The data envelopment analysis model, evaluating the efficiency of vietnamese commercial banks

If this study incorporates the related financial indicators tomeasure technical efficiency in banks, the n weight assignment to each indicator will be issued.. By the end of 2009, the fi

NGUYEN THI HONG VINH

THE DATA ENVELOPMENT ANALYSIS MODEL:

EVALUATING THE EFFICIENCY OF

VIETNAMESE COMMERCIAL BANKS

MASTER THESIS IN ECONOMICS

Supervisor: PROFESSOR DR PHAM VAN NANG

HoChiMinh City – 2011

NGUYEN THI HONG VINH

THE DATA ENVELOPMENT ANALYSIS MODEL:

EVALUATING THE EFFICIENCY OF

VIETNAMESE COMMERCIAL BANKS

MASTER THESIS IN ECONOMICS

Supervisor: PROFESSOR DR PHAM VAN NANG

HoChiMinh City – 2011

First and foremost, I offer my sincerest gratitude to my supervisor, Professor Dr.Pham Van Nang for his continuous support during my research, for his patience,motivation, enthusiasm, and immense knowledge His guidance helped me in all thetime of research and writing of this thesis I could not have imagined having a betteradvisor and mentor for my Master study

I gratefully acknowledge all the members of the proposal examination committeefor their valuable comments and constructive suggestions

I would like to express my sincere gratitude to all instructors and staff at Faculty ofBanking and Postgraduate Faculty, University of Econimics HoChiMinh City for theirsupport and the valuable knowledge during my study in UEH

My special gratitude is extended to my English teacher, Mr Paul Scott, for hisgrammatical proofreading of the Thesis draft I am much indebted to Mr Scott for hisprecious time to read this thesis and gave his critical comments about it

It is a pleasure to pay tribute also to the Dr Le Phan Thi Dieu Thao and mycolleagues at the International banking faculty, University of Banking Hochiminh Cityfor offering me opportunity to study and finish the Master course

Lastly and most importantly, I wish to thank my beloved parents, and my fiancé,

Ho Xuan Hien Also, I give thanks to the one above all of us, the omnipresent Fatherfor His endless love and spiritual support during the completion of this project

The thesis investigates the efficiency of a sample of Vietnamese commercialbanks for the period of 2007-2009, by using the Data Envelopment Analysis (DEA)approach After analyzing, the research concludes that the technical efficiency of thesebanks was, on average, increasing from 0.683 in 2007 to 0.864 in 2009

It was also found that the average cost efficiency of the sampled banks was 53.7percent, and the average annual growth of the Malmquist index was negative 2.6percent over the study period; however, there is still an opportunity to improve thisindicator The results presented in the thesis will be helpful to bank managers inidentifying their banks‟ efficiency performance and the underlying reasons for theirsuccesses or failures It will also help banks in strategic planning, and help policymakers in their attempts to improve the overall efficiency of the banking industry andidentify the need for reforms of the domestic banks

