Moral hazard in vietnamese commercial banks and solutions,graduation thesis

MINISTRY OF EDUCATION STATE BANK OF VIET NAM AND TRAINING Topic: Moral Hazard in Vietnamese Commercial Banks and Solutions Student’s name Nguyen Thi Le Ngoc Class ATCB – K13 Super

MINISTRY OF EDUCATION STATE BANK OF VIET NAM AND TRAINING

Topic: Moral Hazard in Vietnamese Commercial

Banks and Solutions

Student’s name Nguyen Thi Le Ngoc

Class ATCB – K13

Supervisor Dr Pham Thi Hoang Anh

Student number 13A7510128

Hanoi, May 2014

TABLE OF CONTENTS ACKNOWLEDGEMENT

LIST OF ABBREVIATION

LIST OF FIGURES AND TABLES

INTRODUCTION

1 Rationale of the study 1

2 Research objectives 1

3 Scope of the study 1

4 Research methodology 2

5 Thesis structure 2

CHAPTER 1: THEORETICAL FRAMEWORK FOR MORAL HAZARD IN COMMERCIAL BANKS 1.1 Commercial banks 3

1.1.1 Definition 3

1.1.2 The role of commercial banks in VN’s economy 4

1.2 Asymmetric information in commercial banks 5

1.2.1 Concept and nature of asymmetric information 5

1.2.2 The inefficiency of information asymmetry 6

1.2.3 Cases of asymmetric information 8

1.3 Moral hazard problem in commercial banks 9

1.3.1 Definition 9

1.3.2 Causes of moral hazard 10

1.3.2.1 Internal cause 10

1.3.2.2 External cause 11

1.3.3 Consequences of moral hazard 12

1.3.4 Popular measures to prevent moral hazard 13

CHAPTER 2: ACTUAL SITUATION AND IMPACT OF MORAL HAZARD PROBLEM ON VIETNAMESE BANKING SYSTEM

2.1 Some well-known cases of moral hazard in Viet Nam 15

2.1.1 Moral hazard caused by customers 15

2.1.1.1 Facts and causes 15

Furthermore, I would also like to extend my thanks to the lectures in Foreign Language Faculty, Banking Academy, who have help build up my knowledge and necessary skills over the past four years I hope that this foundation will contribute to my future career and life

Last but not least, I would like to offer sincere thanks to my family and friends for their consistent support Their assistance, experience and encouragement are truly important for me to fulfill this demanding task

LIST OF ABBREVIATIONS

VIB Vietnam International Bank

Agribank Vietnam Bank for Agriculture and Rural Development

Vietin Bank Vietnam Bank for Industry and Trade

Exim Bank Vietnam Export Import Bank

Vietcombank Joint stock commercial Bank for Foreign Trade of Vietnan

Navi Bank Nam Viet Bank

M&E Mechanical and Electrical

LIST OF TABLES AND FIRGURES

Figure 1 The inefficiency of asymmetric information towards buyers Figure 2 The inefficiency of asymmetric information towards sellers

Table 1 The internees and their sentences pronounced at the trial for Huyen Nhu’s case

INTRODUCTION

1 Rationale of the study

Over the past twenty years of innovation, the banking system has been extended with a total of approximately 70 banks in which 60% are commercial banks In recent years, these commercial banks have evolved into large-scale and professional organizations It can be clearly seen that on the one hand, with a variety of services and the availability of modern channels, they attract more and more customers On the other hand, banks are in need of a bigger number of qualified staff However, the quantity is not associated with the quality when banks are unable to control the growing volume of both clients and human resources Among them exists the people who intentionally risk doing activities beneficial to themselves but harmful to the bank This is called moral hazard which arises from the imbalance of information between the parties involved in a contract

Moral hazard has become a serious problem as it brought about intensely unwanted consequences not only to individuals but also organizations and even the macroeconomy suffers without much preparation Being aware of how alarming this matter is, the author of this thesis expects that after looking into the situation, the recommendatons offered can contribute partly to the prevention of the moral hazard issue in order to facilitate the operation of commercial banks and banking system

2 Research objectives

This work aims at the following objectives:

- Systematize the theoretical framework for moral hazard problem

- Analyze some noticeable cases of moral hazard in Viet Nam and seek causes

- Provide suggestions to minimize the impact of moral hazard in Vietnam

banking sector

3 Scope of the study

The thesis studies the reality of moral hazard in Vietnam in recent years and offer solutions to improve this situation for the coming years

