The implications of economic freedom on bank efficiency: An empirical evidence of Vietnamese commercial banks

TABLE OF CONTENTS DECLARATION TABLE OF CONTENTS ABBREVIATIONS LIST OF TABLES LIST OF FIGURES ABSTRACT CHAPTER 1: INTRODUCTION ................................................................................................... 1 1.1. Research objectives .............................................................................................................. 2 1.2. Research questions................................................................................................................ 2 1.3. Research scope and methods................................................................................................ 3 1.4. Research Structure ................................................................................................................ 3 CHAPTER 2: LITERATURE REVIEW ........................................................................................ 4 2.1. Theoretical Literature ........................................................................................................... 4 2.1.1. Theory of economic freedom........................................................................................ 4 2.1.1.1. The concept of economic freedom ........................................................................ 4 2.1.1.2. Economic freedom Indicators................................................................................ 5 2.1.2. Theory of bank efficiency ............................................................................................. 9 2.1.2.1. The definition of Bank efficiency ......................................................................... 9 2.1.2.2. Bank efficiency - financial ratios approach .......................................................... 9 2.1.2.3. Bank efficiency - Production Possibility frontier (PPF) approach.................... 11 2.1.3. Economic freedom and bank efficiency..................................................................... 15 2.2. Empirical studies................................................................................................................. 17 2.2.1. Economic freedom ...................................................................................................... 17 2.2.2. Financial freedom........................................................................................................ 20 2.2.3. Freedom from corruption ............................................................................................ 20 2.2.4. Government spending ................................................................................................. 22 2.2.5. Property rights ............................................................................................................. 22 2.2.6. Business freedom......................................................................................................... 23 2.3. Control variables................................................................................................................. 24 2.3.1. Bank size ...................................................................................................................... 24 2.3.2. Equity/Assets (Bank capitalization) ........................................................................... 25 2.3.3. ROAE (Profitability) ................................................................................................... 26 2.3.4. Loans/ Total assets (Credit risk) ................................................................................. 26 CHAPTER 3: DATA AND METHODOLOGY.......................................................................... 28 3.1. Research method................................................................................................................. 28 3.1.1. Data Envelopment Analysis (DEA) ........................................................................... 28 3.1.2. The bootstrap DEA method ........................................................................................ 30 3.2. Model specification ............................................................................................................ 32 3.3. Variables description .......................................................................................................... 34 3.3.1. Variables for DEA....................................................................................................... 34 3.3.2. Variables for truncated regression.............................................................................. 36 3.3.2.1. Dependent variable............................................................................................... 36 3.3.2.2. Independent variables .......................................................................................... 36 3.4. Data source.......................................................................................................................... 41 CHAPTER 4: RESULTS AND DISCUSSION ........................................................................... 42 4.1. Descriptive statistics ........................................................................................................... 