000080969 DEFAULT RISK ESTIMATION, BANK CREDIT RISK, AND CORPORATE GOVERNANCE (ƯỚC TÍNH RỦI RO MẶC ĐỊNH, RỦI RO TÍN DỤNG NGÂN HÀNG VÀ QUẢN TRỊ DOANH NGHIỆP)

000080969 DEFAULT RISK ESTIMATION, BANK CREDIT RISK, AND CORPORATE GOVERNANCE (ƯỚC TÍNH RỦI RO MẶC ĐỊNH, RỦI RO TÍN DỤNG NGÂN HÀNG VÀ QUẢN TRỊ DOANH NGHIỆP)

Bee) SMES Hợi be No

HANOI UNIVERSITY FACULTY OF MANAGEMENT AND TOURISM

DEFAULT RISK ESTIMATION, BANK CREDIT RISK,

AND CORPORATE GOVERNANCE

Submitted by

Student: Pham Thi Ngoc Hoa Supervisor: PhD Dao Thanh Binh

A thesis submitted as a requirement for the degree of

Bachelor of Finance and Banking

THỨ VIÊN ĐẠI HỌC HA NỘI HANOI UNIVERSITY LIBRARY

May 2014

ABSTRACT Through years, lenders always have their big concern about how to identify financial capability of debtors to guarantee their returned cash flows As a main function of bank is accepting or borrowing from their customers or credit institutions to make loans to others, default risk is the oldest, the most important and primary risk in banking sector Especially in these years after the recent financial crisis, a huge amount of banks’ loan unfortunately became bad debt, default probability of banks consequently increases, and creditors also gradually lost their belief on banks Therefore decreasing credit risk is a main job of manager and owners of banks, one tool is through corporate governance The thesis consisting about 14,900 words and 49 pages explores the relationship between default probability of banks due to their credit risks and the corporate governance structures of these banks from the perspective of creditors The cumulative default probabilities are estimated for a sample of Vietnamese commercial banks to measure their risk taking behavior This thesis samples in 15 Vietnamese commercial banks from 2008

to 2012 to provide evidence that, after controlling for firm specific characteristics,

commercial banks with smaller Board size of a bank, number of female shareholders in

Board of directors, shareholder equity, and long term loan are associated with

significantly lower credit risk levels Larger number of Supervisory Board and short term

debt has relationship with lower credit risk levels

STATEMENT OF AUTHORSHIP

"Except where reference is made in the text of the thesis, this thesis contains no material published elsewhere or extracted in whole or in part from a thesis or any other degree or diploma

No other person's work has been used without due acknowledgment in the main text of the thesis

This thesis has not been submitted for the award of any degree or diploma in any other tertiary institution."

ACKNOWLEDGEMENT

This thesis would not have been possible without the guidance and the help of several individuals who in on the way or another contributed and extended their valuable assistance in the preparation and completion of this study

First for most, my utmost gratitude to Ms DAO Thanh Binh, PhD, Lecturer of Finance

and Banking as well as my direct supervisor during this research procedure I would like

to give special thanks to her enthusiastic guidance, truly helpful feedback and valuable suggestion that she provided during the preparation period from the initial to the final level

My thanks also go to all teachers in the Faculty of Management and Tourism who have taught me scientific studying and researching method Thus I could finish this thesis with much eases

In addition, I wish to thank my friends - Ms Dao Minh Tam FB10 and Mr Hoang Minh Thanh ~ BAO9 for their supports in getting data

Last but not least, my family and friends who are always source of motivation to any of

my jobs and this research is not an exception

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1.1.1 The overview of banking credit risk and default risk estimation 1

2.1 Literature review of bank’s credit risk, default risk estimation

2.1.2 Literature review of default probability estimation model Ï7

2.2.1 Theories on corporate governances ỉn øeneraÌ - 55c 18

2.2.2 Theories on corporate governances in banking sector 2

2.3 Literature review of relationship between default risk estimation, bank credit

risk and Corporate ZOVErMANCE .scsssecscesessesesneeeenesnencenearentsseseenenncacenecscanenseeseaseneeneese 26

iv

3 QUANTITATIVE ANALYSIS: THE LINK BETWEEN DEFAULT RISK, BANK

LIST OF TABLES

Table 1: Bank financial strength rating denotation (BFSR)

Table 4: Description of explanatory variables of Z-seore modđel -. ‹ :-‹: + 13

Table 6: Cut off value for Z`ˆ-score model for Vietnamese businesses 15

Table 8: Model’s derived and actual ratings by international agencies

1 Introduction

Through centuries, lenders have their big concern about how to develop tools or strategies

to assess the credit risk and forecast default of the debtors to guarantee their returned cash flows Especially in these years after the recent financial crisis, the term “credit risk” becomes one of the most persistent banking-related issues in over the world which is observed and discussed regularly in many financial articles, journals or research papers Credit risk refers to the risk that a borrower will default on any type of debt by failing to make required payments Default means a failure of the debtors in paying fully or partially the principal and interest to their lenders, but also the risk of a decline in the

credit standing of the borrower is credit risk In this situation, default does not necessarily

incur, but it does imply that probability of default increases In the end of 2009, as a result

of a survey, 66% of the respondents stated credit risk as the largest cause of concern over the next 18 months (Roy, 2009)

According to some studies, at least two-thirds of IMF member countries have gone

through banking crisis in last twenty years Hundreds of banks have been faced difficulties, raising the different types of banking risks, one of the most serious one is credit risk The easy increase of lending in mortgage loans excessed the risk management capability of the bank When the financial crisis 2007-2008 happened, thousands of businesses and individuals went bankrupt, lack of cash flows to repay the loans led banks

bedeviled with these bad debts Therefore, the credit risk of banks is perceived as a key feature of the liquidity panic in this global financial crisis period