KEY WORDS: Data Envelopment Analysis (DEA), efficiency, commercial banks,

Vietnam

Table of Contents

Acknowledgement 2

Abstract ii

Table of Contents iii

List of Tables vi

List of Figures vii

Abbreviations viii

Chapter 1: Introduction to the study 1

1.1 Introduction 1

1.2 Research background 1

1.2.1 Rationale of the study 1

1.2.2 Overview of the Vietnamese banking system 3

1.3 Research objectives and questions 6

1.3.1 Research objectives 6

1.3.2 Research questions 7

1.4 Scope and Limitation 7

1.5 Research method 7

1.6 Implications of research 9

1.7 Structure of the study 9

Chapter 2: Literature Review 11

2.1 Introduction 11

2.2 Commercial banks 11

2.2.1 Definition of commercial banks 11

2.2.2 Function of commercial banks 13

2.2.3 Major factors affecting commercial banks‟ performance 14

2.3 Efficiency and factors affecting efficiency of commercial banks 16

2.3.1 Efficiency 16

2.3.2 Main factors affecting efficiency of commercial banks 17

2.4 The measurement of efficiency of Commercial banks 19

2.4.1 Efficiency analysis by the traditional method of financial indicators 19

2.4.2 Efficiency analysis by parametric frontier efficiency approach 21

2.4.3 Efficiency analysis by Non- parametric approach (DEA) 22

2.5 Literature review on measuring efficiency of banking system in Vietnam 25

2.6 Summary 26

Chapter 3: Research methodology 27

3.1 Introduction 27

3.2 Research design 27

3.3 Descriptions of Data Sample and Variables 29

3.3.1 Characteristics of Research Sample on the Vietnamese banks 29

3.3.2 Description of Variables 30

3.4 Data analysis techniques 33

3.5 Conclusion 43

Chapter 4: Empirical results of the research 44

4.1 Introduction 44

4.2 Descriptive Statistics 44

4.3 Analysis of Efficiency Estimates 46

4.4 Productivity Improvement with Malmquist index 53

4.5 Conclusion 56

Chapter 5: Conclusion and suggestion 57

5.1 Introduction 57

5.2 Conclusions from the research questions 57

5.2.1 Conclusions related to the first question 57

5.2.2 Conclusions related to the second question 59

5.3 Recommendations of the research study 60

5.3.1 Recommendations for Vietnamese commercial banks 60

5.3.2 Recommendations for State Banks of Vietnam 63

5.3.3 Recommendations for Government 64

5.4 Contributions of the research findings 65

5.4.1 Theoretical contribution 65

5.4.2 Methodological contribution 66

5.5 Implications of the research 66

5.6 Limitations of the research and further research 67

5.7 Conclusion 68

References ix

Appedix xii

List of Tables

Table 1.1 Number of commercial banks in Vietnam, 2007 -2009 4

Table 1.2 Some developments of Vietnamese banking system (2007 -2009) 5

Table 3.1 Sample of Vietnamese banks 29

Table 4.1: Summary of Variables on Vietnamse commercial banks, 2007 -2009 45

Table 4.2: Technical efficiency of commercial banks, 2007 -2009 47

Table 4.3: Summary of Estimated Efficiency Measures, 2007 -2009 49

Table 4.4: Estimated Efficiency Scores for Individual Banks, 2007 -2009 50

Table 4.5 Number of banks with DRS, IRS, and Cons, 2007 -2009 53

Table 4.6: Malmquist Index summary of Annual Means 54

Table 4.7 Malmquist Index Summary of Individual Commercial Bank Means, 2007 -2009 55

List of Figures

Figure 3.1 Research process 28

Figure 3.2 Relationship between input-output factors and efficiency of commercial banks 33

Figure 3.3: Technical and Allocative Efficiencies 34

Figure 3.4: Technical and Allocative Efficiencies from an Output Orientation 35

Figure 3.5: Efficiency Measurement and Input Slacks 38

Figure 3.6: Calculation of Scale Economies in DEA 40

Figure 4.1 Trend of interest income and non-interest incomes, 2007-2009 46

Figure 5.1 The results of TE, PE, SE, AE, CE of 22 Vietnam commercial banks, 2007 -2009 58

Total factor productivity changeAllocative efficiency

Technical efficiencyCost efficiencyPure technical efficiencyScale efficiency

Total factor productivityIncreasing returns to scaleDecreasing returns to scaleConstant returns to scaleEarnings Per ShareReturn On Assets ratioReturn On Equity ratioJoint-stock commercial banksState-owned commercial banks

Chapter 1: Introduction to the study1.1 Introduction

This chapter provides a general introduction for the study, section 1.1 Section 1.2examines the research background in which the gaps in the empirical studies ofcommercial banks‟ efficiency are identified, and overview of Vietnamese bankingsector is introduced Section 1.3 defines the research questions and objectives of thestudy

In addition, section 1.4 discusses scope and some limitations of the current study.Section 1.5 briefly discusses the general aspects of research methodology such asresearch types and research design

Section 1.6 provides implications of this study Section 1.7 introduces the structure

of the study The structure of chapter 1 is provided in Figure 1.1

1.2 Research background

1.2.1 Rationale of the study

In January 2010, Vietnam concluded three full years of membership in the WorldTrade Organization Along with its integration into the WTO, the banking industry isexperiencing significant changes The financial liberalization which started in the

1990„s, and continues even is the cause of these important changes in Vietnam, overthe last twenty years, the financial system in general, and the banking system inparticular, has been transferred from a monopoly system into a diversified systemwhich allows all participants to compete fairly and effectively

Within these past years, the banking system in Vietnam has gradually developed

by increasing 1.) the number of banking institutions, 2.) the relative size of thebanking sector in the economy, 3.) the amount of credits for the economy, 4.) and the

amount of other banking services

However, the banking system in Vietnam has affected by the recent worldfinancial and economic crisis The negative affects are an increased number ofinstitutions declaring bankruptcy and instability of the system (proven by theliquidation crisis at the end of 2008 and the high non-performance loans ratio) .Despite these affects, our main issue, our overall concern is whether or notVietnamese commercial banks are functioning effectively

Traditionally, the evaluation of banks‟ performanc e usually employs a financial ratio method by which it provides a simple description about the bank‟s financial

performance in comparison to previous periods Thus, bank managers chronologicallymeasure and compare their efforts However, a major weakness of ratio analysis isthat there is a lack of agreement in the literature about the relative importance ofvarious types of indicators If this study incorporates the related financial indicators tomeasure technical efficiency in banks, the n weight assignment to each indicator will

be issued The financial ratio method can be an appropriate method when firms use a

single input or produce a single output However, as in many organizations, banksemploy various inputs to provide various services (outputs) Which ratios are selected,

or which measures are chosen, becomes an issue to evaluators, especially when a greatnumber of related financial indicators are involved One of the solutions is toaggregate average among all indicators in order to integrate a single measurement.DEA approach can be employed to solve the issue of weight assignment Thisapproach uses a mathematical programming method to generate a set of weights foreach indicator

So far, there is still a lack of empirical research about the efficiency of the bankingsector in Vietnam over the past decades The confidential nature of Vietnamese bankshas made it difficult for both foreign and Vietnamese researchers to access criticaldata from banking institutions, except for the standard Annual reports.

