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Bank
Does bank competition promote competition
economic growth? Empirical
evidence from selected
South Asian countries 201

Bijoy Rakshit and Samaresh Bardhan Received 5 July 2018

Revised 3 October 2018
Department of Humanities and Social Sciences (HSS), 27 December 2018
27 February 2019
Indian Institute of Technology Ropar, Ropar, India 12 March 2019
Accepted 21 March 2019
Abstract
Purpose – Bank competition and financial stability are often cited as important drivers of economic growth.
Bank competition plays a very significant role in enhancing the efficiency and determining the stability of a
financial system. However, a question of interest is whether bank competition enhances or hindrances the
economic growth of a country. The purpose of this paper is to investigate the role of bank competition and
financial stability on economic growth for selected South Asian economies over the period 1997–2016.
Design/methodology/approach – To investigate whether bank competition enhances or hinders economic
growth, the author applies a two-step estimation technique. First, the author estimates bank competition using
the Lerner index and adjusted Lerner index and, second, examines the joint effect of bank competition and
financial stability on economic growth applying both panel regression model and system GMM techniques.
Findings – Empirical findings reveal that the banking sector in South Asian economies is competitive as
indicated by the estimated values of Lerner and adjusted Lerner index. Moreover, the joint effect defined by
the interaction between banking competition and banking stability also reveals a positive and significant
impact on economic growth. This finding implies that both banking competition and banking stability are
significant long-term determinants of economic growth in South Asian economies.
Practical implications – This paper suggests flexible banking regulation policies such as low net interest
rate margins, lesser activity restrictions and entry of foreign banks along with few contestability measures to
increase bank competition in South Asian countries. This is because as higher the competition, greater is the
chance for efficient allocation of resources and hence economic growth.
Originality/value – This paper is the first of its kind that considers the joint role of bank competition and
financial stability on economic growth. The application of a semi-parametric approach in the estimation of
marginal cost is also a unique contribution to empirical literature.
Keywords Economic growth, Lerner index, Bank competition, Semi-parametric
Paper type Research paper

1. Introduction
How does bank competition affect economic growth? Despite the importance of this question
to regulators and policy makers, there has not been a broad attempt to answer it. The
relationship between bank competition and economic growth has remained as an inconclusive
policy and academic debate. This is due to the reason that the theoretical predictions on the
effect of bank competition on economic growth are not well documented. Two strands of
literature discuss the direct and indirect effect of bank competition on economic growth. The
first strand of literature that focuses on relationship lending, as well as the relevance of bank
competition on firms’ access to finance, affect the long-run economic growth indirectly (Rajan,
1992; Petersen and Rajan, 1995; Berlin and Mester, 1999). In the second stream of literature,
few studies embarked on the direct impact of bank competition on economic growth (Boot and
Thakor, 2000; Cetorelli and Gambera, 2001; Claessens and Laeven, 2004a, b; de Guevara and
Maudos, 2011). Boot and Thakor (2000) suggest that fiercer bank competition always results
South Asian Journal of Business
in higher economic growth as the competitive banking system provides greater availability of Studies
credit to firms at lower interest rates. Vol. 8 No. 2, 2019
pp. 201-223
However, there has been a growing body of empirical literature that questions whether © Emerald Publishing Limited
2398-628X
the role of financial stability should be addressed while analyzing the relationship between DOI 10.1108/SAJBS-07-2018-0079
SAJBS bank competition and economic growth[1]. There is an association between bank
8,2 competition and financial stability, and it is considered as a highly contested issue in
financial literature (Keeley, 1990; Allen and Gale, 2004; Yeyati and Micco, 2007; Beck et al.,
2010; Kasman and Carvallo, 2014). There are also separate studies on the role of bank
competition on stability. The question of whether bank competition is good or bad for its
stability has been a widely debated issue in academic and regulatory circles (Schaeck and
202 Cihák, 2014). Despite the enormous volume of published research that has been carried out
separately on bank competition and stability, there appears to be no consensus on the joint
role of bank competition and financial stability on economic growth. This study attempts to
examine the role of bank competition and financial stability on economic growth in some
selected South Asian economies to address the gaps.
The South Asian economies provide a very fertile ground to investigate the relationship
between bank competition and economic growth. The primary objective of financial sector
liberalization in South Asian economies was to promote bank competition and foster economic
growth through regional financial development. Following a tedious economic performance,
the financial system in these economies has undergone several structural changes[2]. The
South Asian economies have experienced significant structural transformation from a highly
regulated banking system to a competitive one. The structural transformations in South
Asian economies have potentially led to the liberalization in the banking sector by reducing
the interest rates spread. In addition, several deregulation measures made the entry norms of
foreign banks easy with the help of the South Asian Association for Regional Cooperation and
the World Trade Organization.
These structural changes mentioned above have made the financial sector in the region
more competitive and efficient (Perera et al., 2006). However, there has been an ongoing
debate on the achievements of liberalization policies in the region. Most of the liberalization
programs were undertaken with the purpose of allowing foreign bank’s entry, removing
restrictions on banking activities, minimizing government interference, adopting more
liberal interest rate policy and other structural reforms. There is a consensus that even after
two decades of financial sector reforms, there is a dearth of information whether the
liberalization programs that changed the scenario of commercial banking actually fostered
growth substantially. In recent times, empirical evidence supports that economies with the
vibrant financial sector and effective implementation of financial sector policies have
witnessed a gradual increase in banking competitiveness. Despite the growing volume of
literature emerged on the measurement issues of bank competition, there is no literature that
considers both bank competition and economic growth in South Asian economies. Hence,
investigating the impact of bank competition on economic growth gathers a great deal of
attention from regulators and policy makers.
Given the background, we are motivated by the following arguments. First, bank
competition improves the quality of financial products and services by boosting the
efficiency of the production process (Cecchetti et al., 2011). It also introduces a certain degree
of innovations in the financial sector, which in turn augments the overall growth of
the banking industry in the long run. Over the decades, extant literature documented the
relationship between competition and stability, which has long been identified in banking
literature and validated the linkage in the actual pursuit of competition policy (Carletti and
Hartmann, 2003; Vives, 2001, 2010; Martinez-Miera and Repullo, 2010). Second, growth
potential and the economic development of a nation largely depend upon the financial
services that map the nexus between users and providers of capital. In bank-based financial
systems, banks play a crucial role in transferring the services through mobilization and
allocation of savings and, therefore, a competitive banking system has potential
repercussion on the allocation of capital, level of firms’ growth, industrial expansion and
hence economic development (Berger et al., 2003; Jayaraman et al., 2016). Third, in contrast,
policy makers argue that if the degree of bank competition appears to be less, it might Bank
adversely affect the banking system by making the system more costly. The higher cost competition
may lead to the reduction in quality of banking services, thereby curtailing the effective
demand for external financing and resulting in promoting sub-optimal growth (Claessens
and Leaven, 2005). Motivated by these arguments, we attempt to examine the impact of
bank competition on economic growth by addressing the following three questions:
RQ1. Does banking competition in South Asian countries enhance the economic growth? 203
RQ2. Does banking stability exert a significant positive impact on economic growth?
RQ3. What is the joint role of bank competition and banking stability on economic growth?
Our major concern is to deal these three questions in the light of South Asian countries.
The empirical literature on the consanguinity between bank competition and economic
growth reveal contradictory findings. Prevailing theories render the ambiguous answer to
the question of how banking competitiveness assists firms’ access to finance and stimulates
growth through employment generation and firm creation. However, the significant impact
of bank’s market structure and competition on access to external finance and growth has
received a great deal of attention from academicians and policy makers (e.g. Rajan and
Zingales, 1998; Boot and Thakor, 2000; Berger et al., 2004, Zarutskie, 2006). Conventional
economic theories argue that banks exercising higher monopoly power often reach a point
where they charge higher interest rates. Higher interest rates always result in a lesser
quantity of credit to firms (Maudos and Fernandez de Guevara, 2006). Therefore, given the
investment projects and opportunities, there is a greater likelihood that banks exercising
higher market power will reduce the incentives to invest in those sectors that are heavily
reliant on external finance. However, an alternative view has emerged which states that the
potential role of bank competition on credit availability may be linked to the degree of
asymmetric information in the market (DellAriccia and Marquez, 2005; Sengupta, 2007). A
less competitive banking market is likely to be associated with more credit availability and
can significantly affect the growth trajectory of an economy (Petersen and Rajan, 1995).
In this context, this paper makes the following contributions. Principally, this paper
analyzes the association between bank competition and economic growth and further goes
on investigating the impact of banking stability, in particular, and the joint effect of bank
competition and banking stability, in general, on economic growth in South Asian countries.
First, we use a two-stage estimation approach to study the core objective of examining bank
competition on economic growth. In the first stage, we estimate the Lerner (1934) index and
adjusted Lerner index (Koetter et al., 2012) to assess the competitive conduct of six South
Asian countries (Afghanistan, Bangladesh, India, Nepal, Pakistan and Sri Lanka) covering
the period 1997–2016. Second, as opposed to parametric and nonparametric approach, we
estimate the Lerner index and adjusted Lerner index using a semi-parametric approach.
This semi-parametric approach is claimed to be an improvement over commonly used
parametric approaches because it allows for a flexible cost function. In the second stage, we
applied the Lerner index and adjusted Lerner index (a measure of bank competition) and
Z-score (a measure of bank stability) as explanatory variables along with another set of
variables. Third, this study is the first of its kind that considers both bank competition and
financial stability and its impact on economic growth in South Asian economies.
The outcomes of this study provide some important insights for policy makers and
regulators. Information pertaining to the positive association between bank competition and
economic growth influences the priorities set by the policy makers and advisors in
formulating the financial sector policies. Furthermore, the credible empirical evidence
regarding the positive impact of banking stability on economic growth highlights the need
for research in the determinants of financial development to ensure the banking stability.
SAJBS Policy makers should ensure a competitive banking environment in the South Asian
8,2 countries considering the fact that a competitive banking system will allocate resources
more efficiently, and, as a result, economic growth in these countries might experience a
positive growth. To this end, the central banks of these respective countries should aim at
strengthening policies that favor competition in their individual banking sector.
The rest of this paper is structured as follows. Section 2 provides a brief overview of
204 South Asian banking markets. Section 3 delineates the relevant empirical literature about
bank competition and its relationship with economic growth. Section 4 explains the
methodology and data sources. Section 5 produces empirical findings and discusses the
results. Finally, Section 6 concludes the paper with some policy recommendations.