In Vietnam, a banking survey 2013 of KPMG stated that 57% and 14% of Vietnam bank’

total assets are “loans and advance to customers” and “Placements with and loans to other Credit institutions” respectively Therefore, credit risk is the oldest, the most important

and primary risk in banking The profit of commercial banks mostly comes from credit activities, in Vietnam, it account for about 90% of the total commercial banks’ revenue But at the same time, this source of income leads banks severe damages when a number

of loans become non-performing, sometimes causing banks to face insolvency risk

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Therefore, stakeholders of banks will choose the bank which has lower probability of default In order to manage both credit risk and its consequence namely insolvency risk,

in the same survey of KPMG in 2013 showed that 90% of interviewed Vietnamese commercial banks were to increase budgets for developing advanced credit risk management in the next 12 months

The influence of credit risk is very adverse to the banks Large losses generated by borrowers can leave the banks into insolvency and possibly even bankruptcy Banks definitely need a measurement tool to estimates their insolvency risk by default probability Consequently, managing credit risk will help banks reduce their default probabilities The lower bank is considered to undergo probability of default, the higher

bank has creditworthiness, which can improve the image, trustworthiness of the banks to

the public, especially their depositors and lenders Bank with low default probability will reduce the lending interest rate charged by lenders as well as expected deposit interest

rate of their customers (as compensation for bearing higher default risk) Therefore,

managing credit risk and default probability are crucial jobs of the management level of any bank

1.1.2 The overview of corporate governance

In contrast with the long study about the credit risk, corporate governance mechanism has

researched only the last three decades The issue refers to the system by which corporations are directed and controlled The mechanism is about accountability, ownership and control, compensation and incentives It can be denied that, a successful business cannot lack “healthy” corporate governance, so, this young scrutiny field

deserves attention of society and practitioners

Corporate performance is a critical concept that concerns the way and manner in which financial, material and human resources available to an organization are judiciously used

to achieve the overall corporate objective of an organization It keeps the organization

generate a better prospect for future opportunities The effective corporate governance should be enhancing investor’s confidence in the economy of the country Corporate

accountability as well maintaining an effective channel of information disclosure that

would foster good corporate performance A study of Gompers, Ishii and Metrick (2003)

for a sample firms during the period of 1990s revealed that longs (shorts) firm with strong (weak) governance characteristics may generate an abnormal return of 8.5% per year

With the crucial role of this issue, in recent years, the mechanism has been discussed in academic society, business circle, and regulatory bodies

Under the most common corporate governance practice that business’ goal is to maximize the shareholder, it supposed that the main responsibility of the management is guarantee shareholders’ interest The most serious disadvantage of this practice is it ignores other

stakeholders’ wealth like employees, customers, creditors Although debt holders have

priority in claimant in the case of bankruptcy, they have to bear higher default risk when firm have incentive to invest in risky investment for desire of higher return In contrast, equity holders will benefit if the project successful The shareholder-oriented corporate governance may impair the firm value, consequently harm firm’s related parties’ wealth

especially debt holders

However, there is no single model of corporate governance to apply all firms Governance

practice varies not only across countries but also across firms or industries One of the most outstanding differences between corporate governance mechanisms is in the

ownership and control of the firm (Maher and Andersson, 2000) Systems of corporate

governance can be differentiated based on the degree of concentration in ownership and control and the identity of controlling shareholders While some businesses have the

corporate governance systems are characterized by wide dispersed ownership, others

seemingly have system to be characterized by concentrated control or ownership

However, the differences are all need to comply with the countries’ legal framework, institutional policies and culture history

In Vietnam, Enterprise Law 2005 has made a significant progress in enhancing corporate governance regulation in general and that for Shareholding Company in particular

However, enforcement of the enterprise law is often reviewed from the aspect of state

management rather than corporate governance within an enterprise (Nguyen Cung, 2008) The study about the issue is not adequate and rudimental that is not enough thoroughly to address outstanding problems of businesses According to an assessment carried out by

IFC (international Finance Corporation), the scoring of Vietnam corporate governance

reduced from 44.7 in 2010 to 42.5 in 2011 This setback of Vietnam businesses (Han Phi,

2012) causes us less attractive to the investors Most Vietnamese companies recently have basic knowledge of corporation governance

In Vietnam banking sector particularly, when several banks have expanding their business, altogether more competition not only between local banks but also with

increasing number of foreign banks, the pressure of bank regulation bodies to build a

sustain developing corporate governance becomes more and more intensive According

to Molynex (2011), a consultant on Corporate Governance of the IFC, corporate

governance in Vietnamese banking syetem seems to receive greater consideration

compared to the average but it still need to be better

It is clear that one of the attributed causes to credit risk is poor corporate governance

practice As a result, higher bank credit risk will lead to higher probability of default As

stated above, the shareholder-oriented corporate governance approach only protect the

equity holders rather than other stakeholders including creditors It is expected that

default risk will be higher for the firm with corporation governance mechanism designed

to maximize shareholders wealth at the expense of creditor (Switzer and Wang, 2013)

Therefore, by looking at banking industry, specifically in Vietnamese commercial banks, the thesis seeks to investigate the relationship between banks’ default probabilities and corporate governance together with updated bank credit risk information through

accounting information in a timely manner

The outcome of the research can be as a reference material for bank owners, managers,

other stakeholders and policy makers in their analysis and projects related to the influence

of corporate governance on banks’ credit risk, default estimation Hopefully, it

contributes something to the market place

To bank's owners and managers

Y An overview of international and Vietnamese commercial banks’ corporate

governance, and credit risks

v A statistical analysis of Vietnamese commercial banks’ corporate governance

indicators and credit risk indicators to banks’ default estimation

To banks’ other stakeholders

Y Different methods in evaluating banks’ credit risk and default probability by

worldwide models and Vietnamese-based model

v¥ A measurement tool to compare different Vietnamese commercial banks in corporate governance, credit risks and default estimation

