Competition and Innovation

Kienpin Tee, Zayed U., kienpin.tee@zu.ac.
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Relationship and Granger Causality between Competition
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and Innovation: Banks in the Eurozone
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Kienpin Tee, Zayed U., kienpin.tee@zu.ac.ae
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Relationship and Granger Causality between Competition and Innovation: Evidence from
Banks in the Eurozone
Abstract
Based on samples of banks from the initial 11 Eurozone member states, this study achieves two
goals. First, this paper presents new evidence to explore the relationship between competition
and innovation. Second, this paper examines Granger causality runs between the two variables.
Using the technology gap ratio to measure bank innovation and the Lerner index and Boone
indicator to measure bank competition, the paper reveals an inverted-U relationship between
competition and innovation. Using the full sample, the Granger causality tests indicate a full
negative bidirectional causality between competition and innovation. When separate Granger
causality test is examined on each of the upward slope and the downward slope of the inverted-U
curve, the results indicate a positive bidirectional causation between competition and innovation
along the upward slope, whereas a lack of support of causality link between competition and
innovation along the downward slope.
Keywords: Competition, Innovation, Stochastic frontier analysis, Granger causality, Technology
gap ratio, Lerner index, Boone indicator, Bank, Eurozone
JEL Classification: D21, G21, L10, O30