2. An overview of South Asian banking markets

One of the major objectives of financial sector deregulation in South Asia was to enhance
economic performance via bank competition. However, after a decade of liberalization, the
performance of the financial sector in these regions remained controversial among a group of
policy makers. This is due to the paucity of information whether the degree of bank
competition in these economies is positively contributing to economic growth. In order to
provide an idea about the recent progress of South Asian banking industry, we present
Table I that describes a brief statistics of selected South Asian banking markets. It is evident
from the statistics that commercial banking sectors in this region constitutes relatively higher
values for the ratio of total banking sector assets to the real gross domestic product (GDP).
However, the total deposits of customers to real GDP in the selected countries are also
considerably high. The cumulative credit lending of the commercial banks to private and
government institutions exceeds customer deposits to real GDP ratios, and therefore
commercial banks in this region considered an important intermediate between savers and
investors in the process of allocation of capital. As far as the structure of banking market is
concerned, the market structure of these countries is relatively concentrated as the domestic
banks (both private domestic banks and state-owned) dominates the foreign-owned banks in
terms of assets and liabilities. The reason for dominance is that in this region the foreign
sector banks are operating only in major cities with limited branch expansions.
In the year 2016, there were total 250 licensed commercial banks in the six countries of
South Asia of which 65 were foreign-owned. However, the operations of foreign banks in