To the governance and State Bank in Vietnam

v A reference for regulations related to banks’ corporate governance to protect banks’ customers, lenders or other stakeholders from banks’ credit risk,

corporate governance In this part, the recent status of credit risk and corporate

governance in Vietnamese banking sector are also revealed Besides, the author of the

research introduces literatures review of prior international and local researches about

banks’ credit risk, default risk estimation and corporate governance It is done by combining and analyzing information available on text books, articles and the internet

from different reliable sources

On the other hand, primary research employs quantitative methodology utilizing the method of MDA (Multivariate Discriminant Analysis) with the effective assistance of EVIEW software This approach will take the sample in Vietnamese commercial banks to determine the link between between bank default probability, corporate governance

indicators and bank credit risk indicators, which is derived from the sample of 15 selected banks namely VCB, CTG, BIDV, EIB, STB, ACB, MB, TCB, VIB, Saigonbank,

Maritimebank, VPB, SHB, ABB, and Sea Bank within the period of 01/01/2008 - 31/12/2012 on yearly bases Firstly, bank default probability will calculated based on its credit rating score which is a function of return on equity, net profit margin, assets utilization, equity multiplier, net non-interest margin and net non-interest expense margin With the bank credit risk indicators (accounting figures): shareholder equity (book value),

short term debt, short term loan, long term loan, provision and allowance for credit losses;

all of those will be taken into account Lastly, corporate governance variables are board

female shareholders in board of directors, number of executive members in board of directors, and capital adequacy ratio

2 Literature Review

2.1 Literature review of bank’s credit risk, default risk estimation

2.1.1 Literature review of bank’s credit risk

Various tools have been created to assess and manage credit risk Lenders rely on external experience and use credit ratings (ordinal scale) provided by credit rating agencies Others utilized credit scorecards (numerical scale) to rank existing and

potential customers according to their risk level, and then choose appropriate risk

management strategies In this thesis, both approaches will be introduced

2.1.1.1 Ordinal scale of credit rating

International credit rating agencies

Credit rating of a business is usually assigned by credit rating agencies Credit ratings

agencies are companies who are the main authorized entities to assign credit ratings to institutions that issue debt obligations A rating agency is expected to devote and maintain

the highest possible level of analytical competence and integrity Nowadays, there are many agencies or companies building models to determine the credit rating, but three of the most famous and prestigious ones are Moody’s, Standard and Poor’s and Fitch Ratings However, their detailed models are still kept in secret According to Paul Clarke (2013), the three major rating agencies hold a collective market share of roughly 95%, in

which, approximately 40% of the market was claimed by Standard & Poor’s, and

Moody’s and 15% by Fitch Ratings

Despite wide recognition, according to Postnova (2012), external credit ratings have also

been criticized recently One of the reasons is credit rating agencies are paid by debt-

issuing companies, who wish to be rated This action may lead to 1) only good performing issuers are willing to pay for the ratings (and skewed probability distribution

of credit ratings as a result); and 2) rating agencies are fear of losing customer so being

reluctant to downgrade rating Another cause is long-term and familiar relationship

between rating agencies and mangers of clients may potentially impact the objectiveness

of judgment However, despite criticism, ratings from external credit ratings play an important factor in investment decision-making and attract much attention of business world, regulators and media

Particular in banking sector, Moody’s and Fitch Ratings give the bank financial strength ratings with the notion as specified as follow:

Table 1: Bank financial strength rating denotation (BF.SR)”

In the above table, it can be seen that Moody’s does not have separate ratings for the cases of default and modest financial strength with high likelihood of outside support instead they combine these cases and classify them in the same level of credit risk

' Gradations may be used among the ratings A to E: A, B+, B, B-, C+, C, C-, D+, D, D-, E+ and E,

? Gradations may be used among the ratings A to E: i.e, A/B, B/C, C/D, and D/E No gradations apply to the

F

3 Source: Bond Market Association (November 2010)

Appendix 2 and 3 show some popular rating categories, namely the equivalent baseline

risk assessment ratings for general firm, together with the long term and short-term bonds

for banks only Besides baseline rating acting as the standard for every rating category,

there are numerous rating scales For instance, theses Appendixes describe bank individual financial strength rating, long-term and short-term rating system and denotations Similarities and differences in the three agencies’ rating system can be seen quite clearly from these tables In term of bank individual rating, excluding S&P, the two remaining companies’ rating classification and denotation are quite identical, except for the fact that Fitch uses A-to-F rating scale while Moody’s utilize only A-to-E scale, and the gradation denotation between the two are different Meanwhile, concerning the long- term and short-term ratings, those of S&P’s and Fitch are relatively in common, whereas Moody’s makes use of rather dissimilar rating symbols and scale classifications

Vietnamese commercial banks’ ratings by international agencies

While Vietnam has received country’s rating for a long time, Vietnamese commercial banks got used to this only for the past few years In May 2006, BIDV became the first

state-owned bank in Vietnam to be ranked by Moody’s with grade E for the stand-alone

rating And on August 16th 2006, Techcombank became the first joint-stock commercial

bank to be rated also by Moody’s with grade D in terms of the same category as BIDV

Since then, other banks have annually got their rating by not only Moody’s but also S&P

and Fitch Comparing with Moody’s and Fitch, S&P least does rating activities for Vietnamese commercial banks, but mainly focuses on country rating