1. Introduction
The relationship between product market competition and innovation has been a
controversial topic for the past several decades. Existing empirical studies that investigate the
relationship between competition and innovation mainly focus on manufacturing and technology
industries (e.g., Besen & Johnson (1986) in the broadcasting industry, Robinson (2001) in the
healthcare industry, and Gruber and Koutroumpis (2012) in the telecommunication industry).
Very few studies investigate this issue in the banking sector. Among those who have contributed
to investigating the relationship between competition and innovation in the financial sector are
Schaeck and Cihak (2008), Bos et al. (2013), Chava et al. (2013), and Cornaggia et al. (2015). To
further substantiate this area of knowledge, this study applies Data Envelopment analysis (DEA)
to explore the relationship between competition and innovation for a sample of 11 Eurozone
members with respect to different benchmark currencies.
This study focuses on a sample of European banks because the Eurozone provides a
mature ground for analyzing the effects of changes in the intensity of competition and innovation.
Spanning 1998 to 2015, the sample period of this study incorporates several major periods of
global economic expansion and recession. During the last two decades, bank market
consolidation has been a major trend worldwide. The global phenomena of technological
innovation, bank market liberalization and deregulation have facilitated the process of bank
mergers and acquisitions. In Europe, this bank consolidation process was emphasized by the
efforts to establish a single European financial market, based on the belief that market
competition would increase bank productivity through bank innovation.
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Along with the goal of creating a single European financial market since the 1990s,
European banks have also experienced dramatic changes in the regulatory environment, aimed at
creating a level playing field for competition among banks. For examples, the idea of ‘single
passport’, was implemented to allow banks to operate across all EU member countries with
uniform standard in acquiring licenses, maintaining capital requirements, and meeting
supervisory guidelines. These financial revolutions have brought significant implication for
competition among European banks. Furthermore, over the past decade, the European Union
banking market has also had to face the challenge of the financial consolidation and integration
of the additional twelve new member-states.
To analyze the relationship between competition and innovation in Eurozone banks, I
pursue a two-step approach. In the first step, I examine whether the relationship between bank
competition, measured by the Lerner index and the Boone indicator, and bank innovation,
measured by technology gaps, exhibits a linear relationship, e.g., Schumpeter (1942), Nickell
(1996), Blundell et al. (1999), Carlin et al. (2004) and Okada (2005), or an inverted-U
relationship, e.g., Aghion et al. (2005) and Bos et al. (2013). In the second step, if there is a
significant relationship from the first step, I run another causality check between competition and
innovation in banking. Using dynamic panel data Granger causality tests, this study aims to
extend the existing literature by examining the link between the level of competition and the
level of innovation.
This paper contributes to the extant innovation management literature in two ways. The
first contribution is that this paper, to the best of my knowledge, is the first to explore the
relationship between competition and innovation in the European banking industry. Other
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existing papers, e.g. Bos et al. (2013) and Cornaggia et al. (2015), mostly focus on samples from
the US banking industry. The European Union is the second largest economy in the world;
therefore, a précis on the link between competition and innovation would be unreliable if we
ignored the European banking industry. Also, there are several noteworthy divergences between
the U.S. and E.U. capital markets. Compared to the US market, the competition for depositor
money is more severe in Europe because not only there are many more banks, but also there are
non-bank competitors. For example, post offices in some European nations accept deposits.
Consequently, European banks fund much of their operations by borrowing. Compared to the
American rivals, European banks have much higher loan-to-deposit ratio. As for bank customers,
European companies rely far more heavily on bank lending. Generally, the fact that
approximately 80 percent of corporate debt in Europe originates from bank lending, and the
remaining 20 percent comes from the corporate bond markets is a total inverse of the U.S.
The second contribution of this paper is that this paper is the first to use a panel Granger
causality approach to test the direct relationship between bank competition and bank innovation.
Existing literature usually examines unidirectional impact from competition to innovation and
not the other way around. (e.g. Scherer (1967); Levin et al. (1985); Aghion and Griffith (2005);
Aghion et al. (2005); Bos et al. (2013); Cornaggia et al. (2014); Hashmi et al. (2005)). It is
obvious that new technologies can profoundly affect the functioning of the banking industry. The
most recent examples include the use of mobile banking apps that are disrupting conventional in-
store banking business. These disruptive innovations can deliver important benefits to
competition and consumers, in terms of new and better services, and can stimulate innovation
and price competition from established providers.
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The results show that the squared term of the bank competition variable is negatively
significantly related with innovation, proving that the relationship between bank competition and
innovation reveals an inverted-U relationship.
Using the full sample, the Granger causality tests indicate a full bidirectional negative
causality between competition and innovation. Using the partial sample contained in the upward
slope of the inverted-U, the Granger causality tests indicate full bidirectional positive causality
between competition and innovation. Using the partial sample contained in the downward slope
of the inverted-U, the Granger causality tests shows that there is no causality link between bank
competition and bank innovation. The causality results are robust when both competition
measurements, Lerner index and Boone indicator, show the similar findings.
The findings above show that even thought the relationship between competition and
innovation displays an inverted-U shape, only the upward slope demonstrates a meaningful
causality association. The bidirectional causality along upward slope suggests that increasing
competition encourages banks to innovate to outshine their peers, and that increasing
technological innovation boosts banks to invest more expenses to keep up with their competitors.
The market competition later reaches a sufficient level that an increase in innovation can no
longer improve any competition.
2. Literature Review
Schumpeter (1942) first suggests that market competition depresses firms’ initiative to
innovate because of losing monopoly rents. However, some later empirical evidence from
Nickell (1996), Blundell et al. (1999), Carlin et al. (2004) and Okada (2005) discover a positive
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relationship between competition and innovation. Aghion et al. (2001) propose an "escape-
competition effect" to explain these findings, in which they argue that competition may
encourage firms to innovate to surpass their competitors. Using data from the manufacturing
industry in the UK, Aghion et al. (2005) later discover an inverted-U relationship between
competition and innovation. Reconciling the theory with evidence, they suggest that the escape-
competition effect initially kicks in until competition becomes so saturated that the diminishing-
returns effect starts to dominate the relationship.
*** Insert Figure 1 ***
In recent years, with the global trend of bank consolidation, the number of banks in
Europe has also reduced (refer to Figure 1). Smirlock et al. (1984) and Maudos (1998) argue that
the remaining largest banks, because of bank market consolidation, have become more efficient,
and the bank market has become less competitive. Until the 2000s, there was a general belief that
mergers did not clearly contribute to banks’ devotion to financial technology improvements due
to low competition, e.g. Berger and Hannan (1989, 1998); Hannan and Berger (1991); Neumark
and Sharpe (1992); Houston and Ryngaert (1994); Pilloff (1996). Clearly, low competition in the
banking industry has discouraged bank innovation.
From the year 2000, the aftermath of the dot-com bubble has forced more emerging firms
to pay attention to the presence of asymmetric information, contagion phenomena and imperfect
competition, or the specific impacts of bank competition and regulation on bank performance
(among others, De Bandt and Davis (2000); Allen and Gale (2000); Demirgüç-Kunt and Levine
(2000); Bikker and Haaf (2002); Berger et al. (2004); Weill (2004); Hasan et al. (2009); Schaeck
et al. (2009); Tabak et al. (2011)). Banks have since then shown more willingness to spend
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increased investment on improving financial technology due to soaring competition in the market.
These studies clearly show that competition has forced the growth of innovation, regardless of a
low or high competitive environment.
On the other hand, along with technological advancement, bank market liberalization and
deregulation have facilitated the process of bank mergers and acquisitions. As a result, the bank
industry has become more concentrated and less competitive. Studies and evidence presented by
Altunbas and Marqués-Ibáñez (2007), Cloodt et al. (2006), and Penetta et al. (2009) provide
further support for the interpretation that innovation is the factor that fosters market competition.
Accordingly, it is ambiguous whether a change in bank competition precedes a change in
a bank innovation or vice versa. Up to now, not many authors have used Granger-type causality
tests to investigate the empirical relationship between bank market competition and bank
innovation. Among others, Idun and Aboagye (2014) use the example of Ghana and find
evidence of unidirectional Granger causality from bank competition to economic growth as
well as bidirectional Granger causality between financial innovation and economic growth.
Most existing literature only examines unidirectional causality tests running from competition
to innovation and not from efficiency to innovation. (e.g. Scherer (1967); Levin et al. (1985);
Aghion and Griffith (2005); Aghion et al. (2005); Bos et al. (2013); Cornaggia et al. (2014);
Hashmi et al. (2005))
3. Data and Methodology
3.1 Data
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The sample of this study consists of all the banks of the initial eleven Eurozone member
states: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands,
Portugal and Spain. The list of all the banks is collected from the European Central Bank
website. Year-end financial data from each bank is gathered from two sources: BankScope and
DataStream. These two databases complement each other for the missing data. The sample
period covers from 1989 (the last data available before the Euro was introduced on Jan 1, 1990)
to 2015 (the most recent available data when this study was conducted). Referring to Table 1,
there are a total of 114,926 bank-year observations for over 8,300 banks.
*** Insert Table 1 ***
Figure 1 shows that the total number of banks in the Eurozone has declined consistently
throughout the sample period. This finding is in line with the fact that the rising intensity of
competition in the European banking sector has induced more bank consolidations, and that
improving technological innovation has facilitated the process of bank mergers and acquisitions
(Ferreira 2013). Data are expressed in the Euro currency of the year 1990. The sample of this
paper covers several European countries with various institutional settings. I control for such
different characteristics by including some state-level control variables such as Herfindahl
Hirschman Index (HHI) and total banking system assets. Such different characteristics are well
controlled when I study the effect of competition on innovation and vice versa.
3.2 Measuring Innovation - Technology gap ratio
The existing studies on innovation have mostly focused on the manufacturing industry.
These studies mainly rely on patents, R&D expenditures, or population of research personnel as
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indicators of innovative level (e.g., Helpman (1993) and Cohen and Klepper (1996)). Evaluating
innovative activity in the financial sector is more challenging, as patents in the financial sector
rarely exist and do not exist at all in the European Union. The fact that R&D information are not
applicable in the banking sector, as addressed by Frame and White (2004), has hampered the
motivation of financial innovation for a long time.
Following Bos et al. (2013) and Iren and Tee (2017), this study uses the technology gap
between a firm and a benchmark covering all available technologies as a proxy for innovation.
The technology gap of each firm is measured by an array of different indicators reflecting both
input into and output from financial innovations. According to their methodology, firms are
always assumed to minimize production cost along with the invention or adoption of new
technology. To present the idea of such technical change in a cost function, I apply a meta
frontier approach, as pioneered in the studies done by Hayami and Ruttan (1970), Lau and
Yotopoulos (1989), and Mundlak and Hellinghausen (1982). The meta frontier embodies the
most updated technologies available across firms and across time. Any technology improvement
will be measured, from time to time, against the benchmark meta frontier, which merges all
existing technologies.
Innovation is reflected by changes in the technology gap, which measures the difference
between currently available technology and optimal technology over the whole period, with
values between zero and one, with value one being the highest level of innovation. To obtain the
technology gap of each firm in each year, I apply Stochastic Frontier Analysis (SFA) to estimate
the minimum cost frontier available in each year and then envelope the annual cost frontiers to
obtain a meta frontier (refer to Hayami and Ruttan (1970), Mundlak and Hellinghausen (1982),
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and Lau and Yotopoulos (1989)). In the first step, the following annual translog cost frontiers are
estimated using stochastic frontier analysis:
TCit  f * ( wit , yit , zit )e vit  uit (1)
where TC is defined as total operating cost, with i = 1, ..., I bank in t = 1, ..., T period. w
represents the vector of input prices, y is the output vector, z is a vector of control variables, v is
random noise assumed to be i.i.d. with vit ~ N(0, σ2v) and independent of the explanatory
variables (see Aigner and Schmidt (1977) and Coelli et al.(1998)). u is the inefficiency term
assumed to be i.i.d. and is independent of vit.
Following Bos and Schmiedel (2006), I treat a bank as an intermediary between
depositors and borrowers. Accordingly, bank outputs are defined as loans (Y1) and investments
(Y2), and off-balance sheet items (Y3). More precisely, loans consist of commercial and
industrial, real estate, consumer, and other outstanding credits. Investments consist of securities,
equity investments, and other investments. Off-balance sheet items represent credits and other
guarantees which are not reported on the balance sheet. The study covers three input prices,
namely the price of labor (W1), the price of financial capital (W2), and the price of financial
capital (W3). The price of labor (W1) equals the total employee expenses scaled by the total sum
of assets. The price of financial capital (W2) equals the total interest expenses per unit of total
assets, and the price of physical capital (W3) equals all non-interest operating expenses divided
by the sum of assets. Finally, the variable equity/total assets (Z) controls for differences in equity
capital risk across banks. In line with Mester (1996), banks with lower equity ratios are assumed
to be riskier. The dependent variable in equation (1) is the total operating cost (TC).
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Table 2 displays the statistical values of all the input prices, outputs, and dependent
variables in estimating the technology gaps.
Banks are assumed to minimize total costs and operate in perfectly competitive input
markets. Cost efficiency score estimates are obtained as follows:
CEit  exp( ˆ it ) (2)
where CE=1 for banks that operate on the annual frontier (no inefficiency). Banks
locating above the annual cost frontier are inefficient and have cost efficiency scores less than
one.
In the second step, I use Data Envelopment Analysis (DEA) to estimate the meta frontier
as the envelope around the annual cost frontiers. The annual cost frontiers are represented by the
parameter estimates. The estimates of the technology gap (GAP) are estimated by fitting the
minimum cost meta frontier (fmeta) as follows:
T N
Min.Distance    | ln f * ( wit , yit , zit )  ln f meta ( wit , yit , zit ) |
t 1 i 1
subject to ln f * ( wit , yit , z it )  ln f meta ( wit , yit , zit )
In the above constrained minimization problem, the absolute distance between the annual
cost frontier and the meta frontier is minimized subject to the constraint that the total cost from
the annual frontier is equal to or larger than total cost from the meta frontier. As a result, the
technology gap is defined as:
f meta ( wit , yit , zit )

