2
1
5
8
26
21
163

1
2
2
4
2
1
3
5

1
1
1
1
1

2
2
2
3
9
10
55

1
1
1
4

1
1
7

Table II.
Distribution of location
choices and origins of
foreign banks

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136

larger than pij for all j m. McFadden (1974) demonstrates that if the error terms
1im are independently distributed with the cumulative distribution function Fa
exp2exp2a
(the type I extreme value distribution), the probability that market m
offers investor i the highest profit among all the markets and all the possible alternatives
is given by the logit expression:
expz im g xi b m
Pr yi mjx i ; z i PJ
;
j1 expz ij g x i b j

i 1; . . . ; J ;

where J is the number of alternative markets and b1 0 by normalization.

Variables. The dependent variable ym is a dummy variable that indicates the
location choice of investor i:
(
1; if investor i chooses market m to set up a business outlet in;
yim
0; otherwise:
where m takes on values 1, 2 or 3, that is, there are three alternative markets that a
bank investor can choose from. There were 15 provinces and municipalities in China
where foreign banks established outlets by the end of 2006. We divide them into three
markets according to their average population density during 1980-2006. More
specifically, the provinces and municipalities with a population density larger than 700
people per square kilometer are grouped into market 3, i.e. yi3 1 means that a large
market with high-population density is chosen by investor i; the ones with population
density in the range of 300-700 people per square kilometer are grouped into market 2,
i.e. yi2 1 means that a medium market with medium population density is chosen by
investor i; the rest whose population density is lower than 300 people per square
kilometer are grouped into market 1, i.e. yi1 1 means that a small market with
low-population density is chosen by investor i.
We control for a set of explanatory variables to investigate the location decisions of
foreign banks in China. Based on whether the variables change across alternatives,
explanatory variables are grouped into two types: alternative-specific variables which
are observable attributes of each alternative market, and individual-specific variables
which are specific to an individual bank investor but not to the alternatives so that they
do not change across alternatives. The conditional logit model is employed to run
regressions, since we believe both the attributes of the markets and banks own
characteristics are important in location choices.
There are two alternative-specific explanatory variables. The first one, the per
capita GDP of a market, controls for variations in the level of economic development.
Furthermore, since per capita GDP is known to be inversely correlated with
economic volatility in international studies, we use its inverse as a proxy for economic
risk. When a foreign bank plans to invest in a market, the level of local economic
development and risk are important in its decision. A priori, we expect a rich region
with higher per capita GDP to be more attractive to foreign banks than a region with
lower per capita GDP. The second alternative-specific explanatory variable, the imports
and exports as a share of total GDP, captures the effects of economic openness. The
degree of openness in international trade is a commonly used proxy for the openness of
a local economy, which should be a factor in a foreign banks location choice.

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We expect the coefficient of this variable to be positive, meaning that foreign banks are
more likely to enter a market with a higher degree of openness.
We include a set of individual-specific variables that are specific to an individual
bank investor. In the literature, many empirical studies test the follow-the-clients
hypothesis. It is hypothesized that the trade linkages between the home and host
countries and FDI flows of non-financial sectors have a pull effect on foreign bank
entry into the host country. The argument is that foreign banks tend to offer more
tailored services to their home country customers (who are living in the host country),
especially corporate customers, than local banks of the host country. Foreign banks
follow their customers through cross-border business establishments in order to
prevent the loss of this particular group of customers to their competitors in the host
country. To test this follow-the-clients hypothesis, a variable representing the trade
linkage between a foreign banks home country and a specific market in China where
the bank has chosen to locate its new business establishment is included in our
regression model as a regressor. Specifically, this trade linkage variable is defined as
the ratio of the trade volume between the banks home country and the banks chosen
market to the total international trade volume of that market by the end of the year in
which this market entry takes place.
For the banking industry, as one of the most information-intensive sectors, many
aspects of its activity are dependent crucially on information. For foreign banks, some
may gain better proprietary information about the needs of the host countrys
customers than their competitors. This kind of competitive advantage may be gained
through natural geographic advantages or through accumulated knowledge from
business experiences before entry. In our regression model, we add two variables to
capture the effects of information advantages. The first one is a dummy variable to
indicate whether the banks home country is in Asia or not. Asian banks may have an
information advantage due to their geographic proximity to China. The second
variable is the ratio of a banks bilateral trade with China to the total international
trade volume of China by the end of the year during which an entry takes place. Active
trade contacts may give a bank an information advantage.
Two variables reflect a banks size: the banks total assets in US$; and the total
number of branches and subsidiaries that the bank has set up in China. However, these
two proxies of size have different meanings. Total assets represent the economic
resources owned by the bank. The amount of total assets has been traditionally used to
indicate whether the bank is large or small. However, the total number of business
establishments a bank has opened in China reflects the scale of business that the bank
has in China. It is a strategic choice of a foreign bank.
The banks profitability, as measured by the return on average asset (ROAA), is
included in our regression model as an individual-specific variable. Some existing
empirical studies show that more profitable banks tend to be more active in providing
cross-border financial services. We intend to test whether the profitability of a foreign
bank has a significant effect on its location choices in China.
Finally, we include two explanatory variables to capture the effect of sequential
entry of foreign banks. One is the total number of years that a foreign bank has
already been in the Chinese market at the time when it decides to set up a new business
outlet. This is to reflect the sequence of entry among different foreign banks. Also, to
reflect the sequence of a foreign banks setting up its business outlets, we add variable