In 2012, Moody’s have given the rating for eight Vietnamese commercial banks Although in the past few years, Moody’s rated Vietnamese commercial banks with quite stable grades, in 2012, they simultaneously downgraded the credit rating of eight commercial banks Specifically, they decreased bank financial strength rating from E+ to

E of ACB, MB, SHB, Sacombank, Techcombank, VIB, Vietinbank and BIDV, projecting

for the stable prospect Meanwhile, in the same year, six commercial banks were rated by

Fitch, including Vietcombank, Sacombank, Vietinbank, Agribank, BIDV and ACB but

some of banks without bank financial strength point Among them, Sacombank, ACB, VietinBank and Agribank were evaluated with the grade B for long-term counterparty with stable prospects in 2012 BIDV was rated B+ short-term counterparty credit rating and B long-term rating respectively Vietcombank used to be given grade D/E in 2010

and 2011 because of the deterioration of credit quality and problem in maintaining

reasonable capital adequacy ratio The rating of VCB in 2012 by Fitch was unavailable

due to Fitch’s revocation S&P in 2012 rated Vietcombank, Sacombank and

Techcombank long-term credit at B + from BB-with a stable outlook, rated unchanged B + and forecasted stable outlook for BIDV and Vietinbank

Local credit rating agencies

In Vietnam, credit rating has just been recognized for some recent years and on the way

of forming and developing Besides rating from foreign credit rating agencies, some Vietnamese companies have created and gradually improved their own rating system to assess primarily Vietnamese enterprises Pioneers in this new field are Credit Information Center (CIC) under State Bank of Vietnam, Credit Information and Rating Company (Vietnam Credit), Credit Rating Vietnam Joint-stock Company (CRV) and most recently, Private Credit Bureau Investment Joint Stock Company (PCB)

Established in February 1999 under Decision 68/1999/QD-NHNN9 of State Bank of

Vietnam, and re-established in December 2008 under Decision 3289/QD-NHNN by Governor of SBV, CIC is now a non-productive affiliate of the State Bank of Vietnam

who is self-responsible for operation, finance and recurrent expenditures CIC has the function of collecting, processing, storing, analyzing and forecasting credit information with the aim of supporting State Bank management; of providing banking information services in accordance with Constitution and State Bank’s regulations Great advantages

of CIC’s Vietnam Credit Information System are on the immense information and database After processing and analyzing the database, Credit Information System will score and categorize the rating as follows:

Table 2: CIC’s rating classification‘

The most recent and noticable publication of CIC is Credit ratings for the top 1,000 enterprises in 2012 Specifically, 277 businesses achieved rating from AA to AAA and

723 businesses with results from BB to A (Nguyen Hien, 2012) No bussiness was ranked

at the average level and below It is a pity that in 1,000 companies CIC gave the rating, there were no distinction between a bank rating and a normal company rating However, results announced by CIC received good responses from public, which helps CIC in the future if improvement can be made to become a full-scale rating agency

The next known credit rating company for banks in Vietnam is “Vietnam Credit”, the

short name of Vietnam Credit Information & Rating Company Limited Established in

2001, Vietnam Credit is the first private company that registered business information services according to the Law on Enterprises Database is also one of the strengths of Vietnam Credit as it has started to collect credit information on business entities in Vietnam since 1996 and developed its own system called as Vietnam Credit Rating The Vietnam Credit Rating is composed on 18 criteria such as capital adequacy ratio, liquidity, business efficiency, managerial ability and experience, brand, quality, service and asset expansion calculated from data in financial statements of banks In December

2009, it’s the first time that Vietnam Credit released the 2009 bank ratings report assessing the health and outlooks of dozens of local banks based on banks’ 2008 and

* Source: CIC's enterprises credit rating charts

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onwards audited financial statements But afterward it was intensely rejected and until the end of 2012, they had not issued other credit rating chart

The third is Credit Rating Vietnam Limited Company (CRV) CRV, which was established in December 2006, became the youngest one amidst three companies and is

on the way of striving to be the best information provider in Vietnam The latest bank ratings report of Vietnam credit was in September 2012, "The annual report credibility of Vietnam 2012" summarized by Nhat Nam had some points which were deeper and closer

to the reality of Vietnam market than prior reports The detail ratings are summarized as the following table:

Banks have high competitiveness, great market

operation and long-term growth potential

Banks have ability to compete fairly, good

market power, good financial strength and

operate reasonably stable business with good

growth potential

Bac A Bank, HDBank, Maritime Bank, OcB, Saigonbank, Southern Bank, PG Bank, VIB

and VietABank

Banks have average competitiveness, limited

market power but it still delivers value to the

bank Banks have financial capacity acceptable

and stable business operation or financial

capacity with business operation less stable

Banks have limited competitiveness These

banks are constrained by one or more of the

following factors: weak business network,

financial

ABBank, Baoviet Bank, DaiABank, Habubank, Kienlong Bank, MHB, NamABank,

Next, Private Credit Bureau Investment Joint Stock Company (PCB) is established in

2007, PCB only began operation on 16/7/2010 and is expected to officially provide services for more than 20 banks starting from Quarter I/2012 PCB has charter capital of VND 50 billion, 70% of which is contributed by 11 Vietnamese commercial banks, including ACB, ABBank, Vietinbank, BIDV, Southeast Asia Bank, Techcombank, Vietcombank, SCB, VIB, Vietbank and VPBank Besides, the Italian CRIF S.p.A group,

its strategic partnership, owns 20% and the remainder 10% of charter capital will be sold

to another strategic partner With the help of CRIF in the beginning operations by providing experts and technical systems, PCB aims at becoming Vietnam's first international-standard private credit information company to supply

