The impacts of innovation and trade openness on bank market power: the proposal of a minimum distance cost function approach and a causal structure analysis

Abstract

This study estimates output market power in the Chinese banking industry using the multi-output Lerner index. We propose a minimum distance cost function approach, which allows us to determine not only the level of market power but also the non-profit maximizers and efficiency level of Chinese banks. Following the first-stage analysis, we employ the generalized method of moment system estimator to evaluate the impacts of bank innovation and trade openness on market power in a multi-output banking context. In particular, we innovatively propose a causal structure analysis based on Wang and Blei (2019) to validate and verify the robustness of our results. We also assess this relationship for different types of bank ownership in China. The findings suggest that Chinese banks exhibit high market power in loans. Furthermore, the results show that bank innovation and trade openness have a significant negative impact on market power in loans, but a significant positive impact on market power in securities. The results also indicate a significantly negative impact of trade openness on overall market power. We find that higher levels of innovation among state-owned and joint-stock commercial banks improve the overall level of market power. The results suggest that, for all bank ownership types, trade openness has a significant negative impact on market power in loans but a significant positive impact on market power in securities. The impact on the overall level of market power is consistently significant and negative.