GAPit  (3)
f * ( wit , yit , zit )
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Innovations by banks improve their technology set and, consequently, shrink the gap
between the current technology set and the best available technology set, or meta frontier. The
result is an increase in GAPit, which is bounded between 0 and 1, where a firm reaches 1 when it
operates on the meta frontier. In short, the higher the value of GAPit ratio, the more innovated a
bank is.
Table 3 shows the summary statistics of technology gap ratio by the eleven Eurozone
member states from 1998 to 2015.
3.3 Measuring Competition - Lerner Index
Following Schaeck and Cihak (2008), I use the Lerner index of market power to measure
the degree of competition in banks. The Lerner index is a popular measure of the level of
competition in banking. It specifies the divergence between product prices and marginal cost of
production, which indicates the degree of market power. To gauge an Lerner index, we must first
estimate the subsequent translog cost function using three input factors (labor, deposits, and
capital), one output (total assets), and three netputs (fixed assets, loan loss provisions, equity
capital) as follows:
2 2
1 1 2 2
ln C   0  1 ln A   2 ln A2    kWk   h ln Yh    km ln Wk ln Wm
2 k 1 h 1 2 k 1 m 1
2 2 2 2
1 2 2
   k ln A ln Wk    k ln A ln Yh   kh ln Wk ln Yh   ln Yh ln Yn (4)
m 1 m 1 k 1 h 1 2 h1 n1
 ln c  ln  c
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where C denotes total cost, A is total assets, W is the vector of inputs (the price of labor
(W1), the price of financial capital (W2), and the price of physical capital (W3)), and Y is the
vector of outputs (loans (Y1) and investments (Y2), and off-balance-sheet items (Y3)).
Then I calculate marginal cost by differentiating Eq. (4) with respect to A as follows
C c
mcit   [1  1 ln A  1 ln W1  2 ln W2  1 ln Y1   2 ln Y2 ] it (5)
A A
I calculate the Lerner index as the mark-up of output prices over marginal cost of
production as follows
pit  mc
LI it  (6)
pit
where pit denotes the output price of bank i at time t and is defined as total revenue
(interest and noninterest revenue) divided by total assets. The Lerner index ranges between zero
and one. The larger the Lerner index, the less the competition and the more the market power.
Figure 2 illustrates the evolution of the Lerner indices, by country, over time. Higher
value of the Lerner index indicates lower level of competition. Overall, there are upward trends
of the competition level in every country, indicating that the banking sector in the Eurozone is
having progressively less competition. During the recessions in 2000 and 2008, more banking
players left the markets, the surviving banks thus enjoy more market powers, as indicated by the
surges in the graph. The banking systems in Portugal and Germany exhibit, on average, the
highest level of competition, indicating that banks in these markets do not wield much market
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power. Meanwhile the banking system in Italy has always displayed the highest values of the
Lerner index of above 0.7, indicating banks in Italy are facing less competition.
3.4 Measuring Competition - Boone Indicator
Another popular way of measuring competition is the Boone indicator, as introduced by
Boone (2008). Unlike the Lerner index, the Boone indicator is calculated as the elasticity of
profits in relation to marginal costs. The underlying principle behind the Boone indicator is the
positive relationship between profit and bank efficiency. The formation of the Boone indicator is
based on Relative Profit Differences (RPD) that, from its theoretical properties, proves to be
more robust than the Lerner-Index.
Boone develops a broad set of theoretical models (see Boone (2000), (2001) and (2008),
Boone et al. (2004), and CPB, (2000)), and establishes the Boone indicator as a proxy for bank
competition. Following Boone et al. (2004), I consider every bank in our sample set to follow a
demand function in which each bank i produces one product qi. The bank faces a linear demand
curve of the form:
p(qi , q j  i )  a  bqi  d  q j (7)

j i
and has constant marginal costs mci. It maximizes profits πi = (pi – mci) qi with the optimal
output level qi. By having a > mci and 0 < d ≤ b, the first order condition for a Cournot-Nash
equilibrium can then be written as:
a  2bqi  d  q j  mci  0 (8)

i j
When N banks produce positive output levels, the N first-order of equation (8) becomes:
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qi (mci )  [(2b / d  1)a  (2b / d  N  1)mci   mc j ] / [(2b  d ( N  1))(2b / d  1)] (9)

j
Profits πi is defined as variable profits excluding entry costs k. Hence, a bank enters the
market if πi ≥ k in equilibrium. Equation (9) displays a linear relationship between output and
marginal cost.
In a bank market, competition can increase in three ways. First, competition increases
when the bank products become quick substitutes, that is, d increases (assuming d<b). Second,
competition increases when entry costs k decline and entry occurs. Boone et al. (2004) show that
efficient firms achieve more profit when there is a stronger substitution and a lower entry cost.
Third, competition increases when b, which measures price sensitivity of the demand for bank
services, increases along with the greater market power of bank i and all other banks.
Following equation (9), the relationship between profits and marginal costs can be
rewritten as:
(2bp / d p  1)a p  (2bp / d p  N p  1)mc1, p   j mc jp

