Foreign-Owned Banks in the United States: Earning Market Share or Buying It?

Author(s): Robert Deyoung and Daniel E. Nolle

Source: Journal of Money, Credit and Banking, Vol. 28, No. 4, Part 1 (Nov., 1996), pp. 622-636
Published by: Blackwell Publishing
Stable URL: http://www.jstor.org/stable/2078074
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 ROBERT DEYOUNG
DANIEL E. NOLLE

Foreign-OwnedBanksin the UnitedStates:

EarningMarketShareor BuyingIt?
ANXIETIES ABOUTTHE DECLINING INFLUENCE of U.S.
banksin international marketsmadeheadlines,andprompted Congressional inquir-
ies, in the late 1980sandearlyl990s. Morerecently,however,concernaboutU.S.
banks'competitiveness overseashasgivenway to alarmaboutthe growingmarket
shareof foreignbanksin U.S. markets. 1By oneestimate,foreignbanksholdnearly
50 percentof all existingcommercialandindustrial loansmadeto U.S. businesses.
Moreover,foreignbanksmadethesegainsswiftly,morethandoublingtheirshareof
the U.S. marketin thepastten years.
Despitethis impressivegrowth or perhapsbecauseof it foreignbankswere
not particularly profitable.This studyinvestigatesthe relativeprofitefficiencyof
foreign-ownedU.S. banksandU.S.-ownedbanksbetween1985and 1990, years
duringwhichforeignbankmarketsharewasexpandingrapidly.Weemploya profit
frontiermodelsimilarto the one pioneeredby Berger,Hancock,and Humphrey

The authcorsthank Philip Bartholomew,Sigbj0rnBerg, Allen Berger, Jeffrey Brown, MarshaCour-

chane, HenryHassanwalia,William C. Hunter,ThomasLutton,ArthurMcMahon,JosephScalise, Gary
Whalen, participantsat conferencesheld by the AtlanticEconomic Society in Montrealand by the Luigi
Bocconi University in Milan, and two anonymousreferees for their helpful comments. The views ex-
pressel in this paper are those of the authorsalone, and do not necessarilyreflect those of the Office of
the Comptrollerof the Currency,the Departmentof the Treasury,or their staffs.
1. Concerningthe competitivenessof U.S. banks abroad,see "InternationalCompetitivenessof U.S.
FinancialInstitutions,"Hearingsbefore the Subcommitteeon FinancialInstitutionsSupervision,Regula-
tion and Insurance(U.S. House of Representatives1990), and "Reportof the TaskForce on the Interna-
tional Competitivenessof U.S. FinancialInstitutions"(LaFalce, 1990). Concerningthe inroadsmade by
foreign banks in the United States, see "U.S. Banks Lose CorporateClients to LendersAbroad,"The
WallStreetJournal (FredR. Bleakley, Sept. 29, 1992); and "Estimateof ForeignBank Lending in U.S.
Raised," The WashingtonPost (James R. Kraus, June 16, 1992).
ROBERTDEYOUNGandDANIELE. NOLLEareseniorfinancial economistsin theOJ$ice
of
theComptroller
of theCurrency.
Journalof Money,Credit,andBanking,Vol. 28, No. 4 (November 1996, Part 1)
Copyright 1996 by The Ohio State University Press
 ROBERTDEYOUNGAND DANIEL E. NOLLE : 623

(1993), and modify the model so that it is less sensitive to variationsin asset size.
Ourresults suggest that foreign-ownedU.S . bankswere significantlyless profiteffi-
cient than U.S.-owned banks duringthis time period. Althoughthere was little dif-
ference between the two sets of banks in terms of outputefficiency, foreign-owned
banks had a distinct disadvantagein terms of input efficiency, a disadvantagepri-
marily driven by excess expenditureson purchasedfunds. These results imply that
foreign-ownedbanksmay have placed growthaheadof profitability,expandingtheir
portfolio of loans faster than their ability to develop the relationshipsnecessary to
maintainan accompanyingbase of core deposits.

1. RECENTPERFORMANCEOF FOREIGNBANKS IN THE UNITED STATES

The share of commercial and industrial(C&I) loans to U.S. businesses held by

foreign banks increaseddramaticallybetween 1983 and 1993. Using conventional
measures, the combined marketshareheld by foreign banks doubledfrom 14 to 32
percentduringthe period.2Perhapsthe most popularexplanationfor the increasein
foreign banks' lending to U.S. businesses is that foreign banks "followed"clients
from their home countriesinto U.S. markets.3Havingestablisheda presencein the
United States, many foreign banks grew their marketshare by purchasingloans in
the secondary market (Calomiris and Carey 1994), or by acquiringexisting U.S.
banks (Kraus 1995), ratherthan by originatingnew loans.
Foreignbanksmay also have exploiteda varietyof cost advantagesrelativeto U .S .
banksto gain a competitiveedge. ZimmerandMcCauley(1991) concludedthatfor-
eign banks enjoyed cost of capital advantagesover U.S.-owned banks. McCauley
and Seth (1992) and Terrell(1993) found similaradvantagesfor foreign bankscon-
cerningcost of funds. Frankeland Morgan(1992) and Wagster,Cooper,and Kolari
(1994) found thatdifferencesin cross-countryregulatoryrequirementsmay have re-
duced foreign banks' costs relative to U.S. banks.
Given these supposed cost advantages, foreign banks should have been able to
gain market share by underpricingU.S. banks,4 by producinghigher-qualityser-
vices than UOS.banks,5 or both, and still have maintainedprofits roughly in line

