Financial freedom and bank credit risk: Evidence from the European Union

Abstract

This paper investigates the dynamics between economic and financial freedom indexes relative to banks’ risk-taking. Particularly credit risk is examined and hence impaired loans and loan loss reserves denote risk. Time period for the study is pre-crisis (2006) and mid-crisis (2008) and the dataset used in the study consists of EU-15 countries and the final sample includes 150 banks from these countries.

All bank specific data is collected from Bureau van Dijk’s bankscope. Data for the economic freedom index is collected from the Heritage Foundation. Multivariate regression is developed to test the hypotheses.

Empirical evidence is found that the greater the economic or financial freedom is, the less prone banks are to having impaired loans. The dynamics of loan loss provisions are in line with impaired loans and thus greater freedom index scores reflect less loan loss provisions. The estimations provided significant results for pre and mid-crisis periods where the latter period was also considered as a robustness test for the model.