42 4.1.1. Efficiency estimates .................................................................................................... 42 4.1.2. Truncated regression estimates................................................................................... 44 4.1.3. Vietnam economic freedom overview ....................................................................... 46 4.2. Correlation........................................................................................................................... 48 4.3. Result ................................................................................................................................... 50 4.3.1. First stage result - Bank efficiency............................................................................. 50 4.3.2. Second stage result - Truncated regression result ..................................................... 53 4.4. Sensitive Test ...................................................................................................................... 60 CHAPTER 5: CONCLUSION ...................................................................................................... 65 5.1. Conclusion and policy implication .................................................................................... 65 5.2. Limitation ............................................................................................................................ 66 REFERENCES APPENDIX ABBREVIATIONS GCC Gulf Cooperation Council BE Bank efficiency EF Economic freedom FF Financial freedom PCBs Private Commercial Banks SOBs State Owned Banks SSA Sub- Saharan African TE Technical efficiency LIST OF TABLES Table 3.1: The overview of input and output variables to estimate bank efficiency scores (DEA) in first stage ............................................................................................. 35 Table 3.2: The overview of explanatory variables to regress in second stage............... 40 Table 4.1: A summary statistics of variables used to estimate the bank efficiency (first stage) in Vietnamese commercial banks from 2010 to 2018 ........................................ 42 Table 4.2: A summary statistics of variables used for truncated regression (second stage) to investigate economic freedom effects on bank efficiency during period 2010- 2018................................................................................................................................ 44 Table 4.3: Viet Nam economic freedom index 2010-2018............................................ 46 Table 4.4: Correlation matrix among variables in truncated regression ........................ 49 Table 4.5: Banking efficiency (TE) scores in the period 2009-2018............................. 50 Table 4.6: the distribution of Vietnamese bank Technical Efficiency scores 2010- 2018 ............................................................................................................................... 53 Table 4.7: Second stage result - Truncated regression result......................................... 53 Table 4.8: Merger and Acquisition in Viet Nam commercial banks 2012-2015........... 60 Table 4.9: Sensitive Test ................................................................................................ 61 Table 4.10: Summarize result between second step regression and sensitivity test ...... 64 LIST OF FIGURES Figure 2.1: Technical efficiency (TE) - Allocative efficiency (AE) - Economic efficiency (EE) ............................................................................................................... 12 Figure 2.2: Input- Oriented approach (IO)..................................................................... 13 Figure 2.3: Output- Oriented approach (OO)................................................................ 14 Figure 3.1: Variable Returns to scale Model (VRS) and constant Returns to scale Model (CRS) .................................................................................................................. 30 Figure 4.1: Graph of average efficiencies of Viet Nam banks 2010-2018 .................... 52 THE IMPLICATIONS OF ECONOMIC FREEDOM ON BANK EFFICIENCY: AN EMPIRICAL EVIDENCE OF VIETNAMESE COMMERCIAL BANKS Abstract The effect of economic freedom on the economy’s well-being has been widely documented. However, it is absent from the literature of empirical evidence about effect of economic freedom on the banking sector. This study employs the overall economic freedom index and the index’s components which are derived from Heritage Foundation to examine their effect on Vietnamese commercial bank’s effieciency. In first procedure, we obtain efficiency scores of 39 banks in Viet Nam using Data Envelopment Analysis (DEA), over the period 2010-2018 with 299 observations. Then second step, the efficiency scores estimated from DEA method will be regressed on economic freedom indexes, applying truncated regression model combined with bootstrapped confidence intervals while controlling for bank specific characteristics. Additionally, we carry out a sensitive analysis using a fractional logit estimator as a robustness check. We find strong evidence supporting that far greater economic freedom positively impacts the efficiency of banks in Vietnamese banking sector. However, the influence of