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138

ORDER, which is the number of outlets the bank has already opened in China at the
time when it opens a specific outlet in China.
To summarize, the explanatory variables in our regression model are:
PCGDP

per capita GDP of a local market in 10,000 yuan.

TRADE

the share of international imports and exports in total GDP of a market.

FOLLOW the ratio of the trade volume between a banks home country and its
chosen market to the total international trade volume of that market.
ASIA

a dummy variable to indicate whether a foreign banks home country is

in Asia.

INFO

the ratio of a foreign banks bilateral trade with China to the total
international trade volume of China.

ASSETS a foreign banks total assets in million US$.

BRANCH the total number of business establishments a foreign bank has in China
by the end of 2006.
ROAA

a foreign banks return on average asset.

YEAR

the number of years since a foreign banks entry to China at the time
when it opens a specific outlet.

ORDER

the number of outlets that a foreign bank has in China at the time when
it opens a specific outlet.

3.3 Regression results

Table III presents the estimated coefficients generated by the maximum likelihood
estimation of equation (2).
We observe that each of the two alternative-specific variables PCGDP and TRADE
has the same estimated coefficient regardless of which alternative market is used as the
reference category. The estimated case-specific coefficients, in contrast, vary when a
different market is used as the reference category. The first column in the table shows
the regression results when Market3, the large market with a high-population density,
is used as the reference category; the second column shows the regression results when
Market2, the medium market with a medium population density, is used as the
reference category; and the last column shows the regression results when Market1,
the small market with a low-population density, is used as the reference category.
Interpretation of the coefficients. For a conditional logit model, an interpretation of the
magnitude of an estimated coefficient is not straightforward. We compute the partial effects
for this model and present the marginal effects relative to the means of the independent
variables in Table IV. An interpretation in terms of the odds ratio will also be provided.
As expected, each of the two alternative-specific variables PCGDP and TRADE has
a positive effect on the probability of entry. Specifically, if a market enjoys a 10,000
yuan marginal increase in local per capita GDP (PCGDP), the probability that a foreign
bank chooses this market to open a new business establishment in will, respectively,
increase by 0.4 per cent for the small market, 0.8 per cent for the medium market and
1 per cent for the large market. Put differently, a one standard deviation increase in

Dependent variable: market

Reference choice:
Reference choice:
Market3
Market2
Market1
Market2 Market1 Market3
Alternative-specific variables
PCGDP

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TRADE
Case-specific variables
FOLLOW

0.042
(0.181)
0.017 * *
(0.007)

Reference choice:
Market1
Market2
Market3

0.042
(0.181)
0.017 * *
(0.007)