2. See Nolle (1995). Using a broadermarketdefinitionthatincludesoffshorelendingby foreignbanks

to U.S. businesses, foreign banks'marketshareof C&I loans to U.S. businesses increasedfrom 19 to 47
percentbetween 1983 and 1993.
3. Foreign business firms have engaged in a growing volume of internationaltrade with, and direct
investmentinto, the United States over the past decade. Hultmanand McGee (1989), Budzeika (1991),
and Grosse and Goldberg (1991) all showed that foreign banks enteredthe U.S. marketto service the
internationaltrade and direct investmentneeds of their home-countryclients. However, Terrell(1993,
p. 913) noted that once in the United States, "many foreign banks have expandedtheir customer base
by actively soliciting business from U.S. companies."Terrell'sconclusion was reinforcedby Seth and
Quijano (1991, 1993), who found a diminishing link between trade and direct investment flows from
Japaninto the United States and the growthof Japanese-ownedbanks in the United States.
4. Calomirisand Carey(1994) showed that, over the 1986- 1993 period, foreign-ownedbanksunder-
priced U.S.-owned banks by between 25 and 42 basis points on loans to investment-gradefirms.
5. Two surveys by GreenwichAssociates (1988, 1992) noted thatU.S. corporateborrowerspreferred
foreign banks to U.S. money center and regional banks due to more competitive loan pricing, better
internationalservice capabilities, and innovative internationalbankingalternatives.
624 : MONEY, CREDIT,AND BANKING

with those earned by U.S.-owned banks. However, both Seth (1992) and Nolle
(1995) found that profitrates at foreign-ownedbanksoperatingin the United States
lagged behind profitrates for U.S.-owned banks duringthe past decade. For every
year but 1987 (when U.S. money center banks provisioned for problem loans to
LDCs), these studies concluded that returnon assets (ROA) and returnon equity
(ROE) at foreign banks were less than that for a group of similar U.S. banks.
Three recent studies suggest that cost inefficiency may explain the low prof-
itability of foreign-ownedU.S. banks. Chang, Hasan, and Hunter(1995) estimated
a stochastic cost frontier model for a panel of foreign-owned and U.S.-owned
multinationalbanksoperatingwith U.S. chartersbetween 1984 and 1989. In regres-
sions that control for asset size, bank holding company form, and foreign lending
activity,the authorsfound thatcost efficiency is negativelyrelatedto foreignowner-
ship. Nolle (1995), using thick frontierestimates of cost efficiency from DeYoung
(1996), concludedthatthe averageforeign subsidiarywas less cost efficientthanthe
average U.S. bank in every year but one between 1984 and 1992. In a thirdstudy,
Elyasiani and Mehdian (1993) used data envelopment analysis to measure cost
efficiency for a sample of foreign-owned and U.S.-owned banks in 1988. The
authorsfound that foreign subs were less cost efficient than U.S. banks, although
the difference was not statisticallysignificant.

2. MEASURING
PROFITEFFICIENCY

Cost efficiency models assume that banks take currentinput prices and output
quantitiesas given, then seek to minimize costs by hiring the optimal levels of in-
puts. As such, any inefficiencies estimated using these models must be attributed
exclusively to hiring an excess amount, or a suboptimal mix, of inputs. Alter-
natively, a bank can be inefficient if it produces too few, or a nonoptimalmix of,
outputsgiven the inputsit employs and the prices thatit faces. Thatis, in additionto
being cost inefficient, a bank might also be revenue inefficient. By not recognizing
this possibility, cost-based models can misrepresentthe natureand extent of ineffi-
ciency in banks. For example, in orderto produceabove-averageservice quality, a
bank will probablyhave to hire more and/or more expensive inputs, and as a result
the bank may be mistakenly identified as cost
inefficient by a purely cost-based
model. But such banks may actually be profit
efficient since the markettends to
pay more for higher quality service, these banks may generateadditionalrevenues
large enough to offset their relativelyhigh expenses.
This section presentsthe profitefficiency model that we use to estimatetechnical
inefficiency in foreign-ownedand domestically owned U.S. banks. The model is a
modified version of a profitefficiency model introducedby Berger, Hancock, and
Humphrey(1993, henceforthBHH), and allows us to generateseparateestimatesof
input and outputinefficiency.6We assume that banks attemptto maximize variable

