Banks can enter new countries either through greenfield entry or by acquiring local banks. I model the effect of a foreign bank's mode of entry on the stability of the local financial sector. Banks exert costly effort when they extend credit. Limited liability creates an agency problem which leads to under provision of effort. I show that the diversification of the foreign bank's loan portfolio mitigates the agency problem, and permits the foreign bank to extend credit during downturns where the local banks are forced to contract credit. The risk management framework employed by the foreign bank creates a divergence in the behaviour of a greenfield entrant and an acquirer. The greenfield entrant does not own a portfolio of local loans, and therefore, it has a greater risk taking capacity than the acquirer. Thus, competition, and thereby the distortion of the local banks' incentives to exert effort, is greater following greenfield entry than following entry through acquisition.
Financial Markets Group Discussion Papers DP 623