Dynamics of innovation and efficiency in banking system: An application of SFA and meta-frontier method

One of the most important problems in innovation arguments is how to identify and measure innovation. In industry sector, the available measurements to identify innovation activities are number of patents, R&D expenditure and share of R&D workers. Unfortunately these measurements for service sector especially financial sector are problematic and not readily available. This paper, following Bos et al. (2009), proposes changes of Technology Gap Ratio (TGR) as innovation activity in banking system and investigates it for the US commercial banks in years 2000-2013. For this purpose, at first step, the annual cost frontier functions (as representative of technology set for each year) are estimated by applying Stochastic Frontier Analysis (SFA). Consequently, the efficiency scores for each year are calculated for banks which operate under the same frontier functions. Then, the meta-frontier analysis is employed to estimate the potentially available cost function for the whole period. In next step, the TGR which indicates the relative distance of annual cost frontier function to the most efficient cost function (meta-frontier cost function) for the whole period is calculated. Finally, changes of TGR as a proxy of financial innovation during the time are illustrated by proper Salter curves. Results show that the average of TGR for the period 2000 to 2011 was associated with 2.88% annual growth rate. In other words, commercial banks in this period demonstrated an increasing level of innovation in their activities including financial products and services. In contrast, the results show that in last two years (2012 and 2013) this ratio had a considerable reduction, even less than the initial year. Thus, it seems that they have been less involved in innovation activities during the recent years.