INTRODUCTION
Research objectives
- This study measures commercial bank’s efficiency in Viet Nam during the period of 2010-2018
- This study investigates the effects of economic freedom on banking efficiency in Viet Nam during the period of 2010-2018
Research questions
To determine the impact of economic freedom on bank’s efficiency, this study particularly aims to answer the following questions:
- How are the Vietnamese commercial bank’s efficiency scores between 2010 and 2018?
- Whether and how economic freedom affects on bank’s efficiency?
Research scope and methods
This study analyzes a data sample of 39 commercial banks in Vietnam, encompassing both listed and unlisted institutions, over the period from 2010 to 2018 Utilizing a quantitative analysis method, the research follows a two-step approach to derive its findings.
- First step: Estimation of efficiency scores by using DEA (Data envelopment analysis), these efficiency scores are measured by technical efficiency (TE)
- Second step: Bank efficiency scores are regressed against an array of economic freedom variables and other bank specific factors in truncated regression model combined with bootstrapped confidence intervals
This study analyzes a dataset spanning nine years to assess bank efficiency, measured through Technical Efficiency (TE) using the Data Envelopment Analysis (DEA) method The research focuses on independent variables, including bank-specific factors and economic freedom indices sourced from The Heritage Foundation's 2018 report.
Research Structure
The study contains five chapters:
LITERATURE REVIEW
Theoretical Literature
2.1.1.1 The concept of economic freedom
The concepts of freedom and capitalism have their roots in classical economics, with influential thinkers such as Adam Smith, John Locke, and more recently, Milton Friedman Since the time of Adam Smith, economists have emphasized the importance of individual choice in demand and supply, competition in business, international trade, and the protection of property rights as vital elements for driving economic progress.
In his seminal work "The Wealth of Nations," Adam Smith highlighted the crucial role of the invisible hand in promoting the efficiency and functionality of free markets, ultimately leading to increased national wealth Similarly, Milton Friedman asserted in 1962 that economic freedom is fundamental to a free society, as it fosters greater efficiency in managing economic activities compared to alternative approaches.
Friedrich Hayek, in his seminal works "The Road to Serfdom" (1944) and "The Constitution of Liberty" (1960), emphasizes that true progress lies in individual freedom, which must be balanced with government laws He argues that economic freedom is not an absence of government but rather a framework within which individual liberties can thrive, necessitating government action to prevent violence and fraud Economic freedom encompasses rights related to the production, distribution, and consumption of goods and services, advocating for absolute property rights, freedom of movement for labor and capital, and minimal coercion According to Gwartney and Lawson (2002), economic freedom reflects the degree to which a market economy operates through voluntary exchange, free competition, and the protection of personal and property rights.
Economic freedom is defined as the ability of individuals to pursue their economic livelihoods with maximum autonomy and minimal obstruction, as stated by The Heritage Foundation (2014) This concept goes beyond the mere absence of government interference; it emphasizes the importance of mutual liberty among all individuals While enjoying economic freedom, individuals must also respect the rights and freedoms of others within a framework of law Governments play a crucial role in protecting citizens from one another, ensuring positive economic rights like property and contracts, which defend against potential abuses Ultimately, economic freedom, supported by the rule of law, efficient governance, and open markets, is essential for human dignity, allowing individuals to shape their lives in ways that maximize their happiness Thus, it serves as the foundation for broad-based economic dynamics that foster sustainable growth and enhance societal prosperity.
Economic freedom is assessed through four key indicators: the Fraser Institute, the Heritage Foundation, Freedom House, and Scully & Slottje (1991) Each of these indicators employs distinct methodologies and reflects varying purposes and interpretations of economic freedom Currently, the Fraser Institute and the Heritage Foundation remain the primary sources utilized for measuring this concept.
• The Fraser Institute: This indicator was produced by Hames Gwartney and Robert Lawson, and it has been more widely used than any measures of economic freedom.
The article analyzes economic freedom data from 1980 to 2008, distinguishing itself from the Heritage Foundation's index, which relies on third-party information Key components of economic freedom include personal choice, voluntary exchange, competitive freedom, and the protection of privately owned property The index evaluates several factors: the size of government through expenditures, taxes, and enterprises; the legal framework and security of property rights; access to stable currency; international trade freedom; and regulations affecting credit, labor, and business.
Freedom House initially published its assessment of economic freedom in 1996, although this publication has since been discontinued They defined economic freedom through two key dimensions: the absence of government interference in citizens' rights to exchange goods and services, and the establishment of rules by the state that govern contracts, property rights, and other essential institutional frameworks for economic activities The Freedom House framework includes six indices: the freedom to hold property, the freedom to earn a living, the freedom to operate a business, the freedom to invest earnings, the freedom to trade internationally, and the freedom to participate in the market economy.
