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

Abstract The thesis investigates the efficiency of a sample of Vietnamese commercial banks for the period of 2007-2009, by using the Data Envelopment Analysis DEA approach.. Section 1.2

-

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

Acknowledgement

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 the time of research and writing of this thesis I could not have imagined having a better advisor and mentor for my Master study

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

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

My special gratitude is extended to my English teacher, Mr Paul Scott, for his grammatical proofreading of the Thesis draft I am much indebted to Mr Scott for his precious 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 my colleagues at the International banking faculty, University of Banking Hochiminh City for 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 Father for His endless love and spiritual support during the completion of this project

Abstract

The thesis investigates the efficiency of a sample of Vietnamese commercial banks for the period of 2007-2009, by using the Data Envelopment Analysis (DEA) approach After analyzing, the research concludes that the technical efficiency of these banks 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 53.7 percent, and the average annual growth of the Malmquist index was negative 2.6 percent over the study period; however, there is still an opportunity to improve this indicator The results presented in the thesis will be helpful to bank managers in identifying their banks‟ efficiency performance and the underlying reasons for their successes or failures It will also help banks in strategic planning, and help policy makers in their attempts to improve the overall efficiency of the banking industry and identify 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

Abbreviations

pech Pure technical efficiency change

tfpch Total factor productivity change

AE

TE

Allocative efficiency Technical efficiency

Chapter 1: Introduction to the study 1.1 Introduction

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

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 as research 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 World Trade Organization Along with its integration into the WTO, the banking industry is experiencing significant changes The financial liberalization which started in the

1990„s, and continues even is the cause of these important changes in Vietnam, over the last twenty years, the financial system in general, and the banking system in particular, has been transferred from a monopoly system into a diversified system which 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 the banking 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 world financial and economic crisis The negative affects are an increased number of institutions declaring bankruptcy and instability of the system (proven by the liquidation 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 not Vietnamese commercial banks are functioning effectively

Traditionally, the evaluation of banks‟ performance 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 chronologically measure and compare their efforts However, a major weakness of ratio analysis is

that there is a lack of agreement in the literature about the relative importance of various types of indicators If this study incorporates the related financial indicators to measure 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, banks employ various inputs to provide various services (outputs) Which ratios are selected,

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

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

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

The results presented in this research will be helpful to bank managers in measuring their banks‟ efficiency performance, and identifying the underlying reasons for their successes or failures It will also help banks in strategic planning, and help policy makers in their attempts to improve the overall efficiency of the banking industry

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 the government, 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 as foreign trade or investment did exist, but they were organized as sub-units of the State Bank of Vietnam (SBV); moreover, they operated like government organizations rather 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 specialize d 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 institutions had focused on internal resources, thus gradually strengthening their financial capacity Credit institutions continued to increase their total assets through such services as fund mobilization from organizations and individuals, credit extension (loans, guarantees) to the economy and other services As compared to 2008, total assets of the entire system increased by 36.39% The SOCBs‟ assets accounted for the largest 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 institution system 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:%

GDP growth rate 8.20 8.50 6.18 5.32 Deposit growth rate 36.53 47.64 22.84 29.88 Credits growth rate 25.44 53.89 23.38 37.53

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

Due to the fast growth of the economy, banking activities experienced very fast growth 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 the banking sector was 22.87% (it was in fact nearly 50% in 2007, but decreased in 2008 due to the effect of global financial crisis), in which capital mobilized through State -Owned Commercial Banks (SOCBs) was decreasing and capital mobilized through other 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 2007-2009 was financial crisis which affected all sides of financial markets This challenged the banking sector in Vietnam To overcome the difficulties, Vietnamese commercial banks must perform more effectively One of the main problems of the Vietnamese banking sector, especially the commercial banks, is how to effectively improve their efficiency and how to foster productivity growth These are important questions at a time when opening up the financial market (according to WTO accessing commitment) 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 a business problem Objectives explain the purpose of the research in measureable terms and define standards of what the research should accomplish In solving the research problem this study has the following objectives:

- To investigate to the efficiency of the Vietnamese commercial banks

- To analyze the changes in the productivity and technology of the Vietnamese commercial banks