0.032 * *
0.023 *
0.009
20.023 *
(0.015)
(0.013)
(0.016)
(0.013)
ASIA
1.813 * * *
0.600 * *
1.213 * * 20.600 * *
(0.446)
(0.300)
(0.478)
(0.300)
INFO
2 0.015
20.033 *
0.018
0.033 *
(0.024)
(0.020)
(0.026)
(0.020)
ASSETS
0.001
20.000
0.001 *
0.000
(0.000)
(0.000)
(0.000)
(0.000)
BRANCH
0.063 * * *
0.046 * *
0.017
20.046 * *
(0.022)
(0.019)
(0.021)
(0.019)
ROAA
2 0.182
0.020
20.202
20.020
(0.169)
(0.111)
(0.176)
(0.111)
YEAR
0.082 * *
0.058 * *
0.024
20.058 * *
(0.034)
(0.023)
(0.034)
(0.023)
ORDER
2 0.016
20.084 * *
0.068
0.084 * *
(0.042)
(0.040)
(0.043)
(0.040)
Number of observations
1,590
1,590
Log-likelihood value
2425.979
2425.979
McFaddens R 2
0.268
0.268
Cragg & Uhlers R 2
0.501
0.501
Percent correctly predicted
0.642
0.642

0.042
(0.181)
0.017 * *
(0.007)
2 0.009
2 0.032 * *
(0.016)
(0.015)
2 1.213 * * 2 1.813 * * *
(0.478)
(0.446)
2 0.018
0.015
(0.026)
(0.024)
2 0.001 * 2 0.001
(0.000)
(0.000)
2 0.017
2 0.063 * * *
(0.021)
(0.022)
0.202
0.182
(0.176)
(0.169)
2 0.024
2 0.082 * *
(0.034)
(0.034)
2 0.068
0.016
(0.043)
(0.042)
1,590
2 425.979
0.268
0.501
0.642

Notes: Significant at: *10, * *5, * * *1 per cent level; standard errors in parentheses

local per capita GDP will increase the odds ratio of entering this market by 5.9 per cent
(e 0.042 1.37 1.059). Further, foreign banks are more likely to enter a market with
better economic development and lower economic risk (with odds ratio e 0.042).
However, the effect of economic development and economic risk on location choices is
insignificant.
In contrast, openness of a local economy has a significant positive effect on foreign
bank entry (with odds ratio e 0.017), where the openness variable TRADE is measured
by the share of the local economys international trade in total GDP. Specifically, a
marginal increase in TRADE by 1 per cent will increase the probability of a foreign
banks entry by 0.2 per cent for the small market, 0.3 per cent for the medium market
and 0.4 per cent for the large market. Alternatively, one standard deviation increase in
TRADE raises the odds ratio of entering this market by 99.7 per cent (e 0.017 40.68).
For case-specific variables, the marginal effects on the three alternative markets
necessarily sum to zero. The variable FOLLOW is the ratio of trade volume between
a banks home country and the chosen market to the total international trade volume.
We find that, when FOLLOW is marginally increased by 1 per cent, the probability

Location
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Table III.
Results of maximum
likelihood regressions

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140

Table IV.
Marginal effects of the
independent variables

Marginal effects
Market1
Alternative-specific variables dp/dz
PCGDP
0.004
(0.017)
TRADE
0.002 * *
(0.001)
Case-specific variables dp/dx
FOLLOW
0.002 *
(0.001)
ASIA
0.141 * * *
(0.034)
INFO
20.001
(0.002)
ASSETS
0.000 *
(0.000)
BRANCHES
0.005 * *
(0.002)
ROAA
20.018
(0.015)
YEAR
0.006 * *
(0.003)
ORDER
0.001
(0.004)

Market2
0.008
(0.035)
0.003 * *
(0.001)
0.004
(0.002)
0.068
(0.054)
2 0.006 *
(0.004)
2 0.000
(0.000)
0.007 * *
(0.003)
0.009
(0.021)
0.009 * *
(0.004)
2 0.016 * *
(0.007)

Market3
0.010
(0.042)
0.004 * *
(0.002)
2 0.006 * *
(0.003)
2 0.209 * * *
(0.058)
0.007 *
(0.004)
2 0.000
(0.000)
2 0.012 * * *
(0.004)
0.009
(0.024)
2 0.015 * *
(0.005)
0.015 *
(0.008)

