Credit risks at central people’s credit fund hatay branch and some solutions to minimize that

THE STUDY: MANAGEMENT OF CREDIT RISKS AT CENTRAL PEOPLE’S CREDIT FUND – HA TAY BRANCH.... 2.5.1 Current situation of credit risks at central people’s credit fund Hatay branch..... 2.5.2

TABLE OF CONTENTS

ACKNOWLEDGEMENT …………

ABSTRACT LIST OF ABBREVIATIONS LIST OF FIGURES AND TABLES INTRODUCTION 1 Rationale

2 Aims of the study

3 Scope of the study

4 Methodology

5 Structure of the study

DEVELOPMENT CHAPTER 1 : LITERATURE REVIEW THEORETICAL BACKGROUND OF CREDIT RISKS IN CERDIT INSTITUTIONS’ACTIVITIES 1.1 THE CREDIT ACTIVITIES OF CREDIT INSTITUTIONS

1.1.1 The concept of credit

1.1.1 The role of credit

1.1.1 Types of credit

1.2 CREDIT RISKS IN CREDIT INSTITUTIONS’ ACTIVITIES

1.2.1 What is risk?

1.2.2 Viewpoints on credit risk

1.2.3 Types of credit risk

1.2.4 Causes of credit risks

1.2.5 Criteria for evaluating credit risks

1.2.6 The impact of credit risks on credit institutions’ activities

1.3 SOME EXAMPLES OF GOVERNMENT REGULATIONS IN CONTROLLING RISKS OF CREDIT INSTITUTIONS

CHAPTER 2: RESEARCH METHODOLOGYError! Bookmark not defined. 2.1 RESEARCH QUESTIONS

2.2 THE SUBJECTS: CCF – HA TAY BRANCH

2.2.1 History and development of CCF Hatay branch

2.2.2 Services offered

2.2.3 Organization structure

2.2.4 Overview of activities at CCF Hatay branch

2.3 DATA COLLECTION INSTRUMENTS

2.4 DATA COLLECTION PROCEDURES

2.5 THE STUDY: MANAGEMENT OF CREDIT RISKS AT CENTRAL PEOPLE’S CREDIT FUND – HA TAY BRANCH

2.5.1 Current situation of credit risks at central people’s credit fund Hatay branch

2.5.1.1 Overdue debts

2.5.1.2 Bad debts

2.5.2 Evaluating the management of credit risks at central people’s credit

fund Hatay Branch

2.5.2.1 Achievements

2.5.2.2 Weaknesses

2.5.2.3 Reasons for the CCF Hatay branch’s weaknesses

2.6 DATA ANALYSIS AND FINDINGS

CHAPTER 3: IMPLICATION/RECOMMENDATIONS 3.1 ORIENTATIONS FOR CREDIT ACTIVITIES AT CENTRAL PEOPLE’S CREDIT FUND – HA TAY BRANCH IN THE NEAR FUTURE

3.1.1 Orientation for developing credit products and services

3.1.2 Targets for the year 2011

3.2 SOLUTIONS TO MINIMIZE CREDIT RISK AT CENTRAL PEOPLE’S CREDIT FUND – HA TAY BRANCH

3.2.1 Improving the quality of researches and analyzes of customers

3.2.2 Collecting adequate information on customers

3.2.3 Tightening supervision over credits

3.2.4 Enhancing the quality of human resource

3.2.5 Diversifying credit portfolio

3.2.6 Using appropriately credit assessment models

3.2.7 Obeying Basel Committee’s principles

3.3 IMPLICATIONS

3.2.1 Implications to the government and related sectors

3.2.2 Implications to the State Bank of Vietnam

2.2.3 Implications to CCF Hatay branch

CONCLUSION

Summary of the study

Suggestions for further study

REFERENCES APPENDIX

INTRODUCTION

1 Rationale of the study

Concerns about unsafe credit activities and vulnerable credit riskmanagement system have been climbing these years, from the United States‟troubled mortgage lending (2008) to the European debt crisis (2010) It urges thesignificance of a sound credit risk management in lending organizations Creditrisk is a popular type of risk that credit institutions must deal with In bankingbusiness, credit risk happens when “payments can either be delayed or not made

at all, which can cause cash flow problems and affect a bank’s liquidity Hence,credit risk management in a bank basically involves its practices to “manage”, or

in other words, to minimize the risk exposure and occurrence For a bank,lending activities form a critical part of its products and services In fact, morethan 70% of a bank’s balance sheet generally relates to this aspect of riskmanagement Therefore, credit risk management is crucial to any bank’s success