Therefore, the aim of this paper is to provide an empirical research on theefficiency of the Vietnamese banking system, in the period of 2007- 2009, in order toget a brief view of how efficient the banking system is, and what need to change toimprove the performance of this sector The author uses a data envelopment analysis(DEA) model for this purpose The panel data of twenty two Vietnamese commercialbanks was used for the empirical research

The results presented in this research will be helpful to bank managers inmeasuring their banks‟ efficiency performance, and identifying the underlying reasonsfor their successes or failures It will also help banks in strategic planning, and helppolicy makers in their attempts to improve the overall efficiency of the bankingindustry

1.2.2 Overview of the Vietnamese banking system

Prior to the Renovation reforms initiated in 1986, Vietnam functioned under a

centrally planned economy: the objectives and modes of production by thegovernment, not the market Vietnamese banking could be described as „mono-banking system,‟ because the State Bank of Vietnam acted both as a central bank and

a global commercial bank In fact, before 1988, special purpose banks in areas such asforeign trade or investment did exist, but they were organized as sub-units of the StateBank of Vietnam (SBV); moreover, they operated like government organizationsrather than commercial banks In March 1988, the banking system officially changed

to a two-tier system (Decree No 53/HDBT of the Prime Minister) Then, the State

Bank of Vietnam acted as the central bank, overseeing four (state owned) commercial

banks (SOCB) which specialized in different areas of banking activity

Almost economists agree that the most significant financial liberalization started in

May 1990, when the two important Decrees were announced: one was the Decree on

the State Bank of Vietnam; and the other was the Decree on Banks, Credit cooperative

and Financial companies These two Decrees divided the Vietnamese financial system

from monopoly (or one-tier) system into two-tier system: the SBV now mainly acts as

a central bank; other banks and financial companies can have freedom to be

independently established, performed and even closed

Table 1.1 Number of commercial banks in Vietnam, 2007-2009

Source: State Bank of Vietnam, Annual Report, 2007 -2009

Table 1.1 shows the number of banks in the system over the period 2007-2009 By

the end of 2009, the financial and banking system developed rapidly: the number of

banking institutions in Vietnam reached 93; the credit institutions comprised of five

state owned commercial banks (SOCB); one social policy bank; 37 joint stock

commercial banks; five joint venture banks; 40 foreign bank branches; and 5 100%

foreign owned banks

Total equity of credit institutions reached Vietnam Dong (VND) 282,612 billion,

and accounted for 9.32% of total assets, of which, chartered capital was VND 208,873

billion The growth of total equity and chartered capital showed that credit institutionshad focused on internal resources, thus gradually strengthening their financialcapacity Credit institutions continued to increase their total assets through suchservices as fund mobilization from organizations and individuals, credit extension(loans, guarantees) to the economy and other services As compared to 2008, totalassets of the entire system increased by 36.39% The SOCBs‟ assets accounted for thelargest part of the whole system (45.5%, as compared with 51.8% in 2008) The ratio

of non-performing loans over total loan outstanding of the entire credit institutionsystem stood at 1.99%, lower than the rate of 2.13% at end – 2008

Table 1.2 Some developments of Vietnamese banking system (2007-2009)

Unit:%

Source: State Bank of Vietnam, Annual Report, 2007 -2009

Due to the fast growth of the economy, banking activities experienced very fastgrowth during the last few years At end of 2008, banking sector assets equaled 120%

of GDP The system is highly concentrated at the top, but fragmented at the bottom.The largest four SOCBs – including partially privatized Vietcombank and Vietinbank– control 60% of all assets Also in 2008, the amount of capital mobilized through thebanking sector was 22.87% (it was in fact nearly 50% in 2007, but decreased in 2008due to the effect of global financial crisis), in which capital mobilized through State -Owned Commercial Banks (SOCBs) was decreasing and capital mobilized throughother commercial banks was increasing (SBV, 2008); hence, the amount of domestic

credits that banking sector provided to the economy was nearly comparable with total GDP (ADB, 2009).

One of the most striking features of the world economy in the period of 2007-2009was financial crisis which affected all sides of financial markets This challenged thebanking sector in Vietnam To overcome the difficulties, Vietnamese commercialbanks must perform more effectively One of the main problems of the Vietnamesebanking sector, especially the commercial banks, is how to effectively improve theirefficiency and how to foster productivity growth These are important questions at atime when opening up the financial market (according to WTO accessingcommitment) is implemented

1.3 Research objectives and questions

1.3.1 Research objectives

According to Zikmund (1997), a research objective is the researcher‟s version of abusiness problem Objectives explain the purpose of the research in measureable termsand define standards of what the research should accomplish In solving the researchproblem this study has the following objectives:

commercial banks

1.3.2 Research questions

Research questions involve the research translation of “problem” into the need forinquiry (Zikmund 1997) As discussed above, the current research leads to thefollowing research questions:

Q1 How is the current efficiency of the banking system in Vietnam?

Q2 What effect are the changes in productivity and technology of Vietnamesecommercial banks‟ having on efficiency?

Thus, it is important to answer these questions and from that, a clearer view on the Vietnamese banking system will be revealed

1.4 Scope and Limitation

This study was conducted with only 22 Vietnamese commercial banks in theperiod of 2007-2009 Additional research with many more banks and larger scope ofwhole banking industry is really necessary to precisely assess the scale and measureefficiency of banks Moreover, additional research that encompasses the largerbanking industry will inform and alert policy makers about macro -economic trends

• Causal research is conducted to identify cause-and-effect relationships among variables where the research problem has already been narrowly defined.

Choosing a type of research depends upon the research questions that theresearcher wants to answer This research study is designed to measure efficiency ofthe commercial banks in Vietnam; thus, “exploratory” is viewed as an appropriateresearch type Also, this research is designed to identify the cause -and-effectrelationships between the other dimensions of factors and banks‟ efficiency Causalresearch is also implemented in combination with descriptive research In summary, a

combination of exploratory and causal research is chosen for this research.