- To contribute to knowledge of measuring efficiency in banking sector

1.3.2 Research questions

Research questions involve the research translation of “problem” into the need for inquiry (Zikmund 1997) As discussed above, the current research leads to the following 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 Vietnamese commercial 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 the period of 2007-2009 Additional research with many more banks and larger scope of whole banking industry is really necessary to precisely assess the scale and measure efficiency of banks Moreover, additional research that encompasses the larger

• 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 the researcher wants to answer This research study is designed to measure efficiency of the commercial banks in Vietnam; thus, “exploratory” is viewed as an appropriate research type Also, this research is designed to identify the cause -and-effect relationships between the other dimensions of factors and banks‟ efficiency Causal research 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 are four types of research design from which to select: survey, experiments, observation and secondary data (Zikmund 1997) Selection of research design is based on the advantages and disadvantages of each kind of research design and on the circumstances in which the research problem is defined In this research, the secondary 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 Data Envelopment Analysis (DEA) To measure productivity changes and to evaluate the productivity changes into technical efficiency and technological changes, we will use the Malmquist total factor productivity inde x to explore the differences in productivity 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 on bank efficiency on the world The research is a reference for researchers, lecturers, and Vietnamese students in banking and finance, and in the world of banks‟ efficiency, in Vietnam banking industry

Finally, the present study will be a reference of research methodology not only in banking 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, research questions, a brief research methodology overview, implications and limitations of research

Chapter 2: Literature Review

Chapter 2 provides a literature review of measurement of banks‟ efficiency in the world 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, details the research methodology design, research procedures and justification of the data analysis

Chapter 4: Research Results

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

Chapter 5: Conclusion and Implication

The chapter points out conclusion and implication from the findings of this research project, based on the research questions and hypotheses This chapter also discusses the implications, recommendations, contributions and limitations of the research in banking industry In addition, the recommendations for further research are provided

Chapter 2: Literature Review

2.1 Introduction

This chapter provides a literary review for the current study by mentioning the efficiency of commercial banks as well as previous research relative efficiency of commercial banks, beginning with a general introduction in section 2.1 Section 2.2 defines the commercial banks, and their functions and factors affect commercial banks Section 2.3 conceptualizes the efficiency; and how to measure efficiency is presented in section 2.4 This section (2.4) provides previous research on evaluating the efficiency of commercial banks, especially measuring banks‟ efficiency by the DEA 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 Credit Institutions of Vietnam,1 is “bank means a type of credit institution which may

conduct all banking operations Based on their characteristics and operation objectives, 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 was passed

on June 16, 2010, by the XIIth National Assembly of the Socialist Republic of Vietnam

at its 7th session

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

1.)Taking demand deposits, time deposits, savings deposits and deposits of other types

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

3.) Extending credit by: Lending; Discounting and re-discounting negotiable instruments and other valuable papers; Providing bank guarantee; Issuing credit cards; Domestic factoring; international factoring for banks licensed for international payment; 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, authorized payment, collection, authorized collection, letter of credit and bank card, and collection and payment services

b.Providing international payment services and other payment services after obtaining 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 Banks make most of their income from the interest on loans The principal bank liabilities are deposits The significance of transaction accounts has diminished as other financial institutions have offered these types of accounts in competition with commercial banks

2.2.2 Function of commercial banks

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

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 system takes 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 to handle 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 difference between the rates at which they borrow and lend, after taking into account all of their expenses

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 those who need money They use deposits to make loans to borrowers Historically the short-term deposits were used to finance short-term commercial lending

Financial intermediation between depositors and borrowers is crucial to the growth and stability of the economy Economic growth depends on a large volume of savings and the effective allocation of the savings to productive and profitable uses By offering 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, foreign exchange, and credit default risks Commercial banks and their affiliates are able to offer various types of life insurance policies, annuities, and related products In addition, they can provide brokerage services-buying and selling securities for their customers – 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 of others for a fee, under the terms of a trust agreement Trust departments provide fee income 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 insti tutions Many institutions 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 increased and exceeded the low fixed returns on their assets The market value of their assets declined 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 sed payments are derived from revenues generated by a defined pool loans This has allowed 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 commercial banks Computer technology had also reduced the cost of screening and monitoring loan 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 the banks to become more efficient; consequently, it‟s become more difficult for banks to achieve 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 placed geographic limits on banks, the products and services they can offer, and the interest rates 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 for their 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 can choose alternative strategies to react to greater competition from domestic and international rivals and they can also adopt the new technology with varying degrees