 1, p (mc1, p )  (10)
[(2bp / d p ( N p  1))(2bp / d p  1)]( p p  mc1, p )
where price, p p , stands for the price of the bank service in period p. The Boone indicator, BI, is
the profit elasticity of marginal costs derived from this equation (10):
BI  d  1, p / dmc1, p ( mc1, p /  1, p )  0 (11)
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The value of BI is always expected to be negative, where mc1, p is the average value of
marginal cost in period p and  1, p is the average profit in period p. As such, the more negative
the Boone indicator, the higher the degree of competition.
Figure 3 illustrates the evolution of the Boone indicator, by country, over time. Like the
Lerner indices, there are upward trends of the Boone indicator in every country, indicating that
the Boone indicator is a close substitute for the Lerner index. The bank competition dropped
seemingly when there were recessions in the 2000 and 2008. Although the trends of the Boone
indicators among the Eurozone nations are like those of the Lerner indexes, the rank of
competition among the countries is different. Using the Boone indicators, the banking systems in
Luxembourg and Netherlands exhibit, on average, the lowest values for the Boone indicator,
indicating that banks in these markets were facing more competition than in other countries.
Meanwhile, the banking system in Portugal and Ireland have always displayed the highest values
of the Boone indicator, indicating that banks in these two countries were enjoying the benefits of
less competition.
4. Empirical Results and Discussions
4.1 The Impact of Competition on Innovation
This section aims to study the effect of competition on innovation in the Eurozone banks.
Table 4 shows the results of the Generalized Least Squares (GLS) and the Ordinary Least
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Squares (OLS) models using Technology Gap ratios as dependent variables. Models 1-4 display
the effect of the competition level, as measured using the Lerner index, on innovation while
models 5-8 shows the effect of the competition level, as measured using the Boone indicator on
innovation. All eight models show statistically significant linear and inverted-U relationships
between competition and technology gap ratios. All four square terms under Model 1-4 and one
of the four square terms under Model 5-8 are significant at the one percent level. The relationship
between competition and innovation is strong, as indicated by the reported R-squares ranging between
0.33 and 0.55. When the innovation index, as measured by the technology gap ratio, is compared against
the composite competition index, as measured by the average values of the Lerner index and the Boone
indicator, we obtain a clear inverted-U bell curve as indicated in Figure 4. The innovation experiences a
quadratic concave function against the market competition. The innovation level reaches its peak of 2.2
when the competition index is around 0.6.
These results are consistent with theory and evidence reported by Bos et al. (2013) in the
US banking industry and Aghion et al. (2005) and Hashmi (2007) in other industries. To avoid
the problem of endogeneity, Hausman-Wu tests are performed across all models in Table 4. The
endogeneity test shows that the competition term and its squared term are safely treated as
endogenous regressors. Based on the Hansen test, which is used for testing over-identifying
restrictions in a statistical model, the null hypothesis that the instrument variables are valid
cannot be rejected.
Table 4 further presents several robustness checks to examine whether a significant linear
or inverse-U relationship exists for many alternative model specifications. First, I use the Boone
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indicator in model specification 5 and 6 to mirror model 1 and 2. The results of using the Boone
indicator are quite like the results of the Lerner index, except for the significance level of the
square term being ten percent instead of one percent. Second, model specification 3 and 4
includes several control variables, such as equity-to-asset ratio, market share, total assets, asset
growth, square term of asset growth, and Herfindahl Hirshman Index (HHI). A linear and an
inverted-U relationship between competition and technology gap ratio are again obtained after
controlling for other factors that may affect innovation. Third, using the Boone indicator as an
alternative competition variable, I include similar control variables in model 7 and 8. The
significance level drops a little. For the GLS model, the inverted-U relationship shows a 5%
significance level, while for the OLS model, the inverted-U relationship shows a 10%
significance level.
The risk variable (equity divided by total assets) coefficient is positive and significant at
the 1% level. This finding shows that an increase in the equity ratio is associated with a higher
technology gap ratio, suggesting that banks in Europe tend to invest more to improve their
technologies when the debt level is lower. This finding is against Aghion et al. (2005) and Bos et
al. (2013), who propose that debt pressure leads to more innovation. Market share is negatively
associated with technology gap across all models. This negative effect reflects an example of
diseconomy of scale where the banks suffer from a larger increase in marginal costs when output
is increased. Meanwhile, bank size in terms of total assets is mostly positively related to the
dependent variable in all models, suggesting that banks with larger assets, especially loan
amounts, tend to increase investments in technology more efficiently than smaller banks.
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Asset growth is negatively related to technology gap, suggesting that an expanding bank
may not always keep pace with the need for relevant technology improvement. I also include a
quadratic term of asset growth to account for nonlinearities. The square term of asset growth
displays a U-shape or a positive relationship with technology gap. Such a finding indicates that
once a bank reaches an optimal expansion rate, the bank is likely to invest aggressively to ensure
its business is supported by updated technology.
4.2 Granger Causality Tests
The Granger causality test, first proposed by Granger (1969), is a popular statistical test
for verifying whether one time-series variable can forecast another. A variable X, that changes
over time, is said to Granger-cause another variable Y, which also evolves over time, if both X's
own past values and Y's own past values can make better predictions than only Y's own past
values. In our case, I would like to investigate a two-way effect between bank competition and
innovation. In other words, I analyze whether
a) bank competition Granger-causes bank innovation (if predictions of innovation based
on its own past values and on the past values of bank competition are better than
predictions of innovation based only on its own past values.) or
b) bank innovation Granger-causes bank competition (if predictions of competition
based on its own past values and on the past values of bank innovation are better than
predictions of competition based only on its own past values.)
In both cases a) and b), I follow Berger (1995) and run the following Granger causality
tests.
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n n
yit   0    j yi (t 1)   j xi (t 1)  Z it  i   it (12)
j 1 j 1
4.2.1 Granger Causality Tests on the Entire Sample
Based on equation (12), I first regress measures of innovation (technology gap ratio) on
lags of both itself (yt-1 , yt-2 ) , and on the measures of competition ( xt-1 , xt-2 ); Zit is a vector of
control variables; ηi is a bank-specific effect and εit denotes the error term. A similar regression is
then run with the competition variable (Lerner index or Boone indicator) as dependent variable.
For this analysis, a panel data estimator is used together with bank-fixed effects.
Based on full sample of 114,926 year-firm observations, Table 5 shows the results of
Granger causality tests between competition and innovation. I perform eight model specifications
based on equation (12). In each model, I use two annual lags in the baseline setup. Compared to
a deeper lag structure, this lag setup avoids losing excessive information. In this Granger
causality analysis, I focus on the joint significance of the two annual lags of x. If the two annual
lags are significant, we can predict that x Granger-causes y, in the sense of changes in x
preceding changes in y.
Columns (1) and (2) in Table 5 are based on two annual lags of the dependent and
independent variable. In these baseline regressions, I include log market share and log total
assets as control variables. In column (1), the technology gap ratio is predicted by its own lags
and the lags of the Lerner index. Both sums of lagged coefficients are negative and significant at
the one percent level. e.g. one unit increase of technology gap ratio at t-1 causes 0.3458 decrease
19
in the current technology gap ratio, and one unit increase of Lerner index at t-1 causes 0.1254
increase in the current technology gap ratio. Likewise, column (2) shows that the Lerner index is
predicted by its own lags and the lags of technology gap ratio. Both sums of lagged coefficients
are also negative and significant at the one percent level. e.g. one unit increase of technology gap
ratio and of Lerner index at t-1 decrease the current Lerner index by 0.0015 and 0.3256,
respectively. The results of the Granger causality tests suggest that there is a full bidirectional
causality running between bank competition (based on the Lerner index) and bank innovation,
including a -0.2 causality of running from competition to innovation, and a -0.0015 causality
running from innovation to competition.
To control for the factors that may also affect the dependent variables, I incorporate four
additional control variables, i.e., asset growth, square term of asset growth, Herfindahl Hirshman
Index (HHI), and log of total banking system assets. Each European country in the sample
carries unique institutional settings; I control for such different characteristics by adding HHI
and banking system assets1 which are calculated on the state level. As such, I also include a set
of country dummies to control for the variation on the country level. The results are presented in
columns (3) and (4). Both sums of lagged coefficients are again negative and significant at the
one percent level. There is a full bidirectional causality running between bank competition
(based on the Lerner index) and bank innovation. This finding validates the findings of column
(1) and (2) that causality runs from bank innovation to bank competition based on the Lerner
index and vice versa.
Like the results of Table 4, the results in column (3), where bank innovation is used as a
dependent variable, show a negative coefficient of asset growth and a positive coefficient of
1
Total banking system assets are added to control for the size of the different systems (Bresnahan, 1989).
20
square term of asset growth. These findings suggest that a bank may not improve its required
technology as fast as its business expansion, and that there is a turning point where the bank
increases its technology level faster than its asset growth. Column (4), where the Lerner index is
used as a dependent variable, on the other hand, has a positive coefficient of asset growth and a
negative coefficient of square term of asset growth. These findings indicate that the faster a bank
