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, from 2010 to 2018 Utilizing a quantitative analysis method, the research employs 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
Over a nine-year period, the analysis reveals an unbalanced dataset focusing on bank efficiency, measured by Technical Efficiency (TE) using the Data Envelopment Analysis (DEA) method The study examines various bank-specific factors alongside economic freedom indices sourced from The Heritage Foundation in 2018.
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 like Adam Smith, John Locke, and Milton Friedman shaping these ideas Since the time of Adam Smith, economists have emphasized the importance of choice in demand and supply, competition in business, international trade, and the protection of property rights as crucial elements for fostering economic progress.
In his seminal work "The Wealth of Nations," Adam Smith highlighted the crucial role of the invisible hand in promoting efficiency and prosperity within a free market economy This concept suggests that individual self-interest inadvertently contributes to the overall well-being of society Similarly, Milton Friedman asserted that economic freedom is essential for a thriving society, as it fosters greater efficiency in managing economic activities compared to alternative approaches Together, these ideas underscore the importance of free markets in driving national wealth and enhancing societal progress.
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 law He argues that economic freedom is not the absence of government intervention but rather a framework where the government plays a crucial role in preventing violence and fraud to ensure optimal conditions for individual efficiency However, excessive government coercion can undermine economic freedom, highlighting the delicate balance needed between liberty and regulation for a thriving society.
Economic freedom encompasses the rights and liberties related to the production, distribution, and consumption of goods and services, as outlined by The Heritage Foundation in 2014 It emphasizes the importance of property ownership, the unrestricted movement of labor, capital, and goods, and minimal constraints on economic activities necessary only to protect individual liberties Individuals should have the freedom to work, produce, consume, and invest as they choose, with their rights upheld by fair legal frameworks Gwartney and Lawson (2002) further define economic freedom as the degree to which a market economy operates, characterized by voluntary exchange, free competition, and the protection of personal and property rights.
Economic freedom is defined as the ability of individuals to act with maximum autonomy and minimal obstruction in pursuit of their livelihoods and prosperity It encompasses not only the absence of government coercion but also the mutual respect for the economic rights of others within the framework of the rule of law Governments play a crucial role in safeguarding these rights, ensuring protection against the destructive tendencies of individuals Essential rights like property and contracts are vital for both societal and individual defense Ultimately, economic freedom, supported by the rule of law, efficient governance, and open markets, is fundamental to human dignity, allowing individuals to shape their lives in ways that enhance their happiness Thus, economic freedom is key to fostering broad-based economic dynamics that promote sustainable growth and societal prosperity.
Economic freedom is assessed through four key indicators, primarily developed by the Fraser Institute and the Heritage Foundation These indicators are constructed using specific methodologies and serve distinct purposes, reflecting the broader concept of economic freedom The Fraser Institute and the Heritage Foundation have been the main sources for these indicators to date.
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 from 1980 to 2008, distinguishing its findings from the Heritage Foundation's index, which relies on third-party data Key components of economic freedom include personal choice, voluntary exchange, competition, and the protection of private property The index evaluates various factors such as government size, legal frameworks and property rights, access to stable currency, international trade freedom, and the regulation of credit, labor, and business.
Freedom House first 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 state infringements on citizens' rights to exchange goods and services, and the establishment of rules by the state that govern contracts, property rights, and other essential institutional prerequisites for economic activities The Freedom House framework includes six indices: the freedom to hold property, earn a living, operate a business, invest earnings, trade internationally, and participate in the market economy.
Scully and Slottje (1991) : This was an effort to build the first measures of Freedom
In 1980, data was collected from 141 countries, highlighting fifteen distinct freedoms that encompass various aspects of personal and economic liberties These include the freedom of the exchange rate system, military draft exemption, property ownership, movement, information access, and civil liberties as measured by the Gastil index Additionally, the data addresses economic classification by Gastil-Wright, along with freedoms related to printing and press, broadcasting, domestic and international travel, peace, work permits, seeking opportunities without permission, and holding real estate.
The Heritage Foundation, in collaboration with the Wall Street Journal, produces an annual Index of Economic Freedom, which has been tracking economic performance since 1995 across 161 countries This index evaluates twelve distinct areas of economic freedom, emphasizing both a nation's global trade interactions and the individual liberties of citizens to manage their labor and finances without excessive government interference Each area of economic freedom is scored from 0 to 100, and the overall score is 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 (covering fiscal freedom and taxation), Regulatory Efficiency (encompassing business and labor freedom), and Market Openness (which includes trade and investment freedom) This study focuses on specific indicators within these categories that are particularly relevant to the banking sector.