• Scully and Slottje (1991) : This was an effort to build the first measures of Freedom
In 1980, data from 141 countries revealed fifteen distinct characteristics related to freedom, including exchange rate system freedom, military draft exemption, property rights, and movement freedom It also assessed civil liberties through the Gastil civil freedom index and classified economic systems according to Gastil-Wright Additional freedoms examined included the right to print and broadcast information, travel both domestically and internationally, and the ability to seek employment without permission, as well as the freedom to own real estate and live in peace.
The Heritage Foundation, in collaboration with the Wall Street Journal, produces an Economic Freedom Index that has been tracking economic performance since 1995 across 161 countries This index evaluates twelve distinct areas of economic freedom, emphasizing individual liberties in labor and finance while also considering a country's global trade interactions Each area is scored on a scale of 0 to 100, with the overall score being the average of these individual scores The twelve freedoms are categorized into four main groups: Rule of Law (including property rights and judicial effectiveness), Government Size (fiscal freedom and taxation), Regulatory Efficiency (business and labor freedom), and Market Openness (trade and investment freedom) This comprehensive assessment is crucial for understanding the factors that contribute to personal and national prosperity, particularly in relation to the banking sector.
Financial freedom is defined by an index that measures banking security and independence from government control It emphasizes the importance of accessing a formal financial system that provides essential payment and investment services, as well as diversified savings and credit options An open banking environment fosters competition by extending financing opportunities and promoting entrepreneurship, leading to more efficient financial intermediation However, state banking and financial regulators, while ensuring transparency and honesty in financial markets, can sometimes hinder efficiency.
Excessive government spending poses a significant threat to economic freedom, as it often necessitates higher taxes or risks stifling private sector activity Additionally, when governments operate without market discipline, it can result in increased bureaucracy, decreased productivity, and inefficiency, further eroding economic freedom.
Property rights play a crucial role in motivating workers and investors within a market economy, as they enable the accumulation of private property and wealth To safeguard these rights, a fair and accessible judicial system is essential, ensuring equality and non-discrimination for all Moreover, the transparency and effectiveness of this judicial system are critical factors that significantly influence a country's potential for long-term economic growth.
Corruption undermines economic integrity, allowing certain groups or individuals to exploit the system at the expense of the broader population This results in excessive barriers to business operations, leading to increased transaction costs and the prevalence of bribery.
Business freedom measures the extent to which entrepreneurs can easily start, license, and close their businesses Any obstacles encountered in these processes can hinder business development and ultimately impact job creation negatively.
Numerous studies indicate that the Heritage Foundation's economic freedom index is the most reliable measure, as it focuses on government-controlled policies (Heckelman, 2000) In contrast, the Fraser Institute's index lacks clarity in measuring economic freedom and updates only every five years, making it less effective for short-term economic assessments This study emphasizes the annual updates provided by the Heritage Foundation, highlighting its relevance in evaluating economic freedom.
2.1.2.1 The definition of Bank efficiency
Empirical studies
The relationship between economic freedom and bank efficiency is well-established in economic theory, indicating that greater economic freedom leads to higher bank efficiency due to fewer constraints on cost management Numerous studies support this notion, including Chortareas (2013), who examined the correlation between the economic freedom index, sourced from the Heritage Foundation database, and the efficiency of commercial banks across 27 European Union member countries.
From 2001 to 2009, the author employed the DEA method to assess banks' technical efficiency scores, followed by a truncated regression model with bootstrapping to analyze the relationship between these scores and economic freedom variables The findings indicate that greater economic freedom positively influences bank efficiency, particularly in countries with robust political systems and quality governance Conversely, Sun and Chang (2011) highlight that lower degrees of liberalization can increase liquidation and switching costs, adversely affecting bank performance Chen (2009) argues that technology spillovers from liberalization enhance profit efficiency, while banks in more liberated economies have better opportunities to scale operations, leading to improved efficiency Economic freedom enables banks to access credit markets and international customers, thereby enhancing profitability through improved technology and strategic development (Prasad et al., 2003) Additionally, Baggs and Brander (2006) demonstrate a correlation between higher freedom levels and increased bank credit to the private sector, resulting in better performance Other research, including Claessen et al (2001), suggests that greater openness in banking markets, characterized by increased foreign penetration, lowers bank margins and boosts system efficiency Glick et al (2006) further note that deregulation often leads to enhanced risk measurement, transparency, and lending efficiency among banks, positively impacting performance Flannery (1984) also observes that restrictions on U.S commercial banks establishing multiple service locations can lead to inefficient operational practices due to limited market entry.