different economic freedom counterparts on efficiency banking sector is not as uniform as economic freedom overall index such as the higher the degree of property rights, business freedom and freedom from corruption, the better the bank’s performance while negative effects of financial freedom on bank efficiency. Besides, the empirical findings also show the positive relationship between capitalization and bank efficiency as well as credit risk and bank efficiency Keywords: Banks, economic freedom, bank efficiency, DEA, truncated regression bootstrap, Viet Nam 1 CHAPTER 1: INTRODUCTION Efficiency is the most important aim of most business including banks, and bank efficiency is a widely discussed topic because of its vital roles in creating a stable and profitable banking sector then impact on economic growth in each country. As a perspective that individual’s liberty to pursue its own economic goals will lead to efficient outcomes is as instinctive as the economics theory itself, we have seen that most countries trying to close to economic freedom. However, most of studies recently just focus on the relationship between economic freedom (EF) and economic growth, less studies have been carried about effect of economic freedom on banking sector, which is one of the most important financial intermediary playing an important role in providing funding sources for economic growth (Ferreira,2015). EF plays a vital role for the banking sector’s development which categorizes of priority for developing nations and improving efficient banking system in a globalized economy. Theoretically argued, EF helps to motivate the environment leading to efficiency financial system’s establishment or being innovative ideas and producing capacities, but the relationship between EF and financial activities still remains vague (Terpilih, 2010). For example, one of component in economic freedom is financial freedom, and the effect of financial freedom (FF) in emerging markets of financial markets is not easily determined as it relies on kind of reform and conditions of financial constrains in the market (Ağca et al., 2007). As a study from Kose et al., (2003), the influence of FF and integration on banking sector and economic growth is hard to determine because it could rely on the governance’s quality and institutions. They points that the integration in developing countries is lack of experience, and government could create higher uncertainty shocks to banking sector resulting in lower efficiency. Lou et al., (2016) find that the openness with high level leads to shrink of bank performance due to the lack of technologies, skills, the high level of competition and knowledge. Higher freedom and openness also lead to the higher dependence on each others and fragility of banking sectors in the world such as credit risk, economic and information shock (Anginer and Demirguc-Kunt,2014), which can affect bank efficiency ( BE). 2 On the other hand, Asharf (2017) finds that freedom increases the bank’s development levels by decreasing cost and bank credit risk. The author also finds that freedom helps to remove barriers of trading and stimulate lending diversification which creates more bank credit demand and banks’ chances to growth. Reducing restrictions in banking activities due to FF provides more potential chances to improve BE and profitability (Chen, 2009). Banks tend to have higher profitability, efficiency in countries that have high economic and freedom (Tennant and Sutherland 2014). A study from Ahamed (2017) also shows that foreign Banks’s entry following freedom policies will improve the host country’s banking system because of the “technology spillover” effects which positively impact on the financial institution’s performance. In Viet Nam, particularly this time, the Association of Southeast Asian Nations (ASEAN) banking system has been preparation for the multilateral- liberalization before of the year 2020 and this is basing on the ASEAN Banking Integration Framework (ABIF) in 2014. Therefore, we expect Vietnamese banking system to achieve higher liberalization, freedom and integration level in 2020. This keys on that the importance to understand the impact of EF on BE to have appropriate actions for the aim of maintaining stable and efficient banking system for economic development in the long term. This study follows this spirit by examining the impact of economic freedom on the efficiency of Vietnamese commercial banks during the period of 2010 to 2018 1.1. 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 1.2. Research questions To determine the impact of economic freedom on bank’s efficiency, this study particularly aims to answer the following questions: 3 - How are the Vietnamese commercial bank’s efficiency scores between 2010 and 2018? - Whether and how economic freedom affects on bank’s efficiency? 1.3. Research scope and methods The data sample of this study includes 39 commercial banks in Viet Nam between 2010 and 2018. They are both listed and unlisted banks. This study employs quantitative analysis method with using a two-step approach: - 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 The data is unbalanced over 9 years examining: the dependent variable is bank’s efficiency which is measure by Technical efficiency (TE) with DEA method, and independent variables are bank specific factors and economic freedom indexes derived from The Heritage Foundation 2018. 