6. Although the original BHH model estimatedboth technical and allocative inefficiencies, we esti-
mated technical inefficiencies only. BHH assumed that allocative inefficiencies arise because banks
 ROBERTDEYOUNGAND DANIEL E. NOLLE : 625

profits Trin the short run by choosing a vector of variable netputsx, given fixed
factors z and a vector of input and output prices p. Hence, banks maximize Tr=
L px, where netputs are positive for outputquantitiesand negative for input quan-
tities. We specify the following quadraticvariableprofitfunction:

tz n-I n-I
(PuZ()IPn E (i +2
(i)(PilPsw) E E Xij(PiPjlPn)
i=l i=l j=l

k k k n-I k

+ E +2
13rzr E E fOrszrzs
+ E E rYir(PilPn)Zr + e (1)
r=l r=ls=l i=l r=l

and derive netputdemandsusing Hotelling's lemma:

n-I k

Xi(PuZi) AtI(p,Zg)l8Pi(0li (i) + E + E rYirzr

Xij(PjlPn) + Vi (2)
j=l r=l

where i indexes the n differentnetputs, e and v are randomdisturbanceterms with

zero means, and linear price homogeneity is imposed by using the nth netputprice
as the numeraire.7The xi measurethe actuallevel of each netput, and are relatedto
optimal netputlevels by the identityxi* = xi + (i, where x* is the optimal level of
each netputand ( (( > O)is the deviationof each netputfrom its optimallevel. The
(i measurethe underproductionof outputs(positive netputs)and the overuse of in-
puts (negative netputs)given levels of prices and fixed factors.8Multiplyingthe (i
by their associatednetputprices and summingover i yields estimatedvariableprofit
. .

nefficlency:

n
INEFF= H(p,z,O)-(P,Z,() = E (iPi (3)
i=l

INEFF is easily decomposedinto separatemeasuresof inefficiencyfor each of the n

netputs.

choosenetputsbasedon shadowrelativepricesthatmisrepresent actualrelativeprices.Inorderto solve

theresultingnonlinear profitmodel,BHHconstrained therelationships betweenshadowpricesandactu-
al pricesto be identicalforall banks.Thisconstraint is inappropriate in a studylikeoursthatcompares
inefficiencyacrosstwo setsof banks.Furthermore, estimatingtheresultingnonlinear modelis a costly
computational processthatis notlikelyto yieldmuchadditional information, sincebankefficiencystud-
ies (see Berger,Hunter,andTimme1993)generallyfindonlysmallamountsof allocativeinefficiencies
in banks.In termsof the BHHmodel,we constrained all of theTsto be equalto 1, whichmakesthe
modellinearandassumesthatmanagers observerelativepricescorrectly.
7. Theparameters of themodelareestimatedusingIteratively SeeminglyUnrelated Regression tech-
niques,afterdropping thenthnetputequation andimposingsymmetry byrestricting0,7 = oy, andf rs = Xsr.

8. Requiring the(, to be positivesatisfiestheBHHdefinitionof technicalinefficiency.

 626 : MONEY, CREDIT,AND BANKING

Before estimating the model, we replace the original interceptterms ((xi - (Z)
with averageinterceptterms ((xi - (i mean) where (i mean is the theoreticalpopula-
tion mean for (i. The remaindersfrom these substitutions,((i mean - (i) are ab-
sorbed into the errors, which become vi + (eiSmean - (1) and e + (inSmean - in)-
When these transformederror terms are averagedacross time for each bank, the
random components vi and e should converge toward zero, leaving only bank-
specific information(gi mean - (i) and (g,n mean - (,n) in the averageerrorterms. This
approachis a direct analog to the "distribution-free" cost frontiermethodology in-
troducedby Berger (1993). Let vi and e^representthe resultingaverageresidualsfor
each bank, and let vi and e-representthe maximumvalues for these averagesacross
all banks. Then we can calculatethe (i as follows:

(i= vi- vl; (4a)

Cn= e-e. (4b)

Thus, the bank with the largest averageresidual vi or e^is assumed to be the most
efficientbankfor netputi, and is assigneda value of zero for gi. The values in (4) are
then used to generatethe inefficiencyestimatesin (3).
To preventoutlyingresiduals(for example, unusuallylucky banks, or dataerrors)
from definingthe efficientfrontier,and also to preventunrealisticallylarge estimates
of inefficiency for individualbanks (for example, unusuallyunluckybanks, or data
errors), we adjust the average residual terms prior to calculating the inefficiency
terms in (4).9 Banks are separatedinto deciles accordingto their averageasset size
during the sample period. Average residuals for individualbanks that are greater
than the ninety-fifthpercentile, or less than the fifth percentile, of the distributions
of averageresidualswithineachassetdecileare set equal to those thresholdvalues.
This procedureimproveson a similartruncationprocedureused in the BHH model,
which constrainedaverageresidualsto remainwithin the fifth and ninety-fifthper-
centiles of the distributionsof averageresidualsfor the entiresample.Because the
moments of the entire sample distributionare dominatedby large banks, the BHH
proceduretruncateslarge bankresidualsfrequently,but truncatessmall bankresidu-
als infrequently,creatinga bias in (4) that overstatesestimatedinefficiencyin small
banks relative to large banks. We reportthe results of the model using both trunca-
tion schemes below.