In a small country like Vietnam, the financial sector is still in the developmentphase and many credit institutions have not been able to establish a firm riskmanagement framework, particularly credit risk management, in order to preventunfavorable events This is dangerous when Vietnamese banks’ customerservices are still in their infancy and banks’ revenue depends heavily on lendingactivities and credit growth is central to any bank’s profit In addition, the controlwork from the central bank, though playing a growing role, has not beenprotective enough Access to credit information and history is very limited Thus,small banks and credit funds are facing the big question of establishing a strongcredit risk management framework in order to maximize their profits and to gaincompetitive advantage over their rivalries Central people credit fund (CCF) - ajoint stock credit institution which is supervised by SBV is not an exception CFF provides financial services to LCFs and the general public, including SMEs,farmers and CCF staff Thus, its operation has all specific characteristics of ancommercial bank, especially in potential credit risk This is where the researchproblem for this thesis arises Instead of analyzing other credit institutions thathave quite more comprehensive risk management framework, the researcher is

far more worried about the practices in central people’s credit fund Hatay branch

which are still weak and less competitive in banking market What could they have done in order to prevent or at least lessen the bad impact of credit risks happening?

In brief, all of the facts mentioned above have encouraged me to direct my study

on: “Credit risks at Central people’s credit fund Hatay branch and some

solutions to minimize that”

2 Aims of the study

The biggest objective of this research is studying the current situation of creditactivities, analyzing credit risks at CCF Hatay branch during the 2008-2010period and then giving some suggestions to minimize these risks

This thesis also explains to the readers the significance of credit riskmanagement in banking in general and CCF Hatay branch in particular

3 Methods of the study

Research methodology is a philosophical framework for any research Itcontains the data used and the research data collection techniques For this thesis,both primary and secondary data are used Secondary data are collected from theliterature (books, journals, previous research papers, electronic sites, etc.), theSBV regulation database, the CCF, PCFs annual reports and published internalpolicies Primary data are gathered by the researcher through both qualitative andquantitative methods An in-depth interview was conducted with three creditstaffs in the branch to gain insight into the office’s daily credit operations Aquestionnaire was also designed and handed to 30 peoples to find out more aboutthe staffs’ characteristics and practices

4 Scope of the study

Because of the limitation of the writer’s knowledge, experience and time, thisstudy only focuses on the management of credit risks in short, medium and longterm loans at CCF Hatay branch from 2008 to 2010

5 Organization of the study

Besides an Introduction giving a brief description of the research including the reason for choosing topic, scope, aims and methods of the study and a Conclusion which summarizes the main points of the study and gives suggestion for further study, this thesis was divided into three main chapters:

Chapter 1 : Literature review providing a theoretical background of credit risks in financial institutions’ activities

Chapter 2 : Method methodology showing the method used to evaluate the

practice of managing credit risk at CCF Hatay branch

Chapter 3 : Implication/ Recommendations suggesting some solutions to

minimize credit risks at the CCF Hatay branch

THEORETICAL BACKGROUND OF CREDIT RISKS IN CERDIT INSTITUTIONS’ ACTIVITIES

1.1 THE CREDIT ACTIVITIES OF CREDIT INSTITUTIONS

1.1.1 The concept of credit

We are living in a world of credit Everyday, in every way, we become moreand more involved in various aspects of this credit world As consumers,business people, and bankers, we are experiencing continued growth in usingcredit Therefore, all of us need to understand what credit is, and how it is used.Some concepts such as a credit transaction, credit activity and credit line areoften mentioned in everyday life, however, many people may not understand theexact meaning of these IN fact, it is hardly to give a clear definition of creditbecause of its large scale

Traditionally, credit may be defined as “ a transaction between two parties inwhich one ( the creditor or lender) supplies money, goods, services or securities

in return for a promise of future payment by the other ( the debtor or borrower)”.Such transactions normally include the payment of interest to the lender

In the case of a credit institution, credit means lending or advances made by it.The bank itself is the lender, and the borrower from an credit institution is theinterest or commission charge that they have to pay through the life of thelending