4 Reasearch methodology

In order to find out the most logical and reasonable answer to the problem, this thesis will retrieve information resources from books, lectures, newspapers, magazines, and the Internet Thus, by collective method, deduction, analysis, statistics, this thesis will present and analyze the real state caused by moral hazard in Vietnam commercial banks and propose some suggestions

5 Thesis structure

Apart from Introduction and Conclusion, the thesis consists of 3 chapters:

- Chapter 1 : Theoretical framework for moral hazard problem in commercial banks

- Chapter 2: Actual situation and impacts of moral hazard problem on Vietnamese banking system

- Chapter 3: Recommendations of solutions to deal with moral hazard problem in Vietnamese commercial banks

Chapter 1 Theoretical framework for Moral hazard problem in commercial banks

1.1 Commercial banks

1.1.1 Definition

According to US laws, a bank is any business offering deposits subject to withdrawal on demand (such as writing a check or making an electronic transfer of funds) and making loans of a commercial or business nature Particularly, commercial bank is a type of bank which sells deposits and makes loans to businesses and individuals A bank links together deficit entities – an individual or entit that spends more than it currently earns and then must borrow money and surplus entity – an individual or entity that spends less than it currently earns and therefore can save money and invest in different channels One party would like to mobilize fund in the least expensive and efficient way while another wants to ensure the best return on investment

In Vietnam laws, commercial bank means a type of credit institutions which may conduct all banking operations and other business activities under Law No.47/2010/QH12 of June16, 2010 on Credit Institutions for profit Banking operations can be defined as the trading in and regular provision of one or some of the following services: deposit taking, credit extention and via-account payment

Banks generally have offerred services throughout history which are carrying out currency exchanges, discounting commercial notes nad making business loans, offering saving deposits or demand deposits, safekeeping of valuables, supporting government activities with credit, and offering trust services Recently, they have evolved and offerred even a wider range of services such as granting consumer loans, offering equipment leasing, selling insurance policies, selling retirement plans, making venture capital loans, etc

1.1.2 The roles of commercial banks in the economy

CBs, due to their specialness, play some basic and vital roles in all countries all over the world though its level of influence may range in terms of the development of those nations Whether in a developed economy or a developing one, the roles of CBs can be listed as below

The first role of CBs is to be an intermediate which encourage individuals and institutions to save and then transfer their savings to the individuals and institutions planning to invest in new projects as well as satisfy the need for liquidity and reduce the risks and transaction costs not only for surplus entities but also for deficit ones Previously, significant transaction costs, especially information cost used to impede small and invividual investors’ participation in the financial market, but the presence of commercial banks as information-producing bodies gradually decrease transaction costs thanks to their economies of scale and specialization Therefore, the fund flows become more smooth well-oriented when potential savers and borrowers are indirectly connected by commercial banks through the fund mobilizing and allocating process

Secondly, the process of making payment would not be executed safely and conveniently without CBs as they carry out payments for goods and services on behalf

of the customers They act as payment agents by opening checking or current accounts for customers, paying cheques drawn by customers on the bank, and collecting cheques deposited to customers' checking accounts Banks also allow customers to make payment via other channels such as automated clearing house (ACH), wire transfers or telegraphic transfer, electronic funds transfer at point of sale (EFTPOS - an electronic payment system based on the use of payment cards, such as debit or credit cards, at terminals located at points of sale) and automated teller machine For example, nowadays, people can pay electricity, water or phone bills and paying salaries using bank services.These services are very easy and gives the users a sense of security and comfort Additionally, CBs support international goods, servicers and capital

transactions in which the difficulties between two parties of different countries always arise because of the diversity in geographic features, cultures and the monetary systems

of each country However, the existence of CBs operating on an international scale will facilitate the settlement of such transactions With the commercial banks, the interests

of the parties involved in international transactions can be handled more easily, quickly and cheaply Regular business deals with foreign countries in export and import activities shall boost the domestic economy as a result

Other roles of CBs can be named as agency role, policy role, etc Actually, CBs

is an indirect channel through which the Government intervenes in the macro economy For example, to implement a loose currency policy, the central bank often buys securities from CBs Consequently, this action will drive the interest rate to drop and create favorable conditions for the investors, and the domestic economy will benefit in deed In anotherway, the central bank can reduce or increase the money supply by affecting the ability of commercial banks to create demand deposits Closely related to the central bank, CBs serve as a delegated monitor which enables the government to regulate the financial market in particular and the economy in general without imposing too many administrative measures on the whole population, which is often accompanied with negative attitude and inflexibility