Besides the above credit rating agencies, there is one company, to some extent, involved

in this field It is named as Enterprise Credit Rating Appraise Science Center (CRC) founded in 2007 under Vietnam Union of Science & Technology Associations However, CRC just releases credit rating appraise, not credit rating grade or score; therefore, relative ranks between enterprises are not clear

Vietnamese credit rating agencies are on the way to develop, correct and improve their method and operation With issuance of Decree 10/2010/ND-CP, from April 2011 onwards, it is hoped that the credit rating system and companies’ structure will be rearranged more logically and synchronously so that they can run more efficiently and effectively

2.1.1.2 Numerical scale of credit rating

International credit risk models

Besides the credit scores provided by external services as discussed above, other models

to assess the creditworthiness of firms are the financial statement-based models such as

Alman Z-score model, structure models like Merton/MKYV, etc They are utilized as the

preference of each country or industry and their results sometimes lead to inconsistent ratings, especially for small and medium sized firms

The most widely and easily used credit scoring model is Altman Z-~score, which originally built by the idea of William Beaver in 1967 However, while Beaver used

univariate analysis of some indicators to distinguish low and high-bankruptcy firms,

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Altman after one year developed the model to employ Multivariate Discriminant Analysis

(MDA) approach but initially developed for manufacturers In this model, he collected 66

manufacturing firms, the outcomes are divided into two group The sum of 33 firms in the

first group went fail from 1946 to 1965 The second group comprised of paired non-

bankruptcy firms, in term of industry and size After collecting data, he tested the list of

22 potential financial indicators and eventually five variables which has the most

significant to predict the financial distress of the company formed the model as below:

In which, Z = overall score for manufacturers

The explanatory variables and their meanings:

size

assets to generate earnings from operations

X4 Market Value of Equity / Book | Consideration of the market’s view of the

with the extremely high accuracy about 94% of the initial sample with 95% of all firms in

the bankrupt and non-bankrupt groups assigned In addition, for the further analysis of this model for the later in 1976 to 1995 and 1996 to 1999 sampled in bankrupt companies,

the Z-Score determined correctly more than 82% With this success, the model has been a

reliable tool for loan evaluation

However, with the emergence of large, public service companies encouraged him to

develop a second Z-Score model for non-manufacturing companies The Z”-Score

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(Altman, Hartzell and Peck, 1995) was introduced for the non-manufacturers The study

was investigated a sample of Mexican companies that had issued Eurobonds denominated

in US dollars in 1995 As the nature of non-manufacturing companies, this model minimizes the effects of manufacturing-intensive asset turnover by removing the last component (sales / total assets)

In which, Z** = overall score for non-manufacturers

Liabilities

The meanings of dependent variables of the non-manufacturing companies are the same

as manufacturers

For the prediction of bankruptcy as the result of Z-score, the cut-off value which separate

firm into 3 zones: “safe” zone where the business is unlikely to fail, “distress” zone where

highly likelihood of default will be considered and the “grey” zone is 95% for one year and 70% within 2 years The detailed borders are presented in the below table:

Table $: Cut off value for original Z-score model

Local credit risk models

As mentioned on the Credit rating by the international models, the original Z-score model and the Z”-score model were developed using data in the U.S and Mexico respectively Therefore, if these models are applied for Vietnam market, the study will face several limitations Acknowledging this problem, the first model Z-score for Vietnam was built in

2010 by Dao et al After a careful examination and selection of variables, they have formed a standardized for Vietnamese non-manufacturing firm:

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Z’’ = 0.123X1 + 0.456X;› + 0.206X; — 0.216X, + 0.357X; + 0.758X; + 0.392X;

(Equation 2.3)

Where, Z`` = overall score for non-manufacturers

Xị = Retained earnings / total assets

X2 = Market value of equity / Total liabilities

X3 = Market value of equity / Book value of equity

X4 = Total liabilities / Total assets

Xs = Net income / Sales

X6 = Cash / current liabilities

X7 = Net income / Book value of equity

Similar to the international Z-score models by Altman, the model by Dao et all (2010) also classifies non-manufacturers into 3 different zones using cutoff values shown in the

Table 6: Cut off value for Z’’-score model for Vietnamese businesses

In the scope of this paper, the limitation of this model is it cannot apply for unlisted Vietnamese commercial banks, so that the market value of equity is unable to observe daily Moreover, as the above Z-score was built within the scope of non-manufacturing firms in general, in order to study the credit score for specific Vietnamese commercial bank sector, there must be more adjustment which will reflect banks’ typical characteristics Therefore, we do not employ the Z’’-score model for the study of credit standing of Vietnamese commercial banks in this thesis

Besides the Z’’-score model for Vietnamese non-manufacturing, there is another study for evaluating credit standing of Vietnamese commercial banks taken by the Dao (2012) In this model, she took the sample of includes 12 Vietnamese commercial banks In which, seven Vietnamese commercial banks which have been ranked by Moody’s and Fitch at

that time were chosen: four state-owned banks (Vietcombank, Vietinbank, BIDV,

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Agribank) and and three joint-stock banks (Asia Commercial Bank, Techcombank and

Sacombank) Moreover, Seabank, Eximbank, An Binh Bank, Military Bank and Saigonbank had also been chosen to study on

As the main purpose of the research is to study credit rating of Vietnamese commercial banks, the scholar would compare the actual ratings of banks by foreign as well as

domestic credit agencies with the derived results of the studied model To fulfil this task,

the bank financial strength ratings by foreign and domestic credit agencies were quantified More specifically, grades A, B, C, D, E and F (if any) are converted into

scores 5, 4, 3, 2, 1 and 0, following the principle: the better grade, the higher score