Afghanistan Bangladesh India Nepal Pakistan Sri Lanka

Number of licensed commercial banks 15 57 88 34 31 25

Of which domestic/foreign* 12/3* 48/9* 57/31* 29/5* 27/4* 12/13*
Total bank assets to real GDP na 62 61 59 60 57
Non-performing loans to total gross
loans (%) 11.07 8.39 9.18 na 12.15 2.63
Domestic credit to government by banks
(% of GDP) na 08 23 09 16 10
Domestic credit to private sector by banks
(% of GDP) 3.59 44.44 49.77 80.83 16.39 45.81
Depositors with commercial banks
(per 1,000 adults) 188.98 724.90 1731.2 657.0 380.09 na
Borrowers from commercial banks
Table I. (per 1,000 adults) 3.05 73.02 14.05 na 21.17 18.58
Overview of South Commercial bank branches (per 1,000 adults) 2.21 8.44 7.15 9.58 10.38 7.81
Asian banking Note: *Denotes the number of foreign banks among total number of commercial banks
markets 2016 Source: Author’s calculation
these regions are limited, and they have centered their operations in major cities with limited Bank
branch networks. The commercial banking sector in India that evolved over the last two competition
decades is still growing while providing banking services to a large section of Indian
population. In Afghanistan, the commercial banking segment comprises – state-owned
banks (SOBs), private commercial banks (PCBs) and foreign banks. As of December 2016,
the banking system in Afghanistan embodies 15 fully licensed commercial banks with few
branches of foreign banks. According to the Central bank of Afghanistan (2016) report on 205
“Banking Supervision – Quarterly Financial Sector Financial Statistics, Q4,” the commercial
banking in Afghanistan comprises 416 branches of which SOBs own 130 branches, 279
branches are owned by PCBs and only 7 branches are for foreign banks. It is worthwhile to
mention that despite the gradual boom in the Afghan banking industry, most Afghans
remained “unbanked” with only a small percentage of Afghan’s currency holding.
The commercial banking scenario in Bangladesh does not significantly differ from
the rest South Asian countries. The commercial banking industry in Bangladesh is
predominant by government-owned banks with a very limited presence of foreign banks.
The banking sector in Bangladesh has four categories of scheduled banks – state-owned
commercial banks (SCBs), state-owned development financial institutions, PCBs and foreign
commercial banks. Moreover, one newly licensed PCB was permitted to operate in 2016.
As a result, the number of scheduled commercial banks increased to 57 in 2016 from 56 in
2015. The number of bank branches also increased to 9,654 in December 2016 from 9,397 in
December 2015. At the end of June 2017, the total number of bank branches increased further
to 9,720. The foreign-owned branches in Bangladesh own 31 out of 4,925 total commercial
bank branches. Financial sector liberalization in Bangladesh commenced in the year 1982 with
the de-nationalization of two of the six (Pubali and Uttara Bank) previously nationalized banks
(NCBs) with the priority to enhance competitiveness in the entire banking industry.
Since the 1990s, the banking system in India has undergone significant structural
transformation and witnessed a huge emergence of financial institutions for providing
banking services to different sectors of the economy. Post financial sector reforms in 1992,
the sector was opened to greater competition by withdrawing the entry restrictions on new
private sector banks and by adopting more liberal entry policy for foreign banks in line with
the recommendations of the Report of the Committee on the Financial System (chaired by
Shri M. Narasimham).In India, as of 2016–2017, only 288 out of 116,394 commercial bank
branches were foreign owned (Reserve Bank of India, 2016/2017, p. 170). Public and private
sector banks report 91,445 and 24, 661 bank branches, respectively. The foreign sector
banks account approximately 4 percent of India’s total deposits.
As far as Pakistan is concerned, the banking industry in Pakistan is strictly regulated
and controlled by the central bank (State Bank of Pakistan) till the mid-1990s. The process
of financial sector liberalization in Pakistan has potentially led to the privatization of SCBs
and encouragement of few private sector banks to adopt market-oriented practices. It is
worth mentioning that the major challenges faced by the banking industry in Pakistan in
ensuring a competitive and efficient sector have been the dominance of inefficient
government-owned banks, massive political interventions and high administrative cost
associated with low productivity (State Bank of Pakistan, 2004). As of 2016, the total
number of reported commercial banks in Pakistan stood as 31, of which 5 banks are public
sector commercial banks, 21 banks are domestic private banks and 4 banks are foreign
banks only. In short, all the six banking markets over the years have undergone significant
structural transformations with the aim to improve productivity, efficiency and
competitiveness to realize the potential growth of the financial sector in particular and
economic growth in general.
The history of modern commercial banking in Nepal started in 1937 when Nepal Bank
Limited was set up. However, it did not come into the notice of public until 1989; Nepal
SAJBS started to liberalize the banking sector in the country. As a result, more liberal policies were
8,2 taken toward foreign and private sector banks. At present, out of 34 commercial banks, only
5 foreign banks are operating in Nepal As of July 2016, the total number of branches of
commercial banks increased to 1,682. Nepal Rastra Bank has consistently been encouraging
the commercial banks to open bank branches in remote areas to bring the unbanked people
to the banking system. While the number of commercial bank branches has been increasing
206 gradually every year, a large number of bank branches are largely concentrated in urban
areas only. Operations of commercial banks still seem to be concentrated in the central
region with 835 branches (49.6 percent of total branches). Eastern Development Region and
Western Development Region in Sri Lanka account 18.37 (309 banks) and 17.42 percent (293)
of total bank branches. The far western has the lowest number of bank branches, i.e.
93 (5.53 percent of total branches).
Sri Lanka had undertaken deregulation measures in 1977 by permitting the domestic
banks to raise their interest rates base with market interest rates to ensure a positive real rate
of return to its savers. The commercial banking sector in Sri Lanka is considered as the most
important sector in the domestic financial system. The banking sector in Sri Lank continued to
expand its assets base and branch networks very rapidly. As of 2015–2016, Sri Lanka has a
total of 25 licensed commercial banks, of which 13 banks are domestic banks and 12 banks are
foreign (Central Bank of Sri Lanka, 2015-2016). The banking sector in Sri Lanka continued its
support for economic growth and development by enhancing its banking services.

3. Literature review
In this section, we present the literature review into four major parts. The first strand of
literature demonstrates bank competition and several models employed to explain bank
competition. The second strand of literature delineates the relationship between bank
competition and economic growth. The third part discusses the literature related to financial
stability and economic growth. Finally, the last part of our literature gives us an idea
regarding the joint role of bank competition and financial stability on economic growth.

3.1 On bank competition

There is a plethora of literature on bank competition. The literature on bank competition can
be classified into two broad structural and non-structural approaches. Structural approaches
of bank competition such as structure-conduct-performance hypothesis postulate that
competitive behavior of firms is largely determined by the structure of the market. The widely
used structural measures of bank competition are concentration ratios and Hirschman
Herfindahl index. Non-structural measures of bank competition are influenced by the New
Empirical Industrial Organization (NEIO) approach. These measures are based on the models
of Iwata (1974), Bresnahan (1982), Panzar and Rosse (1987) and Lau (1982).
Some other non-structural measures of bank competition are Lerner index, adjusted
Lerner index and Boone indicator (profit elasticity). One of the advantages of these measures
is that it allows the estimation of market power (inverse of bank competition)for bank-wise
as well as year-wise, which is required for this particular study. Existing studies have used
both structural and non-structural measures of bank competition. Fernandez de Guevara
et al. (2005) estimated the market power for major European countries applying the Lerner
index and summarized that the market power of these European countries had not declined
despite many market-liberating policies. Maudos and de Guevara (2007) applied the Lerner
index to compute the social welfare loss caused by market power. Efthyvoulou and Yildirim
(2014) assessed market power in Central and Eastern European (CCE) banking markets
considering the impact of the global financial crisis on CEE banking markets. Findings
reveal that country-level banking market power converged at some level during the
pre-crisis period. Clerides et al. (2015) used all the three measures of bank competition,
namely, Lerner index, adjusted Lerner index and Boone indicator, to estimate the degree of Bank
competition in the banking sector of 148 countries covering the period 1997–2010. Braggion competition
et al. (2017) investigated the impact of increasing bank concentration on bank lending in
Britain over 1885–1925. They concluded that borrowers in counties with higher bank
concentration received smaller loans and submitted more collateral than borrowers in other
counties submit.
Perera et al. (2006) measured competition and market structure in South Asian banking 207
and investigated whether traditional interest-based product market segments are more
competitive. The conclusion of the study based on the reduced form of Panzar–Rosse
H-statistic affirmed that countries (Bangladesh, Pakistan, India and Sri Lanka) earn revenue
under the condition of monopolistic competition during the period 1995–2003. In the Indian
banking context, Prasad and Ghosh (2007) used the Panzar–Rosse model to examine the
competitive conduct of Indian commercial banks by hypothesizing that competition in the
Indian banking sector had increased since the inception of financial sector reforms in 1992.
Das and Kumbhakar (2016) estimated market power and efficiency in Indian banking and
found that bigger banks enjoyed higher market power in the loan market resulted in higher
profits through their influences on prices or cost advantages. Liu et al. (2012) investigated
the nature of competition in four South-East Asian countries (Indonesia, Malaysia,
Philippines and Vietnam) and its effect on a bank’s risk-taking behavior). The empirical
findings suggest that increasing competition is not positively related to bank’s risk-taking
behavior and the results appear robust to different estimation approaches.