In terms of language, a credit has the similar meaning as a loan to someextent For example, a short-term and long-term credit is often understood as ashort-term and long-term loan respectively

1.1.2 Types of credit

In order to manage and control a large scale of credit, credit is often classifiedinto different groups according to various criteria

1.1.2.1 Time of credit

a Short-term credit: is a type of credit which is advanced for a year or less with

an agreement that they will be repaired in one payment at the end of the period

b Medium and long-term credits: are those with maturities longer than one year.Evidence of the transaction is the promissory note, either secured or unsecured.Usually, such credits are repaid at specified intervals mutually agreed on by thelender and borrower.

1.1.2.2 Subjects involving in credit activities

a Private credit: is credit used by individuals and businesses in order to carry

on exchanges in the private sector of the economy

Private credit includes:

- Consumer credit: is the use of credit as a medium of exchange forthe purchase of finished goods and services by the ultimate user

- Business credit: describes the credit relationship involved inpurchasing goods, raw materials, and inventory for resale, or obtainingfunds to start, maintain, and operate business activities, using credit as amedium of exchange

b Public credit: is credit extended or used directly by a government agency to

finance the goods, services, and welfare programs it offers to citizens.Governments borrow money primarily through the sale of bonds and othersecurities if tax revenues are not sufficient to cover current spending needs

1.1.3.3 Security

a Unsecured credit: is a credit that bases solely on the creditworthiness of theborrower, and on which no collateral is pledged The evidence of this type ofcredit is usually the borrower’s signed promissory note

b Secured credit: is a credit that relies not only on the borrower’s promise to paybut also on a pledge of some specified property The bank can exercise its lien onthe collateral in the event the borrower defaults

1.1.3.4 Borrowing purposes

a Real estate credit: which is secured by real property- land, buildings, and otherstructures It includes short-term loans for construction and land developmentand longer-term loans to finance the purchase of houses, apartments, or foreignproperties

b Financial institution credit: contains credit to banks, insurance companies andother financial institutions.

c Agriculture credit: which is extended to farm and ranch operations to assist inplanning and harvesting crops and to support the feeding and care of livestock

d Commercial and industrial credits: which are granted to business to cover suchexpenses as purchasing inventories, paying taxes, and meeting payrolls

e Credits to individuals: include credit to finance the purchase of automobiles,appliances, and other retail goods to repair or modernize homes, cover the cost ofmedical care and other personal expenses, either extended directly to individuals

or indirectly through retailed dealers

1.2 CREDIT RISKS IN CREDIT INSTITUTIONS’ ACTIVITIES

Some of the major risks that bankers are concerned with are credit risk,operational risk, liquidity risk and legal risk, which are discussed below

1.2.1.2 Types of risks of credit institutions

Operational risk is the risk of loss resulting from non-financial problems, such

as technology ( e.g., technological failure and deteriorating systems), employees (

e.g., human error), customer relationships (e.g., contractual disputes), capitalassets ( e.g., destruction by fire and other catastrophes) and external events(e.g.,

external fraud) In other words, operational risk is associated with a bank’s

overall organization and can arise whenever existing technology malfunctions orback-office support systems break down

c Liquidity risk

“Liquidity risk is the risk that a sudden in liability withdrawals may leave afinancial institution in a position of having to liquidate assets in a very shortperiod of time and at low prices.” (Wikipedia)

Faced with liquidity risk, a bank may be forced to borrow emergency funds atexcessive cost to cover its immediate cash needs, thus reducing its earnings

d Legal risk

“Legal risk is the risk from uncertainty due to legal actions or uncertainty inapplicability or interpretation of contracts, laws or regulations” (Wikipedia)Legal risk may also occur when there are contradictions in the legal system.Sometimes, commercial banks are confused by various regulations and they facedifficulties in following one rule which may go against another

Despite innovation in the financial service sector, credit risk is still the majorsingle cause of bank failures due to the fact that nearly 90% of a bank’s revenuegenerally brought by credit activities Thus, the effective management of this risk

is central to a commercial bank’s performance That is the reason why the thesiswill mainly focus on credit risk and its management approach

1.2.2 Viewpoints on credit risk

Financial institutions’ credit capital often involves in all economic periods,therefore, danger that are exposed to the economy as a whole are believed to bethe dangers to credit institutions as well Although each bank has differentconsiderations for credit risk management, it is hardly denied that credit risk is aninherent part of banking activities

In addition to the above mentioned definition, credit risk also refers to the risk offinancial losses due to unexpected changes in the credit standard of debtors andcounterparty in a financial agreement It occurs as an obstacle that preventsbusinesses from increasing profits.

