Does democracy matter in banking performance? Exploring the linkage between democracy, economic freedom and banking performance in the European Union member states

Abstract Literature on the effects of socio‐political factors and the quality of political‐economic institutions on banking performance is scarce and mixed. To contribute to this literature, this study analyzes whether democracy and economic freedom affect the banking sector in European Union member countries. We provide empirical evidence of the influence of democracy and economic freedom on banking performance using a sample of 27 countries from 2001 to 2020, and accounting‐based return on assets (ROA) and return on equity (ROE) as performance measures. A dynamic model (system GMM) was used to address issues such as heteroscedasticity, serial correlation, and endogeneity. These findings indicate that democracy is positively associated with banking performance, whereas economic freedom negatively affects it in the sample countries. Additionally, this study adds to the growing literature on the relationship between control variables (macroeconomic determinants, bank‐specific factors, or a country's legislative regime) and banking performance. This study is practically valuable for managers, investors, stakeholders, policymakers, and academicians.