Excessive freedom in the banking sector may lead to increased risk-taking, potentially resulting in poor performance and contributing to global financial crises Numerous studies indicate that economic liberalization can drive banks to adopt riskier behaviors, ultimately harming their performance For instance, Sufian (2014) investigates the effects of economic freedom on Malaysian banks' efficiency using a two-stage approach that combines Data Envelopment Analysis (DEA) and bootstrap regression The findings reveal that greater business freedom often correlates with decreased operational efficiency in banks This highlights the need for policymakers and regulators to impose stricter limits on banking activities to mitigate risks.
Liberalization tends to lead banks to expand their operations and take on greater risks, which can result in poor management and weak corporate governance, ultimately hindering bank performance (Baggs and Brander, 2006) In emerging countries, such as Vietnam, the lack of technology and competitive advantages often leads banks to engage in riskier practices with low returns following the introduction of liberalized policies (Aebi et al., 2012) The Vietnamese banking system, characterized by weak technology, performance, and efficiency, is likely to experience lower performance due to deregulation and increased economic freedom Additionally, inadequate economic frameworks during credit booms can increase the likelihood of economic recessions (Klomp and Haan, 2015) Emerging economies often lack the necessary technology and transparency to compete effectively with foreign banks, resulting in lower efficiency (Lou et al., 2016) Furthermore, the co-dependence of banks in liberalized emerging markets exposes them to systemic and insolvency risks (Gulamhussen et al., 2014) The impact of banking regulation and supervision on performance varies based on the type of regulation, with government intervention often justified to prevent monopolistic behaviors and excessive risk-taking (Chortareas et al., 2012; Freixas and Santomero, 2004) Regulatory frameworks play a crucial role in enhancing bank operational efficiency across different countries (Barth et al., 2006), while changes in monetary policy due to increased liberalization can introduce uncertainty that adversely affects bank financial performance (Freixas and Jorge, 2008).
Based on these arguments above, the hypothesis can be expressed as follow:
H1: Economic freedom increases bank efficiency
To test our hypothesis, we analyze the components of the Economic Freedom Index, which includes overall economic freedom, financial freedom, government spending, property rights, freedom from corruption, and business freedom Additionally, we account for other freedom factors to comprehensively assess a country's broader environment for economic activities.
Chortareas (2013) examines the relationship between financial freedom and bank efficiency within the European Union, revealing that greater financial freedom correlates with improved overall bank efficiency Properly implementing financial openness can significantly reduce bank failure risks by providing more opportunities and diversifying risks, thus enhancing bank performance (Abiad et al., 2008) Additionally, Ağca et al (2007) demonstrate that financial freedom positively influences bank lending and performance by encouraging firms to increase their leverage through long-term loans Furthermore, Vu and Turnell (2010) analyze the liberalization policies of the Vietnamese banking system, concluding that financial freedom reduces regulatory constraints and boosts bank cost efficiency, ultimately leading to improved performance.
A study by Lin et al (2016) involving 12 Asian economies reveals that increased foreign ownership can improve bank cost efficiency, ultimately leading to enhanced performance.
Sufian (2014) explores the link between economic freedom and bank efficiency, revealing that increased financial freedom negatively affects the efficiency of banks in Malaysia Conversely, as Vietnam embraces multi-integration and liberalization, it is anticipated that a higher level of financial freedom will positively influence bank efficiency.
H2: Financial freedom will increase bank’s efficiency
Corruption, characterized by dishonesty and decay, undermines governance by compromising integrity and allowing individuals to benefit at the expense of the collective Achieving freedom from corruption is essential for fostering equitable treatment and enhancing regulatory efficiency (Miles et al., 2006).
Research by Sufian and Habibullah (2010) highlights a significant positive relationship between corruption freedom and bank performance, while Demirguc-Kunt and Huizinga (1999) indicate that corruption negatively affects bank efficiency This suggests that governments should implement stronger measures to combat corruption to improve the financial performance of the banking sector Additionally, a study on the effects of corruption on bank lending in Africa by Charles I Anaere (2014) further confirms that corruption has a detrimental impact on bank lending and contributes to agent cost issues.
Several studies, including Khemaies (2017), suggest that corruption can positively impact bank performance by enabling banks to leverage political relationships to access potential customers, thus enhancing their performance This implies an expected negative relationship between freedom from corruption and bank efficiency (BE) Additionally, Zheng et al (2013) argue that corruption allows banks to address existing governmental issues, enabling them to benefit from advantageous financial transactions Faccio (2010) further notes that the complexities and time-consuming nature of administrative procedures can lead banks to utilize corruption to save time and reduce opportunity costs, ultimately improving BE Furthermore, banks with political connections can navigate challenges more effectively and secure priority funding through corrupt practices.