1.4. Research Structure The study contains five chapters: Chapter 1: Introduction Chapter 2: Literature Review Chapter 3: Data and Methodology Chapter 4: Result and Discussion Chapter 5: Conclusion 4 CHAPTER 2: LITERATURE REVIEW This chapter provides theories about economic freedom and bank efficiency as well as previous researches the relationship between them. 2.1. Theoretical Literature 2.1.1. Theory of economic freedom 2.1.1.1. The concept of economic freedom Freedom (Liberalization) thinking and capitalism ideal have been generated since classical economics like Adam smith, John Locke and recently Milton Friedman. Since Adam smith, economists have believed that freedom to choose demand and supply, competitive in business and trade with other countries and ensure the property right which is essential components for economic advances (North and Thormas, 1973). Moreover, Adam Smith, in the book “ The wealth of Nations”, who had emphasized that the invisible hand role in a free market to help an economy comparatively work and function well , then increasingly wealth of nations. Milton Friedman (1962) said “I believe that freedom society exists because of economic freedom bringing more efficiency than other solutions in controlling economic activities” Hayek foresaw decades ago in the book the road to Serfdom:“the guiding principle in any attempt to create a world of free man must be this: a policy of freedom for the individual is the only truly progressive policy” (F.A.Hayek, 1944). Furthermore, in “ The constitution of Liberty “ (1960) of Friedrich Hayek, he analyses that economic freedom should be understood as freedom under government’s law, and freedom does not mean that absence of all government actions. Therefore, economic freedom is not an absolute freedom, whereas government actions must have. Freedom requires forces, violence and fraudulent to be prevented, except using government forces to make sure best situations with aim for individual efficiency. If the government’s coercion is exceed limits, economic freedom will be hurt. 5 In The Heritage Foundation 2014 “A comprehensive view of economic freedom encompasses all liberties and rights of production, distribution, or consumption of goods and services. The highest forms of economic freedom should provide an absolute right of property ownership; full freedom of movement for labor, capital and good; and an absolute absence of coercion or constraint of economic activity beyond that which is necessary for the protection and maintenance of liberty itself. Individuals are free to work, produce, consume, and invest in any way they choose under the even- handed application of laws, with their economic freedoms at once both protected and respected by the state”. According to Gwartney and Lawson 2002, EF means the extent to which a market economy is in place, where the central components are voluntary exchange, free competition and protection of person and property. In conclusion, following The Heritage Foundation (2014): “economic freedom is the condition in which individual can act with maximum autonomy and minimum obstruction in the pursuit of their economic livelihood and greater prosperity. However, the goal of economic freedom is not simply an absence of government coercion or constraint, but the creation and maintenance of a mutual sense of liberty for all. As individuals enjoy the blessings of economic freedom, they in turn have a responsibility to respect the economic rights and freedoms of others within the rule of law. Governments are instituted to ensure basic protections of one citizen over another. Positive economic rights such as property and contracts are given societal as well as individual defense again the destructive tendencies of others. At the end, economic freedom enhanced and secured by the rule of law, government size, regulatory efficiency, and market openness, is a vital element of human dignity, enabling individuals plan and direct their lives in ways that maximize their happiness as they see fit. Therefore, economic freedom is the key to achieve the broad-based economic dynamic that ensures lasting growth and increases prosperity for society as a whole”. 2.1.1.2. Economic freedom Indicators There are four indicators of economic freedom: The Fraser Institute, The Heritage Foundation, Freedom house, and Scully & Slottje (1991). They differ in the 6 methodswhich they have been constructed, and purposes and the conception of economic freedom embodying. The first two Indicators (Fraser Instituteand The Heritage Foundation) have been using up to now.  