Notes: Significant at: *10, * *5, * * *1 per cent level; standard errors in parentheses

of choosing the small market and the medium market over the large market, respectively,
increases by 0.2 per cent (with statistical significance) and 0.4 per cent (without statistical
significance), which implies that the probability of choosing the large market necessarily
decreases by 0.6 per cent. Alternatively, a one standard deviation increase in FOLLOW
raises the odds ratio of entering Market1 vs Market3 by 55.0 per cent (e 0.032 13.69 ) and
that of entering Market2 vs Market3 by 37.0 per cent (e 0.023 13.69 ), but reduces the odds
ratio of entering Market2 vs Market1 by 11.6 per cent (e 2 0.009 13.69 ). This implies that
entering the small market (Market1) is consistent with the follow-the-clients hypothesis,
while entering the medium market (Market2) or the large market (Market3) is not.
The dummy variable, ASIA, indicates whether a foreign banks home country is in
Asia or not. Compared with a non-Asian bank, an Asian bank has a 14.1 per cent
higher probability of entering the small market, 6.8 per cent higher probability of
entering the medium market, but 20.9 per cent lower probability of entering the large
market in China. In terms of odds ratio, a foreign bank based in Asia is more likely to
choose Market1 (odds ratio e 1.81) and Market2 (odds ratio e 0:60 ) than a non-Asian bank.
In the choice between Market1 and Market2, an Asian bank is less likely to enter
Market2 than a non-Asian bank (odds ratio e 2 1.21). To summarize, the marginal effects
and odds ratios of ASIA demonstrate that those foreign banks whose home countries
are in Asia are more likely to expand their businesses in the hinterland of China.
INFO, as measured by the ratio of bilateral trade between a foreign banks home
country and China-to-Chinas total international trade volume, represents the

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information advantage of the bank. INFO shows an opposite marginal effect to the
variable ASIA in the choice of alternative markets. Increasing INFO by 1 per cent will
reduce the probability of entering the small market and medium market by 0.1 and
0.6 per cent, respectively. Thus, the probability of entering the large market will increase
by 0.7 per cent. Alternatively, a one standard deviation increase in INFO raises the odds
ratio of entering Market3 vs Market1 by 13.4 per cent (e 0.015 8.36), that of entering
Market3 vs Market2 by 31.8 per cent (e 0.033 8.36), and that of entering Market1 vs
Market2 by 16.2 per cent (e 0.018 8.36). That is, those foreign banks whose home countries
have more trade activities with China tend to distribute their business establishments
between the large and small markets.
Two variables, ASSETS and BRANCHES, are used as proxies for the size of a
foreign bank. ASSETS (the banks total assets) exhibits a negligible effect on the
choice of the three alternative markets. However, the effect of BRANCHES (the total
number of business units opened in China) is both economically and statistically
significant. With each additional business establishment in China, the probability that
a foreign bank chooses the small market increases by 0.5 per cent and the medium
market by 0.7 per cent, implying that the probability of choosing the large market
necessarily declines by 1.2 per cent. Alternatively, a one standard deviation increase in
BRANCHES raises the odds ratio of entering Market1 vs Market3 by 95.1 per cent
(e 0.063 10.61) and that of entering Market2 vs Market3 by 62.9 per cent (e 0.046 10.61).
Hence, the scale of business that a foreign bank intends to have in China does affect its
location choices. A foreign bank with an intention to have a large business scale in
China is more likely to enter the hinterland of China.
Although the profitability measure, ROAA, has always been a key variable for
evaluating a banks management performance, especially a banks efficiency in
managing its assets, it appears to be an insignificant factor in a foreign banks location
choices. However, although insignificant, a foreign bank with a higher return on average
assets is shown to have a higher probability of entering the large or medium market.
Finally, both sequential entry variables, YEAR and ORDER, exhibit significant
effects. First, increasing YEAR by one unit, i.e. having operated in the Chinese market
for an additional year increases the probability that the foreign firm chooses the small
and medium markets by 0.6 and 0.9 per cent, respectively, and decreases the
probability that it chooses the large market by 0.15 per cent accordingly. Alternatively,
a one standard deviation increase in YEAR raises the odds ratio of entering Market1 vs
Market3 by 83.5 per cent (e 0.082 7.40) and that of entering Market2 vs Market3 by
53.6 per cent (e 0.058 7.40), but reduces the odds ratio of entering Market2 vs Market1 by
16.3 per cent (e 2 0.024 7.40). Second, for variable ORDER representing the order in
which a bank sets up its business outlets, we find that the probability that a bank
opens a new outlet in the large market increases by 1.5 per cent and that in the small
market increases by 0.1 per cent, implying the probability of choosing the medium
market decreases by 1.6 per cent. Alternatively, a one standard deviation increase
in ORDER raises the odds ratio of entering Market1 vs Market3 by 10.1 per cent
(e 2 0.016 6.64), but reduces the odds ratio of entering Market2 vs Market3 by 42.8 per cent
(e 2 0.084 6.64) and that of entering Market2 vs Market1 by 36.3 per cent (e 2 0.068 6.64).
In summary, the longer a foreign bank has been in China, the more likely it will enter
the hinterland of China; and a newly opened outlet of any foreign bank is most likely to
choose the large market but least likely to choose the medium market.