3. DATA AND VARIABLES

Our sample consists of 1,812 annual observations of 62 foreign-owned U.S.

banks (that is, U.S.-based subsidiaries of foreign banks), and 240 U.S.-owned

9. For individualbanks, we also constrained(, so that it could not exceed x,. This imposes the com-
mon sense condition that estimated netput inefficiencies be no largerthan the actual amount of those
netputsproducedor purchasedby the bank.
 ROBERTDEYOUNGAND DANIEL E. NOLLE : 627

banks located in the same metropolitanstatistical areas (MSAs) as the foreign-

owned banks, for the period 1985 through1990. Unlike U.S. branchesand agencies
of foreign banks, foreign-ownedsubsidiariesface the same legal and regulatoryre-
quirementsas do U.S .-owned banks.lOObservingbanksonly from the same MSAs
ensures as much as possible thatboth sets of banksfaced similarmarketconditions.
We define a bank to be foreign-ownedif at least 25 percentof its stock was owned
by foreign persons or institutionsin every year from 1980 through1990.
We specify two variantsof the variableprofitequation(1), each of which charac-
terizes banks as financial intermediaries.In the first specification, banks purchase
two variable inputs (purchasedfunds and labor) and combine them with two fixed
inputs (core deposits and physical capital) to produce two variable outputs (total
loans and securities). The interestpaid on purchasedfunds is nettedout of variable
profits, but the interest paid on core deposits is not because core deposits are as-
sumed to be fixed inputs. Using this definitionof variableprofitsmay bias our esti-
mates of profit efficiency against foreign-owned banks, which employ high
proportionsof purchasedfunds financing(see Table 1). We guardagainstthis bias in
the second specificationby redefiningcore deposits as a variablenetput. Although
core deposits are generallyconsideredto be quasi-fixedinputs, the second specifica-
tion captures banks' limited ability to substitute between core deposits and pur-
chased funds in the short run.l l
We hold three additionalfactorsfixed in both specifications.First, because nonin-
termediationoutputs (fees from selling mutualfunds, servicing mortgages, issuing
letters of credit, etc.) comprise a largerproportionof revenue for some banks than
for others, we include noninterestincome as a fixed factor. DeYoung (1994) shows
that cost models that omit noninterestincome can substantiallyoverstateinefficien-
cy in fee-intensive banks. Second, because financialmarketsassociatelow levels of
capital with higher risk of default, thinly capitalizedbanks may have to pay higher
rates for purchasedfunds. Following Hughes and Mester (1993), we include equity
capital as a fixed factor to control for the cost of this risk. Third, banks with rela-
tively risky portfolios may also have to pay higher rates for funds, and in addition
may incurhigherlaborexpenses to administerlargeramountsof problemloans. Al-
though it is an imperfectmeasureof portfolio risk, we include risk-weightedassets
as a fixed factor to control for the costs associatedwith risky assets.12

10. Foreign-ownedsubsidiariesare separatelycapitalized,full-servicebankswith U.S. bankcharters.

In contrast, foreign-ownedbranchesare not separatelycapitalized, and foreign-ownedagencies are not
separatelycapitalized, generally cannot accept deposits, and do not provide a full rangeof bankingser-
vices. Hence, foreign-owned subsidiariescompare more naturallyto U.S.-owned banks. In any case,
branchesand agencies (which are licensed, not chartered)file an abbreviatedcall report,so thereis insuf-
ficient data to estimate the profitmodel for these institutions.
11. Because banks deliver checking services to core depositors, core deposits have characteristicsof
both inputsand outputs. Customerspay for these services by acceptinglower interestrates, holding mini-
mum balances, and paying fees for using tellers, ATMs, and other depositorservices. Takingthis into
account, we define the price of core deposits as interestexpenses minus service charges on deposit ac-
counts, divided by core deposits.
12. Risk-weightedassets are based on the Basle Accord capitalrequirements,which assigns different
weights to differenttypes of bank assets but makes few distinctionsamong types of loans. However, the
risk-weightedassets variabledoes captureinterbankdifferencesin loan-to-assetratios, and does distin-
628 : MONEY,CREDIT,
ANDBANKING

TABLE 1
DESCRIPTIVE
STATISTICS
Foreign-OwnedSubsidiaries U.S.-Owned Banks
(62 banks) (240 banks)
Standard Standard
Mean Deviation Mean Deviation
VariableNetputs (percent of assets)
Loans 58.93 18.50 61.50b 14.56
Securities 16.02 10.69 19.84a 12.84
PurchasedFunds 25.48 15.35 14.80a 9.16
Core Deposits 55.59 21.52 77 37a 13.49
Employees (per $ million of assets) 57.70 2.80 71 77a 2.81
Prices (percent)
Price of Loans 10.49 1.54 11.30a 1.44
Price of Securities 8.04 1.49 8.24a 1.31
Price of PurchasedFunds 8.73 2.92 8.60 2.76
Price of Core Deposits 3.68 1.24 3.74 1.20
Price of Labor ($1,000 per employee) $31.60 $7.81 $29.06a $ 7.42
Fixed Factors (percent of assets)
Physical Capital 1.76 1.33 1.87 1.26
Core Deposits 55.59 21.52 77 37a 13.49
Equity 7.69 3.29 7 25b 2.87
Risk-WeightedAssets 73.57 21.93 71 43c 16.99
Non-interestIncome 0.94 0.69 l.lOa 0.97
Other Characteristics
Cash-to-Assets (percent) 16.92 14.00 963a 5.29
Non-performingLoans-to-Assets (percent) 2.06 2.09 132a 1.56
Returnon Assets (percent) 0.29 1.17 0.71a 1.25
Returnon Equity (percent) 2.33 24.45 g ggc 147.00
Assets ($ billions) $ 1.99 $4.05 $ 2.40 $10.13
NOTES:Mean averages, six annual observationsfor each bank.
a,b and c indicate slgnificantdifference between the means for the forelgn-ownedsubsldiariesand the U.S.-owned banks at the 1, 5, and 10
percent levels, respectively, in a two-tailed test.

