Market entry, privatisation and bank performance in transition by Steven Fries,* Damien Neven**, Paul Seabright*** and Anita Taci**** March 2006 Abstract This paper examines how market entry and privatisation have affected the margins and marginal costs of banks in the post-communist transition by estimating bank revenue and cost functions. To allow parameters of the functions to change over time, we divide our large panel dataset into three sub-periods. In the first sub-period (1995 – 1998), we find that privatised banks earned higher margins than market entrants or state-owned banks, while newly established foreign banks had significantly lower marginal costs. By the third sub-period (2002 – 2004), foreign banks were the low marginal cost providers of services, while domestic private banks earned significantly higher margins. Combining margins and marginal costs to calculate mark-ups shows that initially privatised banks had the largest mark-ups, an indication that they could attract more demand for their services. Our evidence therefore indicates that, in the post-communist transition, entry of foreign banks was associated with lower costs and privatisation of state banks with greater capacity to attract demand for services. In contrast, state-owned banks persistently under-performed in controlling costs and attracting demand. JEL codes: G2, L1, L8, P2 Keywords: banking, imperfect competition, cost functions, transition. * Corresponding author, European Bank for Reconstruction and Development, One Exchange Square, London EC2A 2 JN, United Kingdom, email: friess@ebrd.com . ** Graduate Institute of International Studies, University of Geneva, and CEPR. *** Université de Toulouse I and CEPR. ****European Bank for Reconstruction and Development, One Exchange Square, London EC2A 2 JN, United Kingdom. We thank Nadia Aleshina for valuable research assistance and Erik Berglöf, Wendy Carlin, Christa Hainz, Shelagh Heffernan, Mark Schaffer and Claudia Senik-Leygonie for helpful comments and suggestions. The funding of the Japan-Europe Cooperation Fund is gratefully acknowledged. The usual disclaimer applies.