Financial Innovation, Strategic Real Options and Endogenous Competition:

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. _______________________ Nickerson: Department of Economics, Clark Hall C310, Colorado State University, Fort Collins, Colorado 80523-1771, Phone: 970-491-5249, Fax: 970-491-2925, Email: [email protected]. Sullivan: Payments System Research, Federal Reserve Bank of Kansas City, 925 Grand Boulevard Kansas City, MO 64198, Phone: 913-881-2372, Fax: 913-881-2425, Email: [email protected]. We would like to thank Allen Berger, Zvi Bodie, Raphael Bostic, Diana Hancock, Rob Jones, David Malmquist, Leon Petrosjan, Ron Phillips, Venk Sadanand, Sherrill Shaffer, Dan Spulber, Jim Wilcox, Bob DeYoung, Bill Lang, seminar participants at American University, Colorado State University, Georgia State University, University of British Columbia, Victoria University of Wellington and participants at the Asia-Pacific Finance Meetings, the Annual FMA Meetings, the 14 Annual Australasian Finance and Banking Conference, and the Conference on Innovation in Financial Services and Payments at the Federal Reserve Bank of Philadelphia for helpful comments and correspondence on earlier drafts of this paper, as well as members of the Electronic Money Working Group of the U.S. Department of the Treasury and the Federal Reserve Bank of Kansas City for comments on institutional and legal content. Opinions expressed are those of the authors and do not necessarily reflect those of the Federal Reserve Bank of Kansas City, the Federal Reserve System, or Freddie Mac. Financial Innovation, Strategic Real Options and Endogenous Competition: Theory and an Application to Internet Banking David Nickerson and Richard J. Sullivan