All financialdata was collected from the Reportsof Conditionand Income (call
reports).l3To be included in the sample, banks had to have been in continualexis-
tence from 1980 through 1990. Banks based in unit banking states were excluded
from the sample, as were the following: banks reportinga nonpositive amount of
total loans, securities, purchasedfunds, or core deposits; banks having less than
twenty full time equivalent(FTE) employees; or banks having physical capital less
than $50,000 in any year during the sample period. Finally, because netputprices

guish highly collateralizedmortgageloans from otherloans. An alternativemeasureof (ex post) portfolio

risk is nonperformingloans, but we eschew this measurebecause it is likely endogenousto bankefficien-
cy (see Berger and DeYoung 1995).
13. All stock variables are averages of beginning-of-yearand end-of-yearvalues. Prices were con-
structedby dividing the annualrevenueor expense associated with a variablenetputby the annualaver-
age for thatvariablenetput.Loans include all loans held by the bank. Securitiesincludeall securitiesheld
outside of the bank's tradingaccount. Labor equals the numberof full time equivalent(FTE) workers
employed by the bank. Purchasedfunds include time deposits in excess of $100,000, federal funds pur-
chased, demand notes issued to the U.S. Treasury,and other borrowedmoney. Core deposits include
transactionsdeposits, money market deposits, and savings deposits. Physical capital equals the book
value of the bank's premises and fixed assets. Equity equals common stock, perpetualpreferredstock,
capital surplus, undividedprofits, and cumulativeforeign currencytranslationadjustments.Noninterest
income equals fee income and net gains associatedwith nonlendingactivities. Risk-weightedassets were
estimatedusing the proceduredeveloped by Avery and Berger (1991), and were graciouslyprovidedby
those authors.
 ROBERTDEYOUNGAND DANIEL E. NOLLE : 629

were constructedratherthanobserved, bankswith unrealisticallylow or high prices

in any year duringthe sample period were excluded.

3.1 SummuryStatistics
Table 1 displays summarystatisticsfor the 62 foreign-ownedbanks and the 240
U.S.-owned banks in our sample over the 1985-1990 period. Foreign-ownedsubs
used fewer employees per dollar of assets than did U.S.-owned banks, but paid
them higher wages and benefits. The former result suggests that foreign-owned
banks used labor inputsratherefficientlyand/or pursueda less labor-intensivebusi-
ness strategy.14 For example, foreign subs had fewer core deposits (which require
the productionof depositor services) than did their U.S.-owned counterparts.By
relying less on core deposits, foreign-ownedbanks had to finance a considerably
largerportionof their assets with purchasedfunds thandid U.S .-owned banks. This
may indicate that foreign-ownedbanks had difficultycompeting for deposits from
domestic customers.l5 Even though foreign-owned and U.S.-owned banks paid
similar rates for purchased funds and core deposits, the mix of financing put
foreign-ownedbanks at a relative cost of funds disadvantage.
The average-sized(mean) bank in both groups held around$2 billion of assets,
although the median bank in each group was less than a quarterof this size. As a
percentage of assets, foreign-ownedbanks held fewer loans than did U.S. banks,
and also held a substantiallydifferentmix of loans (not shown).16 Foreignsubs held
significantlygreateramountsof business loans, and significantlysmalleramountsof
real estate and consumerloans, thandid U.S.-owned banksof similarsize. The low
level of consumerlending is consistent with the low levels of core deposits at these
banks, reinforcingthe notion that foreign-ownedbanks either chose not to, or were
unable to, compete effectively for U.S. retailcustomers. The data also suggest that
forelgn subs invested their nonloan assets less profitably than did U.S.-owned
banks, holding fewer securities and substantiallymore cash per dollarof assets.
On average, foreign-ownedbanks earnedlower rates on their loan and securities
portfolios than did their U.S. counterparts.Comparedto U.S.-owned banks, for-
eign subs chargedsignificantlyhigherrateson consumerloans, similarrateson real
estate loans, and significantlylower rates on business loans (not shown). The lower
prices for business loans suggests that foreign banks either underpricedtheir U.S.-
owned competitorsin order to gain marketshare, tended to lend to higher quality
borrowers,or both.
PretaxROA and ROEwere weak at foreign-ownedbanks. Reliance on purchased

14. The latterresult is consistent with anecdotalevidence thatforeign banksmust offer higher wages
and benefits to entice senior managersto live abroad,or to offset the perceptionamong Americanstaff
that opportunityfor advancementwithin the organizationis limited. See "ForeignBanks in America,
Challenges and Opportunities"(CBM Group,Inc. 1995).
15. The average foreign-owned bank in our sample financed less than 2 percent of its assets with
funds purchased from, or funds deposited by, foreign governments, corporations, and financial
institutions.
16. The working paperthat supportsthis article, DeYoung and Nolle (1995), contains additionalin-
formationon loan portfolios and loan prices for the banks in our sample.
630 : MONEY, CREDIT,AND BANKING

funds increased interest expenditures at these banks, while high levels of low-
yielding assets and relatively low noninterestincome depressedrevenues. In addi-
tion, foreign subs had high levels of nonperformingloans, which probablyreduced
revenuesfurtherand requiredadditionallaborexpendituresto administer.The high-
er incidence of nonperformingloans reflects higher ex post credit risk, and could
have a numberof explanations,including a business-intensiveloan mix, poor loan
underwritingand monitoringpractices, and/or a relative unfamiliaritywith U.S.
borrowers.Risk-weightedasset ratios were also higher at foreign-ownedbanlis, al-
though this variableprimarilyreflects asset mix ratherthanex ante creditrisk.17 To
some degree, foreign subs offset the higherriskinessof theirloan portfoliosby hold-
ing higher levels of equity capital.