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. It covers the time period data from 1980 to 2008. It is different with the index created by the Heritage Foundation that is constructed by third party information. The cornerstones of economic freedom include personal choice, voluntary exchange, freedom to compete and security of privately owned property. In fact, the index measures : Size of government ( expenditures, taxes, and enterprises); Legal structure and security of property rights; access to sound money; freedom to trade internationally; regulation of credit, labor and business  Freedom House: First published in 1996 of economic freedom, but then this publication has been discontinued. They defined economic freedom through two different dimensions: lack of state infringements on citizen’s right to exchange goods and services, and the second one is the state establishmentof the rules governing contracts, property rights and other institutional prerequisites required for the product of economic affairs. The Freedom house includes six indices (freedom to hold property, freedom to earn a living, freedom to operate a business, freedom to invest one’s earnings, freedom to trade internationally and freedom to participate in the market economy)  Scully and Slottje (1991): This was an effort to build the first measures of Freedom House. This data is only available in 1980, including 141 countries and having fifteen different characteristics: exchange rate system freedom, freedom from military draft, property freedom, movement freedom, information freedom, civil freedom index of Gastil, classify Gastil – Wright for economy system, printing and press freedom, broadcast freedom, freedom to travel inside, freedom to travel outside, peace freedom, working permit freedom, freedom to seek without permission, freedom to hold real estate. 7  The Heritage Foundation: This index is a series of twelveeconomic measurements produced by the Heritage Foundation and Wall street Journal. This index has an advantage like The Fraser Institute as continuous data, and this has been constructed since 1995, including 161 countries and public every year. The Index of economic freedom takes a broad and comprehensive view of a country performance, measuring twelve separate areas of economic freedom. Some of the aspects of economic freedom are concerned with a country’s interactions with the rest of the world such the extent of an economy’s openness and trade. However, mostly assessing the liberty of individuals to use their labor or finances without undue restraint and government interference. Each of the economic freedom plays a vital role in developing and sustaining personal and national prosperity. Every economic freedom is individually scored on a scale of 0 to 100. An overall economic freedom score is a simply average of its scores on the twelve individual freedoms. For presentational clarity, the twelve economic freedoms are classified into four widely categories: Rule of law (property rights; freedom from corruption; judicial effectiveness); Government size (fiscal freedom, government spending; tax); Regulatory efficiency (business freedom, labor freedom, monetary freedom); Market openness (trade freedom, investment freedom, financial freedom). Besides the overall economic freedom index, we have selected these indicators below (in four categories above) which are closely related to the banking sector in order to carry on this study. - Financial Freedom: The index is a measure of banking security as well as independence from government control. Being to access and function well in a formal financial system that ensures the availability of payment and investment services to individuals, diversified savings, credit.By extending financing chances and promotingentrepreneurship, an open banking environment encourages competition to bring the most efficient financial intermediation. Banking and financial regulators by the state that is over the assurance of transparency and honesty in financial markets can decrease efficiency. 8 - Government spending: The cost of excessive government is a central issue in economic freedom. Excessive government spending eventually will be financed by higher taxationor run a great risk of crowding out private economic activity. Even worse, a government’s insulation from market discipline often leads to bureaucracy; lower productivity and inefficiency then undermine economic freedom. - Property rights: The ability to accumulate private property and wealth is understood to be a central motivating force for workers and investors in a market economy. The protection of private property requires and judicial system that is available to all equally and without discrimination. And the transparency and effectiveness of the judicial system have proven to be key determinants of a country’s prospects for long term economic growth. - Freedom from corruption: In the perspective of EF, corruption can be expressed as the integrity’s failure in the economic system or a distortion when special groups or individuals are able to take at the expenses of the whole. Then a country imposes numerous burdensome barriers on conducting business, higher transaction costs or bribery. - Business freedom: this index expresses the degree of freedom of entrepreneurs are able to start businesses or in order to obtain licenses and the ease for closing a business. Obstacles to any of these three activities are able to be deterrents to business and then to job creation. Accordingly to many studies, the best indicator is Heritage Foundation because it has been mostly based on the policies which governments can control actually (Heckelman, 2000). On the other hand, the index by Fraser institute is mostly ambiguous efforts to measure economic freedom, and updating by each five years will be hard to consider economy measurement in short term. In this