The Determinants of Foreign Banking Activity in South East Europe Do FDI in Manufacturing Bilateral Trade and EU Policies Matter

This research paper attempts to find explanatory variables for foreign banks activity
in SEE and CEE, mainly among three categories of factors: FDI (in manufacturing),
bilateral trade, and EU policies. We proxy billateral banking activity by the consolidated
foreign claims of reporting banks between source and recipient countries. Our sample
includes 12 source countries (of which 10 are EU members) and 16 recipient countries
(from SEE, CEE and former Soviet Union), and it covers the 1995-2004 period. We found
that bilateral trade and the interest rate differential are significant and bear the expected
sign, which means that foreign banks follow the customer and exploit profit opportunities.
Foreign direct investment (FDI) was found to be weakly significant and only with a twoyear lag, which means that banking activity is generated by non-financial FDI only after that FDI matures. Banking sector reform, a proxy for EU policies imposed to Eastern
European countries, also appears significant. Lack of corruption is less important, while
distance does not matter. This paper also finds that an increase in foreign banks activity
in a recipient country is correlated with an increase in the Human Development Index,
but also with an increase in inequality (as reflected by the Gini coefficient) possibly due
to the limited extent and depth of the local financial markets.