Selecting research design is the next step after choosing type of research There arefour types of research design from which to select: survey, experiments, observationand secondary data (Zikmund 1997) Selection of research design is based on theadvantages and disadvantages of each kind of research design and on thecircumstances in which the research problem is defined In this research, thesecondary data methods are used to address the problem

Two different approaches can be taken to measure efficiency: the non-parametric(or linear programming) and parametric (or stochastic frontier production function)approaches This paper uses the first approach, commonly known as DataEnvelopment Analysis (DEA) To measure productivity changes and to evaluate theproductivity changes into technical efficiency and technological changes, we will usethe Malmquist total factor productivity inde x to explore the differences inproductivity between these banks

Second, the study also helps policy makers in their attempts to improve the overall efficiency of the banking industry.

Third, the results of this research contribute complementarily to the literature onbank efficiency on the world The research is a reference for researchers, lecturers, andVietnamese students in banking and finance, and in the world of banks‟ efficiency, inVietnam banking industry

Finally, the present study will be a reference of research methodology not only inbanking field in particular but also the other social sciences

1.7 Structure of the study

This research is structured into 5 chapters:

Chapter 1: Introduction

This chapter introduces the research including research background, researchquestions, a brief research methodology overview, implications and limitations ofresearch

Chapter 2: Literature Review

Chapter 2 provides a literature review of measurement of banks‟ efficiency in theworld as well as in Vietnam This chapter also presents a research model of the study.

Chapter 3: Methodology

In this chapter, the author discusses methodology utilized in the research, detailsthe research methodology design, research procedures and justification of the dataanalysis

Chapter 4: Research Results

Based on the research objectives and scope, research methodology concerned inchapter 1, and literature review and empirical model presented in chapter 2, thischapter describes sampling and processing data It also analyzed the data collected andthe findings of the research

Chapter 5: Conclusion and Implication

The chapter points out conclusion and implication from the findings of thisresearch project, based on the research questions and hypotheses This chapter alsodiscusses the implications, recommendations, contributions and limitations of theresearch in banking industry In addition, the recommendations for further researchare provided

Chapter 2: Literature Review2.1 Introduction

This chapter provides a literary review for the current study by mentioning theefficiency of commercial banks as well as previous research relative efficiency ofcommercial banks, beginning with a general introduction in section 2.1 Section 2.2defines the commercial banks, and their functions and factors affect commercialbanks Section 2.3 conceptualizes the efficiency; and how to measure efficiency ispresented in section 2.4 This section (2.4) provides previous research on evaluatingthe efficiency of commercial banks, especially measuring banks‟ efficiency by theDEA method Then, section 2.5 mentions some research about measuring banks‟efficiency in Vietnam Finally, section 2.6 provides a summary

2.2 Commercial banks

2.2.1 Definition of commercial banks

The working definition of a commercial bank, according to the Law on CreditInstitutions of Vietnam,1 is “bank means a type of credit institution which may

conduct all banking operations Based on their characteristics and operationobjectives, banks include commercial banks, policy banks and cooperative banks

And commercial bank means a type of bank which may conduct all banking operations and other business activities for profit.”

1 Law No 47/2010/QH12 of June 16, 2010, on credit institutions This Law waspassed on June 16, 2010, by the XIIt h National Assembly of the Socialist Republic ofVietnam at its 7t h session

The law also mentions that banking operations mean the trading in and regularprovision of one or some of the following services:

1.)Taking demand deposits, time deposits, savings deposits and deposits of othertypes

2.) Issuing deposit certificates, promissory notes, treasury bills and bonds to raisecapital at home and aboard

3.) Extending credit by: Lending; Discounting and re-discounting negotiableinstruments and other valuable papers; Providing bank guarantee; Issuing credit cards;Domestic factoring; international factoring for banks licensed for internationalpayment; Other forms of credit after obtaining the Slate Bank's approval

4.) Opening payment accounts for clients

5.) Providing payment instruments

6.) Providing the following payment services, includes:

a.Domestic payment services, including check, payment order, authorizedpayment, collection, authorized collection, letter of credit and bank card, andcollection and payment services

b.Providing international payment services and other payment services afterobtaining the State Bank's approval

In general term, commercial banks are private, profit-seeking enterprises,balancing risk and return in their portfolio management with the goal of maximizing

shareholder wealth.2 The two principal bank assets are loans and securities Banksmake most of their income from the interest on loans The principal bank liabilities aredeposits The significance of transaction accounts has diminished as other financialinstitutions have offered these types of accounts in competition with commercialbanks.

2.2.2 Function of commercial banks

Banks perform three basic functions: (1) they provide a leading role in thepayments system; (2) they intermediate between depositors and borrowers by offeringdeposit and loan products; and (3) they provide a variety of financial services,encompassing fiduciary services, investment banking, and off -balance sheet risktaking

Banks are the core of the payments system Payment refers to the means by

which financial transactions are settled The role of banks in the payments systemtakes on an important social dimension because an efficient payments system is vital

to economic stability and growth The payment system can be divided into two parts:1.) the retail payment system used by individuals to pay their bills or receive funds 2.)the large-dollar payments system used by business concerns and governments tohandle large-dollar domestic and international payments and receipts

Banks are one type of financial intermediary In financial terms, the deposits

represent bank liabilities and the loans are assets Their profit is the differencebetween the rates at which they borrow and lend, after taking into account all of theirexpenses

2 Benton E.Gup, James W.Kolari (2005), Commercial banking textbook, the

Management of Risk, John Wiley and Sons, Inc

Commercial banks act as intermediaries between those who have money and thosewho need money They use deposits to make loans to borrowers Historically theshort-term deposits were used to finance short-term commercial lending.

