The credit risk management of agribank’s bien hoa branch 2

Microsoft Word F69703116 doc 4 Chapter2 Reasoning Basis in Managing Credit Risks Contents of Chapter2 includes (1) Managing risk in the banking business; (2) Overview of managing credit risks of the bank 2 1 Managing Risk in the Banking Business 2 1 1 Generalizing about risk 2 1 1 1 Risk concept In general, risk can define as the possibility that actual future returns will deviate from expected returns In other words, it represents the volatility of returns Risk can define as the volatility of t.

Chapter2 Reasoning Basis in Managing

Credit Risks

Contents of Chapter2 includes: (1) Managing risk in the banking business; (2) Overview of managing credit risks of the bank

2.1 Managing Risk in the Banking Business

2.1.1 Generalizing about risk

2.1.1.1 Risk concept

In general, risk can define as the possibility that actual future returns will deviate from expected returns In other words, it represents the volatility of returns Risk can define as the volatility of the unexpected outcomes, generally the value of assets or liabilities of interest Firms can expose to various types of risks, which can broadly classify into business and non-business risks (Philippe Jorion, 2000)

2.1.1.2 Categorizing risks

There are many ways to approach risk and we can divide it into systematic and unsystematic risks

Systematic risks (undividable risks): are the risks from the elements outside the company, which are uncontrollable and have the widespread influence to the market Systematic risks are the ones coming from the outside of an industry or business such as war, inflation, economical and political events, etc

Unsystematic risks (dividable risks): result from the accidental or uncontrollable events, which only affect some companies or some industries These elements can be changed of labor force, managing ability, bringing a legal action, regulating policy of the government Most of the investors who have the minimum understanding of this field can eliminate the dividable risks by holding an enough big portfolio, which has from tens

to hundreds of stocks

2.1.2 Risks and managing risks in the banking business

2.1.2.1 Risks in the banking business

2.1.2.1.1 Concept

In the banking business activities, risks are the unexpected events, which lead to the loss to the assets of the bank, reduce the real profit compared to the budgeted one or

spend a further amount of expense to finish a certain finance practice when they occur (Phan Thi Cuc, 2009)

2.1.2.1.2 Categorizing

Figure 2-1 Categorizing Risks in The Banking Business

(Philippe Jorion, 2000)

Credit Risk: is the risk generating in the process of providing credit of the bank, shown in reality through inability to pay debts or not just-in-time paying debts of customers to the bank All of the forms of providing credit of bank including short term, medium term and long term loans, financial leasing, discount on valuable documents, financing import and export processes and projects, guaranteeing liquidation contain credit risks (Phan Thi Cuc, 2009)

Operational Risk: According Basel (1998d) and Jorion (2000), the operational risk generally can be defined as arising from human and technical errors or accidents This

RISK IN ACTIVITIES

OF BANK

Operational Risk

Credit Risk

Liquidity Risk

Legal Risk Market

Risk

includes Freud, management failure, technical errors and inadequate procedures and controls Operational risk also can lead to market and credit risk

Liquidity Risk (unable liquidity): occur in the case that the bank losses the liquidity, convertibility of assets to cash, or borrowing power to meet the need of a settlement contract (Phan Thi Cuc, 2009)

Legal Risk: Customers and other people can take legal actions to the bank Reason

of taking legal actions comes from the common operational processes For example, according to the customers, the rejecting of providing the credit limit again is unreasonable However, some cases can come from the reasons, which are not from the business activities of the bank such as financing the customers who polluted the environment and the bank can take a legal action by the third party suing When solving the legal action of a bank, for example, the contract of leasing and the guaranteeing asset standard have problems, or the government suddenly changes the macro policy in economic structure, prior field, etc These things can create the risk of loss for the bank

(Le Thi Tuan Nghia, 2007)

Market Risk: arises from movements in the level or volatility of market prices Value at risk tools now allow users to quantify market risk in a systematic fashion (Philippe Jorion, 2000)

2.1.2.2 Managing risks in banking business

Managing risks is the process of approaching risks scientifically, entirely, and systematically to identify, control, prevent, and reduce the damage, loss, bad effects of risks Managing risks includes the steps shown in the following exhibit:

Figure 2-2 The Steps of Managing Risks in Operation of Bank

(Phan Thi Cuc, 2009)

IDENTIFY

-ING

RISKS

ANALYZ -ING RISKS

EVALUAT -ING RISKS

CONTROL LING AND PREVENT-ING RISKS

FINANC -ING RISKS

* Identifying risks:

About the managing risks, Phan Thi Cuc (2009) has to identifying risks; it is the process of identifying continuously and systematically Identifying risks include the work of observing, considering, researching operational environment and entire activity

of the bank to list all kinds of risks, not only eliminate the occurred and occurring risks but also forecast the forms of risks, which newly occur at the bank Based on the above basis, the appropriate solutions in controlling and financing risks suggest

Besides, Phan Thi Cuc also purposes that to identifying, managers have to compile the list of the occurred, occurring and potentially appearing risks of the bank by the following methods: preparing the research questionnaire about risks and continuing investigation, analyzing the financial statements, flow of chart method, inspecting the real field, analyzing the contract, working with related governmental agencies

* Analyzing risks:

Phan Thi Cuc (2009) points out to analyze risks is to identify the causes making risks This is a complicated work, because not every risk comes from the only cause but from many causes

To analyze risks is to find effective methods to prevent risks When the cause or the influence affecting the change find, we can prevent risk effectively (Phan Thi Cuc, 2009)

* Evaluating risks:

Phan Thi Cuc (2009) also considers that to evaluate risks, we need to collect, analyze and estimate the data Based on the result, we prepare the matrix to evaluate risks To evaluate the important level of risk to the bank, we use both criteria: the frequent occurrence of risk and the margin of risk - the serious level of damage Between the two, the second plays the determining role

* Controlling and preventing risks:

The main work of administration is controlling risks Controlling risks is using the methods, skills, tools, strategies, the operational programs to prevent, avoid, and eliminate the damage, loss, unexpected influence occurring at the bank There are many risk controlling methods such as avoiding risks, preventing loss, eliminating loss, transferring risks, diversifying risks, information management (Phan Thi Cuc, 2009)

* Financing risks:

Phan Thi Cuc (2009) points out when the risks occur, firstly we need to observe, identify accurately the loss of assets, human resources, legal value Then we need to have

appropriate financing ways to risks These ways can divide into two categories: risk self-overcoming and transferring

2.1.3 Influence of risks to banking operations and social economy

In the banking operations, the first influencing risk can cause loss to the assets of the bank The frequent losses are losing the principle of loan when lending, increasing the operation expenses, decreasing profit, and asset value Besides, risks make the reputation of the bank and the trusts of the customers go down, and the bank can loss its goodwill A bank operating with loss result continuously, with insufficient liquidation making a large number of customers withdraw their deposits, which obviously causes the bank to go bankrupt Thus, it influences thousands of depositors, and businesses which need the capital, and makes the economy recess, prices increase, purchasing power decrease, unemployment decrease, order of society confuse, and moreover a lot of domestic bank collapse (Phan Thi Cuc, 2009)

Besides, risks of the banks also influence the world economy because in the circumstance of going international and globalization now, every country's economy depends on the area and world's economy On the other hand, the relation of currency, investment among the developed countries is close so the risks of the banks in one country will affect directly to other related countries' economies These have shown by the financial crisis of 1997 in Asia, of 2001-2002 in South America and of 2008 in the U.S

2.2 Overview of Managing Credit Risks of the Bank

2.2.1 Credit concept

Credit comes from Latin: Credittum- meaning trust or confidence In Vietnamese, credit means borrowing

Credit is the transaction between two subjects; one lends the other one money or property for using in a certain time based on the rule of returning the principle and interest within the agreed time (Le Thi Tuan Nghia, 2007)