1.2 Asymmetric information problem in commercial banks

1.2.1 Concept and nature of asymmetric information

Asymmetric information means the buyer and the seller of some kind of goods have different amount of information about the attributes of that goods In other words, asymmetric information is a situation in which one party, in a transaction, has more or superior information compared to the other This often happens in transactions where the sellers know more than the buyers (asymmetry of information towards buyers), though the reverse can happen as regularly as well (asymmetry of information towards

sellers) Potentially, asymmetric information may lead to undesired results for one

party because the superior party can take advantage of the other party’s lack of

information and knowledge to satisfy themselves only However, asymmetric

information nowadays is not as common as it once was because of

increasing transparency and legal requirements for information disclosure, as well as

technological advances

1.2.2 The inefficiency of information asymmetry

If information is not only imperfect but also asymmetric, inefficient outcomes

may be the consequence This inefficiency is possible for both buyers and sellers,

which can be illustrated by the two diagrams below

Information asymmetry towards buyers

Hypothesizing that the market has perfect information, the quantity and the price are

Source: http://gafin.vn

However, without necessary information about the attributes of a product, the seller is willing to buy a lower amount or number as illustrated by D1.When the buyer has little information about products compared to the supplier, the Demand curve shifts

to the right from D0 to D1 The supply curve is supposed to be unchanged The quantity actually bought in the market now is Q1 which is lower than Q0 - the socially effective quantity The gain in the buyer’s surplus when having no information asymmetry is

CS0 = KBQ0O – PoBQ0O = KBP0 The gain in the seller’s surplus at that time is PS0=

P0BQ0O – FBQ0O = P0BE Then the gain in social welfare is W0 = KBF

When the market is stable at A (P1, Q1), the gain in social welfare now is W1 = KCAF Therefore, the loss to the society (welfare loss) is equivalent to the area of triangle ABC because of the inefficient consuming In this case, triangle ABC is called

“the efficiency loss” or “the zero loss” If the producer can provide information about the real quality of the product to the consumer with the information cost lower than the zero loss, it is necessary to implement the act of supplying information and the society will benefit from the difference between welfare loss and the information cost

Information asymmetry towards sellers

Source:http://gafin.vn

Assuming that the information in the market is perfect, the equilibrium quantity is Q0 and equilibrium price is P0 When the seller lacks access to information, the supply curve shifts to the right from S0 to S1 as asymmetric information promotes the market to supply more than the amount needed by the society The supplied quantity Q1 is smaller than Q0 The demand curve is supposed to remain stable Social welfare also suffers in this case which is represented by the efficiency loss equal to the area of triangle ABC

In a word, whether it is asymmetric information towards sellers or buyers, the common result would be the loss in social welfares on account of the inefficiency of the market performance

1.2.3 Cases of asymmetric information

Asymmetric information results in 2 problems called adverse selection and moral hazard

The word “adverse selection” has long been invented by one economist named, Goerge Alkolof when he discovered a problem in used-car market The field is then updated by Joseph Stigliz who won a nobel prize This is a popular problem happening before the act of signing contracts in insurance and capital market Adverse selection arises as a problem for the buyer when products of different qualities are sold at the same price and the fact is that prior to purchase, the buyer cannot distinguish between products of different qualities Similarly, the seller may suffer adverse selection when selling products of identical quality are sold at the same price to buyers of different qualities but prior to the sale, the seller cannot distinguish between buyers of different qualities Whatever the sources of adverse selection is, the consequence is the same: low-quality products, or high-risk buyers, high-quality products, or low-risk buyers For example, a bank that sets one price for all types of its checking account customers may run the risk of being adversely selected against by its low-balance, high-activity

and hence least profitable customers Taking another example, in banking industry again, bank might wish to raise interest rate for business project or plan that are risky in order to avoid credit risk In fact, it tend to have a difficult period of time classifying customers, and need a premium above the current rates to make up for the risks arising out of the incapability to select who should be lent to However, the risky borrowers will visit the bank, not the good firms since they do not want to be equated with the bad ones and let their credit history be devalued by paying such high interests In this example, high interest rate policy is a bank target towards all borrowers, but in the end the most risky borrowers emerge as potential customers and also a threat to the bank unfortunately Consequently, banks end up with a loan portfolio containing the majority of bad credit risks

