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The Panzar-Rosse test has been widely applied to assess competitive conduct, often in specifcations controlling for firm scale or using a price equation. We show that neither a price equation nor a scaled revenue function yields a valid measure for competitive conduct. Moreover, even an unscaled revenue function generally requires additional information about costs and market equilibrium. Our theoretical findings are confirmed by an empirical analysis of competition in banking, using a sample covering more than 110,000 bank-year observations on almost 18,000 banks in 67 countries during 1986-2004.

NON-TECHNICAL SUMMARYThis paper investigates the measurement of competition in the EU banking sector. Bank competition is pivotal to monetary policy as it may affect the way changes in the policy rates of the European Central Bank (ECB) are passed on to the interest rates that banks offer their customers.The paper uses a new approach, the so-called Boone indicator, to estimate competition in the loan markets of the euro area. To our knowledge, this is the first paper which applies this method to the banking market. This indicator measures the effect of efficiency on performance in terms of profits or market shares. The idea underlining the Boone indicator is that competition enhances the performance of efficient firms and impairs the performance of inefficient firms, which is reflected in lower profits or smaller market shares.Our approach is innovative in the sense that this method allows measurement of competition not only for the entire banking market, but also for separate product markets, such as We apply the Boone indicator to the loan markets of the five major countries in the euro area and, for comparison, to the UK, the US and Japan over 1994-2004. Our findings indicate that the US had the most competitive loan market, whereas Germany and Spain were among the best competitive EU markets. The German results seem to be driven partly by a competitive commercial banking sector reflecting the distinct nature of its "three-pillar" banking system. In Spain, competition remained strong and relatively stable over the full sample period, indicating the progress the Spanish banking system has made since the major liberalisation reforms in the late 1980s and early 1990s. The Netherlands took up a more intermediate position among the countries in our sample, despite having a relatively concentrated banking market dominated by a small number of very large players. Italian competition declined significantly over time, which may be due to the partial reconstitution of market power by the banking groups formed in the early 1990s. French and British loan markets were less competitive overall. In Japan, competition in loan markets was found to increase dramatically over the years, in line with the consolidation and revitalisation of the Japanese banking industry in recent years. ECB Working Paper Series No 768June 2007 The paper also measures competition among specific types of banks. Commercial banks, which are more exposed to competition from foreign banks and capital markets, tend to be more competitive, particularly in Germany and the US, than savings and cooperative banks, which typically operate in local markets. An exception is Japan, where competition among savings and cooperative banks was considerably stronger than competition between commercial banks. This may indicate the adverse impact of the banking crises on bank competition, as the commercial banks were particularly hard-hit by the severe banking crisis that engulfed Japan during the 1990s.All in all, according to the Boone indicator, competitive condition...