3.2 Bank competition and economic growth

Bank competition is considered as one of the important determinants of economic growth and
has motivated many researchers to relook at the role of bank competition in accelerating
economic growth (Cetorelli and Gambera, 2001; Coccorese, 2008a, b; Fernandez et al., 2016;
Laowattanabhongse and Sukcharoensin, 2017; Jayakumar et al., 2018). It helps to grow those
industries that are primarily dependent on external finance. Theoretical, as well as empirical
literature on bank competition and growth is still at its early stage. Pellényi and Borkó (2009)
studied the impact of bank competition along with a set of institutional variables on firms’
entry in a sample of European manufacturing industries over the period 1995–2006. Their
findings supported the fact that banking competition helps industrial growth via firms’ entry.
Goldberg (2009) overviewed the macroeconomic consequences of banking sector globalization,
financial crises and economic growth. Chen (2006) investigated that the developments in
financial intermediation in China have positively contributed to economic growth.
de Guevara and Maudos (2009) carried out a study on regional financial development
and bank competition, upon which they assessed the impact of bank competition on firms’
growth. They analyzed the effect of regional financial development and bank competition on
firms’ growth using the Spanish provinces as a testing ground. Findings revealed that firms
in industries with a greater dependence on external finance grow faster in the more
financially developed province. Bonaccorsi di Patti and Dell’Ariccia (2004) also conducted a
similar study where they showed how bank competition helps firm creation. They
investigated the potential effect of competition on the creation of firms in the non-financial
sector by explicitly allowing the heterogeneous effects across borrowers characterized by
different degrees of asymmetric information. Carbo-Valverde et al. (2009) examined the
financial innovation in the banking industry and its impact on regional firm’s growth. Apart
from this, few emerging literature also shed light on the issue of bank competition and its
impact on country’s overall economic growth (de Guevara and Maudos, 2011; Ajisafe and
Ajide, 2014; Banya and Biekpe, 2017). Keeping a line with the empirical literature, we test
our first hypothesis, which states that bank competition exerts a positive impact on
economic growth in South Asian economies.
SAJBS 3.3 Financial stability and economic growth
8,2 An unstable financial system is normally considered as a contributor to financial crises.
Crisis has had dire implication for economic growth. The efficient and smooth functioning of
an economy largely depends on a sound financial infrastructure in terms of a set of the legal
and regulatory system. Cheang (2004) regarded the importance of stability of the domestic
financial sector as an important factor for FDI inflow. When foreign investors make
208 strategic decisions whether they should set up business enterprises in markets outside their
origin, they generally take the stability aspect into consideration. This is expected that
inflow of foreign capital could enhance the overall performance of an economy. The
importance of finance in economic growth is a well-investigated topic. Schumpeter (1912),
Goldsmith (1962) and McKinnon (1973), the pioneers of this topic, so extensively
investigated the finance-growth nexus. However, research on the importance of finance in
economic growth is still undergoing. Lucas (1988), Neusser and Kugler (1998) and
Chandavarkar (1992) were not in favor of considering finance as an important determinant
of economic growth. Lucas even mentioned that “the importance of financial matters is
much overstressed” and none of the pioneers of development economics even list finance as
a determinant of economic growth.
Even though a good volume of literature discussed the finance-growth nexus in South
Asia, there is very little evidence on financial stability and economic growth. Literature has
documented that the stability of the financial system is very crucial in augmenting economic
growth. A stable financial system is one that enhances economic performance whereas an
unstable system is one that hinders growth. A financial system that is strong and robust is
generally less susceptible to the risk that a financial crisis will erupt in the wake of real
economic disturbances and is more resilient in the face of crises that do occur (Bank of
International Settlements, 1997). Soedarmono et al. (2011) find that higher economic growth
contributes to neutralize greater risk-taking and higher instability in less competitive
markets. This paper contributes to the existing literature on financial stability and economic
growth by discussing the impact of financial stability on economic growth in some selected
South Asian countries. In this regard, we formulate the second hypothesis that the degree of
bank competition will enhance the financial stability in these economies that would help
economic performance to boost further.

3.4 Bank competition, financial stability and economic growth

In recent times, there has emerged a growing body of literature that examines the
relationship between financial development and economic growth (e.g. see Craigwell et al.,
2001; Laeven, 2005; Ngare et al., 2014; Creel et al., 2015). The cited literatures have concluded
that financial development promotes economic growth. However, very little attention has
been paid to the role of bank competition in the financial sector, especially in the banking
sector. Bank competition can significantly influence efficiency, innovation and quality of
financial services and products (Cetorelli and Gambera, 2001; Vives, 2010). Coccorese
(2008a, b) mentioned that some degree of bank competition that increases financial stability
helps economic growth in the long run. There are two strands of empirical literature that
need to be addressed while examining the interrelation between bank competition, financial
stability and economic growth. First, whether the joint role of competition and stability
should be considered (Allen and Gale, 2004; Berger et al., 2009; Hou and Wang, 2016).
Second; whether there is a long-run equilibrium relationship between bank competition,
bank stability and economic growth (Fernandez et al., 2016; Creel et al., 2015). This paper
attempts to examine the joint role of bank competition and financial stability on economic
growth in a few selected South Asian economies. Based on the arguments, we present our
third hypothesis, which states that bank competition and financial stability jointly have a
positive repercussion in augmenting the economic growth in these economies.
4. Methodology and data Bank
4.1 Econometric model competition
Motivated by the NEIO approach, we employ Lerner index and adjusted Lerner index to
measure competition in selected South Asian countries. Main advantages of using these
models are its simplicity, precise and straightforward interpretation and, above all, these
models do not impose any stringent data requirements. However, all these measures of
the degree of bank competition require a measure of marginal cost (MC). Contrary to the 209
previous empirical literature on measurement of bank competition, we employ a
semi-parametric approach, for the estimation of MC. We present a brief discussion of all
proposed methods as follows:
(1) Lerner (1934) index: this measure of market power is based on the industrial
organization approach and demonstrates the ability of an individual bank to charge a
price above MC. It also typically implies price-cost margins and is formally defined as:
Lerner i ¼ P i –M C i =P i ; (1)
where MCi, is the long-run marginal cost of firm i, and Pi is the output price of the
same firm i. The value of Lerner index ranges between 0 and 1. If there is no market
power, Lerner index takes the value zero that corresponds to perfect competition, and
a larger value reflects greater market power that corresponds to a situation of less
competition and greater wedge between price and MC.
(2) Adjusted Lerner index (2012): Koetter et al. (2012) claimed that an estimated Lerner
index (price-cost margins) in the traditional approach does not correctly reflect the
true extent of market power. An improved version of the efficiency-adjusted Lerner
index was proposed by these authors as follows:
pi þtci mci  qi
Adjusted Lerner ¼ ; (2)
pi þtci
where πi is the profit of firm i, and tc, mc and q are total cost, marginal cost and total
output of firm I, respectively. As in standard Lerner index, the value of Adjusted
Lerner also ranges from 0 to 1, with larger values corresponding to greater market
power and hence less competitiveness and vice versa.
Since in Equations (1) and (2), all the values of the variables are observable except the MC,
we need to estimate the MC first. For the estimation of the MC required for the above indices,
we follow Delis (2012) and Delis et al. (2014) and specify the following cost function:


tcit ¼ f qit ; W l;it ; W k;it ; W d;it ; (3)
where wl denotes the price of labor, expressed as the ratio of personnel expenses to a number
of employees. wk denotes the price of physical capital, calculated as the ratio of capital
expenditures to fixed assets. wd denotes the price of deposits, defined as total interest
expenses over total customer deposits, tc represents total costs defined as the total of
operating expenses and other financial expenses such as interest expenses. q denotes the
total earning assets of a bank. We consider the cost function specified in standard log-linear
form and impose the usual linear homogeneity restriction in input prices (i.e. we normalize
total cost and other input prices by the price of deposits before taking logs):
ln tcit ¼ b1 þb2 ln wl;it þb3 ln wk;it þ a1 ln qit : (4)
We use a semi-parametric partial linear smooth coefficient (PLSC) model to estimate
equation (4)[3]. The PLSC model uses local polynomial fitting regression and the Gaussian
SAJBS Kernel function to obtain estimates of a1 for each bank at time t. The advantage of using the
8,2 PLSC technique is that it allows the model to be linear in regressors, but their coefficients are
allowed to change “smoothly” with the value of another variable, z, which is the linear
combination of two input prices (see Appendix 2 for details of the semi-parametric model).
The econometric form of (4) based on the PLSC method is as follows:

ln tcit ¼ b1 þa1 ðzit Þln qit þb2;it ln wl;it þ b3;it ln wk;it þeit ; (5)
210
where e is the stochastic disturbance and z is the smoothing variable required by the PLSC
approach. The model is semi-parametric in the sense that it treats only the coefficient a1 as a
function of z. From Equation (5), we can obtain the MC for each bank i at time t:
 
@tcit tcit
¼ a1 ðzit Þ : (6)
@qit qit

For empirical estimation, we need to properly choose input variables which are highly
correlated with a1 such that it allows variation of a1 across banks and time. Following
previous literature, we use input prices for this purpose. The advantage of using input
prices is that these affect a1 to a large extent and also play a significant role in the
estimation of MC. Following Delis et al. (2014), we consider a linear combination of input
prices and define the smoothing variable, zit ¼ lnwl,it+lnwk,it, which is used in (6) for the
final estimation of MC.

4.2 Estimating bank competition and growth

This section discusses the measures of bank competition and economic growth for the six
selected South Asian countries with a broader economic and institutional setting. Both the
measures of bank competition have a sound theoretical foundation and strong empirical
appeal. The basic model we use to study the effect of bank competition on economic
growth is the fixed effect model of panel regression. We use the annual growth rate of per
capita GDP as dependent variable and Lerner index, adjusted Lerner index and a set of
control variables as independent variables. The benchmark econometric model takes the
following form:

yit ¼ ai þjLI þbALI i;t þgX it þeit ; (7)

where yit is real per capita GDP growth; ALI is the adjusted Lerner index; Xit the set of
control variables; and i and t the country and period, respectively. The details of the
variables used in Equation (7) are explained in Table II. Trade openness which
has been used as an explanatory variable in our empirical model is expected to have a
positive impact on economic growth. This is because greater openness to international
trade has a positive repercussion on growth (Keho, 2017). As far as gross fixed
capital formation is concerned, a positive coefficient is expected between capital
formation and economic growth. Ongo and Vukenkeng (2014) find a positive impact of
gross capital formation on economic growth in CEMAC sub-regions. The nexus between
inflation and growth has been a theoretically debated issue. Empirical literature finds both
positive and negative impact of inflation on growth in both the short run and long run
(De Gregorio, 1992; Sarel, 1996; Khan and Ssnhadji, 2001). Regarding government
effectiveness, we expect a positive sign with respect to economic growth. Good
governance, by promoting more efficient divisions of labor, more productive investment
and faster implementation of social and economic policies, leads to higher economic
growth (United Nations, 2005).
 Data
Bank
Variables Definitions sources competition
Dependent variable
GDP per capita The dependent variable used in this study is real GDP per capita growth. WDI
growth This definition has been chosen in line with the study conducted by
Claessens et al. (2006). They used the logarithm of per capita GDP as a
proxy to measure the economic performance of a country 211
Competition variables
Lerner index Details have been given in the methodology section OC
Adjusted Lerner index Details have been given in the methodology section OC
Control variables
Trade Openness It is calculated as the ratio of the country’s total trade, the sum of WDI
import and export to total GDP. It represents the multifaceted nature of
trade policy (see Leamer, 1988; Sachs et al., 1995 for details). Here, we
use trade openness as a percentage of GDP
Gross Capital This variable is defined as a measure of the total value of a producer’s WDI
Formation acquisition, fewer disposals of fixed assets during the accounting
period plus certain additions to the value of non-produced assets
realized by the productive activity of the institutional unit. Uremadu
(2008) further defines gross fixed capital formation as an addition in
the stock of capital assets
Z-score Z-score as a measure of financial stability has been computed as the World Bank
inverse of the probability of insolvency (ROA + E/A)/δ(ROA), where δ
(ROA) is the standard deviation of ROA (source: World Bank
publication reports on Global Financial Development)
Inflation This is defined as a proxy by the annual growth rate of CPI index, and WDI
this variable is used to account the macroeconomic stability
Domestic Credit This variable is defined as the total assets for the ratio of total banking WDI
(% of GDP) sector assets to the real gross domestic product (GDP). It amounts to
total domestic credit provided by commercial banks to government
institutions only
Government This is defined as a proxy by the annual growth rate of CPI index and WDI
Effectiveness this variable is used to account the macroeconomic stability Table II.
Notes: WDI, World Bank Development Indicator; OC, own calculations Variable definitions