Rating gradations are expressed in \decimal: Gradations of Moody’s by adding “+” or “-”

is translated into a 0.75 and 0.25 value; gradation of Fitch by adding a “/” between two

absolute ranks is translated into a 0.5 value For instance, E- will be changed into 0.75, E+ into 1.25, D/E into 1.5 and so on

After defining the bank sample size, a list of 15 financial ratios has been calculated based

on consolidated financial data in four years from 2006 to 2009 of studied 12 banks are collected However, there were only six ratios significantly influencing the expected credit ratings of Vietnam commercial banks The final model is detailed as following:

In this model,

R= expected credit score

ROE (Return on equity) = Net income available to shareholders / Equity

NPM (Net profit margin) = Net income / Operating revenue

AU (Assets utilization) = Revenue / Total assets

EM (Equity multiplier) = Total assets / Equity

NNIM (Not non-interest margin) = (Non-interest income - non-interest expense) / Total assets

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NNIEX (Net non-interest expense margin) = Non-interest income / Non-interest expense

Her model proves that ROE has strongly positive relationship with the credit score Contrast to ROE, EM and credit score are negatively related because the higher EM

indicates the more banks’ rely on debts to finance; thus, increasing the chance of default

and decreasing the credit rating Next, NNIM negatively, not positively as expectation, impacts on the credit rating It is the abnormal situation of Vietnamese banking industry that leads to the unusual coefficient of NNIM and conflict with NNIEX Finally, the most controversial result comes from NPM NPM should be positively related with banks’ credit rating but in fact negatively This may due to compensate the effect of variable

ROE

Though three biggest international rating agencies so far have rated for a few Vietnamese

commercial banks, unfortunately there are number of other Vietnamese commercial

banks not yet rated by these reliable agencies Besides, the ratings by local agencies actually are still controversial Therefore, this study by the Dao (2012) will provide investors for another branch mark to evaluate banks’ creditworthiness With high

accuracy in estimating creditworthiness of Vietnamese commercial banks, this thesis will

utilize this model for credit score projection

Interpreting Z-score allows us to identify the situation of a business and realize which zone is the firm currently in However, Z-score does not provide a specific probability of default therefore fail to be a comparable measure for investment Therefore, the market indeed needs a method that can resolve this problem

So far, there are many alternative approaches for calculating the default probability Default probability may be estimated from historical data of actual defaults using modern techniques like logistic regression Default probability may be predicted from the

observable prices of credit default swap, bonds and options on ordinary shares In the case

of Vietnam, among the effort to estimate the business default probability, there is an

outstanding approach initiated by Dao and Dang (2010) in which estimated credit rating

is used to calculate the probability of default as following:

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BDP = 1+12xeCR (Equation 2.5)

In which,

BPD = Bank default probability

CR = Credit score (in Equation 2.4)

In their research, the authors used logarit function to approximate the formula of default probability, which is proved to generate a very close estimation of default probability for

62 Vietnamese firms in their sample Furthermore, in this research of Dao and Dang (2010), they also proposed a framework for the relative correspondence between default probability and S&P’s ratings In this framework, rating are assigned to different probability of default ranges based on S&P’s transition table from default probabilities to ratings for Asian corporates in 10 years with necessary adjustment for Vietnamese firms The creditworthiness of the entities were rated through analyzing a wide ranges factors like environmental conditions, competitive position, management quality, and the financial strength of the business

The advantages of this approach are clearly seen with simple calculation, interpretation and especially suitable with Vietnam practical context Moreover, the implication of the study conducted by the scholar Dao and Dang (2010) had relative accurate results in the case of Vietnam market Because of the 62-firm sample including Vietnamese commercial banks, together with mentioned advantages, this method will be chosen to employ to calculate default probabilities of Vietnamese commercial banks in this

research

2.2.1 Theories on corporate governances in general

There are two basic approaches for the corporation governance, the shareholder model

and the stakeholder model In its narrowest sense (shareholder model), corporate

governance can be used to describes the formal system of accountability of senior

management to shareholders In its widest sense (stakeholder model), corporate governance often describe the network of both internal and external relations involving

the corporation We decided to introduce both approaches in this thesis

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Shareholder Model

The shareholder theory was originally proposed by Milton Friedman (1970) and it states that the sole responsibility of business is to increase profits to maximize shareholder wealth The success of the firm in this model can be judged though its market value (shareholder value) Therefore, managers and directors will be encouraged to perform implicitly aligning with the wealth of shareholders The underlying problem of corporate governance in this model comes from the principal-agent relationship arising when there

is a separation between beneficial ownership and executive decision-making This happens because the principal (owners of the firm) delegate the agent (the managers) to control the business day-by-day Since the managers are not the owners of the firm, regardless of their decision-making may be the same or different from firm value- maximizing target, they do not bear the full costs or reaping the full benefits

The principal-agent problem is also an essential element of the “incomplete contracts”

view of the firm developed by Coase (1937), Jensen and Meckling (1976), Fama and Jensen (1983), Williamson (1975, 1985), Aghion and Bolton (1992), and Hart (1995)

This is because the principal-agent problem would not arise if it was possible to write a

“complete contract” to motivate managers to act in stockholders' best interests However, complete contracts are infeasible, since it is impossible to foresee or describe all future contingencies This incompleteness of contracts means that investors and managers will have to allocate “residual control rights” in some way, where residual control rights are the rights to make decisions in unforeseen circumstances or in circumstances not covered

by the contract Therefore, as Hart (1995) states: “Governance structures can be seen as a

mechanism for making decisions that have not been specified in the initial contract.”