Financial freedom is defined by the index as a measure of banking security and independence from government control It emphasizes the importance of accessing a formal financial system that provides essential payment and investment services, diversified savings, and credit options for individuals An open banking environment fosters competition, enhances financing opportunities, and promotes entrepreneurship, leading to more efficient financial intermediation Additionally, state banking and financial regulators play a crucial role in ensuring these standards are met.
Excessive government spending poses a significant threat to economic freedom, as it ultimately necessitates higher taxation or risks crowding out private sector activity Moreover, the lack of market discipline can result in bureaucratic inefficiencies, leading to lower productivity and further compromising economic freedom.
Property rights are fundamental in a market economy, driving workers and investors to accumulate wealth Ensuring the protection of private property necessitates an equitable judicial system that is accessible to everyone without discrimination Moreover, the transparency and efficiency of this judicial system are crucial factors influencing a country's potential for sustained economic growth.
Corruption undermines economic integrity, allowing specific groups or individuals to exploit resources at the expense of the broader population This leads to excessive barriers for businesses, resulting in increased transaction costs and the prevalence of bribery.
The Business Freedom Index measures the extent to which entrepreneurs can start, license, and close businesses with ease Any obstacles encountered in these processes can hinder business development and, consequently, job creation.
Empirical studies
Economic theory establishes a clear link between economic freedom and bank efficiency, indicating that a higher degree of freedom leads to greater efficiency due to fewer constraints on cost management This relationship is supported by various studies, including Chortareas (2013), who examined the connection between financial freedom, as measured by the economic freedom index from the Heritage Foundation, and bank efficiency across 27 European Union member countries.
From 2001 to 2009, the author employed the DEA method to assess the technical efficiency of banks, subsequently utilizing a truncated regression model with bootstrapping to analyze the relationship between efficiency scores and economic freedom variables The study reveals a significant positive impact of economic freedom on bank efficiency, particularly in terms of cost advantages, indicating that higher financial freedom correlates with greater benefits for banks This effect is especially pronounced in countries with more liberal political systems and higher quality governance In contrast, research by Sun and Chang (2011) highlights that low-liberalized policies can elevate liquidation and switching costs, negatively affecting bank performance Chen (2009) discusses the spill-over effects, while Prasad et al (2003) argue that increased economic freedom allows banks to expand their operations, enhancing efficiency and profitability through better access to credit markets and international customers Furthermore, Baggs and Brander (2006) demonstrate a link between higher freedom levels and increased bank credit to the private sector, leading to improved performance Claessen et al (2001) note that greater openness in banking markets, through increased foreign penetration, can reduce margins and boost efficiency Glick et al (2006) find that deregulation is associated with improved risk management and lending efficiency in banks, ultimately enhancing performance Flannery (1984) similarly points out that restrictions on US commercial banks hinder their operational efficiency by limiting their ability to establish multiple service locations.
Excessive freedom in banking can lead to increased risk-taking, potentially resulting in poor performance and contributing to global financial crises Numerous studies indicate that economic liberalization (EF) can prompt banks to engage in riskier behaviors that ultimately harm their performance For instance, Sufian (2014) investigates the effects of EF on bank efficiency in Malaysia, employing a two-stage approach that includes Data Envelopment Analysis (DEA) and bootstrap regression The study reveals that greater business freedom is associated with a decline in operational efficiency among banks These findings underscore the need for policymakers and regulators to impose stricter limits on banking activities to mitigate risks.
Liberalization in banking often leads to increased operational scale and higher risk exposure, which can hinder effective management and performance, particularly in emerging markets like Vietnam, where technological and competitive deficiencies persist (Baggs & Brander, 2006; Aebi et al., 2012) The Vietnamese banking system may experience lower performance due to deregulation and economic freedom, compounded by a lack of technological advancement and transparency (Klomp & Haan, 2015; Lou et al., 2016) Furthermore, the interdependence among banks during liberalization can heighten systemic and insolvency risks (Gulamhussen et al., 2014) The impact of banking regulation on performance varies depending on the type of regulation, with government intervention often necessary to prevent excessive risk-taking and monopoly power (Chortareas et al., 2012; Freixas & Santomero, 2004) Overall, effective regulation is crucial for enhancing operational efficiency across different banking sectors (Barth et al., 2006), while shifts in monetary policy due to liberalization can introduce uncertainty that negatively affects financial performance (Freixas & Jorge, 2008).
Based on these arguments above, the hypothesis can be expressed as follow:
H1: Economic freedom increases bank efficiency
To evaluate our hypothesis, we analyze various 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 accurately reflect a country's broader economic environment.
Chortareas (2013) explores the relationship between financial freedom and bank efficiency within the European Union, revealing that greater financial freedom correlates with improved bank performance Properly implementing financial openness can significantly reduce the risk of bank failures by providing more opportunities and enabling risk diversification (Abiad et al., 2008) Additionally, Ağca et al (2007) demonstrate that financial freedom positively influences bank lending and overall 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 alleviates regulatory constraints and enhances cost efficiency, ultimately leading to improved banking outcomes.