Financial intermediation between depositors and borrowers is crucial to the growthand stability of the economy Economic growth depends on a large volume of savingsand the effective allocation of the savings to productive and profitable uses Byoffering depositors financial instruments that have desirable risk/return characteristics,commercial banks encourage savings; and by effectively screening credit requests,they channel funds into socially productive and profitable uses

Other financial services of the banks are off-balance sheet activities and insurance

and securities related activities; trust services Banks use financial derivatives –interest rate swaps, financial futures, and options – to hedge interest rate, foreignexchange, and credit default risks Commercial banks and their affiliates are able tooffer various types of life insurance policies, annuities, and related products Inaddition, they can provide brokerage services-buying and selling securities for theircustomers – and may act a securities dealer, buying and selling for their own account.Finally, they may offer investment banking services such as underwriting securities.Commercial banks may operate trust departments in which they manage the funds ofothers for a fee, under the terms of a trust agreement Trust departments provide feeincome for the banks

2.2.3 Major factors affecting commercial banks’ performance

The principal factors that have affected the operations of commercial banks in recent years:

It is clear that commercial banks affecting by inflation and volatile interest

rates The sharp increase and high level of interest rates places intense pressure on the

financial system, and contributed to the failure of a large number of institutions Manyinstitutions had borrowed short-term funds and made long-term real estate loans at

fixed rates of interest When interest rates soared, their cost of borrowing increasedand exceeded the low fixed returns on their assets The market value of their assetsdeclined Equally important, large numbers of borrowers defaulted on their loans.

Securitization has had a major impact on the structure of the financial service

industry Securitization is the issuance of a debt instrument in which the promi sedpayments are derived from revenues generated by a defined pool loans This hasallowed banks to break up or “unbundle” the lending process and have greater access

to the capital markets

A transformation in the technology involved in the delivery of financial services,

especially a decline in the cost of delivery, has had a significant impact on commercialbanks Computer technology had also reduced the cost of screening and monitoringloan portfolios

The more sophisticated customers making banking markets more efficient and

making it, the more difficult for banks to earn an acceptable risk adjusted return.Sophisticated and informed customers, along with competitive forces are causing thebanks to become more efficient; consequently, it‟s become more difficult for banks toachieve an acceptable risk adjusted return

Increased competition from the capital markets has played a role in the decline of

bank‟s market share of financial assets

Deregulation, especially deposit rate deregulation effects to banks‟ performance.

Deregulation of banks refers to the reduction or elimination of laws that placedgeographic limits on banks, the products and services they can offer, and the interestrates they can pay

Despecialization, which has led to financial service organizations, provides a

portfolio of financial services Improved communication and computer technology has

also played a role in de-compartmentalization They have a significant competitive

advantage in that they are not limited by the same legal and regulatory constraints as

banks There is also competition from business concerns that provide trade credit fortheir customers.

With the exception of securitization, banks have little control over these factors.What bank managers can control is their reaction to these events Thus, they canchoose alternative strategies to react to greater competition from domestic andinternational rivals and they can also adopt the new technology with varying degrees

P= Out

In

in which

Out: Output variables (such as quantity, revenues, profit, etc.)

In: Input variables (such as wages, cost, expense, etc.)

Efficiency, however, is not only productivity but also economy, or value money (SNZ, 2010) Researchers always regard it as economic efficiency, whichincludes technical efficiency and allocative efficiency (Hall & Lieberman, 2006)

-for-In general terms, a financial institution or a bank (referred to as decision-makingunit or DMU) can be said to be efficient if it cannot produce more output without acorresponding relative increase in inputs, or if it cannot reduce its inputs without acorresponding relative decrease in output

2.3.2 Main factors affecting efficiency of commercial banks

A commercial bank, as a financial intermediary organization, bridges regional

savings and regional investment in the economy; so the changes of external factors such as economic, political and social environment influence the operation of banks

When the economic growth is high and stable, the business sector in the economy need

to expand production and business, thus increasing the demand for loans; then

commercial banks can easily expand their credit operations Furthermore, a growing economy enables the ability of bad debt to be reduced because the financial capacity of enterprises has been enhanced

In reality, the development of market economy has demonstrated the importance of

legal systems to business management If the legal system has not adapted with the

requirements of economic development, this will become a major hindrance toeconomic development process Unlike developed countries, which have fairlycomplete systems of laws, Vietnam has inadequate legal systems This is actually animpediment to the activities of commercial banks

Some internal factors within Vietnam‟s commercial banks such as the factors of

financial capability, the ability of management, application of advanced technologies,the level and quality of labor have significant influence to efficiency of banks

The financial capability of commercial banks is often manifested through the ability

to expand sources of equity, because equity represents the financial strength of a bank

Potential of equity affects the business scope of banks such as the ability to mobilizecapital and loans, the ability to finance investment and the level of techno logicalequipment Profitability is also a factor to reflect the financial capacity of a bankbecause it demonstrates the effectiveness of business capital Another factor is to thecapacity of preventing and combating risk of a bank If the bad debt reserve increases,the risk must increase to offset risk, which means that the financial capability to offsetlosses may occur Conversely, if the bad debt reserve for losses increases, but notenough to offset bad financial situation, then the financial capacity to cover theseexpenses is reduced.