expands its assets, the more competitive the bank is, and that there is an inverted-U relationship
between bank competition and bank asset growth: once a bank reaches its maximum competition
point, an increase in asset growth rate will only shrink the bank competition. The HHI and the
log of total banking system assets are negatively and significantly related to their dependent
variables, as shown in column (3) and (4). As such, banks operating in more concentrated and
larger markets have less innovation and less competition.
As a robustness check, I repeat the tests in model specification (1) - (4) by replacing the
Lerner index with the Boone indicator, and the results are presented in columns (5) - (8). In the
baseline setup of column (5) and (6), the technology gap ratio is predicted by its own lags and
the lags of the Boone indicator, and the Boone indicator is predicted by its own lags and the lags
of technology gap ratio. Both sums of lagged coefficients are negative and significant at the one
percent level. This result is consistent with the result in column (1) and (2). The magnitudes of
the estimates using Boone indicators are less than the ones using Lerner indexes. For example,
there is a -0.1033 causality of running from competition (Boone indicator) to innovation, as
compared to a -0.2 causality effect using Lerner index. The different outcomes resulting from
different measures of bank competition are not surprising. Amir (2000), Bulow and Klemperer
(1999), Rosenthal (1980) and Stiglitz (1989), for example, present models in which the Lerner
index tends to overestimate industry competition level when the competition level is highly
21
intense. Corts (1999) also shows that the estimates of the Lerner index sometimes underestimate
the level of market conduct compared to the Boone indicator.
By adding four additional control variables, column (7) and (8) mirror the tests on
column (3) and (4) respectively, with the Boone indicator as a measure of competition. In
column (7), technology gap ratio is predicted by its own lags and the lags of the Boone indicator.
All four control variables are significant as well. The result of column (8) also shows some
supporting outcomes to the one in column (4). Similar to its base model in column (6), the Boone
indicator is predicted by its own lags and the lags of technology gap ratio. Among the four
control variables, only HHI shows some significant results at the very marginal 10% level.
Overall the results using Boone indicators as a robustness check are consistent with those using
Lerner indexes.
The results from Table 5 are based on the basic assumption of the existence of a linear
relationship between the dependent variable and the independent variable. However, as indicated
by the findings in Table 4, the relationship between innovation and competition exhibits an
inverted-U curve. More competition (a lower Lerner Index) Granger causes more innovation and
also that even more competition (an even lower Lerner Index) now Granger-causes more
innovation. Thus, to overcome the fundamental contradiction of findings between Table 4 and
Table 5, I run Granger Causality tests separately on both the negative slope and the positive
slope of the inverted-U curve. The results and explanations are presented at the following section.
4.2.1 Separate Granger Causality Test on Upward-Slope and Downward-Slope of the
Inverted-U Curve
22
As indicated by the concave quadratic function in Figure 4, the relationship between
innovation and competition displays an inverted-U curve, it seems that the initial increase in
competition corresponds with the increase in innovation (Part 1 of Figure 4), and that the further
increase in competition, at the later stage, contracts the innovation (Part 2 of Figure 4). It is more
appropriate if we run a separate Granger Causality test on each of the upward-sloping side and of
the downward-sloping side of the inverted-U relationship.
Running Granger causality test on the upward-sloping side of Figure 4, we obtain the
results in Table 6. Based on partial sample of 77,050 year-firm observations, Table 6 shows
better fits of regressions than the ones in Table 5. The R-squares in Table 6 improve significantly,
ranging between 0.2856 and 0.4952. Like the tests conducted in Table 5, I use two annual lags in
the baseline setup. Columns (1) to (4) check the Granger causality between innovation and
competition, proxied by the Lerner index, and columns (5) to (8) check the Granger causality
between innovation and competition, proxied by the Boone indicator.
As opposed to the Granger results in Table 5, which only show a negative bidirectional
causality between competition and innovation, Table 6 shows significant a positive bidirectional
causality between competition and innovation. For example, under column (1), there is a positive
0.1347 causality of running from competition (Lerner index) to innovation, and under column (2),
there is a positive 0.0477 causality of running from innovation to competition (Lerner index).
These findings are not surprising along an upward sloping curve, where innovation increases as
competition increases.
23
I repeat another Granger causality test on the downward-sloping side of Figure 4. The
results, based on partial sample of 37,876 year-firm observations, are presented in Table 7. As
opposed to the Granger results in Table 6, which shows a significant positive bidirectional
causality between competition and innovation, Table 7 shows that there is no significant
causality link between competition and innovation. For example, under column (1), technology
gap ratio is predicted by its own lags but is not predicted by the lags of the Lerner index, and
under column (2), Lerner index is predicted by its own lags but is not predicted by the lags of the
technology gap ratio. Same findings are found when more control variables are included, as in
column (3) and (4), as well as when the Lerner index is replaced by the Boone indicator, as in
column (5) till (8).
Table 7 suggests that competition and innovation do not have causality effect on one
another. Such findings are unexpected because it is contradicting the proposition of Schumpeter
(1942) who suggests that there is a negative relationship between competition and innovation
because of the diminishing monopoly power of concentrated firms that are losing motivation to
innovate.
5. Conclusion
This study analyzes the relationship between bank competition and bank innovation using
sample data from the banks of the first 11 Eurozone member states who founded the European
Economic and Monetary Union on 1 January 1999. As such, I collect my sample data as early as
1998. I use the technology gap ratio to measure bank innovation, and use the Lerner index and
24
the Boone indicator to measure bank competition. Across the sample period of this study, both
the Lerner index and the Boone indicator point out a general trend that the competition in the
banking industry decreases along with the falling number of banks in Europe.
Using a large sample of data from European banks, this paper seeks to contribute to the
literature on financial innovation in several respects. In the first respect, this study examines the
relationship between competition and innovation in the Eurozone banking industry. I examine
whether the relationship between bank competition and bank innovation exhibits a linear
relationship, as discovered in other industries by Schumpeter (1942), Nickell (1996), Blundell et
al. (1999), Carlin et al. (2004) and Okada (2005), or an inverted-U relationship, as indicated by
Aghion et al. (2005) and Bos et al. (2013). The findings support the latter, when I discover a
significant positive relationship between bank innovation and the coefficient of square term of
asset growth. This suggests that a bank may not improve its required technology as fast as its
business expansion at the initial stage of the industry cycle, but the bank increases its technology
level faster than its asset growth at the later stage. These findings are robust to both GLS and
OLS estimation methods, as well as alternative measures of bank competition such as the Boone
indicator, and remain consistent when I account for other controlled factors that exogenously
affect bank innovation.
In the second respect, using full sample of observations, I apply Granger causality tests to
examine the link between bank competition and bank innovation. Specifically, I am keen to find
out whether bank competition Granger-causes bank innovation or bank innovation Granger-
causes bank competition. The study considers Granger causality models with two lags, both
dependent and independent variables. Granger tests indicate a full negative bidirectional
25
causality between competition and innovation. These results are robust to both competition
proxies, Lerner index and Boone indicator, and to both GLS and OLS estimation methods. The
results remain stable when I control for other factors, including HHI and banking system assets
that impose state-level variation of different institutional settings.
In the third respect, I run Granger causality tests separately on both the negative slope
and the positive slope of the inverted-U curve. The results indicate a positive bidirectional
causation between competition and innovation along the upward slope, but deny any causality
link between competition and innovation along the downward slope. These results are robust to
both Lerner index and Boone indicator, and remain stable when I control for other factors,
including HHI and banking system assets that impose state-level variation of different
institutional settings.
In summary, this study suggests that bank competition and bank innovation display an
inverted-U relationship, and that both variables can be used to predict one another. However,
bank innovation and bank competition show positive bidirectional causation only along the
upward slope, that is, when both variable are rising together. After the peak of the inverted-U
curve, there is no significant causality between competition and innovation.
The fact that there is a positive causality between competition and innovation provides
new propositions from two angles. First this evidence supports the assumption of Aghion et al.
(2001) who claim that competition cultivates innovation as firms attempt to excel to overcome
peer pressure and excel in business. Second, new technologies can profoundly affect the
functioning of the banking industry and improve its competition. The most recent examples
include the use of mobile banking apps that are disrupting conventional in-store banking
26
business. These disruptive innovations can deliver important benefits to competition and
consumers, in terms of new and better services, and can stimulate price competition from
established providers.
On the other hand, the fact that the causality effect stops after certain threshold point
suggests that more competition does not motivates further innovation because there is a ultimate
bottleneck in technological advancement. It also suggests that banks are no longer willing to
spend more money to deliver innovation because the marginal cost of innovation exceeds the
marginal benefit of hammering competitors. Along with technological advancement, bank
market liberalization and deregulation have aided the process of bank mergers and acquisitions.
As a result, the bank industry has become more concentrated and less competitive.
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Figure 1: Total number of banks in Eurozone, 1998-2015