A study by Lin et al (2016) involving 12 Asian economies indicates 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 a negative impact of financial freedom on the efficiency of banks in the Malaysian banking sector Conversely, as Vietnam embraces multi-integration and liberalization, we anticipate that an increase in financial freedom will positively influence bank efficiency.
H2: Financial freedom will increase bank’s efficiency
Corruption, characterized by dishonesty and decay within governance, represents a breakdown of integrity that allows individuals to benefit personally at the expense of the collective Achieving freedom from corruption is essential for fostering equitable treatment and enhancing regulatory efficiency, as highlighted by Miles et al (2006).
Research by Sufian and Habibullah (2010) reveals a significant positive relationship between corruption freedom and bank performance, while Demirguc-Kunt and Huizinga (1999) highlight that corruption negatively affects bank efficiency These findings underscore the need for government interventions to combat corruption and improve the financial performance of the banking sector Additionally, a study by Charles I Anaere (2014) shows that corruption has a detrimental effect on bank lending in Africa, further exacerbating the agency cost problem.
Some studies suggest that corruption may positively impact bank performance For instance, Khemaies (2017) argues that banks can leverage political relationships to access potential customers, thereby enhancing their performance This implies a negative correlation between freedom from corruption and bank efficiency (BE) Additionally, Zheng et al (2013) note that corruption can help banks address existing governmental issues to benefit from advantageous financial transactions Faccio (2010) further highlights that the complexities and time-consuming nature of administrative procedures can lead banks to use corruption to save time and reduce opportunity costs associated with bribery, ultimately improving BE Furthermore, banks with political connections can navigate challenges more effectively and secure priority funding through corrupt practices.
Recent literature presents conflicting findings regarding the relationship between freedom from corruption and bank efficiency; however, we anticipate that increased freedom from corruption will enhance bank lending, ultimately leading to improved bank efficiency in Vietnam.
H3: More freedom from corruption will improve bank efficiency
Government spending is a crucial tool for stimulating economic growth, particularly when directed towards productive sectors like transportation and infrastructure, as highlighted by Easterly and Rebelo (1993) In the context of Viet Nam, a transitioning economy, government expenditure serves as a fundamental driver for economic development However, it can also distort market mechanisms and "crowd out" private sector investments, which typically yield higher profitability and efficiency Furthermore, research by Chortareas et al (2013) indicates that government involvement in the economy, manifested through spending, is often negatively correlated with the efficiency of the banking sector.
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 effectiveness of government enforcement This index reflects the level of corruption and the ability of individuals and businesses to enforce contracts In the banking sector, the quality of the legal framework is crucial for contract enforcement and property rights protection, which facilitates lending by safeguarding the rights of borrowers and lenders Strong property rights and effective collateral laws enhance bank performance by protecting deposits and reducing costs, ultimately improving efficiency However, bureaucratic control and a lack of competition in banking services lead to inefficiencies and diminished accountability Research indicates that judicial efficiency significantly impacts banks' lending spreads, highlighting that better enforcement of property rights is essential for lowering operational costs for households and businesses, thus promoting 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 certain level of insecurity in property rights can be beneficial for economic development, as overly stringent property rights may stifle innovation and motivation Additionally, Easterly (2001) highlights that private titling can lead to societal conflicts and increased inequality, ultimately hindering growth, particularly for the poor Furthermore, Andrianova et al (2008) indicate that property rights may negatively impact bank performance by increasing risks, as banks may feel overconfident in a competitive market, which can reduce their overall 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 variables Drawing from existing literature, it sets forth several expectations regarding how each control variable may influence bank performance.
The relationship between bank size and efficiency remains ambiguous, with varying perspectives in the literature Studies supporting a positive correlation suggest that larger banks benefit from economies of scale and reduced competition, as highlighted by an IMF report (2009) These advantages lead to enhanced performance in larger banks due to their market power in loans and deposits (Delis and Staikouras, 2011) An empirical study by Saghi-Zedek further explores this dynamic, contributing to the ongoing debate on the impact of bank size on efficiency.
Research indicates that larger European banks tend to perform better due to diversification benefits and lower funding costs, despite facing a higher probability of default (2016) De Jonghe (2010) highlights the connection between bank size and economies of scale and scope, as larger banks can operate with lower costs while offering a wider range of products and services, thus enhancing cost efficiency This is supported by Battaglia and Gallo (2017), who 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 a competitive advantage in highly competitive markets, allowing them to withstand challenges better than their smaller counterparts.
A study conducted in 2007 on banks in Egypt indicates that state-owned banks, often the largest in the sector, tend to operate more efficiently than smaller banks due to their connections with politicians and the support they receive from the government.
