Risk management in providing credit of commercial bank

• cooperating with other organisations• Granting loan bank credit occur, they can make the credit system congested and prevent banks,' from I loans and interest to be reimbursed... 1.2 F

MINISTRY OF EDUCATION AND TRAINING

HO CHI MINH CITY UNIVERSITY OF FOREIGN LANGUAGES

SCHOOL OF FOREIGN LANGUAGES

GRADUATION PAPER

Supervisor: Nguy~n Thi Quynh Student: Bui Nguy~n Khang Vy Student Number: FL96732 Class: KA9603 Course: II/96

Ho Chi Minh City

July, 1999

PageAcknowledgements

Abstract

<:

2.3.1 Limiting credit 34

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for me in my future

Once again, I e;'Ctremely thank her for all she has done for me

Besides, I can't forget the help of officers of Housing Bank of Mekong Delta I

would like to thank Mr Huynh Nam Dung, the Deputy General Director, Mr Triln

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assistance

-Providing credit is one of the most useful banking transactions supporting businesses

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It always has strong effect on the banking system as well as the economy Therefore,

economy

some features:

' Using money in the customer accounts to carry out payments for them and

receiving money for customers by crediting and debiting accounts

operations

In order to analyse the credit provision easier, we must understand the term

characteristics Firstly, a person or a bank lends another one an amount of money or

borrowcd and an cxlra of it This extra is called interest The process of providing

credit can be described by the chart below:

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of it through the chart of transactions producing profit in 1999 of HCM City Joint Stock

Commercial Housing Bank

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• cooperating with other organisations

• Granting loan

bank credit occur, they can make the credit system congested and prevent banks,' from

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loans (and interest) to be reimbursed

high risk in doing business becomes even higher due to bad effects of' market

mechanism and open-door policy As a result, credit activities are affected negatively,

medium and long-term credits in order to develop a multi-sector economy operated by

crisis in Asia, banks have a lot of difficulties now Overdue and bad debts, increase

company cases, etc

From those things written above, we can conclude that to have a stable and

well as how banks forecast, identify, and manage risks

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The organization. of this research is as follows: Chapter 1 includes conc~ptions of risks,

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commercial banks

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1.1 Conception of credit risk

having bad effects on their business Nowadays, associated with the fast development

happens, banks suffer serious damages

1.2 Factors causing credit risk

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1.2.1 Internal factors

lot of long-term loans

Figure 1-1 Factors Causing Credit Risk

Young

1.2.1.2 Bad process of providing credit

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• Bankers are lacking in banking knowledge and background.

1.2.2.1 Macro economic policy

foreign policies that are used to manage gross domestic product (GDP), employment,

this problem more specific, we find that any change of macro economic policy will

lead to changes of interest rate, foreign exchange rate, etc These changes are factors

causing risks in monetary business and affecting directly the operations of commercial

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of commercial banks

effectiveness of doing business with foreign countries is evaluated from foreign

exchange rate and trade balance

Cycles of business, prices of goods and service, and the market interest rate of each

,

invasion war, struggle for markets, change of political system, economic punishment

of one country on another etc., usually occur all over the world These make the trade

balance as well as the foreign exchange rate often change All the events above have

goods and servi'ce, interest rates, needs of currency, etc: These are elements affecting

commercial banks

1.2.2.3 Some other factors

They consist of natural disasters, such as flood, drought, fire, etc

1.3 Types of risk in credit activities

1.3.1 Bad debt

Bad debts means debts those are very difficult or unable to collect 1;hey c,an

most possible risk Managing this risk is an important work of bankers because loans

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account for about 60% of banks' asset and most of banks' profits come from them

When this risk occurs, banks will lose a part of or all principles and interests In case

the damages are much more than banks' equities, banks will surely stop operating and

go bankrupt:

1.3.2 Congestion in granting loan

provide credit or transfer them into another types of assets in order to make profits

This situation causes very big difficulties of banks, because commercial banks are the

from public and use this money to lend everyone that has the need (of course, bankers