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IIA test. The conditional logit model assumes that relative probabilities for any two
alternatives depend only on the attributes of those two alternatives. This is called the
independence from irrelevant alternatives (IIA) assumption. Since the IIA assumption
implies that adding another alternative or deleting the included alternatives does not affect
the relative probabilities among the remaining alternatives, we can test it using the
Hausman and McFadden (1984) test based on the comparison of the estimated coefficients
from the full model with those from a restricted model that excludes one of the alternatives.
The null hypothesis is that the odds are independent of other alternatives. Three
Hausman-McFadden tests of IIA are reported in Table V. Because none of these tests
rejects the null hypothesis H0 that IIA holds, we can accept the IIA assumption.
3.4 Empirical implications
The above analysis shows that information asymmetry, firm size and entry sequence
are significant factors influencing foreign banks location choices. We now go on to
discuss implications of these results.
Banking activity is both information and knowledge intensive. Information
asymmetry among foreign banks may be partly due to geographic, institutional and
cultural differences among foreign banks. As a government development strategy, foreign
banks are encouraged to enter under-developed regions, such as west, north-west and
central China. Foreign banks can help China enrich banking products, improve the quality
of banking services, and more importantly, promote international trade and attract
foreign investment to inland regions. Among the foreign banks, Asian banks may have
better knowledge of Chinese local markets due to their geographic proximity to China.
Our empirical results also indicate another channel of knowledge, bilateral trade. On
the one hand, banks whose home countries have a higher degree of bilateral trade with
China may have more advantages in financing trade by following their clients to China. On
the other hand, trading activities provide these banks with experience and knowledge. We
find that foreign banks with such an information advantage tend to enter the large market.
Where to locate outlets is an important long-term plan for a firm. This is particularly
so for foreign banks in a large market like China. Some may be more aggressive in
expanding their branch networks, while others may take a more conservative approach.
We hence take firm size into account in our empirical model. Our empirical results show
that the larger a foreign bank is in terms of the total number of outlets a bank has, the
more likely it is for the bank to expand into the hinterland markets, while smaller banks
with fewer outlets tend to establish their operations in the large market.
Both economics and business literatures give a lot of attention to sequential entry,
due to the popularity of sequential entry in practice. On the one hand, there may be a
first-mover advantage. An early entrant has the advantage of choosing a location early
and hence grabbing a large market share. Due to high-switching costs, bank customers
in particular have a tendency to stay with their original bank. On the other hand, there
may be a later-mover advantage. Due to late resolution of uncertainty, after the market
Omitted alternative