4. RESULTS

Table 2 displays estimates of variableprofit inefficiency for the entire sample of

302 foreign-owned and U.S.-owned banks. Profit inefficiency is expressed two
ways: the ratio of inefficiency to assets, and the ratio of inefficiency to potential
variable profits. Potential variable profits are the variable profits that each bank
would have generatedhad it been free of inefficiency,and are estimatedby adding
the dollar value of inefficiency at each bank (3) to the averagevariableprofitactu-
ally earnedby each bankover the sample period. Results are reportedusing both of
the truncationalternativesdiscussed above: truncatingnetputresidualsuniformlyat
the fifth and ninety-fifthpercentilesof theirsampledistributions,andtruncatingnet-
put residuals at the fifth and ninety-fifthpercentiles of their sample distributions
within asset deciles.

4.1 Overall ProfitIneJ0iciency

When the uniformtruncationscheme is appliedto the netputresiduals,the result-
ing estimates of profit inefficiency-to-assetsare very sensitive to asset size. Profit
inefficiency ranged from 12.06 percent of assets for small banks (less than $100
million in assets) to 1.29 percentof assets for large banks(over $5 billion in assets).
The negative relationshipbetween inefficiencyand asset size is consistentwith prof-
it efficiency resultsproducedelsewhere, but the wide disparityin efficiencybetween
the largest and smallest banks suggests that the uniform truncationscheme arti-
ficially amplifiesthe relationshipbetween asset size and profitinefficiency.18 When

17. Foreign-ownedbanks had significantlyhigher risk-weightedassets despite holding lower propor-

tions of loans, and higher proportionsof cash, than their U.S.-owned counterparts.The difference is
likely attributableto higher levels of real estate loans at U.S.-owned banks, which receive lower risk
weights than other loans.
18. Humphrey(1987) was the firstto reporta relativelywide unit cost dispersionfor small banks, and
a numberof the cost studies reviewed in Berger, Hunter, and Timme (1993) find that small banks are
relatively cost inefficient. Profit efficiency studies that llse models very similar to ours Berger, Han-
cock, and Humphrey(1993); Zhu et al. (1994); Akhaveinet al. (forthcoming)also produceestimatesof
inefficiency that decline with bank size.
 ROBERTDEYOUNGAND DANIEL E. NOLLE : 631

TABLE 2
OF ASSETSAND POTENTIALPROFITS
AS A PERCENTAGE
PROFITINEFFICIENCY
< $100M $100-SOOM $500-$1B $1-SB > $5B all

Mean assets $58 $228 $715 $2,390 $20,922 $2,315

($ millions)
Number of banks 99 122 17 37 27 302
Profit inetficiencyas % of assets:
Truncationuniform 12.06% 11.16% 6.37% 3.46% 1.29% 9.36%
Truncationby asset 7.45% 6.36 6.39% 6.03% 5.02% 6.56%
decile
Profit inetficiencyas % of potential profits:
Truncationuniform 69.64% 68.05% 57.33% 45.60% 29.31% 61.75%
Truncationby asset 56.90% 53.56% 57.47% 59.61% 53.43% 55.60%
decile
NorEs. Banks are grouped by asset slze Averages are unwelghted Estlmates are based on model wlth core deposlts assumed flxed.

the netput residuals were truncatedwithin asset deciles, however, estimatedprofit

inefficiency fell on a much smallerrange, declining from 7.45 percentof assets for
small banks to 5.02 percentof assets for large banks.
Regardlessof which truncationscheme is used, estimatesof profitinefficiency-to-
assets clearly overstatethe impactof inefficiencyon bankearnings.These estimates
imply that the averagebank could have increasedits ROAby more thansix hundred
basis points by eliminatingall inefficiency.This overstatementoccurs because vari-
able profitmeasuresearningsbefore taxes and fixed costs, while the numeratorused
to calculate ROA-net income measures earnings after taxes and fixed costs.
For the 302 banksin our sample, mediannet income averagedonly about 17 percent
of median variable profit. Hence, multiplying our estimates of variable profit
inefficiency-to-assetsby 0.17 is a crudeway to make them somewhatcomparableto
accountingROA. This adjustmentreduces the range of profitinefficiency-to-assets
(truncationwithin asset deciles) to 1.27 percentfor small banksand0.85 percentfor
large banks. Given that averageROA for the banks in our sample was 0.86, com-
pletely eliminatinginefficiencywould have increasedROAby about 150 percentfor
small banks, and by about 100 percentfor large banks, figuresthat seem economi-
cally reasonable
Such crude adjustmentsare unnecessarywhen variableprofit inefficiency is ex-
pressed as a percentageof potentialprofits, because both the numeratorand the de-
nominatorin this ratio are generatedfrom the same statisticalmodel and are based
on pretax, pre-fixed cost measures of income. As with the estimates of profit
inefficiency-to-assets,the estimatesof profitinefficiency-to-potentialprofitsare less
sensitive to asset size when the netputresiduals are truncatedwithin asset deciles.
Using this truncationscheme, estimatedprofit inefficiency ranged in a tight band
between 53 percent and 60 percent of potential variable profits, and followed no
patternwith respect to asset size. These estimates imply that the averagebank, re-
gardless of asset size, could somewhat more than double its earningsbefore taxes
and fixed expenses by eliminatingall input and outputinefficiency.
632 : MONFY, CREDIT,AND BANKING