An effective corporate governance framework can minimize the agency costs and hold-up problems associated with the separation of ownership and control There are broadly four types of mechanisms that can be used to align the interests and objectives of managers with those of shareholders and overcome problems of management entrenchment and monitoring:

Y One solution for ensuring managers to carry out efficient management by directly

compensation plans, stock options, direct monitoring by boards

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Y Another method involves the reinforcing of shareholder’s rights so shareholders have both a greater incentive and ability to monitor management This approach improves the rights of investors through legal protection from expropriation by managers like protection and enforcement of shareholder rights, prohibitions against insider-dealing

Y If shareholders are unhappy with current management, they can encourage the existing board of directors to change the existing management Threat of firing would make them perform for the shareholders’ interests

Y Another way is to utilize indirect method of corporate control such as that provided by capital markets, managerial labor markets, and markets for corporate control e.g take-overs

One of the critiques of the shareholder model framework is the underlying assumption that the conflicts are between strong, entrenched managers and weak, dispersed

shareholders This has resulted in an almost exclusive concentration, in both the analytical

work and in reform efforts, of handling the managing and controlling primary corporate governance issues in the principal-agent context with dispersed ownership

The dominant organizational corporate governance mechanism for the firm is one

determined by concentrated ownership This type of corporate governance mechanism in company with high ownership concentration may lack investor protection However, unlike the dispersed corporation where managers have most of the residual control rights with shareholders having very little power, the concentrated ownership corporation is usually controlled by a majority shareholder or by a group of controlling block holders (Maher and Andersson, 2000) This could be an individual or family, or block holders such as financial institutions, or other corporations acting through a holding company or

cross shareholdings

An alternate motivation behind why ownership concentration is as popular as the prevailing organizational form because it can solve the monitoring problem The obstacle with dispersed ownership is that the incentives to monitor management are weak Shareholders have a common sense of “free-ride” with the expectation that other shareholders will do the job of monitoring The reason is that the benefits from

monitoring are shared with all shareholders proportionally, whereas, the entire costs of

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monitoring claims directly to those who monitor These free-rider issues do not emerge

with concentrated ownership, since the majority shareholder earns most of the profits associated with his monitoring efforts

Another critique of the shareholder approach is that the analytical focus on how to build the corporate governance problem is too narrow The shareholder mechanism to corporate governance is only concerned with directing interests of managers with those of shareholders and with guaranteeing the flow of outside funds to firms However, shareholders are not the primary ones who invest in the corporation The competitiveness and ultimate success of a business is the result of different contributions from a wide range of providers including investors, employees, creditors, suppliers, distributors, and customers, Corporate governance and economic performance will be influenced by the connections among these different stakeholders in the firm

The Stakeholder Model

The stakeholder model takes a broader view of the firm According to the traditional stakeholder model, the corporation is responsible to a wider constituency of stakeholders other than shareholders Other stakeholders may include contractual partners such as employees, suppliers, customers, creditors, and social constituents such as members of

the community in which the firm is located, environmental interests, local and national

governments, and society at large This view holds that corporations should be “socially responsible” institutions, managed in the public interest

The question of who is a stakeholder is controversial Questions arise such as whether stakeholders represent a broad class of those who are affected by or affect the corporation

(Evan and Freeman, 1993), or are only “Those individuals and constituencies that

contribute to [the firms’] wealth-creating capacity and activities” (Post, Preston, and

Sachs, 2002) If stakeholder theory includes only those who affect the corporation and its profits, then it becomes subordinate to shareholder value theory, not an alternative to it A broad framework of stakeholders is offered by Wheeler and Sillanpaa (1997) They include four categories of stakeholders: primary social, secondary social, primary non- social and secondary non-social

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Primary Social Stakeholders Secondary Social Stakeholders

| * Competitors

Primary Nonsocial Stakeholders Secondary Nonsocial Stakeholders

of the business either directly or indirectly but at different levels of concern with different

objectives However, three parties get involved directly and play the central roles in

governing the corporation to ensure all business goals are obtained and shareholders’

wealth are maximized are: Shareholders, Board of Directors and daily in charge personnel often referred as CEOs or Executive Board (Barger, 2004)

One of the critiques of the stakeholder model is that managers or directors may use

“stakeholder” reasons to justify poor company performance Besides, the benefit of the shareholder model is that it provides clear guidance in helping managers set priorities and establishes a mechanism for measuring the efficiency of the firms’ management team and firm profitability On the other hand, the benefit of the stakeholder model is its emphasis

on overcoming problems of underinvestment associated with opportunistic behavior and

in encouraging active co-operation among stakeholders to ensure the long-term profitability of the corporation

One of the most challenging tasks on the reform agenda is how to develop corporate governance frameworks and mechanisms that elicit the socially efficient levels of

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investment by all stakeholders The difficulty, however, is to identify those frameworks

and mechanisms which promote efficient levels of investment, while at the same time

maintaining the performance accountability aspects provided by the shareholder model Ata minimum, this implies that mechanisms that promote stakeholder investment and co-

operation should be adopted in conjunction with mechanisms aimed at preventing

management entrenchment Stakeholder model should provide clear guidance on how the

firms’ objectives and priorities are set In addition, how the firm will attain those objectives and how performance monitoring will be determined also need to be clearly defined

2.2.2 Theories on corporate governances in banking sector

In contrast with the generally rich consideration on corporate governance in general, corporate governance in banking sector has gained little study by scholastics until the recent financial crisis of 2007-2009 The crisis, among other things, recognized bad corporate governance as one of the reason for failure Kirkpatrick (2009) — a master of OECD, one of the most influential international organizations focused on corporate governance developments — gave his evidence that there were insufficient regulatory and accounting standard requirements; poor risk management; and misalignment of remuneration policies with the strategy, risk appetite and long term interests in many firms Different researchers identified different shortcomings of corporate influence, in the same way as unethical behavior and opportunistic conduct or misconduct of the Board

of Directors and Senior Management of financial institutions (Solomon 2010, Clarke and Klettner 2010)