As a special case of asymmetric information, moral hazard happens after the contract is signed, unlike adverse selection The term dates back to the 17th century and was widely used by English insurance industry in the 1900s Early usage of the term implies fraud or immoral behavior However, renewed study by economists in the 1960s did not perceive this term as something to describe the morals of the parties involved such as immoral behavior or fraud but to explain the inefficiencies when risks are underestimated

1.3 Moral hazard problem in commercial banks

be felt by that causing party but borne completely or partly by others They do not take

the full consequences and responsibilities for their actions In fact, they have an incentive to do what benefits them most Thus, a tendency for these moral-hazard creators to act less carefully or even recklessly is an inevitable consequence Particularly, according to Federic Mishkin, “moral hazard in financial market occurs when the lender is subjected to the hazard in which the borrower has an incentive to engage in activities that are undesirable from the lender's point of view, that is, activities that make it less likely that the loan will be repaid” For instance, a borrower may have an intention of putting money in high-risk projects or plans in which he will gain large profit if the project turns out well but if it fails, the risk is transferred to the lender It menas that the lender will have to bear most of the loss, not the borrower In response to this fact, many lenders would prefer not making loans, which results in low fund and investment Otherwise, they must impose penalty on borrowers for carrying out certain activities and supervise the use of fund so as to limit moral hazard

1.3.2 Causes of moral hazard

1.3.2.1 Inernal cause

Moral hazard problem recently has been traced to customers and bankers’ lack

of good will to follow the terms and conditions in the contract or to act in a way so as

to fulfill their individual needs Particularly, moral hazard in banks triggered by bank managers or staff is no longer an occasional situation Often, the credit division will be the first to be blamed and examined owing the typical features of their job if something negative happens Clearly, these officers have direct interaction with clients, assess the documents and make a decision to accept the loan requests or not In fact, news about prosecuting credit officers, managerial officers for illegal behaviors can be seen or heard through the mass media There are some common conducts to be named as lack

of responsibility in assessing customers’ assets or repaying capability, getting a percentage on the disbursed loans, getting partial loans through the customers’ accepted requests, approving the loans when collaterals are not registered for security

transaction yet or when clients donot meet the necessary conditions for lending, disobeying regulations on loan classification, not making provision or invalid provision making, etc However, the problem is becoming severer and alarming when moral hazard doesnot only originate from credit officers like in the past but staff in other divisions such as bank tellers or treasurers are also involved in The common forms are making up the loans, adjusting passbooks or accepting false documents for lending.

1.3.2.2 External cause

Since the borrowers are absolutely who determine where to pour the funds into while the lenders know little about their money usuage, mainly based on the imformation they provide, the information asymmetry is unavoidable In banking activities, moral hazard includes wrong uses of the funds which are initially not stated

in the contract or investment in risky portfolios without any notice to the lenders Lack

of information and monitoring, the lenders are subject to moral hazard when the borrowers make wrong and ineffective use of the loan.It may also happen as customers find whatever ways to break the terms of the contract when the conditions of the business environment are unfavorable, which puts banks at a disadvantage An even more serious problem occurs when there have been a large number of frauds caused by customers having the intention of appropriating banks’ funds by submitting forged documents and dealing contracts In short, signing a loan contract is no evidence of guaranteeing that the banks will earn profit, otherwise they are exposed to higher risk

of default than in any other business contracts

Moreover, it is shown that in many frauds, the arrestees to be prosecuted are simultaneously the bankers This means that the bank staff were in collusion with customers That is to say, moral hazard caused by customers is accompanied by that caused by banking employees

1.3.3 Consequences of moral hazard problem

As previously mentioned, in banking field, moral hazards resulted from CBs’ activities and customers who directly make use of the banks’ capital Then it can be easily inferred that these two subjects are definitely the ones to bear the risk

With regard to banks, when moral hazard takes place no matter which source of

it is, banks are under the possibility of capital or/and interest of the loans but at the same time, they are obliged to pay principal and interest for deposits becoming due Banks consequently cannot balance between ingoings and outgoings, the capital cycle

is limited, which means the real expenditure is higher than expected and generallyh the ineffectiveness of banking business In the event that when one loan is classified as loss loan, the bank may as well use its fund to pay for depositors At a specific point when the fund cannot meet the paying demand, it will fall into payment incapability and then liquidity risk As a result, the scale of that business will be reduced, the financial ability will be narrowed, and the reliability and the competitiveness will be adversely affected not only in domestic market and in foreign one A worse consequence may be the loss

or even bankruptcy if there have been no immediate handle or overcome difficulities The most unexpected scenario is banks will risk anything particularly the extremely risky investment to save the day when being on the verge of bankcruptcy The moral hazard in this case, is even more serious