4.2 Foreign-Owned
BanksversusU.S.-OwnedBanks
For the remainderof our analysis we express inefficiency as a percentageof po-
tential variableprofits, and only use estimates in which the averageresidualswere
truncatedwithin asset deciles. Table3 comparesvariouscomponentsof profitineffi-
ciency for foreignowned and U¢S.-ownedbanks. Overall, the resultsreinforcethe
conclusions of previousstudiesthatfindrelativelylarge amountsof cost inefficiency
in foreign-owned banks. In both variantsof the profit model (core deposits held
fixed or allowed to vary), the average foreign-owned bank incurredsignificantly
higher levels of inputinefficiencythan did the averageU.S.-owned bank. The larg-
est portion of this difference is explained by the overuse of purchasedfunds-
excess expendituresby foreign-ownedbanks on purchasedfunds averagedbetween
18 and 19 percentof theirpotentialvariableprofits,twice as much as at U. S .-owned
banks. This differencewas statisticallysignificantat the 1 percentlevel, and more
than offset foreign-ownedbanks' slightly more efficientuse of core deposits. There
were no significant differences in output efficiencies between the two groups of
banks, which suggests that the excess and/or more expensive inputs purchasedby
foreign subs were not being used to produce additionaland/or higher quality out-
puts. Overall, the gap in variableprofitefficiency between U.S .-owned and foreign-
owned banks averagedbetween 3 and 10 percent of potential variableprofits, de-
pending on whethercore deposits were held fixed ol allowed to vary in the profit
model.
The efficiency differences in Table 3 could be misleading if bank characteristics
that are not controlledfor in the profitmodel are correlatedwith foreign ownership.
For example, if business loans are more expensive to produce and maintainthan
othertypes of loans (they are), and if foreign subs tendedto pursuebusiness lending
strategies(they did), then the averagesin Table3 might exaggerateinputinefficiency
for foreign subs. Table4 reportsregressionsof variableprofitinefficiencyon indi-
vidual bank characteristics,including asset size; loan portfolio mix; regional eco-
nomic conditions; whetherthe bank was a holding company affiliate;and whether

TABLE 3
COMPONENTS
OFVARIABLE
PROFIT
INEFFICIENCY
ASPERCENTAGE
OFPOTENTIAL
PROFITS
A Core Deposlts Fixed B Core Deposits Varlable
Foreign US Difference Foreign US Difference
Total 63.15% 53.65% 9.50%a 82.58% 79 35% 3.23%c
Output 29.32 30.19 -0.87 35.71 39.10 -3.39
loans 20.90 21.60 -0.70 26.73 29.80 -3.07
securities 8.42 8.59 -0.17 8.98 9.30 -0.32
Input 33.83 23.46 10.37a 46.87 40.25 6.62a
purchasedfunds 18.84 10.07 8.77a 18.73 10.21 8.52a
labor 14.99 13.39 1.60 13.87 13.05 0.82
core deposits 14.27 16.99 -2.72b
N 62 240 62 240
NOTESNetput reslduals truncatedwithln asset deciles Averages are unwelghted
a,b and c indicate signiticance at the 1. 5, and 10 percent levels. respectively. in two-tailed tests
 ROBERTDEYOUNGAND DANIEL E. NOLLE : 633

TABLE 4
ORDINARY LEAST SQUARES REGRESSIONS
Core Deposits Fixed Core Deposits Varlable
[1] [2] [3] [4]
INTERCEPT .5814a .5843a .9484a .9498a
(.0699) (.0698) (.0664) (.0665)
FOREIGNDUMMY .0708a .0648a .OSlSb .0487b
(.0241) (.0243) (.0229) (.0232)
FOREIGNDUMMY*ASSETS - .0082C - .0021 - .0057 - .0028
(.0050) (.0063) (.0048) (.0060)
ASSETS - .0014 - .0015 - .0050c _ .0051C
(.0031) (.0031) (.0029) (.0029)
ASSETS2 - .00006 - .00006 - .00004 - .00004
(.00004) (.00004) (.00004) (.00004)
BUSINESSLOAUVSILOAUVS .0462 .0379 - .2699a - .2738a
(.0752) (.0752) (.0714) (.0716)
REALESTATELOANSILOANS -. 2074a -. 2080a -.21 64a -.2167 a
(.0631) (.0629) (.0599) (.0599)
STATEGDP GROVErH .0009 .0009 .0010 .0010
(.0008) (.0008) (.0008) (.0007)
DUMMY
HOLDINGCOMPAUVY .0028 .0020 - .0234 - .0237
(.0198) (.0198) (.0189) (.0189)
OUTLIERDUMMY _.2997c - .1431
(.1825) (.1739)
N 302 302 302 302
Adjusted-R 2 .2005 .2051 .2622 .2614
NOTES:Dependent varlable is valiable profit inefficiency as percentageof potential profits. ASSETSin billions of dollars. STATEGDP
GROWTHequals percent growth, 1985-1990.
Absolute values of standardelTorsappearin parentheses.a,b and c indicate significance at the 1, 5, and 10 percentlevels, respectively, in
two-tailed tests.