The relationship between bank corporate governance and regulation

The existence of principal-agent problem resulting from the separation of ownership and management encourages the governing body to build corporate governance and banking regulation In this light, corporate governance and banking regulations are formed to avoid self-serving and abusive behavior of managers at the expense of shareholders Attempting to handle issues of the same nature, and using similar means to achieve it may cause an overlap between corporate governance and bank regulation (Shull et al, 2007) Mu" Ibert (2009) contended that this relationship might be seen alternative or as

complementary rather than overlapping in a strict sense Caruana (2005), a General

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Manager of Bank for International Settlements, utilized this view when expressing that

"great corporate governance and supervisory actions supplement one another" He

included that "bank regulation and supervision would not be effective in conditions of

poor corporate governance" Sound bank corporate governance was perceived more

important than rather than those of general firms, because the fact that it did not only serve to the benefits of the corporate; it also served to the interests of supervisors by keeping the proper environment for sound and prudent management (Banca d' Italia, 2007)

Ciancianelli and Gonzales (2000) pointed out that both regulation and corporate governance ought to be acknowledged as external drives that influence banks' holders and the managers in diverse ways In term of regulatory system, investors depend on the government in ensuring their bank deposits from expropriating management Bank managers have incentive to take return from high-risk decision at the expense of governance This risk issue might be restored through the utilization of investment

regulations, for example, asset restrictions, interest rate ceilings, reserve requirements,

and separation of commercial banking from insurance and investment banking The impacts of these regulations constrain the capacity of bank managers to over-issue liabilities or divert assets into high-risk ventures In this manner, banking sector not only requires a broader view of corporate governance but also set a strict regulation and supervision for avoiding inappropriate management behavior

Management

Definitely, implementing good corporate governance usually leads to good bank performance and risk management; hence, the two factors are interrelated by nature Interrelationship between the two represents the risk and return trade-off When banks can reduce their risk, they will get higher opportunity to increase their performance (return) Better risk management implies that banks control their operation at lower relative risk and at lower conflict of interests between different stakeholders These advantages of good risk management lead to higher banks performance It increases their reputation and image from public especiatly banks’ stakeholders The lenders or depositors will charge at the lower cost as the result of bearing lower risk The banks also

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get more opportunities to increase the productive assets, leading to higher bank profitability (Cebenoyan and Strahan 2004)

Banks as interest intermediaries are also helpful to illustrate the relationship between corporate governance and risk management The interested parties are not only concemed gaining better profit for their investment but are also concerned the degree of risk they might be exposed In this way, better implementing good corporate governance leads to both higher expected return and also better managing the risk Risk management is specified as mechanisms of corporate governance in banking sector through various perspectives In which, one famous measure of risk management, regulated banks is the Capital Adequacy Ratio (CAR), which measures bank capital over the risk-weighted assets (Dao and Hoang, 2012) Markets have no adequate force to control the operations

of banks In this circumstance, the fundamental responsibility of regulator and regulation

is to serve the stakeholders by controlling and managing the operations of bank with the aim of restrict potentially inappropriate Particularly, regulator and regulation, as external corporate governance, need to manage managerial behavior to make relevant decisions to enhance risk management With the competent managers who are able to reduce the

compensation, and career plans as motivation

In order to build sound corporate governance for better corporate performance and risk management, the ownership structure plays the main factor Agency theory suggests that dispersion ownership decides how the firm is controlled The theory assumes that each

party is pursuit to maximize their own wealth Shleifer and Vishny (1997) suggest that

concentration level of ownership is a significant factor attempting shareholders to monitor managers and to perform corporate governance mechanism The higher level of concentrated ownership shareholders have, the more power to control the firm

Management are defined as Triangle Gap Model by Tandelilin et al (2007) as the

following:

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Figure 1: Triangle Gap Model Bank Corporate Governance

2.3 Literature review of relationship between default risk estimation, bank credit

risk and corporate governance

For the same topic of this research, Switzer and Wang (2013) have conducted the study the impact on default probabilities of banks of several corporate governance mechanisms that have been deemed in the literature review to be beneficial to shareholders and of different credit risk indicators as the view by creditors However, to the extent that these mechanisms impair a firm’s financial situation and hamper the interest of debt holders This analysis took the data in the panel of US banks, including commercial banks and saving banks

In order to approach the default probability, the authors used structural credit model which generates the desired results from both accounting and financial information and thus can be used to provide and update credit risk information in timely manner The

authors assumed that on the time zero, default event occurs when the asset value hits or

falls below the default boundary for the first time Upon default, the firm would liquidate immediately with assets and the default probability can be computed based on the model

of Black and Cox (1976) as:

b=I Œ)

V: asset value

K: face value of the debt

T: Time to maturity

As the asset is non-tradable its price cannot be observed in marketplace The authors used

the algorithm developed by Ronn and Verma (1986) to compute the unknown asset price and volatility by solving following two equations simultaneously:

N(.): the cumulative probability of a standard normal distribution

Since the firm’s equity can be considered as a standard European call option provided the default only occurs at the maturity’, equation 2.7 shows this relationship as inspired by Black and Scholes (1973) Equation 2.8 restricts the relationship between the equity volatility and asset volatility and can be derived by Ito’s lemma As equity prices are observed in the market and the corresponding equity volatility can be calculated by the high-frequency equity price data, the asset value V and asset volatility oy can be computed by solving these two non-linear equations simultaneously given the exogenous default boundary K and maturity T

* This assumption provides computational simplicity since we need to calculate the implied asset value and

asset volatility across firms over several years

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