We further apply the reduced form dynamic panel model. Economic growth ( y) depends
upon bank competition (m), financial stability (x), financial development ( f ) and other
macroeconomic variables (z):

yit ¼ ai yit1 þbi1 mit þ bi2 xit þbi3 f it þbi4 zit þvi þjt þeit ; (8)

where i denotes the country (i ¼ 1, 2, …, 6) and t denotes the time (t ¼ 1996, …, 2016). This is
a general specification which allows for examining the dynamic effect of competition on
growth, individual fixed country effect (v), time effects (φ) and a stochastic term (ε).
Equation (8) is a linear dynamic panel model (Arellano and Bond, 1991). One of the
characteristics of this model is to examine the unobserved effects in the panel model, which
can be fixed or random. However, there are chances that unobserved panel-level effects are
strongly correlated with the lag(s) of the dependent variable, which may again make the
most standard approaches inconsistent. The first differencing transformation in Arellano
and Bond (1991) eliminates the firm-specific unobserved heterogeneity. Blundell and Bond
(1998) following the work of Arellano and Bover (1995) develop a system GMM that
addresses the problem of Arellano and Bond (1991) by expanding the instruments list to
SAJBS include instruments for the level equation. In this paper to capture the dynamic nature of
8,2 bank competition and economic growth over the sample period, we use the system GMM
approach to estimate our models.

4.3 Data sources

Data used in this study were collected from different sources. The sample is drawn from six
212 selected South Asian countries covering the period 1997–2016. To conduct this study, we
collected the estimated values of Lerner (1934) index and adjusted Lerner index (2012) from
the study of Clerides et al. (2015)[4] and World Bank database. For India, we estimate the
Lerner index and efficiency-adjusted Lerner index for 70 commercial banks applying the
semi-parametric approach. For country-specific variables like Gross Capital Formation,
Trade Openness, Inflation, Domestic credit to governments by banks as a percentage of
GDP and Government Effectiveness, we use the World Bank database. To know the details
about the variables used in this paper, see Table II. Data on saving and investment banks,
cooperative banks, regional rural banks (RRB) and other non-banking financial institutions
are excluded in order to maintain the comparability of the results.

5. Results and discussions

5.1 Findings on bank competition
In this section, we report the estimated results of bank competition to trace the trend of bank
competition in selected South Asian economies from the period 1997–2016[5]. It has been
found that the estimated values of both the indices vary significantly across the countries
over the sample period. It is clearly observable that competition has increased across the
countries over time. The average estimated values of Lerner index and adjusted Lerner
index for Afghanistan, Bangladesh, India, Nepal, Pakistan and Sri Lanka are 0.24, 0.16, 0.21,
0.30, 0.20, 0.16 and 0.20, 0.12, 0.13, 0.29, 0.18, 0.12 respectively (Clerides et al., 2015). Since the
lower values of Lerner index signify greater competition, it is evident from the results that
bank competition is higher in Bangladesh, Sri Lanka and Pakistan as compared to Nepal,
India and Afghanistan. It is widely perceived that massive deregulations followed by
financial sector liberalization have improved the competitive conduct of commercial banks
in South Asian countries. The growing competition, particularly in Bangladesh and
Sri Lanka, is the result of financial sector deregulation (Bangladesh Bank, 2000; Central
Bank of Sri Lanka, 2000). Gradual changes in the regulatory policies coupled with structural
transformations have helped these two countries to report higher competition. As far as
India is concerned, regulation policy recommendations in India (Second Narasimhan
Committee, 1997) increased the competitive conduct of Indian commercial banks. In
Pakistan, bank competition was higher till 2001 but after that the imposition of minimum
capital requirements (MCR) and minimum capital adequacy ratio (CAR) by SBP (State Bank
of Pakistan) forced micro and smaller banks to merge with larger banks which in turn
caused the banking sector to become concentrated (Tahir, 2017). The estimated values of the
adjusted Lerner index also support the same interpretation of Tahir (2017). Overall, we can
infer that the South Asian banking system is competitive in nature. Our empirical findings
are in line with Prasad and Ghosh (2007) and Perera et al. (2006).

5.2 Empirical findings on bank competition and economic growth

This section provides a thorough discussion of the regression results and examines the
impact of bank competition on economic growth. Hausman test was conducted to choose the
suitability between the fixed and random effect model. A fixed effect model was accepted for
the empirical estimation. Table III reports the result of empirical estimations of bank
competition and economic growth in South Asian countries.
Dependent variable: GDP per capita Model 1 Model 2 Model 3
Bank
competition
Lerner index −0.19** (1.76) −0.26** (1.89)
Adjusted Lerner index −0.82* (1.64) −0.73* (1.69)
Trade Openness 0.22 (1.07) 1.06 (0.93)
Gross Fixed Capital 0.39* (1.67) 0.65* (1.73)
Inflation −0.12 (−1.30) −0.19** (1.78)
Government Effectiveness −0.14 (−0.27) −0.29 (−0.43) 213
Domestic Credit (% of GDP) 0.64*** (3.58) 0.81*** (3.26)
Time Effect Included Included Included
Country Effect Included Included Included
ProbWχ2 0.0018 0.002 0.012
2
R 0.218 0.192 0.305
Number of countries 06 06 06 Table III.
Observations 114 114 114 Competition and
Notes: *,**,***Significant at 10, 5 and 1 percent, respectively economic growth:
Source: Own calculations fixed effect results