the bankwas foreign-owned.Thesecharacteristics explainedbetween20 and 26

percentof the variancein estimatedprofitefficiency.
The coefficienton the foreignownershipdummywas positiveandsignificantin
all equations.However,in equation(1) the coefficienton FOREIGN*ASSETS was
negativeandsignificant.Thesumof thesetwocoefficientssuggeststhattheefficien-
cy gapbetweenforeign-owned andU.S.-ownedbanksdeclinedwithbanksize, and
thatthesetwo typesof bankswereequallyefficientat around$9 billionin assets.
Closeinspectionof thedatafoundthatthisresultwasdueto a singleforeignsubthat
was verylargeandveryefficient.Whena dummyvariablewas addedto controlfor
this outlyingobservationthe coefficienton FOREIGN*ASSETS declineddramat-
icallyandbecamenonsignificant. Thissingleobservation withstanding,theefficien-
cy disadvantage at the averageforeign-owned bankwasbetween5 and7 percentof
potentialvariableprofits,roughlyconsistentwiththeresultsin Table3.
The remainingcoefficientswere relativelyrobustto changesin the regression
specification.Holdingcompanyaffiliationandeconomicgrowthin thebank'shome
stateduringthe sampleperiodhadno explanatory power.Assetsize hadat mosta
smallnegativeeffecton overallprofitinefficiency a $1 billionincreasein assetsis
associatedwith an increasein inefficiencyequalto just a half percentof variable
profits.Bankswithhighproportions of businessloansandrealestateloanstendedto
634 : MONEY, CREDIT,AND BANKING

be relatively inefficient, perhapsbecause these types of loans require more labor

expense, and/or are more likely to become nonperforming,than are consumer
loans.

CONCLUSIONS

Despite makingsignificantinroadsinto U. S . loan marketsduringthe past decade,

foreign-owned banks have been consistently less profitablethan their U.S.-owned
competitors.This study investigates the extent to which technical inefficiencycon-
tributedto the low profitabilityof foreign-owned U.S. banks between 1985 and
1990. Previouscost-basedefficiency studies of foreign-ownedU.S. may have over-
statedinefficiencyin banksthatprovidehigh qualityservices-banks thathave both
high costs and high revenues. We use a profit-basedmodel similarto thatintroduced
by Berger, Hancock, and Humphrey(1993) to generateseparateestimatesof input
(cost) and output(revenue)inefficiency.In addition,we modify the model so that it
is more stable with respect to asset size.
We find that foreign-owned banks were less profit-efficientthan U.S.-owned
banks, primarilydue to higherinputinefficiency.That is, given the fixed inputsem-
ployed by both sets of banks, the marketprices faced by both sets of banks, and the
variable outputs produced by both sets of banks, foreign-owned U.S. banks em-
ployed greateramountsof costly variable inputs than did U.S.-owned banks. The
primarycause of this efficiency gap was foreign-ownedbanks' reliance on expen-
sive purchased funds financing. While these results are consistent with previous
studies of efficiency in foreign-ownedU.S. banks, we advancethis line of analysis
by identifyingfinancingmix as a majorsource of cost inefficiencyin foreign-owned
banks, and by providingevidence thatforeign-ownedbankswere no less outputeffi-
cient than their U.S.-owned counterparts.
Ourresults are consistentwith the hypothesisthatforeign-ownedU.S. banks sac-
rificed profitabilityin exchangefor increasedmarketshareduringthe late 1980s and
early 1990s. The datasuggest thatthese banksdid not develop the relationshipswith
U.S. retail customersnecessary to raise and maintaincore deposits, and insteadfi-
nanced their growth with expensive purchasedfunds. Of course, our results are av-
erages over all the foreign-ownedbanks in our sample, and not all foreign-owned
banks pursuedthe same business strategiesduringthis time period. Some foreign
subs may purposefullyhave chosen not to develop retailrelationships,choosing in-
stead to pursuea business lending strategythatfailed to producehigh profits.Other
foreign subs may have simply been unsuccessfulin theirattemptsto develop a retail
presence in the United States. In either case, relative unfamiliaritywith U.S. mar-
kets may have contributedto the low profits.
Finally, if foreign-ownedbankswere attemptingto maximizemarketshareduring
the 1980s while their U.S.-owned counterpartswere attempting to maximize
profits then the relatively low profitsand low profitefficiency we find at foreign-
owned banks is not surprising.Futureresearchmight analyze the relativeefficiency
 ROBERTDEYOUNGAND DANIEL E. NOLLE : 635

of foreign-ownedand U.S.-ownedbanksduringa periodover whichthe market

sharesof thetwo sets of bankswerestable.

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