Recent studies show mixed results regarding the relationship between freedom from corruption and bank efficiency However, we anticipate that increased freedom from corruption will enhance bank lending practices, ultimately leading to improved bank efficiency in Vietnam.
H3: More freedom from corruption will improve bank efficiency
Government spending can effectively stimulate economic growth, particularly when focused on productive areas like transportation and infrastructure, as noted by Easterly and Rebelo (1993) In the context of Viet Nam's transitioned economy, government expenditure serves as a crucial lever for economic development However, it can also signal coercion that distorts market mechanisms, potentially leading to a "crowding out" effect where private sector investments, which typically demonstrate greater profitability and efficiency, are hindered Additionally, research by Chortareas et al (2013) indicates that government spending negatively impacts the efficiency of the banking sector, highlighting the complex relationship between government involvement and economic performance.
H4: Higher level of government spending will reduce bank efficiency.
The property rights index measures the legal protection of property rights in a country and the government's enforcement of these laws, which is influenced by corruption levels and the ability of individuals and businesses to uphold contracts A strong legal framework enhances banking sector efficiency by safeguarding contracts and property rights, which is essential for facilitating lending through effective collateral and bankruptcy laws Improved protection of property rights not only ensures that borrowers and lenders are safeguarded but also enhances bank performance by reducing operational costs and increasing contract execution efficiency Conversely, bureaucratic control and a lack of competition can lead to inefficiencies in banking services and diminish accountability Research indicates that judicial efficiency significantly impacts banks' lending spreads, highlighting that robust enforcement of legal contracts is vital for lowering costs for households and businesses, ultimately leading to more effective financial intermediation.
While securing property rights is often viewed as essential for economic efficiency and growth, some scholars argue against this perspective Schmid (2006) suggests that a degree of insecurity in property rights can be beneficial for economic development, as overly stringent rights may stifle innovation and motivation in businesses Additionally, Easterly (2001) contends that private titling can lead to societal conflicts and inequalities, hindering overall growth and particularly affecting pro-poor development Furthermore, Andrianova et al (2008) highlight that property rights may negatively impact bank performance by introducing risks that undermine banks' confidence in competitive markets, ultimately decreasing their efficiency.
Because property right’s protection is very important for banking sectors, we expect the hypothesis as following:
H5: Higher property rights will be higher bank efficiency in Viet Nam.
Control variables
This study explores the relationship between bank-specific factors and efficiency, alongside economic freedom elements Drawing on existing literature, it also presents expectations regarding how each control variable impacts bank performance.
The relationship between bank size and efficiency remains unclear, with varying perspectives in the literature Studies suggesting a positive correlation highlight that larger banks benefit from economies of scale and face less competition, as noted in an IMF report (2009) These institutions often demonstrate superior performance due to their advantageous market power in loans and deposits (Delis and Staikouras, 2011) An empirical study by Saghi-Zedek further supports this view.
Research indicates that larger European banks generally outperform smaller ones due to benefits from diversification and lower funding costs, although they face a higher risk of default (2016) De Jonghe (2010) highlights a correlation between bank size and economies of scale and scope, suggesting that larger banks can operate with reduced costs while offering a wider range of products and services, thus enhancing cost efficiency This aligns with Battaglia and Gallo's (2017) findings, which confirm the significant positive impact of bank size on performance attributed to economies of scale Additionally, Gulamhussen et al (2014) argue that larger banks possess greater competitive strength in highly competitive markets, enabling them to endure challenges more effectively than their smaller counterparts.
A 2007 study on banks in Egypt indicates that state-owned banks, often the largest in the sector, benefit from political connections and government support, leading to greater efficiency compared to smaller banks.
Several studies indicate a negative relationship between bank size and efficiency Kilinc and Neyapti (2012) suggest that larger banks may take on excessive risks due to their "too big to fail" mentality, increasing their chances of failure Buck and Schliephake (2013) argue that smaller banks are more efficient due to simpler operations and lower conflict levels Additionally, Abreu and Gulamhussen (2013) highlight that during the 2008 financial crisis, larger banks engaged in risky activities for higher returns, leading to significant losses Karry and Chichti (2013) also find a negative correlation between bank size and technical efficiency Finally, Mesa et al (2014) illustrate that the relationship between efficiency and bank size is inconsistent across different asset intervals.
