IDEAS home Printed from
MyIDEAS: Log in (now much improved!) to save this paper

Financial innovation, strategic real options and endogenous competition : theory and an application to Internet banking

Listed author(s):
  • David B. Nickerson
  • Richard J. Sullivan

Innovations in financial services continuously influence the scope of financial intermediation and the nature of competition between intermediaries. This paper examines the optimal exercise of strategic real options to invest in such an innovation, Internet banking technology, within a two-stage game, parameterized by the distribution of bank size and uncertainty over the profitability of investment, and empirically tests the results on a novel data set. Unlike traditional options, in which the distribution of the future value of the underlying asset is exogenous and the timing of exercise affects only the return to the option holder, the timing of the exercise of real options in a strategic context allows the option holder to manipulate the distribution of returns to all players. The value of the strategic investment option in our model, as a consequence, depends on both expected future profits as well as the variance of those profits. Expected profits to an entrant depend, in equilibrium, on its size, as measured by existing market share (concentration) or total assets, relative to its rivals. Conditional on the degree of uncertainty, larger banks should, as a consequence, exercise their options earlier than smaller banks, for purely strategic advantages, and act as market leaders in the provision of Internet banking services. Like ordinary options, however, the value of the strategic investment option to both large and small banks increases in uncertainty, implying that early exercise will be more likely the more information is available about potential demand. We test these hypotheses on investment in Internet banking services with data from a sample of 1,618 commercial banks in the tenth Federal Reserve District during 1999. Evidence indicates that relative bank size, as measured by either market share or asset size, positively influences the likelihood of entry into Internet banking, and trend-adjusted variation in income per person (a proxy for uncertainty of demand) negatively influences the likelihood of entry into Internet banking. In addition, market concentration of a bank's competitive rivals has a negative relationship with the likelihood of entering the market for Internet banking services. These relations are evident in both bivariate analysis and in multivariate logit regression analysis.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
Download Restriction: no

Paper provided by Federal Reserve Bank of Kansas City in its series Payments System Research Working Paper with number PSR WP 03-01.

in new window

Date of creation: 2003
Handle: RePEc:fip:fedkpw:psrwp03-01
Contact details of provider: Postal:
1 Memorial Drive, Kansas City, MO 64198-0001

Phone: (816) 881-2254
Web page:

More information through EDIRC

Order Information: Email:

No references listed on IDEAS
You can help add them by filling out this form.

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:fip:fedkpw:psrwp03-01. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Lu Dayrit)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.