study, we consider economic freedom index provided by Heritage Foundation which is updated by every year. 9 2.1.2. Theory of bank efficiency 2.1.2.1. The definition of Bank efficiency The definition of efficiency in general or particularly BE are common terms in the literature of economic discipline. Productivity and efficiency are normally used for each other. In economics, a firm is considered efficient if it can maximize its output using a given certain inputs, or it reaches the Pareto optimal. (Pareto efficiency as a measure of social welfare is used by many scholars as their efficiency goal. A situation is optimal only if no individuals can be made better off without making someone else worse off). An economic system is said to be more efficient than another (in relative terms) if it can provide more goods and services for society without using more resources. Or we can consider total factor productivity (TFP) which is productivity estimation including all factors of production, mean efficiency can be seemed as productivity and be measured by the ratio output/input Productivity (Efficiency) = 𝑂� � 𝑝 �� 𝐼𝑛𝑝�� Out: such as revenues, profit … In: costs, fixed assets, Efficiency is one kind of economy perspective, it has been measured by comparing between the actual values and optimal value of cost, revenues and profit or any expenses which a firm pursues (Daraio and Simar, 2007). In general terms, for the definition of efficiency in banking sector, a bank could be called as efficient only if it is able to produce an expected result with a minimum provided effort of resources. In particularly, there are two approaches to measure the bank efficiency – Financial ratio and production possibility frontier (PPF) 2.1.2.2. Bank efficiency - financial ratios approach The approach from financial ratio can be understood as measuring bank efficiency from financial ratios which are counted from financial statements. In 10 banking sector, many researchers measured operating efficiency ratio by counting percentage between overhead to total assets. The lower ratio is the higher efficiency of the bank. Nowadays, the operating efficiency ratio accordingly to international standard is 0.6, this means any banks which has below this ratio, will be efficient operating and vice versa. Besides, other financial ratios has been preferred such as ROA, ROE (Chen and Liao, 2009) In common, there can be considered into four groups of financial ratios to measure bank efficiency: Profitability rates (ROA, ROE, ROS, C/I), margin rates(Net interest margin), weighted result rates, employment efficiency rates  Profitability rates - ROA: (The rate of Return on Assets): is a ratio to measure the ability of management to utilize the actual financial resources of a bank to create returns. This ratio is widely used to evaluate bank’s performance - ROE: ( The rate of Return on Equity) is a ratio of financial result to a bank’s owner fund - ROS: (The rate of Return on Sales): is a ratio of financial result to a bank’s income. - C/I: ( Costs ratio to incomes)  Margin rates - Net interest margin: a ratio of interest to assets, and interest spread which can be understood as a difference between the average interest bearing assets and the average expenses of interest bearing liabilities.  Weight result rates: reserves balance which is shown as a difference between the building up and dissolution of reserves.  Employment efficiency rates - Assets/ Number of employees - Result/ Number of employees Based on analyzing financial ratios and comparing with other banks and time varying, we conclude about the bank efficiency. However, this approach has few 11 drawbacks, such as financial ratios have to be compared with a consensus standard, while constructing this standard is hard. Or different financial ratios has different conclusion about efficiency, perhaps this bank can be concluded that efficiency using ROA whereas inefficiency in capital (Chen and Liao, 2009) 2.1.2.3. Bank efficiency - Production Possibility frontier (PPF) approach However, in the production economics, the definitions of efficiency and productivity are two different concepts. While the “productivity” is considered as the entire elements that decide the output’s level achieved with the input provided, efficiency has a different meaning in comparison with productivity. Efficiency has been approached by the production frontier, which shows output’s level which can be reached a peak with the same level of input’s level. That is clarified as the ideal relationship between input and output, related to a process to gain the greatest level of outputs with lowest input’s level. And the company producing on this frontier definitely will be seemed as efficiency. There is inefficient producing if this is below the frontier and further distance, more inefficiency it is. In 1957 Farrell took the efficiency’s measurement into the higher degree by establishing the functions of distance between efficiency and producing practically point. Academically, he is remembered largely for the celebrated non- parametric measure of productive efficiency. There are three kinds of efficiency: Technical efficiency – TE; allocative efficiency –AE; economic efficiency- EE TE: The ability of a firm to obtain maximal output from a given set of inputs (Input- orientation) or the ability of a firm to minimize input from a given set of outputs (Output-orientation). AE: the ability of a firm to use the inputs in optimal proportions, given their prices and can be defined as an optimal utilization for the cost minimizing combination of inputs EE: AE multiply with TE expressing the overall efficiency of the company – Economic efficiency EE= TE*AE 12 Assume a model with 2 inputs (x1 and x2) and 1 output (q) as the figure below Figure 2.1: Technical efficiency (TE) - Allocative efficiency (AE) - Economic efficiency (EE) TE = 0Q/0P AE = 0R/0Q EE= 0R/0P The figure above demonstrates three kinds of efficiency with input orientation. Where: SS’: Technical efficiency frontier AA’: Cost line The TE measured 0Q/0P must lay between 0 and 1, at the value of one means that the firm is fully efficient. Reduction in cost if production is at Q’, so at the point Q the TE firm is efficient but AE is inefficient. The economic efficiency EE = TE*AE (or equal to 0R/0P) Furthermore, the PPF’s theory can be processed with two approaches: Input- Oriented approach and Out-put- Oriented approach .The firm with IO is to measure the lowest input’s amount to create a given set of outputs, whereas OO one is in order to predict the maximum output’s level from a provided input’s level.  Input- Oriented approach (IO): 13 Below Figure 2 illustrates a company with x1 and x2 (2 inputs), and 1 output y , SS’ is a frontier which demonstrates each input’s lowest level that can be used to create a provided output (Technical efficiency frontier). If a company works on this frontier, it will be technical efficiency in an input-oriented one because of minimizing the input’s amount. The frontier AA’ (cost line) (which can be built when we already know the input-price ratio) defines the optimal input’s level to archive the lowest cost. TE = 0Q/0P AE = 0R/0Q EE= 0R/0P Figure 2.2: Input- Oriented approach (IO) The distance RQ’ can be interpreted in terms of cost reduction. Then the multiply of technical and allocative one is overall economic efficiency. All of three measures are bounded between zero and one.  Out-put- Oriented approach(OO) : Figure 3 demonstrates that the case in which a company has one input (x) and two outputs (y1, y2). The ZZ’ curve defines that the highest output level can be reached by using given input’s level x (Technical efficiency frontier). The company is TE only if it works on this frontier. DD’ is the price information. The distance CB’ can be interpreted in terms of cost reduction. 14 There measures in this case also are bounded by zero and one. TE = 0A/0B AE = 0B/0C Figure 2.3: Output- Oriented approach (OO) EE= 0A/0C = TE*AE There are exceptional ones by applying both sides (Beccalli et al., 2006) and not consensus on the proper results of IO and OO in BE measurement up to now. Actually, the foundation of theories about efficiency and BE has been established well long time ago and attracted a variety of academic researches carried on such Berger and Deyoung (1997) with different method of evaluation. Inclusion, efficiency concepts are various and diversified, depending on which purpose we can consider as different perspectives. However in this study, Technical Efficiency (EF) is used to measure BE. (TE) of bank that focuses on the ability of bank to reach outcomes with minimum set of inputs. To reach the desired output, we make an effort to minimize the inputs, and then the technological innovations in the banking industry will be reflected on the production frontier. That means if a bank operates on this frontier, this could be considered as technically efficient (TE). And further distance, more inefficient the banks are. Besides, we apply efficiency with input- orientation because it seems that IO method is almost preferred to the OO as banks can 15 focus on managing the input level (costs) ,better than basing on the outputs level.(Dipasha et al., 2012). The measurements and analysis of TE are conducted by Data Envelopment Analysis (DEA), the next section methodology will discuss further. 2.1.3. Economic freedom and bank efficiency This section lays out the relevant theories as well as literatures on BE and EF related to financial sector performance, while we derive the hypotheses below. In fact, there are no existing models of theory to analyze explicitly the impact of EF on BE developed yet, while as far as we have known that few related economic theories are likely to have impact on the banking sector: - Classical economics theory: Classical economics is a broad term that refers to the dominant school of thought for economics in the 18th and 19th centuries. Mostly considering Scottish economist Adam Smith is the progenitor of the classical economic theory. Adam Smith (1776) release of the Wealth of Nations highlights some of the most prominent developments in classical economics. His revelations centered surrounding free trade and a concept called the "invisible hand" which served as the theory for the beginning stages of domestic and international supply and demand. Self- regulating democracies and capitalistic market developments form the basis for classical economics. The classical economists were pragmatic liberals (economic liberalism), advocating freedom of the market, though they saw a role for the state in providing for the common good. Smith acknowledged that there were areas where the market is not the best way to serve the common interest, and he took it as a given that the greater proportion of the costs supporting the common good should be borne by those best able to afford them. He warned repeatedly of the dangers of monopoly, and stressed the importance of competition. To be related to banking sector, an environment of banking and finance in which a lowest government’s level interference and less dependent on central bank as well as financial institutions supervision; especially regulations are limited to enforce contractual obligations and prevent from fraudulence, this will improve bank efficiency. 