8,500
8,000
7,500
7,000
6,500
6,000
5,500
5,000
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Figure 2: Competition Level - proxied by Lerner Indices

0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
Belgium Germany Ireland Spain
France Italy Luxembourg Netherlands

Austria Portugal Finland
32
Figure 3: Competition Level - proxied by Boone indicators

0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
-0.02
-0.04
-0.06
-0.08
-0.1
-0.12
-0.14
-0.16
Belgium Germany Ireland Spain

France Italy Luxembourg Netherlands
Austria Portugal Finland
33
Table 1: Yearly number of banks across 11 Eurozone states

Year Belgium Germany Ireland Spain France Italy Luxembourg Netherlands Austria Portugal Finland Total by year
1998 123 3,238 78 402 1,226 934 212 634 898 227 348 8,320
1999 117 2,996 80 386 1,163 894 209 615 878 223 345 7,906
2000 118 2,742 81 368 1,099 861 202 586 848 218 341 7,464
2001 112 2,526 88 366 1,050 843 194 561 836 212 369 7,157
2002 111 2,363 85 359 989 821 184 539 823 202 369 6,845
2003 108 2,225 80 348 939 801 172 481 814 200 366 6,534
2004 104 2,148 80 346 897 787 165 461 796 197 363 6,344
2005 100 2,089 78 348 854 792 157 401 818 186 363 6,186
2006 105 2,050 78 352 829 807 154 345 809 178 361 6,068
2007 110 2,026 81 357 808 821 155 341 803 175 360 6,037
2008 105 1,989 501 362 728 818 153 302 803 175 357 6,293
2009 104 1,948 498 352 712 801 147 295 790 166 349 6,162
2010 106 1,929 489 337 686 778 146 290 780 160 338 6,039
2011 108 1,898 480 335 660 754 141 287 766 155 327 5,911
2012 103 1,869 472 314 639 714 141 266 751 152 313 5,734
2013 103 1,842 458 290 623 694 147 253 731 151 303 5,595
2014 103 1,808 446 226 496 670 148 218 707 150 271 5,243
2015 99 1,774 416 218 467 656 143 209 678 147 281 5,088
Total 114,926
0
Table 2: Variables, Definitions and Summary Statistics, 1998-2015

Variable Definition Mean Std Dev Min Max Kurtosis Skewness
TC Total cost 816.5470 2,538.1470 0.0420 30,215.1550 3.2482 2.547
PBT Profit before taxes 288.4780 752.9540 0.5050 25,102.7520 -0.0152 0.3582
Y1 Loans 23,415.6870 68,214.7420 0.1010 1,025,478.3580 2.5473 -1.3205
Y2 Investments 20,421.6750 62,357.1590 0.1000 1,256,853.2480 0.2523 -0.2852
Y3 Off-balance sheet items 33,543.6150 125,789.3470 0.1200 10,254,783.2140 1.8523 -0.5852
W1 Labor price 0.1296 0.7563 0.000 89.5260 1.285 -0.2483
W2 Financial capital price 0.0156 0.5246 0.000 0.7260 2.302 0.5893
W3 Physical capital price 2.0950 7.1248 0.0010 45.6520 2.142 -1.214
Z Equity/assets 11.0776 35.2654 0.0010 105.3250 -1.2452 0.4975
Assets Total assets 64,899.8750 185,246.9530 1,500.0100 2,485,789.2010 -0.2583 1.2145
N=114,926. All variables are denoted in 1,000s of EUR, corrected for inflation
Table 3: Technology Gap Ratios Summary Statistics by countries, 1998-2015

Country Mean Std Dev Min Max Kurtosis Skewness
Belgium 0.6894 0.0746 0.385 1 -1.4383 0.2328
Germany 0.7839 0.096 0.295 1 -0.9312 0.3391
Ireland 0.9642 0.0755 0.455 1 1.4689 -1.3019
Spain 0.9998 0.1053 0.5698 1 8.0000 -4.2426
France 0.6053 0.0685 0.2589 1 0.2823 0.8690
Italy 0.8797 0.0856 0.4325 1 -1.5485 -0.3043
Luxembourg 0.5991 0.0542 0.1025 1 -1.3142 0.4977
Netherlands 0.7855 0.0754 0.2587 1 1.4707 -0.2460
Austria 0.6813 0.0701 0.1896 1 1.4142 -0.4665
Portugal 0.7553 0.0851 0.3548 1 -1.5783 0.2968
Finland 0.8371 0.0985 0.4589 1 -1.4403 -0.2424
1
10940
Table 4: Competition and technology gaps

(1) (2) (3) (4) (5) (6) (7) (8)
Specification estimation GLS OLS GLS OLS GLS OLS GLS OLS
Competition (Lerner) 1.4200*** 0.9550*** 1.2102*** 0.5470***