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(for example, the deflation), the amount of money remaining in banks is so much that

customers and cost of transactions, banks will suffer loss If this problem is not solved

and lasts for a long time, banks must go bankrupt

1.3.3 Risks in interest rateInterest rate can be understood as a cost of borrowing money in a certain time In

other words, if a person wants to borrow money, he has to pay an amount of money

banks depends on market situations Thus it fluctuates and changes permanently This

can reduce banks' profit and revenue For example, yesterday a man deposited money

into a bank for saving in one year Interest rate is 0.7% per month But today interest

per month In this situation, thc intercst rate of bank loans is 0.67% per month while

higher than (he cost of Icnding, banks obviously suffer loss

amount of money plus interest (Lawrence, D.S & Charles, W.H (1991) In traduction

1.3.4 Unstable foreign exchange rate

This risk ariscs due to the change of exchange rate between Vietnam dong and

foreign currency It affects loans in foreign currency This risk affects transactions that

are relevant to foreign currency

1.4.1 Damages of banks

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Due to the fact that banks' principals and interest are not repaid, bank revenue

and expenses

When banks suffer overdue debts and cannot collect them at maturity time, they

are not able to carry out the cycle of credit Thus they are lacking in current capital

That makes the public not believe in banks, feel worried and withdraw money.:

difficult for the banks to recover

1.4.2 Damages of economy

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economy

When a bank goes bankrupt clue to credit risk, it will make many other banks go

bankrupt The first reason is all the banks are a system They always have lending or

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banks and withdraw money

their capital or guarantee This makes them not able to do business Moreover, the

fact that a lot of companies collapse has direct bad effects on the economy

credit risk occurs in a bank, the state bank itself will help it and order other banks to

support it

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Risk can be present at every stage of the lending process.

Figure 2-1 Risk in Every Stage of The Lending Process

Applicant not fit and proper

Procedures fail to identify problems

Authorisation limits breached

Wrong details set up

Failure to identify problems with business

Repayment terms breached

Difficulty in recovering bank's monies

Young)

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To ensure that the risks are limited to a minimum, it is essential that there be:'

conducted

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not lent to poor credit risk

(An introduction to loan appraisal in developing countries)

2.1 Identify risk factors

2.1.1 Identify risk factors before providing credit

• They are legal organisations and individuals.

well as their production operations

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borrowers after the interview

In addition, loan officers must pay attention to the background, level of

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borrowers are reliable or not Usually, when economy is stable, loan officers focus on

violated their commitments

business activities of the borrowers

• Collecting information from others banks that refused to grant loans to the

borrowers to know the reasons why they did that By doing this, banks can find

something wrong with their borrowers

2.1.1.3 BOl'rower's financial situation

the financial situation of the bon'owers

loans or not

2.1.1.4 Borrower's purpose and credit term.

do~n their projects financed by the loans in details This document Jill be used by

loan officers to evaluate the loan usage Besides, it can help the banks to evaluate the

and have prompt solutions The bank managers must explain these things to managers

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when they express their purposes unci early and in general, and then use the loans for

another purposes Usually, banks never finance unprofitable projects Borrowers have

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Besides, if borrowers need long-term credits, loan officers must think over this

problem Most of commercial banks are not able to provide long-term credits because

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long-term loans are very risky Usually, banks do not accept long-term loans (usually

exact information about their purposes

2.1.1.5 Feasibility of borrower's project

and identifying the feasibility of the projects are very important

for the policies of the banks or not

• Secondly, loan officers identify in what fields borrowers are doing business,

operating a club

borrowers

(Source: Quan tr! rui ro tin d\lI1g va xU' Iy cac khoan vay co vfrn d~ (1999) Banking

University)

2.1.1.6 Economic conditions

Economic conditions are external factors affecting the ability to repay the loans

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cases, the borrowers meet all the requirements of the banks But at due tirne, they

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feasibility of loans from economic conditions can reduce risk

2.1.2 Identify risk factors after providing credit

2.1.2.1 Checking loan usage of borrowers

Within a certain time (the length of time is up to each bank) after providing

credit, banks must start checking the loan usage of borrowers Then, they will continue

doing this regularly Loan officers are responsible for writing down results of checking

and evaluation of business operations in the credit documents

they committed, and whether they use the loans efficiently and profitably

Besides, banks give advice to their borrowers in order to help them develop their

borrowers

officers can advise their borrowers to open accounts in their banks, and carry business

operations of their borrowers

angry They must calm down and try to find the reasons and solutions Besides, they

,

written down After reading this report, bank managers will have proper solutions to

protect the loans

2.1.2.2 Checking collateral

measuring risks In case the debtors cannot repay the debts, the collateral will be sold

2.2 Methods of identifying risk factQrs

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2.2.1 Analysing financial situation of borrowers

Financial situation plays a very important role in credit activities as well as in the