The empirical results show that bank competition has a significant positive impact on
economic growth at 5 and 10 percent levels, respectively. However, it should be mentioned
that the Lerner index and adjusted Lerner index being the direct measures of bank market
power and indirect measures of bank competition, we have negative signs of LI and ALI’s
coefficients[6]. This simply means that there is an inverse relationship between bank market
power and economic growth and a positive relationship between bank competition and
economic growth in these selected South Asian countries throughout 1997–2016. The
negative coefficients of 0.19 and 0.82 mean that one percent increase in bank competition (as
measured by Lerner index) leads to a 0.19 percent increase in economic growth over the
periods under study. This signifies bank competition has a significant positive impact on
real economic growth. The positive outcome of bank competition on economic growth
supports our first hypothesis that bank competition enhances economic growth in South
Asian economies.
The relationship between trade openness and economic growth is mixed and
inconclusive. However, literature that discussed the possible role of trade openness
on growth in South Asian economies is very less. In our case, we find a positive
but insignificant coefficient of trade openness in relation to real GDP growth for the
six South Asian economies over the period 1997–2016. This is due to the less exchange
rate volatility in the region. Less exchange rate volatility always exerts a positive
impact of investment on its terms of trade[7]. In terms of gross capital formation,
we have a positive and significant coefficient on real economic growth. Gross fixed
capital formation is one of the important determinants of economic growth and plays a
significant role in increasing the physical capital stock in the domestic economy
(Plosser, 1992) and in promoting the technology indirectly (Levine and Renelt, 1992).
However, it is worthwhile to mention that trade openness along with capital formation
has a very positive and strong complementary role to play in promoting economic growth
(Keho, 2017).
There has been a long-standing debate on the relationships between inflation and
growth. The debate is more profound regarding the expected sign between inflation and
growth. In our case, the sign turns out to be negative implying an inverse relationship
between inflation and growth. This finding is in contrast with Mallik and Chowdhury (2001)
and Behera (2014), Mallik and Chowdhury (2001) examined the long-run relationship
between inflation and growth in four South Asian economies (Bangladesh, Pakistan,
India and Sri Lanka) and found a positive relationship between the two variables.
SAJBS Furthermore, our result regarding inflation and growth is in line with Jayathileke and
8,2 Rathnayake (2013). They found a long-run negative and significant relationship between
inflation and growth in Sri Lanka and India. Domestic credit as a percentage of GDP has a
positive and significant coefficient at a 5 percent level. This implies that as commercial
banks provide more credit and loans to its government institutions, it will help the
economies grow faster and maintain higher economic growth. Government effectiveness
214 appears to be negative, which implies greater political pressures, less stable government
and less effective government policies have a negative role to play in enhancing the
economic growth in South Asian economies. However, this negative relationship between
government effectiveness and economic growth suggests some major alerts for long-run
sustainable growth and stability in South Asian economies. Maintenance of strong
democratic institutions in order to create political stability can help in achieving economic
growth in the region. In order to capture the unobserved time-varying factors such as
deregulation and bank supervisory practices in the South Asian countries over the sample
period, we have considered the time trend variable in our panel regression.

5.3 On bank competition, financial stability and economic growth

To examine the dynamics between bank competition and economic growth and to
investigate the joint effect of bank competition and financial stability on growth, we use the
system GMM as a robustness check. Our main purpose of using the system GMM technique
is to address the problem of country-specific unobserved heterogeneity and to report
the fixed time effects of the sample period. Table IV reports the result of system GMM.
The findings based on system GMM suggest that there exists a long-run relationship
between bank competition and economic growth in South Asian economies. The coefficients
of lagged real GDP growth appear to be positive and statistically significant indicating the
persistence of economic growth over the sample period because of bank competition and

Dependent variable: GDP per capita Model 1 Model 2 Model 3 Model 4

Lagged GDP per capita 0.34** (1.75) 0.45*** (3.21) 0.65* (1.54) 0.53** (1.89)
Lerner index −0.20** (1.88) −0.23** (2.16) −0.19** (1.87)
Adjusted Lerner index −0.55 (−0.57) −0.38 (−0.62) −0.37 (−0.76)
Trade Openness 0.12** (1.77) 0.19** (1.88) 0.22*** (2.86)
Gross Fixed Capital 0.77*** (2.43) 0.82*** (2.65)
Inflation −0.65* (−1.66) −0.55 (−0.51) −0.52* (−1.78)
Government Effectiveness −0.17* (−1.61) −0.72* (−1.59) 0.61*** (7.56)
Domestic credit (% of GDP) 0.31*** (2.76) 0.25*** (4.56)
Financial Stability (Z -score) 0.36* (1.67) 0.023 (1.23)
Lerner index × Stability 0.28** (1.98)
Time Effect Included Included Included Included
Country Effect Included Included Included Included
Number of countries 06 06 06 06
Observations 114 114 114 114
Number of instruments 54 55 58 65
Sargan p-valuea 0.98 1.00 1.00 0.97
b
AR(2) p-value 0.38 0.62 0.68 0.65
Notes: aThe Sargan test p-value for over-identifying restrictions, where Ho: over-identifying restrictions are
Table IV. valid; bthe Arellano–Bond test p-value for serial correlation of order 2 in the first difference residuals, where
Bank competition, H0: no autocorrelations. Columns in tables report estimated coefficients of each model. Figures in parentheses
financial stability and represent the value of t-statistics. Equations are estimated using Arellano and Bover (1995) system
economic growth: generalized method of moments (GMM). p-values of AR(2) tests are based on the estimations with Windmeijer
system GMM WC-robust standard errors. *,**,***Significant at 10, 5 and 1 percent, respectively
financial stability in the region. As far as the relationship between bank competition and Bank
financial stability is concerned, we find a positive and statistically significant coefficient competition
between the two variables. This implies that financial stability in the South Asian economies
has positively contributed to its economic growth. This finding lends support in favor of our
second hypothesis, which tests the positive relationship between bank competition and
economic growth. However, while comparing the coefficient signs of the rest explanatory
variables between simple panel regression model and system approach, we fail to draw any 215
significant changes in the coefficients values of both the model. The consistent coefficient
values signify that variables used in the empirical estimations are well suited in explaining
the variations in economic growth. In order to capture the joint effect of bank competition
and financial stability on economic growth in South Asian economies, we estimate Model 4
in Table IV. Model 4 includes the interaction variable between bank competition and
financial stability. We find a positive impact of competition and stability jointly on economic
growth in South Asian countries. Since literature on the joint effect of bank competition and
financial stability on growth is inadequate, we could not support our empirical findings with
other empirical evidence. However, this finding supports our third hypothesis that mentions
the joint impact of competition and stability on growth.

6. Conclusion and policy implications

This paper investigates the interrelationship between bank competition, financial stability
and economic growth in a few selected South Asian countries over the period 1997–2016. To
conduct this study, we employ a two-step estimation procedure. In the first step, we measure
the degree of bank competition using the Lerner (1934) index and adjusted Lerner index
(2012). One of the important requirements of computing these indices is a proper estimation
of MC. In most of the literature, MC is computed parametrically using a translog cost
function. However, in this study, we used a recently developed technique to compute the
MC. We used a semi-parametric approach to estimate MC which reduces the potential gap
between actual and estimated values of MC and enables us to obtain observation specific
MC at each time in the sample. In the second step, we examine the relationship between
bank competition and economic growth. We also examined the joint role of bank
competition and financial stability in these economies. To achieve this, we applied a panel
regression model and system GMM, keeping the Lerner index and adjusted Lerner index as
independent variables and GDP growth per capita as the dependent variable in the
regression model. We found a significant positive relationship between bank competition
and economic growth in the South Asian economies over the period 1997–2016. We also find
that bank competition and financial stability jointly exert a positive impact on economic
growth. Furthermore, the country-specific control variables also have had a significant role
in enhancing economic growth. It appears that bank deregulation and privatization policies
in the region have an impact on bank competition, which, in turn, positively affects the
overall economic growth of the region.
From a policy perspective, central banks of these respective countries should adopt
banking policies that maintain a balance between market power and degree of competition
to ensure the banking stability and productive efficiency. Central banks should strive to
increase the competitiveness, productivity and efficiency of the commercial banking sector
by adopting more liberal interest rates policies and several regulatory reforms. This paper
suggests flexible banking regulation policies and few contestability measures to enhance
bank competition. This is because as higher the competition, greater is the chance for
efficient allocation of resources and hence economic growth. Regulators, in particular,
should keep a balance with the ongoing reforms in the financial sector to create the
necessary structural changes in the direction of the more market-oriented banking system in
the region.
SAJBS However, this paper suffers from certain limitations. First, this study does not take into
8,2 account the short-run and long-run joint effect of bank competition and financial stability on
economic growth and the possible causality that exists among these three variables. Second,
from a methodological perspective, an assessment on parametric and nonparametric
techniques while computing could have been a robust computational task for this study.