(0.0855) (0.1866) (0.0555) (0.1210)
Competition^2 (Lerner) -0.6450*** -0.2451*** -0.6211*** -0.0850***
(0.0244) (0.0584) (0.0548) (0.0210)
Competition (Boone) 2.5601*** 1.6551** 1.5600*** 1.2320***
(0.7588) (0.8271) (0.0852) (0.0152)
Competition^2 (Boone) -0.0560*** -0.0050* -0.0020** -0.0140*
(0.0140) (0.0030) (0.0010) (0.0082)
Equity/total assets 0.0010*** 0.0000** 0.0120*** 0.0251***
(0.0000) (0.0000) (0.0001) (0.0001)
Market share (log) -1.5870*** -0.8751* -1.4231*** -1.4250*
(0.1753) (0.5117) (0.1247) (0.8096)
Total Assets (log) -0.0040*** 0.0150** 0.0220*** 0.0210*
(0.0000) (0.0000) (0.0000) (0.0117)
Asset growth -4.4561*** -1.1231 -3.1251*** -1.1122**
(1.2632) (1.2815) (0.3952) (0.5295)
Asset growth (squared) 0.5473*** 0.4252* 0.2121*** 0.0127
(0.0914) (0.2361) (0.0353) (0.0140)
Herfindahl Hirshman Index 3.1251*** 1.4523*** 1.1217*** 1.2149*
(0.6242) (0.1782) (0.2802) (0.7142)
Country dummies No No Yes Yes No No Yes Yes
Fixed/Random effects Fixed Fixed Random Random Fixed Fixed Random Random
Observations 89582 114926 89582 114926 89582 114926 89582 114926
Number of banks 7457 8320 7457 8320 7457 8320 7457 8320
R-square 0.45 0.33 0.55 0.48 0.34 0.30 0.44 0.41
Hansen J statistics 1.745 1.895 0.797 0.547 2.142 2.485 0.658 0.756
p-value 0.12 0.1566 0.678 0.845 0.1452 0.2275 0.687 0.566

Based on Eq. (11). Clustered standard errors in parentheses; Asterisks indicate significance at the following levels: *0.10, **0.05, ***0.01
Table 5: Granger causality tests between competition and innovation (technology gaps)
(1) (2) (3) (4) (5) (6) (7) (8)
Dependent variable Tech. Gap Lerner Tech Gap Lerner Tech Gap Boone Tech Gap Boone
Tech. Gap (t-1) -0.3458*** -0.0015*** -0.3042*** -0.0025*** -0.3658*** -0.0121*** -0.3254*** -0.0358***
(0.0024) (0.0004) (0.0253) (0.0003) (0.0515) (0.0010) (0.0421) (0.0095)
Tech. Gap (t-2) -0.1452*** -0.0000 -0.0958*** -0.0000 -0.1825*** -0.0120*** -0.1285*** -0.0100**
(0.0145) (0.0010) (0.0092) (0.0001) (0.0085) (0.0085) (0.0258) (0.0080)
Tech. Gap (Total) -0.4910 -0.0015 -0.4000 -0.0025 -0.5483 -0.0132 -0.4539 -0.0458
F-statistic 875.00*** 14.52*** 820.00*** 12.25*** 745.00*** 10.21*** 786.00*** 22.32***
Lerner (t-1) 0.1254*** -0.3256*** 0.1045*** -0.2965***
(0.0245) (0.0263) (0.0142) (0.0152)
Lerner (t-2) -0.3254 -0.1425*** -0.2352 -0.1025***
(0.6523) (0.0142) (0.3253) (0.0015)
Lerner (Total) -0.2000 -0.4681 -0.1307 -0.3990
F-statistic 124.85*** 754.22*** 105.87*** 741.36***
Boone (t-1) 0.0214*** -0.4235*** 0.0125*** -0.3954***
(0.0025) (0.0423) (0.0001) (0.0052)
Boone (t-2) -0.1247 -0.0879*** -0.0951 -0.0541***
(0.1125) (0.0010) (0.0852) (0.0014)
Boone (Total) -0.1033 -0.5114 -0.0826 -0.3413
F-statistic 143.54*** 812.22*** 148.99*** 712.52***
Market share (log) -0.0458*** -0.0325*** -0.0025*** -0.0018*** -0.0596*** -0.0358*** -0.0412*** -0.0012***
(0.0010) (0.0025) (0.0001) (0.0002) (0.0002) (0.0025) (0.0012) (0.0001)
Total Assets (log) -0.0214*** -0.0120*** -0.0020 -0.0001 -0.0852*** -0.0423*** 0.0000 0.0000
(0.0025) (0.0010) (0.0100) (0.0020) (0.0023) (0.0024) (0.0001) (0.0010)
Asset growth 0.0254*** 0.0101*** 0.0485*** 0.0125
(0.0052) (0.0010) (0.0125) (0.0526)
Asset growth (squared) -0.0025*** -0.0152*** -0.0251** -0.0152
(0.0001) (0.0002) (0.0035) (0.0523)
Herfindahl Hirshman index -0.2233* -0.0024* -0.0025* -0.2521*
(0.1313) (0.0014) (0.0015) (0.1483)
Banking system assets (log) -0.1859*** -0.2524*** -0.0002** -0.0205
(0.0258) (0.0014) (0.0001) (0.0325)
Observations 114926 114926 114926 114926 114926 114926 114926 114926
Number of banks 8320 8320 8320 8320 8320 8320 8320 8320
R-squared 0.1545 0.3526 0.1725 0.4025 0.1424 0.3356 0.1728 0.3825
Clustered standard errors in parentheses
*** p<0.01, ** p<0.05, * p<0.1; Herfindahl Hirshman index and banking system assets are measured on the state level.
1
Table 6: Granger causality tests between competition and innovation on the upward slope
(1) (2) (3) (4) (5) (6) (7) (8)
Tech. Gap (t-1) 0.2541*** 0.0425*** 0.4012*** 0.0105*** 0.2589*** 0.0015*** 0.2689*** 0.0028***
(0.0021) (0.0021) (0.0253) (0.0003) (0.0421) (0.0001) (0.0214) (0.0001)
Tech. Gap (t-2) 0.1042*** 0.0052*** -0.0248*** 0.005 -0.0025*** -0.0011 -0.0015*** -0.0125
(0.0015) (0.0001) (0.0092) (0.0100) (0.0006) (0.0058) (0.0005) (0.0852)
Tech. Gap (Total) 0.3583 0.0477 0.3764 0.0155 0.2564 0.0004 0.2674 -0.0097
F-statistic 795.00*** 18.26*** 685.00*** 21.25*** 705.00*** 11.15** 658.00*** 13.55**
Lerner (t-1) 0.0258*** 0.2536*** 0.0982*** 0.0985**
(0.0015) (0.0025) (0.0002) (0.0456)
Lerner (t-2) 0.1089 -0.1528*** 0.0852 -0.1025***
(0.1589) (0.0258) (0.0898) (0.0005)
Lerner (Total) 0.1347 0.1008 0.1834 -0.0040
F-statistic 110.55*** 625.55*** 102.55*** 632.25***
Boone (t-1) -0.0526*** 0.0852*** 0.0325*** 0.0756***
(0.0010) (0.0025) (0.0001) (0.0022)
Boone (t-2) -0.0015 0.0563*** -0.0025 0.058***
(0.0152) (0.0001) (0.0125) (0.0015)
Boone (Total) -0.0541 0.1415 0.0300 0.1336
F-statistic 25.85*** 352.55*** 15.58** 258.44***
Market share (log) -0.0356*** -0.0256*** -0.0145*** -0.0052*** -0.0248*** -0.0582*** -0.0121*** -0.0201***
(0.0040) (0.0025) (0.0001) (0.0002) (0.0002) (0.0022) (0.0012) (0.0001)
Total Assets (log) -0.0156*** -0.0020*** -0.0120 -0.0001 -0.0772*** 0.2533*** 0.0002 0.0000
(0.0045) (0.0001) (0.0100) (0.0020) (0.0025) (0.0035) (0.0035) (0.0010)
Asset growth 0.0094*** 0.0204*** 0.0555*** 0.0269
(0.0023) (0.0010) (0.0155) (0.1025)
Asset growth (squared) -0.0143*** 0.0102*** -0.0244*** -0.1025
(0.0011) (0.0002) (0.0065) (0.5283)
Herfindahl Hirshman index -0.0253 -0.0020 -0.0005 -0.1521
(0.4564) (0.0032) (0.0015) (0.1685)
Banking system assets (log) 0.0125*** -0.2524*** -0.0102*** -0.0102
(0.0025) (0.0028) (0.0050) (0.0444)
Observations 77050 77050 77050 77050 77050 77050 77050 77050
Number of banks 5574 5574 5574 5574 5574 5574 5574 5574
R-squared 0.2856 0.4823 0.3052 0.4952 0.2652 0.4028 0.2935 0.4258
2
Table 7: Granger causality tests between competition and innovation on the downward slope
(1) (2) (3) (4) (5) (6) (7) (8)
Tech. Gap (t-1) 0.1523*** -0.0254 0.1852*** -0.0248 0.0258*** -0.0025 0.0685*** -0.0021
(0.0024) (0.2562) (0.0025) (0.0245) (0.0025) (0.0125) (0.0043) (0.0059)
Tech. Gap (t-2) 0.0154*** -0.0025 -0.0014*** -0.0011 0.0025*** -0.002 0.4856*** -0.0336
(0.0025) (0.0058) (0.0001) (0.0058) (0.0001) (0.0250) (0.0025) (0.0800)
Tech. Gap (Total) 0.1677 -0.0279 0.1838 -0.0259 0.0283 -0.0045 0.5541 -0.0357
F-statistic 654.00*** 2.05 580.00*** 2.15 550.00*** 1.52 510.00*** 2.11
Lerner (t-1) -0.1587 0.0478*** -0.0258 0.0578***
(0.2523) (0.0210) (0.1852) (0.0152)
Lerner (t-2) -0.0254 -0.0523*** -0.0589 -0.0214***
(0.0526) (0.0250) 0.1058 (0.0025)
Lerner (Total) -0.1841 -0.0045 -0.0847 0.0364
F-statistic 3.05 568.00*** 2.89 525.00***
Boone (t-1) -0.0458 0.1058*** -0.2535 -0.0235***
(0.0852) (0.0254) (0.4258) (0.0058)
Boone (t-2) -0.0025 -0.0254*** -0.0254 0.0852***
(0.0254) (0.0002) (0.0658) (0.0025)
Boone (Total) -0.0483 0.0804 -0.2789 0.0617
F-statistic 4.25 458.00*** 3.55 385.00***
Market share (log) -0.0856*** -0.0645*** -0.0155*** -0.0108*** -0.0352*** -0.0748*** -0.0952*** -0.0212***
(0.0025) (0.0025) (0.0015) (0.0015) (0.0015) (0.0075) (0.0025) (0.0085)
Total Assets (log) -0.0956*** -0.0240*** -0.0120 -0.0018 -0.0741*** -0.0896*** 0.0080 0.0000
(0.0105) (0.0010) (0.0250) (0.0056) (0.0025) (0.0055) (0.0080) (0.0021)
Asset growth 0.0344*** 0.0258*** 0.0563*** 0.0665
(0.0063) (0.0010) (0.0085) (0.0852)
Asset growth (squared) -0.0185*** -0.0222*** -0.0858*** -0.0285
(0.0012) (0.0002) (0.0035) (0.0110)
Herfindahl Hirshman index -0.0589 -0.0015 -0.0125*** -0.1221
(0.1058) (0.0014) (0.0005) (0.1483)
Banking system assets (log) -0.1526*** -0.1232*** -0.0002** -0.0104
(0.0345) (0.0011) (0.0001) (0.0852)
Observations 37876 37876 37876 37876 37876 37876 37876 37876
Number of banks 2746 2746 2746 2746 2746 2746 2746 2746
R-squared 0.1825 0.3058 0.2052 0.3522 0.1628 0.2582 0.1825 0.3025