P= Out

In

in which

P: Productivity (or Efficiency)

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, which includes technical efficiency and allocative efficiency (Hall & Lieberman, 2006)

-for-In general terms, a financial institution or a bank (referred to as decision-making unit or DMU) can be said to be efficient if it cannot produce more output without a corresponding relative increase in inputs, or if it cannot reduce its inputs without a corresponding 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 to economic development process Unlike developed countries, which have fairly complete systems of laws, Vietnam has inadequate legal systems This is actually an impediment 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 mobilize capital and loans, the ability to finance investment and the level of techno logical equipment Profitability is also a factor to reflect the financial capacity of a bank because it demonstrates the effectiveness of business capital Another factor is to the capacity 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 offset losses may occur Conversely, if the bad debt reserve for losses increases, but not enough to offset bad financial situation, then the financial capacity to cover these expenses is reduced

Capacity management and administration is the next factor affecting the

performance of banks Executive management capacity primarily depends on the organizational structure of the management apparatus, the level of labor and the effectiveness of the operating mechanism to be able to respond well before the evolution 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 a set 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 its extensive application in social life today, it was hard for the banking industry to maintain 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 the uniqueness 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 human resources 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 will help the bank create loyal customers This reduces the risks that may occur in the business, and this ethical investment will help banks reduce operating costs The process of developing human resources always focused on human resources development 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 become more important to measure the efficiency of financial institutions due to rapid growth

of financial markets If the financial institutions operate more efficiently, they might expect 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,

• Parametric methods based on the knowledge of production function,

• Non-parametric methods that do not require such knowledge

2.4.1 Efficiency analysis by the traditional method of financial indicators

Traditionally, financial indicators are still an important analytical instrument, and the banks‟ owners and potential customers use them to compare and evaluate the performance of banks However, a major weakness of ratio analysis is that there is a lack of agreement in the literature on the relative importance of various types of indicators 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, banks employ various inputs to provide various services (outputs) Which ratio should be selected becomes an issue of evaluators when a great number of related financial indicators are involved These indicators can be divided into four groups: Profitability rates, 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 the average 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 ved result The result rate charged with operating costs, i.e the ratio of operating costs to the result, if the result rate charged with reserves shows a positive value, i e if a bank builds up more reserves than dissolves, it can be said that building up reserves charges the 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 single indicator provides too little information whether or not a given value is correct

To evaluate a particular financial ratio for a bank, comparisons with peer group banks 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 may provide valuable information about the bank‟s performance A potential shortfall of financial ratio analysis is that other factors are held constant To overcome this problem, various financial ratios should be calculated that provide a broader understanding 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 the frontier efficiency analysis approach in evaluating performance of a bank This approach can be divided into two groups that parameters and non-parametric approach Parameter approach requires specifying a particular functional form for the frontier efficiency, and can specify the distribution of inefficiency or random error But if the selected function is incorrect, calculation results will affect the opposite direction of the efficiency index

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

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

recognized In their survey, Berger and Humphrey (1997) summarized that, within the period of 1992-1997, there was about more than 52 percent of researchers preferred using parametric approach in measuring the efficiency of the financial institutions This included Mester (1993); Berger and DeYoung (1996); Peristiani (1997); et al At the 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, the nonparametric approach was preferred

A host of studies have focused on estimating characteristics of the cost function and measuring economies of scale and scope by assuming that all banks were operating efficiently; these studies include Bell and Murphy (1967), Longbrake and Johnson (1975), and Kolari and Zardkoohi (1987) Banker and Maindiratla (1988) argued that the estimated cost function represented the average behaviors of banks in the sample, and the regression procedures could be modified to orient the estimates toward frontier During 1992–1997, efficient cost frontier approaches were used in

116 out 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 technique originally developed by Charnes Cooper & Rhodes (1978) This was developed on a basis 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 linear programming technique where the frontier is assembled on a piecewise basis from the best practice observations (classified as 100% efficient) It does not specify any functional form for the data, allowing this (reflected in the weights for the inputs and outputs) to be determined by the data

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

institutions against which its performance is identified as inefficient This group of efficient institutions is then described as being the reference set for that inefficient institution This is a basis for arguing that DEA provides an operational approach to measurement of efficiency, in that it more directly identifies ways in which inefficiency can be reduced