Capacity management and administration is the next factor affecting the

performance of banks Executive management capacity primarily depends on theorganizational structure of the management apparatus, the level of labor and theeffectiveness of the operating mechanism to be able to respond well before theevolution of the market The next administration capacity executive could be reflected

by the ability to reduce operating costs improve productivity of inputs used to create aset of maximum output

Ability to apply advanced technologies is a reflection of information technology

capacity of a bank Before the development of strong science and technology and itsextensive application in social life today, it was hard for the banking industry tomaintain its competitiveness if it was providing communication services system.Technological capacity of the bank reflect the ability of new technology equipment,including equipment and people, the technology links between banks and theuniqueness of each bank's technology

Finally, the level and quality of workers or the human factor is an important

determinant to the success or failure in any activity of commercial banks The growth

of society requires banks to provi de new services and quality The quality of humanresources must be improved to meet the present changes of the market and society The

use of human resources with professional ethics and good professional standards willhelp the bank create loyal customers This reduces the risks that may occur in thebusiness, and this ethical investment will help banks reduce operating costs Theprocess of developing human resources always focused on human resourcesdevelopment associated with new technology.

2.4 The measurement of efficiency of Commercial banks

The efficiency of banks has been discussed for years Recently, it has becomemore important to measure the efficiency of financial institutions due to rapid growth

of financial markets If the financial institutions operate more efficiently, they mightexpect an improved profitability and a greater amount of intermediated funds

To estimate banks‟ efficiency, we can use different methods These methods can

be classified in various ways:

• The traditional method of financial indices based on balance sheet analysis,

2.4.1 Efficiency analysis by the traditional method of financial indicators

Traditionally, financial indicators are still an important analytical instrument, andthe banks‟ owners and potential customers use them to compare and evaluate theperformance of banks However, a major weakness of ratio analysis is that there is alack of agreement in the literature on the relative importance of various types ofindicators The financial ratio method can be an appropriate method when firms use asingle input or produce a single output However, as in many organizations, banksemploy various inputs to provide various services (outputs) Which ratio should beselected becomes an issue of evaluators when a great number of related financialindicators are involved These indicators can be divided into four groups: Profitabilityrates, Margin rates, Weighted result rates, Employment efficiency rates

The first group of the indicators is profitability rates The most common ones in

this group are:

ROE (the rate of Return On Equity) is a ratio of financial result to a bank‟s own fund; ROA (the rate of Return On Asset) is a ratio which measures the ability of management

to utilize the actual financial resources of the bank to generate returns ROA is

commonly used to evaluate bank management;

(ROS) (the rate of Return On Sale) is a ratio of financial result to a bank‟s

income; (C/I) (Costs ratio)is a ratio of costs to incomes

The second group of efficiency indicators are margin rates Two basic rates of this

group are based on interest margin:

Net interest margin – a ratio of interest results to assets, and interest spread, which can

be interpreted as a difference between the average interest-bearing assets and theaverage expense of interest-bearing liabilities

The next group of financial measures applied in efficiency analysis is weighted

result rates The result rate charged with reserves (reserves balance) which is shown

as a difference between the building up and dissolution of reserves, and the achie vedresult The result rate charged with operating costs, i.e the ratio of operating costs tothe result, if the result rate charged with reserves shows a positive value, i e if a bankbuilds up more reserves than dissolves, it can be said that building up reserves chargesthe bank‟s result, i.e „decreases‟ its level

The last group of measures constitutes the employment efficiency rates The most

frequently used ones are:

• The rate presented as a ratio of assets to the number of employees (job positions);

• The rate presented as a ratio of a result to the number of employees.

Analysis of financial indicators is the most popular efficiency analysis method in banks The number of financial indicators applied can be really big, and interpretation

of achieved results in these cases it more difficult On the other hand, a singleindicator provides too little information whether or not a given value is correct.

To evaluate a particular financial ratio for a bank, comparisons with peer groupbanks are often used Also, it is beneficial to track the ratio analysis over time relative

to other bank Even without comparison with other banks, ratio trends over time mayprovide valuable information about the bank‟s performance A potential shortfall offinancial ratio analysis is that other factors are held constant To overcome thisproblem, various financial ratios should be calculated that provide a broaderunderstanding of the bank‟s financial condition

2.4.2 Efficiency analysis by parametric frontier efficiency approach

Besides the traditional approach, researchers today, in the world, also use thefrontier efficiency analysis approach in evaluating performance of a bank Thisapproach can be divided into two groups that parameters and non-parametricapproach Parameter approach requires specifying a particular functional form for thefrontier efficiency, and can specify the distribution of inefficiency or random error.But if the selected function is incorrect, calculation results will affect the oppositedirection of the efficiency index

A major challenge for both sets of approaches is in distinguishing random errorarising from accounting practice or some other source of inefficiency Each of theparametric approaches has different ways of dealing with random error, whereas thenon-parametric approaches generally ignore it

The parametric approach tends to focus on production function or cost function ofbanks, in which the estimated function through regression model can be viewed as anoptimal function of the banking system (Banker & Maindiratta, 1988) Thus, it ispossible to calculate the efficiency of a certain bank by comparing its production orcost level to that optimal level This parametric estimate is based on a regressionmodel with certain confidence intervals and deviations, therefore, is statistically

recognized In their survey, Berger and Humphrey (1997) summarized that, within theperiod of 1992-1997, there was about more than 52 percent of researchers preferredusing parametric approach in measuring the efficiency of the financial institutions.This included Mester (1993); Berger and DeYoung (1996); Peristiani (1997); et al Atthe same time, however, the assumption of this estimation is very often not tenable,especially when the scale of measurement (sample size) is small In this situation, thenonparametric approach was preferred.

