Financial openness, risk and bank efficiency: Cross-country evidence

• We investigate the interrelationship between financial openness, bank risk and bank profit efficiency.
• Estimation is based on data for 2007 commercial banks in 140 countries over the period 1999–2011.
• Financial openness reduces bank profit efficiency directly, and increases bank risk indirectly through decreased profit efficiency.
• A battery of robustness tests corroborate the validity of the results.

This paper assesses the interrelationship between financial openness, bank risk and bank profit efficiency using a cross-country sample of 2007 commercial banks covering 140 countries over the period 1999–2011. To establish whether the impact of financial openness on both bank risk and profit efficiency occurs directly or through each one of the two bank characteristics (efficiency and risk, respectively), we begin our analysis by investigating the potential reverse Granger causality between profit efficiency and risk using a dynamic simultaneous model via system GMM estimation. We then account explicitly for the role of bank risk in the estimation of bank profit efficiency using stochastic frontier analysis, allowing for the influence of different measures of financial openness and risk alongside other control variables. Our results indicate that financial openness reduces bank profit efficiency directly, not through changes in bank risk. We also find that financial openness increases bank risk indirectly, through the decreased bank profit efficiency channel.