Nonparametric Estimation of Lerner Indices for U.S. Banks Allowing for Inefficiency and Off-Balance Sheet Activities

Abstract

The Lerner index is widely used to assess firms' market power. However, estimation and interpretation present several challenges, especially for banks, which tend to produce multiple outputs and operate with considerable inefficiency. We estimate Lerner indices for U.S. banks for 2001-18 using nonparametric estimators of the underlying cost and profit functions, controlling for inefficiency, and incorporating banks' off-balance-sheet activities. We find that mis-specification of cost or profit functional forms can seriously bias Lerner index estimates, as can failure to account for inefficiency and off-balance-sheet output.

Keywords: Lerner index, banks, market power, nonparametric regression

JEL Classification: C12, C13, C14, G21, L13