A host of studies have focused on estimating characteristics of the cost functionand measuring economies of scale and scope by assuming that all banks wereoperating efficiently; these studies include Bell and Murphy (1967), Longbrake andJohnson (1975), and Kolari and Zardkoohi (1987) Banker and Maindiratla (1988)argued that the estimated cost function represented the average behaviors of banks inthe sample, and the regression procedures could be modified to orient the estimatestoward frontier During 1992–1997, efficient cost frontier approaches were used in 116out of 130 studies related to financial institution frontier efficiency across 21 countries(Berger and Humphrey, 1997)

2.4.3 Efficiency analysis by Non-parametric approach (DEA)

This study uses Data Envelopment Analysis (DEA), a non-parametric techniqueoriginally developed by Charnes Cooper & Rhodes (1978) This was developed on abasis of constant returns to scale, but subsequently extended by Banker Charnes &Cooper (1984) into a model providing for variable returns to scale DEA is a linearprogramming technique where the frontier is assembled on a piecewise basis from thebest practice observations (classified as 100% efficient) It does not specify anyfunctional form for the data, allowing this (reflected in the weights for the inputs andoutputs) to be determined by the data

Because DEA assesses efficiency by comparing a financial institution‟s efficiencywith those of others, each inefficient financial institution will have a group of efficient

institutions against which its performance is identified as inefficient This group ofefficient institutions is then described as being the reference set for that inefficientinstitution This is a basis for arguing that DEA provides an operational approach tomeasurement of efficiency, in that it more directly identifies ways in whichinefficiency can be reduced.

This approach separates cost (input saving) efficiency into technical andallocative efficiencies It also allows the decomposition of technical efficiency intopure technical efficiency and scale efficiency The Malmquist index is commonlyused to assess banks’ productivity changes In order to identify the possiblecauses behind productivity changes, the Malmquist index is usually separatedinto technical efficiency and technological progress changes The objective ofDEA is to measure relative efficiency among similar units that share the sametechnology (or processing procedure) for similar goals (or outputs) by usingsimilar resources (or inputs) The efficiency scores of DMUs are boundedbetween zero and one; fully efficient banks will have an efficiency score of one.3Modern efficiency measurement begins with Farrell (1957) who drew uponthe work of Debreu (1951) and Koopmans (1951) to define a simple measure

of firm efficiency which could account for multiple inputs He proposed that the

efficiency of a firm consists of two components: technical efficiency, which

reflects the ability of a firm to obtain maximal output from a given set of inputs,

and allocative efficiency, which reflects the ability of a firm to use the inputs in optimal proportions, given their respective prices These two measures are then combined to provide a measure of total economic efficiency.

In the past few years, DEA has frequently been applied to banking industrystudies The first application analyzed efficiencies of different branches of a single

3

A Guide to Deap version 2.1: A Data Envelop ment Analysis (computer) program, Coelli T.J., 1998

bank Sherman and Gold (1985) studied the overall efficiency of 14 branches of a U.S.savings bank.

DEA results showed that six branches were operating inefficiently compared to theothers Similar study by Parkan (1987) suggested that eleven branches out of thirty-five were relatively inefficient

Rangan et al (1988) shifted the unit of assessment from branches to consolidatedbanking institutions They applied DEA to a larger sample of 215 U.S banks andattempted to break down inefficiency to that stemming from pure technicalinefficiency and scale inefficiency They employed the intermediation approach byusing three inputs (labor, capital and purchased funds) and five outputs (three types ofloans and two types of deposits) Their results indicated that banks could haveproduced the same level of output with only 70% of the inputs actually used, whilescale inefficiencies of the banks were relatively small, suggesting that the sources ofinefficiency to be pure technical rather than scale

In addition to the heavy concentration on the U S, DEA has fast become a popularmethod of assessing financial institutions efficiency among banking researchers in othernations Fukuyama (1993 and 1995) was among the early researchers particularly amongcountries in Asia to employ DEA to investigate banking efficiency

Employing labor, capital, and funds from customers as inputs and revenue fromloans and revenue from other business activities as outputs, Fukuyama (1993)considered the efficiency of 143 Japanese banks in 1990 He found that the puretechnical efficiency averaged around 0.86 and scale efficiency around 0.98, implyingthat the major source of overall technical inefficiency is pure technical inefficiency.The scale inefficiency is found to be mainly due to increasing returns to scale Healso found that banks of different organizational status perform differently withrespect to all efficiency measures (overall, scale, pure technical) Scale efficiency isfound to be positively but weakly associated with bank size

The nonparametric approach tends to envelop data collected from sampledfinancial institutions in order to estimate the optimal production or cost level of thewhole sample; then scores each institution by comparing its current level with theoptimal one This approach, therefore, is more flexible compare to parametricapproach in analyzing efficiency base on multiple inputs and outputs (Farrell, 1957;Charnes, Cooper, & Rhodes, 1978; Fare, Grosskopf, & Lovell, 1994; Thomas & Tripe,2007; etc.)