Table V.
IIA test results

Market1
Market2
Market3

x2

Degree of freedom

p-value

Evidence

20.29
21.76
20.65

2
2
2

0.92
0.89
1.00

for H0
for H0
for H0

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has become clearer, a later entrant has the advantage of making a more informed
decision. This suggests that the order of entry is an important factor in bank location
strategies. Hence, we have empirically examined the impact of entry sequence on
location choices of foreign banks. We find an older foreign bank that has stayed in the
Chinese market for a longer period of time is more likely to enter smaller markets, and
a newly opened outlet of any foreign bank is most likely to be in the large market but
least likely to be in the medium market.
In reality, a collection of risks makes up the potential threat to foreign banks, such
as regulatory risk, operational risk, credit risk and market risk. In our empirical
analysis, we control for the economic risk of each alternative market. Our empirical
results show that, although foreign banks are risk-averse in location, economic risk
does not influence location decisions significantly. Our explanation is that some risks
apply to all markets, such as regulatory risk, while other risks can be effectively
handled by a banks risk management, such as credit risk.
A market characteristic that we find to be significant to foreign bank entry is the
openness of a local economy. Openness may imply information advantage; it may also
explain the follow-the-clients strategy. Indeed, openness, as measured by international
trade divided by GDP, is found to have a positive influence on foreign banks entry
decisions. In other words, a market with a higher degree of interaction with the outside
world attracts more foreign bank entries.
The return on assets and total assets are considered to be two key financial
indicators of a bank. Foreign banks exhibit considerable variations in these two
variables. Following existing studies on banking strategies, we add these two variables
into our regression model. However, we find these two variables to be insignificant to
foreign banks location strategies. Hence, differences in financial characteristics are not
the reasons why foreign banks choose different locations.
Finally, although the follow-the-clients strategy is greatly emphasized in the
literature, we have mixed results about it. Although foreign banks presence in the small
market can be explained by the follow-the-clients strategy, this strategy cannot explain
foreign banks entries into the larger markets. Note that, besides this follow-the-clients
strategy, the existing literature on multinational banking does not say much about the
other controlling factors, given so much thought by our empirical study.
4. Summary and conclusions
Inspired by the recent opening up of the Chinese banking market, we apply theory on
location strategies to an empirical analysis of foreign banks location strategies when
they enter the newly opened up Chinese banking market. We enrich the existing
literature by including a few realistic aspects in our empirical analysis, such as
heterogeneous demand, economic risk, asymmetric information, firm size, and sequential
entry. Some have never been discussed before, which are especially relevant to a firm
entering a foreign market.
Our main empirical results are: asymmetric information, firm size and entry sequence
are significant determinants of foreign banks location strategies. Specifically, our eight
main empirical findings are:
(1) Asian foreign banks, which are considered to have better knowledge of China,
are more likely to expand into smaller markets of China (the small and medium
markets).

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(2) Foreign banks whose home countries have more trade with China, which may
lead to an information advantage, tend to distribute their outlets between the
large and small markets.
(3) Bank size matters. Smaller banks with fewer outlets tend to establish their
operations in the large market. Larger foreign banks are more likely to enter
smaller markets.
(4) Early foreign bank entrants are more likely to enter smaller markets, since early
entrants tend to be better-informed banks.
(5) Foreign banks prefer the market with less economic risk whatever the market
size. However, economic risk does not influence location decisions significantly.
(6) The openness of a local economy has a significant positive effect on foreign bank
entry.
(7) Financial characteristics are not significant factors in foreign banks location
strategies.
(8) Those foreign banks that have chosen to enter the small market appear to adopt
the follow-the-clients strategy. However, those foreign banks that have chosen
the medium or large markets do not take the follow-the-clients strategy.
Our theoretical and empirical analyses enhance our understanding of many similar
situations, such as financial integration in the European Union through the formation
of a common market and financial deregulation in the USA of interstate bank
branching which allows banks to expand into other states.
Note
1. There are two standard models of spatial competition in the literature: the linear-city model
pioneered by Hotelling (1929), and the circular-city model pioneered by Lerner and Singer
(1939), developed by Vickrey (1964) and made popular by Salop (1979). Here, the distance
between two locations can represent the physical distance, economic distance, or a degree of
product differentiation. In our banking application in Section 2, the distance refers to the
economic distance, which is a reflection of physical distance in China due to a high
correlation between regional and economic differences in China.

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About the authors
Jin Zhang has a PhD in Economics from the Hong Kong University of Science and Technology
and has been an Assistant Professor at Nankai University since 2010.
Jun Shan has a PhD in Industrial Engineering and Logistic Management and has been an
Assistant Professor at Nankai University since 2009. Jun Shan is the corresponding author and
can be contacted at: jshan@nankai.edu.cn
Susheng Wang has a PhD in Economics from Toronto University and has been a Professor in
Economics at Hong Kong University of Science and Technology since 1993.

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