This approach separates cost (input saving) efficiency into technical and allocative efficiencies It also allows the decomposition of technical efficiency into pure technical efficiency and scale efficiency The Malmquist index is commonly used to assess banks’ productivity changes In order to identify the possible causes behind productivity changes, the Malmquist index is usually separated into technical efficiency and technological progress changes The objective of DEA is to measure relative efficiency among similar units that share the same technology (or processing procedure) for similar goals (or outputs) by using similar resources (or inputs) The efficiency scores of DMUs are bounded between zero and one; fully efficient banks will have an efficiency score of one.3

Modern efficiency measurement begins with Farrell (1957) who drew upon the 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 industry studies 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) progra m, 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 the others 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 consolidated banking institutions They applied DEA to a larger sample of 215 U.S banks and attempted to break down inefficiency to that stemming from pure technical inefficiency and scale inefficiency They employed the intermediation approach by using three inputs (labor, capital and purchased funds) and five outputs (three types of loans and two types of deposits) Their results indicated that banks could have produced the same level of output with only 70% of the inputs actually used, while scale inefficiencies of the banks were relatively small, suggesting that the sources of inefficiency to be pure technical rather than scale

In addition to the heavy concentration on the U S, DEA has fast become a popular method of assessing financial institutions efficiency among banking researchers in other nations Fukuyama (1993 and 1995) was among the early researchers particularly among countries in Asia to employ DEA to investigate banking efficiency Employing labor, capital, and funds from customers as inputs and revenue from loans and revenue from other business activities as outputs, Fukuyama (1993) considered the efficiency of 143 Japanese banks in 1990 He found that the pure technical efficiency averaged around 0.86 and scale efficiency around 0.98, implying that 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 He also found that banks of different organizational status perform differently with respect to all efficiency measures (overall, scale, pure technical) Scale efficiency is found to be positively but weakly associated with bank size

The nonparametric approach tends to envelop data collected from sampled financial institutions in order to estimate the optimal production or cost level of the whole sample; then scores each institution by comparing its current level with the optimal one This approach, therefore, is more flexible compare to parametric approach 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 the Vietnamese 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 improve the Malmquist productivity index for these banks (X Q Nguyen & DeBorger, 2008)

In his discussion paper, Le (2006) argued that many banking regulations had been issued since 2005 in order to improve the soundness of the banking system and equitize (privatize) the big SOCBs in Vietnam However, due to the poor sequencing banking reforms, “Vietnam‟s banking system is quantitatively and qualitatively inadequate” (Le, 2006) Hence, the efficiency of Vietnamese banking system in Le view 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 the period of 2001-2003 This research focused on the efficiency performance of these 13 Vietnamese commercial banks in terms of efficiency change, productivity growth, and technological change

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

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

There was also a discussion paper which was presented at the “Asia-Pacific Productivity Conference 2008” concerning the efficiency and productivity of 15 commercial 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 and productivity indices for commercial banks in Vietnam” which showed that the productivity of these banks is on a decreasing trend (X Q.Nguyen & DeBorger, 2008) However, as they concluded, the bootstrapping result proved that this trend is not significant, and therefore, more detailed studies are needed as well

2.6 Summary

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

Chapter 3: Research methodology

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 of either 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 , and secondary 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 the the „why‟ question about how one variable affects another Consequently, the two research 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 the research 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 analyze the data

Figure 3.1 Research process Literature review

(Efficiency, DEA methods)

Colleting financial statement of 22 Vietnam commercial banks

Test the DEA model

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, this research 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, in the 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 the banks 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

1 ABB An Binh Commercial Joint Stock Bank

Vietnam

Housing Development Commercial Joint Stock Bank

8 MB Military Commercial Joint Stock Bank

10 MSB Maritime Commercial Joint Stock Bank

11 OCB Orient Commercial Joint Stock Bank

12 SEAB Southeast Asia Commercial Joint Stock Bank

13 SGB Saigon bank for Industry & Trade

14 SHB Saigon-Hanoi Commercial Joint Stock Bank

18 VAB Viet A Commercial Joint Stock Bank

20 VCB Bank for Foreign Trade of Vietnam

21 ICB Vietnam Bank for Industry and Trade