Several studies indicate a negative relationship between bank size and efficiency Kilinc and Neyapti (2012) argue that large banks may take excessive risks, believing they are "too big to fail," which can lead to potential failures or losses Buck and Schliephake (2013) suggest that smaller banks are easier to monitor due to their simpler operations and lower interest conflicts, resulting in greater efficiency Additionally, Abreu and Gulamhussen (2013) highlight that during the 2008 financial crisis, large banks engaged in riskier activities for higher returns, ultimately leading to significant losses Karry and Chichti (2013) also found a negative correlation between bank size and technical efficiency Furthermore, Mesa et al (2014) demonstrated that the relationship between efficiency and bank size is not consistent when plotting efficiency ratios against total asset intervals.
The capital adequacy ratio reflects a bank's ability to manage risk, with a higher equity ratio indicating reduced risk exposure Although capitalization is crucial for assessing a financial institution's performance, its relationship with risk remains complex Research by Athanasoglou et al (2008) suggests that a strong capital position enables banks to better withstand unexpected losses while effectively seizing opportunities Similarly, Saghi-Zedek (2016) found that banks with higher capitalization experience less vulnerability due to diversification benefits Additionally, Mirzaei et al (2013) reported that well-capitalized banks are less reliant on external funding costs, leading to improved performance Thus, it is evident that higher equity levels can lower capital costs for banks.
A lower capital ratio indicates a riskier financial position, which may lead to a negative correlation with bank performance (Berger, 1995) Research by Meslier et al (2014) highlights the ambiguous relationship between bank capitalization and performance within the Philippine banking sector Similarly, Dietrich and Wanzenried (2011) found that Swiss banks struggle to convert higher capital ratios into increased income, particularly during crises when loan demand is low.
The profitability to assets ratio is a key indicator for assessing bank performance and efficiency, as it reflects how effectively a bank utilizes its assets and manages expenses to generate returns Generally, a higher ratio indicates greater efficiency, as banks with higher returns are better positioned to offer improved services Research by Hasanul et al (2017) highlights the significant impact of the return on average equity ratio on bank efficiency in Bangladesh.
A study by Hou et al (2014) reveals a negative relationship between efficiency and profitability El-Moussawi and Obeid (2010) indicate that profitability affects efficiency in both positive and negative ways within the GCC banking sector from 2005 to 2008 Research by Sufian and Habibullah (2009) shows that return on assets (ROA) does not influence efficiency in Korean commercial banks between 1992 and 2003 Additionally, Matthew and Ismail (2006) assess the technical efficiency and productivity of Malaysian banks from 1994 to 2000, concluding that efficient banks are defined by size rather than profitability (ROAE) Furthermore, Iveta Repkova (2015) examines the determinants of bank efficiency in the Czech Republic from 2001 to 2012, finding that ROA negatively impacts efficiency.
2.3.4 Loans/ Total assets (Credit risk)
According to Demirguc-Kunt and Huizinga (1999), a higher bank loan ratio correlates with improved bank performance, supported by the trade-off theory of credit risk and returns Chen (2009) further emphasizes that loan products are more cost-effective and profitable compared to other bank assets, ultimately 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 their management processes, ultimately boosting bank efficiency This reduction in loan levels decreases funding costs by lowering bankruptcy risks and improves the handling of asymmetric information, further contributing to enhanced bank performance (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 bank efficiency for a more comprehensive understanding.
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 applying the bootstrap Data Envelopment Analysis (DEA) method, where technical efficiency scores are regressed against a variety of environmental factors and additional bank-specific variables This analysis utilizes truncated regression techniques alongside bootstrapped confidence intervals to enhance the reliability of the results.
Farrell (1957) is recognized as a pioneer in the development of the piecewise-linear convex hull approach for modeling efficiency This concept was further advanced in 1978 by Charnes, Cooper, and Rhodes, who introduced the term Data Envelopment Analysis (DEA) and applied the "Constant Returns to Scale" (CCR) mathematical planning model to measure the technical efficiency frontier DEA is a non-parametric linear programming method that constructs a production frontier based on actual input-output data from a given sample Notably, the DEA model 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, first 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 by the vectors xi and yi for the ith bank.
Tec ^ i = min Tec^i, λ { Tec > 0 | yi ≤ ∑ 𝑛 𝑖=1 yi λ; and Tec ^ i xi ≥ ∑ 𝑛 𝑖=1 xi λ; λ ≥ 0 }, i={1,…, n}banks Where:
- y is a vector of bank outputs
- x is a vector of bank inputs
- λ is a Nx1 vector of constant
- Tec ^ i is a technical efficiency score for the ith bank Tec ^ i =1 indicates that the bank is technical efficient, while Tec ^ i