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Competition and Innovation

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Kienpin Tee, Zayed U., kienpin.tee@zu.ac.

Relationship and Granger Causality between Competition

Banks in the Eurozone

innovation along the downward slope.

Keywords: Competition, Innovation, Stochastic frontier analysis, Granger causality, Technology

gap ratio, Lerner index, Boone indicator, Bank, Eurozone

JEL Classification: D21, G21, L10, O30

members with respect to different benchmark currencies.

competition would increase bank productivity through bank innovation.

uniform standard in acquiring licenses, maintaining capital requirements, and meeting

of the additional twelve new member-states.

To analyze the relationship between competition and innovation in Eurozone banks, I

and price competition from established providers.

innovation reveals an inverted-U relationship.

longer improve any competition.

returns effect starts to dominate the relationship.

*** Insert Figure 1 ***

banking industry has discouraged bank innovation.

low or high competitive environment.

Accordingly, it is ambiguous whether a change in bank competition precedes a change in

evidence of unidirectional Granger causality from bank competition to economic growth as

Hashmi et al. (2005))

3. Data and Methodology

*** Insert Table 1 ***

different characteristics by including some state-level control variables such as Herfindahl

3.2 Measuring Innovation - Technology gap ratio

motivation of financial innovation for a long time.

estimated using stochastic frontier analysis:

TCit  f * ( wit , yit , zit )e vit  uit (1)

assumed to be i.i.d. and is independent of vit.

Following Bos and Schmiedel (2006), I treat a bank as an intermediary between

*** Insert Table 2 ***

variables in estimating the technology gaps.

markets. Cost efficiency score estimates are obtained as follows:

CEit  exp( ˆ it ) (2)

minimum cost meta frontier (fmeta) as follows:

subject to ln f * ( wit , yit , z it )  ln f meta ( wit , yit , zit )

technology gap is defined as:

f meta ( wit , yit , zit )

member states from 1998 to 2015.

*** Insert Table 3 ***

3.3 Measuring Competition - Lerner Index

*** Insert Figure 2 ***

3.4 Measuring Competition - Boone Indicator

Another popular way of measuring competition is the Boone indicator, as introduced by

more robust than the Lerner-Index.

curve of the form:

p(qi , q j  i )  a  bqi  d  q j (7)

equilibrium can then be written as:

a  2bqi  d  q j  mci  0 (8)

qi (mci )  [(2b / d  1)a  (2b / d  N  1)mci   mc j ] / [(2b  d ( N  1))(2b / d  1)] (9)

(2bp / d p  1)a p  (2bp / d p  N p  1)mc1, p   j mc jp

BI  d  1, p / dmc1, p ( mc1, p /  1, p )  0 (11)

the Boone indicator, the higher the degree of competition.

*** Insert Figure 3 ***

4. Empirical Results and Discussions

4.1 The Impact of Competition on Innovation

*** Insert Table 4 ***

when the competition index is around 0.6.

*** Insert Figure 4 ***

its business is supported by updated technology.

4.2 Granger Causality Tests

innovation. In other words, I analyze whether

a) bank competition Granger-causes bank innovation (if predictions of innovation based

* Insert Figure 1 *

* Insert Table 1 *

* Insert Table 2 *

* Insert Table 3 *

* Insert Figure 2 *

* Insert Figure 3 *

* Insert Table 4 *

* Insert Figure 4 *

* Insert Table 5 *

* Insert Table 6 *

* Insert Table 7 *

Competition (Lerner) 1.4200* 0.9550* 1.2102* 0.5470*