Regulations, Economic Freedom and Bank Performance: Evidence from the EU-10 Economies

Cost inefficiency scores for banks in ten new EU member countries of Central and Eastern Europe are estimated using a parametric approach (stochastic frontier analysis) for the period prior to and immediately following their accession (2000-2010). These are then employed in both static and dynamic panels to estimate the impact of regulation on bank specific inefficiency in the transition economies. Using the Fraser Index of Economic Freedom (Gwartney et. al, 2012) we find that, among all the indices of economic freedom, the composite regulation index that includes regulation in credit, labour and business is the one that has more importance for the banking sector as it exerts a negative and statistically significant impact on bank inefficiency. By decomposing the regulation index, into its three components (credit, business and labour regulation) we find that strict labour regulation is associated with higher bank inefficiency while certain aspect of credit regulation such as foreign ownership and competition as well as private ownership are significantly associated with decreased bank inefficiency. The dynamic panel-VAR results using impulse response functions and variance decomposition support the validity of these results further. These results are valuable for both academics and policy makers in their attempts to understand what could drive bank inefficiency.