16 - Economic theory: Suggestions from Economic theories that EF tends to affect productive encourages, efforts, and the resource using’s effectiveness. Arguments from economic historians that the central components for economic growth are free to supply or choose resources, trade freedom with others, competing in business and ensure property rights (North and Thomas 1976). In addition, the intuitional issues like lacking investment or weak systems to protect property right and avoid corruption go on defeating the total EF and economic potential (North and Thomas, 1976), so it is easy to link with the relationship between bank performance and economic freedom under economic theory. This can be indicated that a link EF and BE, in particular, the higher the level of EF, the bank’s benefit in terms cost advantages and overall efficiency. - Helping hands (Pigou, 1938): However, another theory considers the role of supervision and less freedom as an appropriate policy such helping hands. The helping hand theory implies that a government’s helping hand will be strong and effective to offset or even ameliorate the failures of market in case of external power, monopoly power and informational asymmetries. In banking perspective, this role of government seems as a bank’s official supervision to limit on bank’s activities as well as restrict on bank entries and insurance of bank deposit scheme as proper policies that alleviate failures of market or help to allocate resources (Barth at al., 2006). This can make bank efficient as much as possible to their roles. - The theory of property rights: Coase (1937); Alchian (1969); Demsetz (1967) are pioneers for this theory. Basing on encourages to direct individuals and organization’s economic behavior, an investor has ability to take return of most efficient choices, then he or she can consider and take each alternative choices, compared with net gain among each choice alternative one. Finally, choosing a choice in which can produce the highest benefit for her. Obviously, this makes the economy operating efficiently. The incentives behind that direct behavior of investor are based on property rights of the investor’s decision. Property rights theory carries on the impact of right assignments on investor’s decision by allocating resources and efficiency. This analysis is assumed in the terms of efficient market’s neoclassical 17 model in which this does not have information issues; zero transaction cost and agent behavior is perfect to maximize the profit from all participants existing in the market (Furubotn & Pejovich, 1972). Besides, each investor who has this right will employs these rights to gain its wealth. By implication in banking sector, such protection provides incentive for borrowers and lenders, and decreases protection costs as well as ensures property rights, then borrowers, investor and lenders can devote fewer resources with no hesitant. 2.2. Empirical studies 2.2.1. Economic freedom a) Supporting evidences: With the basic tenets of economic theory, the relationship between economic freedom and bank efficiency is clearly understand : higher degree of freedom, higher level of efficiency as the less constraints to manage their company in controlling cost, thus business will be more effective. Therefore, we also have many studies support for this ideal. For example, Chortareas (2013) investigated the relationship between financial freedom counterparts or economic freedom index and bank efficiency. This economic freedom had been drawn from the Heritage Foundation database and the sample of commercial banks with 27 European Union member countries collected from 2001 to 2009. The author uses the DEA method to estimate technical efficiency scores of banks in the first stage, then second stage using truncated regression model combined with bootstrapped to regress the efficiency scores with economic freedom variables. This paper finds that a positive significance effects of economic freedom on bank efficiency in term of cost advantages: higher the level of an economy’s financial, higher the benefits for banks. Especially, it tends to be clearer in which countries with more freedom political systems and governments with higher quality governance. Investigating the effects of low-liberalized policies on banks, Sun and Chang (2011) find that if the openness is lower degree, it can go up the liquidation costs or switching costs which may seriously decrease bank performance and get case of bank’s loss. Bank can improve the profit efficiency as a result of the liberalization of Technology