The impact of information technology on the banking industry

Abstract

This paper analyses the effects of investment in information technologies (IT) in the banking sector using bank-level data from a panel of 68 US banks over the period 1986–2005. Although IT can improve bank's performance by reducing operational cost (supply side), it can bring in competition among banks in order to embrace new technology (demand side). Since most empirical studies have adopted the production function approach, it is difficult to identify which effect has dominated. In a differentiated model with network effects, this paper characterizes the conditions to identify these two effects. The results suggest that (at individual firm levels) the bank profits can decline due to adoption and diffusion of IT investment, reflecting negative network competition effects in this industry. Using panel cointegration tests, we confirm that the estimated profit equation is indeed a long-run equilibrium relation.

Keywords:

• information technology
• heterogenous competition
• banking services

Acknowledgements

The constructive comments made by two anonymous referees of this journal are gratefully acknowledged. An earlier version of the paper was presented at the European Economics and Finance Society Annual Conference, 31 May–3 June 2007, Sofia, Bulgaria, and at the Workshop on Knowledge Flows at Queen Mary University of London, 23 March, 2007, London, UK; and we acknowledge the participants for their comments. The usual disclaimer applies.

Notes

1 For updated data until 2006, see http://www.economics.harvard.edu/faculty/jorgenson/recent_work_jorgenson/html.

2 Computers may affect productivity because they are a specific capital input to the production process. This is the approach taken in most existing studies, including both the national and industry-level studies just cited, as well as studies at the plant or firm level, such as Brynjolfsson and Hitt (2000), Dunne et al (2000), Stolarick (1999) and McGuckin et al (1998).

3 See Rohlfs (1974) and Milne (2006). Also see http://en.wikipedia.org/wiki/Network_effect#Benefits.

4 We provide the rationale for treating prices as explanatory variables in Section 2.

5 [0,1] can be interpreted as proportion of population. Our analysis will remain the same even if we consider population growth.

6 To save space, we have omitted proofs of the propositions, which are available from the authors.

7 The original HHI is a summation over the whole industry, but since our sample covers only 68 large banking firms, the index we calculate is not the HHI in original definition. However, we still use HHI to indicate an index for concentration.

8 See Shu and Strassmann (2005) for a review.

9 To save space, we have not presented these results, but they are available on request from the authors.