The capital adequacy ratio is crucial in assessing bank risk, with a higher equity ratio indicating lower risks While capitalization is vital for evaluating a financial institution's performance, its relationship remains complex Research by Athanasoglou et al (2008) demonstrates that a strong capital position enables banks to better withstand unexpected losses and seize opportunities effectively Additionally, Saghi-Zedek (2016) highlights that banks with higher capitalization experience reduced vulnerability due to diversification benefits Mirzaei et al (2013) further report that well-capitalized banks rely less on external funding, leading to improved performance Overall, higher equity levels can lower capital costs, positively influencing bank performance (Molyneux, 1993).
A lower capital ratio indicates a riskier financial position, leading to the expectation of a negative correlation between this variable and bank performance (Berger, 1995) In the Philippine banking system, Meslier et al (2014) identify an unclear relationship between bank capitalization and performance Additionally, Dietrich and Wanzenried (2011) reveal that Swiss banks struggle to translate higher capital ratios into increased income, primarily due to diminished loan demand during economic crises.
The profitability to assets ratio is a crucial indicator for assessing a bank's performance and efficiency, as it reflects how effectively a bank utilizes its assets and manages expenses to generate returns Typically, a higher ratio indicates greater efficiency, as banks with elevated returns can offer improved services, further enhancing their operational effectiveness A study by Hasanul et al (2017) highlights the significant impact of the return on average equity ratio on bank efficiency in Bangladesh.
Research indicates a negative relationship between efficiency and profitability in the banking sector, as highlighted by Hou et al (2014) El-Moussawi and Obeid (2010) further suggest that profitability influences efficiency in both positive and negative ways within the GCC banking sector from 2005 to 2008 In contrast, Sufian and Habibullah (2009) found no significant effect of Return on Assets (ROA) on efficiency in Korean commercial banks between 1992 and 2003 Additionally, Matthew and Ismail (2006) analyzed the technical efficiency and productivity of Malaysian banks from 1994 to 2000, concluding that efficient banks are more characterized by size rather than profitability (ROAE) Similarly, Iveta Repkova (2015) examined the determinants of bank efficiency in the Czech Republic from 2001 to 2012, revealing a negative impact of ROA on efficiency.
2.3.4 Loans/ Total assets (Credit risk)
Demirguc-Kunt and Huizinga (1999) established that a higher bank loan ratio correlates with improved bank performance, supported by the trade-off theory of credit risk and returns Additionally, Chen (2009) highlights that loan products are more cost-effective and profitable compared to other banking assets, contributing to enhanced overall performance.
In contrast, there are few studies are different views with the trade off theory above: higher risk compensated by higher return A study of Beltratti and Paladino
A study conducted in 2015 across 44 countries found that lower loan levels encourage banks to issue loans more cautiously and enhance management processes, ultimately boosting bank efficiency Reduced loan levels lower funding costs by decreasing bankruptcy risks and addressing asymmetric information more effectively, leading to improved operational performance in banks (Flamini et al., 2009).
In summary, numerous studies have explored the relationship between bank-specific factors and bank efficiency However, it is essential to also consider the impact of economic freedom on this relationship to gain a comprehensive understanding of bank efficiency.
DATA AND METHODOLOGY
Research method
In order to examine the impact of economic freedom on bank efficiency, using a two-step approach:
- First step: Data envelopment analysis (DEA) - Estimation of bank technical efficiency scores by using DEA
The second step involves utilizing the bootstrap DEA method, where technical efficiency scores are regressed against various environmental factors (EF) and additional bank-specific variables This analysis employs truncated regression techniques alongside bootstrapped confidence intervals to ensure robust results.
Farrell (1957) is recognized as a pioneer in developing the piecewise-linear convex hull approach, which laid the groundwork for the Data Envelopment Analysis (DEA) method later expanded by Charnes, Cooper, and Rhodes in 1978 They introduced the "Constant Returns to Scale" (CCR) model to assess the technical efficiency frontier DEA is a non-parametric linear programming model that constructs a production frontier based on actual input-output data from a sample, and it can be estimated using either Constant Returns to Scale (CRS) or Variable Returns to Scale (VRS) assumptions.
The constant Returns to scale Model (CRS)
The Data Envelopment Analysis (DEA) method, introduced by Charnes et al in 1978, evaluates the efficiency of banks by analyzing S inputs and M outputs For each bank, the input and output data can be represented using the vectors xi and yi for the ith bank.
- x is a vector of bank inputs
- λ is a Nx1 vector of constant
- Tec ^ is a technical efficiency score for the ith bank Tec ^ =1 indicates that the bank is technical efficient, while Tec ^