Analysing financial status of customers aims at:

that are in bad financial situation and bad management

,some doubtful signals

sheet, income statement, etc

ratios calculated from the financial statements

~ Liquidity ratios

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commonly used liquidity ratios

• Current ratio

assets are viewed as relatively liquid, which means they can generate cash in a

within a year If the current ratio is too low, the firm may have difficulty in

short-term credit

CURRENT LIABILITIES

one or more of the debts - accounts payable or notes payable, or accruals, or

short-term debts, banks must pay attention to working capital

Net Current Assets = Current Asset - Current Liability

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• Quick ratio

The quick ratio measures the firm's ability to meet short-term obligations from

assets because it is generally far less liquid than the other current assets The

liabilities

QUICK RATIO = CURRENT ASSET-INVENTORY

CURRENT LIABILITIES

~ Leverage ratios

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The more predictable are the returns of the firm, the more debt will by

normally include a far lower proportion of debt in their capital structures

leverage ratios have a lot of risks, but can make much profit

• Debt to total assets ratio (Debt ratio)

This ratio equals total debt (total liabilities) divided by total assets

DEBT TO TOTAL ASSETS RATIO = TOTAL DEBT

TOTAL ASSETS

higher rate on its borrowing; beyond some point, the firm will not be able to

borrow at all

• Debt to equity ratio

This ratio equal the firm's debt divided by its equity, where debt can be

defined as total debt or as long-term debt We will use long-term debt since it

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provided by the debt ratio discussed above

DEBT TO EQUITY RATIO = LONG - TERM DEBT

STOCKHLODERS' EQUITY

(EBIT) divided by interest EBIT can be computed by simply adding interest

expense to' income before taxes

INTEREST EXPENSE

outlays, including debt interest, sinking fund contributions, and lease payments:

A fixed charge is a cash outflow that the firm cannot avoid without violating its

contractual agreements The firm periodically deposits money in a sinking fund

the fund was set up

'have the equation:

FIXED-CHARGES COVERAGE RATIO = A

B

}> Profitability ratios

Profitability ratios measure the success of the firm in earning a net return on sales

firm going out of business

The gross margin reflects the effectiveness of pricing policy and of production

course, if the gross margin is increased by raising the price of the firm product,

the gross profit margin, if it increases sales so much so to increase total profits

• Net operating margin

The net operating margin equals net sales minus the sum of cost of goods' sold

and operating expenses, all divided by net sales

NET OPERATING MARGIN = OPERATING INCOME

SALES

the company's product in generating pretax income for the firm For any given

level of sales, the higher the net operating margin the better

This ratio equals net income divided by sales

PROFIT MARGIN ON SALES = NET INCOME

SALES

By itself, profit margin on sales provides little useful information since it mixes

margin) with the effect of the method of financing profits (since net income is

after deduction of interest on debt and of taxes, which are affected by interest)

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This ratio equals net income plus interest on debt, divided by total assets

RETURN ON TOTAL ASSETS = NET INCOME +INTEREST EXPENSE

TOTAL ASSETS

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earned by the firm on a whole for all its investors, including lenders

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This ratio equals the net income available to common stockholders (i.e., net

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RETURN ON EQUITY = NET INCOME TO COMMON STOCKHOLDERS

COMMON STOCKHOLER' EQUITY

2.2.2 Interviewing borrowers

early

potential risks and make right decision

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2.3 Risk management

After analysing, identifying, and measuring risks that may happen in credit

activities, banks start carrying out methods to manage risks

Limiting credit is limiting the loans granted to one borrower One of reasons that

lending

(Source: Tai li~u cho vay h<;1pvan giua cac ngiin hang thllc1ngm?i (1999) Ngiin hang

dllu tll va ph<it triifn Vi~t Nam)

2.3.2 Diversifying credit

-This is a popular policy to reduce risk in credit activities of banks Banks usually

try to grant loans to various sectors (for example, paper sector, textile sector), various

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or this field come to crisis, banks may lose all their loans Therefore, banks tend to

diversify their credit to scatter risk

2.3.3 Choosing credit term

This is an effective method to avoid risk Choosing credit term must base on the

raised fund, operation scale It has effect on liquidity of banks Usually, the longer the

short-term or medium credit

2.3.4 Helping borrowers overcome difficulties

overcome problems

profit

of assets to pay for debts

• Banks help borrowers sell and reduce inventories, or use inventories as

collateral to borrow more money

2.3.5 Transferring risk

In case a customer want to borrow a very large ,amount of money that the bank

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this bank In other words, the bank sells its customer to another bank

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