Figure 2-3 Credit form Shows in the Following Exhibit

2

1 Loan

Refund capital and interest

2.2.2 Credit risks

According Basel (1998b) and Jorion (2000), Credit risk originates from the fact that counterparties may be unwilling or unable to fulfill their contractual obligations The effect of credit risk is measured by the cost of replacing cash flows if the other party defaults However, the risks of the bank mainly focus on credit portfolio This has the hugest risks, and risks frequently occur When a bank encounters a very serious and difficult situation in finance, the cause usually comes from the credit operations of the bank (Le Thi Tuan Nghia, 2007)

2.2.2.1 Concept of credit risks

Credit risks are the risks, which occur during the providing credit process, shown

in the situation that customers do not have the ability to return the debts or pay debts not

in time to the banks (Le Thi Tuan Nghia, 2007)

Hence, credit risks are said to appear in the relation that the bank is the creditor, while the debtor does not or cannot carry out the obligation of paying debt when it matures It occurs during the process of lending, discounting the transferring tools, and the valuable documents, financial leasing, guaranteeing, insuring settlement of the bank

2.2.2.2 Categorizing risks

We can diversify credit risks shown in the following exhibit:

Figure 2-4 Credit Risk Pattern (Source:Le Thi Tuan Nghia, 2007)

CREDIT

ATTENTION RISK

LIST RISK

CHOOSING

RISK

INSURANCE RISK

SKILL RISK DOMESTIC

RISK TRANSACTION

RISK

Based on the above exhibit, credit risk can divide into risk in transaction and risk

in portfolio (Le Thi Tuan Nghia, 2007):

Risk in transaction: is the form of credit risk whose cause comes from the limit in the process of transaction, considering and approving the loan, evaluating the customers

It includes:

Risk in choosing: is the risk related to the process of evaluating and analyzing credit when the bank chooses the effective ways of lending money to suggest the lending decision

Risk in guaranteeing: comes from the guaranteeing standards such as the terms in the lending contract, guaranteeing properties, subjects, ways and lending amount based

on the collaterals

Risk in practice: is the risk related to process of lending and managing loans including using the risk ranking system and processing technically the problematic loans Risk in portfolio: is the form of credit risk whose cause comes from the limit in managing lending portfolio of the bank, divided into two types: intrinsic risk and concentration risk

Intrinsic risk comes from its own element, characteristics, has the inside distinctiveness of every lending subject or from economic industry, field, from the characteristics of the operation or using capital of borrowing customers

Concentration risk: is the case that the bank concentrates too much lending capital

on some customers, lends too much to many businesses operating in the same industry, economic field, certain geographical area, or form of lending which has high risk

2.2.2.3 Ratio of evaluating credit risk

2.2.2.3.1 Overdue debt ratio

Overdue debt is the most important yardstick evaluating the health of the institution It influences all of the main operational fields of the bank The way of determining this criterion with low result indicates that the credit amount of the bank guarantees quality; risk in providing credit of the bank is low On the contrary, if this ratio is high, it indicates the ability of using the bank's working capital low (Le Thi Tuan Nghia, 2007)

Overdue debt ratio = (Overdue debt balance / Total lending loan balance) x 100%

2.2.2.3.2 Bad debt ratio (Le Thi Tuan Nghia, 2007)

Bad debt ratio = (Allowance for compensating risk / Total debt balance) x 100%

2.2.2.3.3 Risk circumstance of losing capital (Le Thi Tuan Nghia, 2007)

Credit risk allowance ratio = (Allowance for credit risk deducted / Debt balance for preparing period) x 100%

2.2.2.3.4 Credit risk factor

This factor shows the density of credit amount in the assets If the credit amount in the total assets is high, the profit will be high, but meanwhile credit risk will be high, too

(Le Thi Tuan Nghia, 2007)

Credit risk factor = (Total lending loan balance / Total assets) x 100%

2.2.2.4 Some signals of realizing credit risks

2.2.2.4.1 Some financial signals (Nguyen Van Tien, 2007)

- Liquidity ratios show weak points

- Return ratios show weak points

- Operational turnovers show weaknesses

- Capital structure is unreasonable

2.2.2.4.2 Some non-financial signals (Nguyen Van Tien, 2007)

* Signals relate to the banks:

- Deposits reduce significantly

- Debts increase

- Borrowing amount frequently increases

- Needs of borrowing amount is in excess of budgeted demands

- Using the financing source with high interest rate is acceptable

- Slow payment of principle and interest of debt to the bank

* Signals relate to managing ways with customers:

- There are changes in human resource structure in the administrating system

- There are conflicts in the managing system

- Little experience, much appearance

- Transferring employees too often

- Dispute in the managing process

- Illegal administrative expenses

- Nepotism management

* Signals in technical and commercial problems:

- Difficulty in developing new products, having no substitution products

- Changes in the governmental policies

- Seasonal products

- There is an indication of cutting expenses

- Changes in the market about interest rate, exchange rate, losing customers, taste, etc

* Signals in processing financial information:

- Increase in ratio of debt unbalance

- Prepare insufficient financial data, delay in submitting report

- Cash balance decreases

- Increase rapidly in accounts receivable and period of paying debts

- Loss in income result

- Deliberate to make the balance perfectly with intangible assets

* Other non-financial signals:

- Degradation of business premises

- Inventory increases due to not sold goods, damage, and obsoleteness

- Discipline the leading officers

2.2.2.5 Cause of credit risks

2.2.2.5.1 Objective cause

Objective cause can influence the credit operation of the bank, reason of overdue debts of the bank is absolutely necessary risk occurring out of the intention and control

of people There are many kinds of objective causes and they are diversified, unpredictable, belong to many fields and have many different characteristics (Nguyen Van Tien, 2007)

- Disaster, fire, epidemic pull the business and manufacturing processes down

- Domestic and international social and economic circumstances

- Environmental factors

- Changes in policies of the government

- Legal environment is disadvantageous, loosing in macro-management

2.2.2.5.2 Subjective cause

* From customers:

This is one of the main and most traditional causes of credit risks Borrowers can

be intentionally or unintentionally unable to pay loan to the bank just in time In general, this cause can be controllable, deal able if the bank supervises, controls and manages the customers well before, within, after distributing the loan to customers (Nguyen Van Tien, 2007) This cause can be considered in the following aspects:

- Because the borrowing customers lack legal capacity

- Using the borrowing capital with wrong purpose, ineffectiveness

- Due to continuous loss in business, unconsumed goods

- Inappropriate way in managing capital causes lacking liquidity

- The business owner borrowing loan lacks managing ability, embezzles, cheats

- Because the subjective intention of the borrowers, they do not want to return the debt to the bank

- Due to the disunity in the internal of the Board of Directors

* From the bank:

Apart from the cause of overdue debt from borrowers, subjective cause includes shortcoming, defect from the bank (Nguyen Van Tien, 2007):

- Judging ability of the lending project of the bank is still weak so the bank lent to the projects, which are unfeasible, risky, unrecalled in a loan while the bank cannot predict the reserve source to amend risks

- In addition to the problem being short of and weak in managing ability, there is also a group of bank staff who lack moral quality taking advantage of their working positions to seek self-interest, embezzle, corrupt, lend intentionally with wrong rule This

is also the cause of increasing overdue debt

- The bank believes subjectively in the collaterals, sponsoring and insuring property, considers them as certainly insuring things for recalling principle and interest

of loan and looks down the check, control of doing projects, prevention of risks The bank does not know the way of using the loan of customers so there is no method of preventing, processing quickly when the loans have the bad signals in the using process

so it makes the debt returning ability unsecured, and debts overdue

- The bank lacks a department that specializes in observing, managing risks, managing maximum credit limit for each customers of different industry, products, and regions to scatter risks

- Bank's control system is too weak and loose, which makes a lot of credit amount concentrating too much on a few borrowers so the peril of losing credit of the bank increases depending on these customers' business operations

2.2.2.6 Effect of credit risks

According Basel (1998b) and Jorion (2000), the effect of credit risk is measured

by the cost of replacing cash flows if the other party defaults However, when we focus

on the credit risk of the bank, we can cite Nguyen Van Tien (2007) supposes bank is the mental centre of the entire economy and a regulating tool of government's macro-economy Thus, if the bank has risk in any operations, especially credit risk; it will cause