Moreover, bank is not the only one that suffers when moral hazard happens Its failure will cause a systematic risk, which can be explained by its functions and roles

as a financial intermediate in mobilizing idle money from savers to loan to individuals and organizations who have borrowing demand Then it can be inferred that whom owners of the debts are exactly depositors, so when credit risk happened, lenders are adversely impacted, also

On the other hand, being aware that some banks are facing credit risk or on the edge of business failure, depositors in other CBs will experience the trend of being anxious and they start thinking of withdrawing money in such an unsafe place to keep

it at home or invest in another safer investment channel The entire banking sytem will have another problem to deal with then

Corporates, as borrowers, depends on the second lenders which are CBs So the bankcruptcy means that there will be no stable funding for buying materials, machineries or paying salaries for workers, the major part of the society The domestic economy may run into a recession as price are to fluctuate, the buying purchase declines, the unemployment rate is bound to be high and the social security is threatened

Looking further, moral hazard is considered one of the causes for the internaltional financial crisises including Asian financial crisis in 1997, Southern American financial depression between 2001 and 2001 and now the crisis resulting from sub-standard loans in the USA which is exerting a strong impact on the globe

1.3.4 Popular measures to prevent moral hazard

The most popular prevention to the moral hazard problem is to make people take partial responsibility for the costs of their expected hazardous or risky actions

This aims at raising people’s awareness about the consequences they may face if they make bad investments On the other hand, if the government usually bails out “too big

to fail” firms when they hold too much risk, then individuals will confront less severe results for their behaviors and thus have no intention to lesson their risky conduct Evidently when people are under protection from the negative side of their choices, they are inclined to take on even excessive risk Given that taking on additional risk will put others at risk or possibly lead to a financial system breakdown, some

procedures are needed to control the act of taking risk and at the same time protect the possible victims

An additional measure against moral hazard is paying more attention to collecting information about customers before, during and after lending along with supervising their usage of the loans to remedy the information asymmetry

One probable method is data sharing What will happen if a person fails to pay a loan on a bad business plan and get his property auctioned but come to another bank and request a loan for the same bad project with a different product? Banks, in fact, often have to deal with this type problem Nevertheless, if banking IT system stores reliable and updated information shared by all banks, this will no more be a serious problem

All in all, CBs though act intermediaries between entities in the society, their influential power has been fully recognized as they provide an extensive diversity of services crucial in people’s life The emergence of CBs is undeniably the remark of the economic evolvement However, there still exists an unavoidable problem called asymmetric information which is attibuted to the market’s failure to function effectively Taking advantage of this fact, many people have a tendency to cause moral hazard because of mainly financial objectives Whatever the origins of moral hazard are, CBs will be subjected to financial difficulties or even bankruptcy accompied by the lenders’ sufferance Eventually, the entire economy are likely to undergo a recession if the matter is not detected timely and handled precisely

Chapter 2 Actual situation and impacts of moral hazard problem on Vietnamese banking system

2.1 Some well-known cases of moral hazard in Viet Nam

2.1.1 Moral hazards caused by customers

2.1.1.1 Facts and causes

Facts

There has been a great deal of customer-related fraud in banking industry It can

be summarized that the majority of tricks are associated with mortgages, loan purposes, business and commercial contracts or money transfer after disbursement Lately there have been technical tricks to appropriate banks’ fund In banking regulations, there are only two forms of lending which are lendings with and without mortgages In fact, criminals defrauded CBs by providing false information about collaterals

The first case happened in the second quarter of 2008 from April to August A man named Nguyen Van Nghia brought 3 certificates of land use right (adjusted photocopies) to Vietinbank Hoa Thanh district, Tay Ninh province to ask for a loan The mortgage was determined to be a rubber gargen and a third-degree house located

in Tan Chau district When the staff of Vietinbank made a field visit to check the mortgage, he showed that staff another house and another rubber garden which is not his property but claimed that they belonged to him Then, his loan request was approved and he borrowed from the bank up to a big sum of 900 million VND However, at the end of 2008, the bank required Nghia to submit the documents proving his initially stated borrowing purpose in the loan contract that is buying production land and the lie was unavoidably discovered After that detection, he escaped far away and was not arrested until July, 2011