2.5 Literature review on measuring efficiency of banking system in Vietnam

Vietnamese researchers usually have dug into the liberalization process of theVietnamese financial system as well as banking sector (Le, 2006; Ngo, 2004, 2009a);

or focused on measuring the efficiency of the Vietnamese commercial banks (Ngo,2010b; V H Nguyen, 2007); or even tried to use bootstrapping technique to improvethe Malmquist productivity index for these banks (X Q Nguyen & DeBorger, 2008)

In his discussion paper, Le (2006) argued that many banking regulations had beenissued since 2005 in order to improve the soundness of the banking system andequitize (privatize) the big SOCBs in Vietnam However, due to the poor sequencingbanking reforms, “Vietnam‟s banking system is quantitatively and qualitativelyinadequate” (Le, 2006) Hence, the efficiency of Vietnamese banking system in Leview was not high as of 2006 This was supported by Nguyen (2007)

In 2007, Nguyen conducted a research on 13 commercial banks in Vietnam for theperiod of 2001-2003 This research focused on the efficiency performance of these 13Vietnamese commercial banks in terms of efficiency change, productivity growth, andtechnological change

In result, the author found that these banks were inefficient in both allocative(regulatory) and technical (managerial capacity) matter, of which the technicalinefficiency was more serious It meant the problem of increasing the efficiency in

using inputs of Vietnamese banks was more important than the problem of increasingefficiency in choosing the right mix of these inputs (V.H Nguyen, 2007).

There was also a discussion paper which was presented at the “Asia-PacificProductivity Conference 2008” concerning the efficiency and productivity of 15commercial banks in Vietnam (included 4 of 5 SOCBs) by Nguyen and DeBorger(2008) The authors argued that their paper “is the first effort to study efficiency andproductivity indices for commercial banks in Vietnam” which showed that theproductivity of these banks is on a decreasing trend (X Q.Nguyen & DeBorger,2008) However, as they concluded, the bootstrapping result proved that this trend isnot significant, and therefore, more detailed studies are needed as well

2.6 Summary

This chapter discussed the efficiency and measurement of commercial banks, andsome related researchers in Vietnam Despite these results, it is clear that futureresearch on the Vietnamese banking system is still in need, especially in efficiency andperformance aspect Only by improving efficiency will help the banking sector ofVietnam compete fairly with foreign banks in the integration process and inimplementing the WTO accessing commitment

Chapter 3: Research methodology

3.1 Introduction

The literary review in the previous chapter introduced and discussed the

theoretical model constructed for this research

The purpose of this chapter is to describe, justify, and explain the researchmethodology used in the study It includes demonstrating how research design, anddata collection and analysis utilized to answer the research questions outlined inchapter 1 This chapter is structured into five sections The following section presentsresearch design, and descriptions of data and variables will be provided in section 3.3.Next, the study shows the data analysis techniques The final sector is the summary

3.2 Research design

The research design provides the answers to theories and hypotheses, which leads

to the next research steps Business research methods can be classified on the basis ofeither function or technique (Zikmund 1997) Based on function, there are three types

of research, including exploratory, descriptive, and causal studies Based on technique,business research can be classified into experiments, surveys, observational , andsecondary studies As indicated by Zikmund (1997), exploratory research focuses on

the research question starting with the how and the what with the main purpose of

clarify and define the nature of a problem; while causal studies are concerned with thethe „why‟ question about how one variable affects another Consequently, the tworesearch questions of the current study indicate that this study combines both

exploratory and causal studies.

In terms of research techniques, secondary research was chosen to assess theresearch questions for this study because the data can be derived from annual reports

of Vietnamese commercial banks The study runs the DEAP 2.1 software to analyzethe data

Figure 3.1 Research process

Literature review

(Efficiency, DEA methods)

Colleting financial statement of 22 Vietnam commercial banks

Test the DEA model

(the sample to n=22)

Quantitative research:

Writing the report

3.3 Descriptions of Data Sample and Variables

3.3.1 Characteristics of Research Sample on the Vietnamese banks

Within more than 90 banks in Vietnam nowadays, the difference between capitals,labor force, location, etc are variable, and their availability are also differ Hence, thisresearch will focus on analyzing twenty-two commercial banks which stand on the top

50 largest enterprises in banking, financial and securities industry of the VNR-500, inthe year of 20094 The 22 Vietnamese commercial banks sampled include four State-owned banks, and eighteen private banks or joint-stock commercial banks Most of thebanks that the author can not get data for are joint-venture banks and small banks.Table 3.1 provides the list of these 22 banks

Table 3.1 Sample of Vietnamese banks

Vietnam Bank for Agriculture and Rural

Bank for Investment and Development of

Vietnam Export Import Commercial Joint

4 VNR500 is the Vietnam Top 500 Largest Enterprises by Revenue Ranking Board, similar to the Fortune 500 Model For mo re details, go to http://vnr500.co m.vn/ranking-table-of-industry?c=SB64

VietnamHousing Development Commercial Joint Stock

Saigon Thuong Tin Commercial Joint Stock

Vietnam Technological and Commercial Joint

Vietnam Joint Stock Comercial bank for Private

3.3.2 Description of Variables

In measuring the technical efficiency and productivity of banks, the mostquarrelsome problem lies in defining outputs and inputs of banking activities Inbanking theory literature, especially based on A N Berger and D.B Humprhey (1997),