216 Notes
1. Claessens and Leaven (2003), Claessens (2009), Wagner (2010), Tabak et al. (2012), Jeon and Lim
(2013), Schaeck and Cihák (2014) and Hou and Wang (2016) favored that issues related to bank
competition and bank stability should be considered together. On the other hand, Fernandez et al.
(2016) and Creel et al. (2015) are of the view that there is a long-run relationship between bank
competition, financial stability and economic growth. Hence, the aspect of competition and stability
should be taken together while explaining growth.
2. It has been found that few South Asian economies including India, Bangladesh, Pakistan and
Sri Lanka have undergone structural transformations as the liberalization policies turned out to be
the main focus of their monetary authorities (Reserve Bank of India, 2002; Central Bank of
Sri Lanka, 2000; Bangladesh Bank, 2000).
3. Details of theoretical discussion of the partial linear smooth coefficient model can be found in
Li et al. (2002), Fan and Zhang (1999) and Mamuneas et al. (2006).
4. Clerides et al. (2015) estimated Lerner index, adjusted Lerner index and Boone Indicator for 145
countries. Like Clerides et al. (2015), our econometric technique is also based on semi-parametric
approach for the estimation of marginal cost, which is an important element required for
calculating Lerner index and Adjusted Lerner index. Therefore, bearing the uniformity in mind, we
have collected data on Lerner index and Adjusted Lerner index for five South Asian countries
(Afghanistan, Bangladesh, Pakistan, Nepal and Sri Lanka) from the work of Clerides et al. (2015).
5. The estimated values of Lerner index and Adjusted Lerner index have not been reported in the
paper. However, the estimated results can be available on request.
6. Throughout this study, we have used market power measures (LI and ALI) as an indirect indicator
of bank competition intensity. This is really an innocuous assumption although several studies
have pointed out that market power measures always do not reflect the expected direction when
there is a change in competitive scenario of banking system. Empirical findings also reveal that
there are theoretically possible scenarios in which price –cost margins increase with more
competition (see Stiglitz, 1987, 1989; Bulow and Klemperer, 2002; Boone, 2008). However, many
studies have employed market power measures to assess bank competition (see Fernandez de
Guevara et al., 2005; Maudos and Solís, 2011; Weill,2013; Koetter et al., 2012; Clerides et al., 2015,
among others).
7. It has empirically been tested that in the long run, trade openness can influence economic growth
by providing access to goods and services, achieving allocative efficiency of resources and
improving total factor productivity (TFP) through technology diffusion (Barro and Sala-i-Martin,
1997; Rivera-Batiz and Romer, 1991).

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Appendix 1

Variables Observations Mean SD Mini. Max.

LI 114 0.210 0.0957 −0.03 0.39

ALI 114 0.167 0.1150 −0.13 0.41
Stability Z-score 114 3.79 1.07 0.09 13.22
GDP per capita 114 3.74 3.0296 −3.36 17.95
Trade Openness 114 50.253 24.098 22.86 137.9
Gross Capital Formation 114 25.328 25.3281 9.33 92.47
Inflation 114 7.679 5.142 −8.28 30.55
Table AI. Government Effectiveness 114 0.3428 0.11 0.15 0.69
Statistical descriptions Domestic Credit (% of GDP) 114 29.47 10.02 4.78 59.17

LI ALI GDP TO GFC INFL GE DC

LI 1.000
ALI 0.9886 1.000
GDP per capita 0.0382 −0.0154 1.000
Trade Openness −0.0108 −0.0636 0.1922 1.000
Gross Capital Formation 0.0081 −0.0512 0.3132 0.0301 1.000
Inflation 0.0620 0.1098 −0.2626 0.254 −0.085 1.000
Table AII. Government Effectiveness −0.0348 −0.0090 0.1279 0.5224 0.1607 0.2543 1.000
Correlation matrix Domestic Credit (% of GDP) 0.2634 0.2607 0.1020 −0.0829 0.5872 0.1189 0.1268 1.00)
Appendix 2 Bank
We can write the econometric form of total cost function as:


competition
Y i ¼ E Y i 9 W i þ ei ¼ X i b1 þV i b2 ðZ i Þ þ ei ; (A1)
In this equation, β2 is a function of one or more variables with dimension k added to the vector Z, which
is a crucial element of the analysis and will be discussed below. The presence of a linear part in
Equation (A1) is in line with the idea of the semi-parametric model as opposed to a fully nonparametric
one. The coefficient of this part is estimated in the first step as averages of the polynomial fitting by 223
using an initial bandwidth chosen by cross-validation ( Hoover et al., 1998). We then average these
estimates β1i and β2i to receive β1 and β2 in Equation (A1). In the second step, we use these average
estimates to re-define the dependent variable as:

Y ni ¼ Y i X i bbi ¼ V i b2 ðzÞþ eni ; (A2)

where the asterisks denote the redefined dependent variable and error term.
β2(z) is a vector of smooth but unknown functions of zi, estimated using a local least squares
approach of the form:
" # " #
 1 X n Dz zE 1 Xn Dz zE
^b ðzÞ ¼ nlk 2
Vj K
j
ðnlÞk1 n
V jV j K
j
¼ ½Bn ðzÞ1 C n ðzÞ; (A3)
2
j¼1
l j¼1
l

where:
 1 Xn Dz zE Xn Dz zE
V j V nj K
j j
Bn ðzÞ ¼ nlk V 2j K and C n ðzÞ ¼ ðnlÞk1 ðnlÞk1 :
j¼1
l j¼1
l

Equation (A3) represents a local constant estimator, where K (z, λ) is a kernel function, λ is the
smoothing parameter (chosen by generalized cross-validation in all models of our paper) for sample
size n, and k is the dimension of zi. The coefficient β2(z) that is evaluated at a point z of Z is a smooth but
unknown function of z. Here, we estimate β2(z) using a local least square approach. Using the PLSC
technique, we allow the model to be linear in the regression but their coefficients are allowed to change
“smoothly” with the value of another variables z.

Corresponding author
Bijoy Rakshit can be contacted at: bijoy.rakshit@iitrpr.ac.in

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