Heffernan ( 2005) has shown that “ credit risk comprises the possibility which asasset or a loan is irrecoverable in the case of default, or the risk of delay inrepayment of the loan: It is often the case in the business of lending that aborrower knows more about its solvency than the lender, therefore, the financialinstitution is being at an informational disadvantage The lender may seek out itssolution by setting a credit line, rather than permitting the borrowers to accesstheir own loan size without any restriction However, the quantitative exposurelimits company’s competitiveness in the market For example, reducing a creditline might make the volume of clients decrease and thereby gains lower profit.Contrary to it, extended credit may lead to higher risk

Some bankers argued that credit risk is mainly associated with the risk inassessment process For example, if a customer is unwilling to provide the bankwith adequate and accurate information on his/her business activities, it will runthe risk of making wrong decision on offering a credit Thus, the most importantstep for bank is to focus on evaluating the borrower’s business condition

1.2.3 Types of credit risk

Credit risk often occurs in the daily activities of a credit institution in varioustypes

to service its debts and its obligations If a borrower has a questionable reputation

or is having financial difficulties, the lender faces the risk that the borrower willdefault Moreover, the default of borrower will downgrade the current value ofthe assets Prior to default, however, there is actually no way to discriminateclearly between firms that will default and those that will not At best, a creditinstitution can only bank probabilistic assessments of the likelihood of default.The loss suffered by a credit institution in the event of a customer; default isusually significant and is determined largely by the details of the particularcontract or obligation

 Excessive capital risk:

Excessive capital risk arises when a bank is able to mobilize a large amount ofcapital from the public but there is not enough demand for loans from itscustomers In this case, there will probably be a growing imbalance between theamount of capital and capital utilization As a result, earnings from the loans’interest can not compensate for bank’s operational costs and payments forinterest of customers’ deposits

 Capital shortage risk:

Contrary to the excessive capital risk, capital shortage risk occurs when a bank

is undercapitalized, which may lead to the loss of making payment ability On theone hand, the bank can not offer a wide range of credits On the other hand, it has

to ask for capital from external sources with such a higher interest rate than that

of its own loans

1.2.4 Causes of credit risks

Commercial banks are still aware of their shortcomings and mismatches in thecredit activities which lead to the above mentioned risks

1.2.4.1 Objective causes

Credit activities probably have direct and massive impacts on the economy,and in return, they are influenced by the objective factors from the society Thus,every commercial bank should realize the potential of credit risks

Firstly, risks in a commercial bank’s activities may result from several factorsassociated with the economic environment such as economic cycle, inflation,foreign exchange rate, interest rate, monetary policy and unemployment rate.When the economy witnesses an enormous growth, industries in general andenterprises will positively thrive as well as generate high earnings Therefore, thedebt collections of commercial banks are probably easier, and customers’ baddebts are mitigated, apart from the case of maturity risk In contrast, in the period

of economic recession, high inflation and unemployment rate accompanied bystrict monetary policy will pose considerable threats to the production and profits

of individuals and business as a whole In this situation, credit risks incommercial banks’ activity are unavoidable

Secondly, political issues and the legal system are also likely to affect greatlybusiness activities in general and credit activities in particular of a bank Acountry with stable politic environment is surely an ideal place for both domesticand foreign investors Besides, without having to worry about political conflicts,crisis and terrorism, people will more concentrate on how to increase theproductivity as well as raising turnover As a result, they can pay back all theirdebts to banks at maturity date, which reduces credit risks for banks On the otherhand, cumbersome and nontransparent legal framework might give a limit toserious frauds in using customers’ capital

Thirdly, commercial banks have to take social factors into consideration aswell, including population, consuming behavior, literacy rate, etc The reason isthat providing unsuitable credit products for the local customers can also putbanks at risk

1.2.4.2 Subjective causes

a From borrowing customers

The level of credit risk may vary depending on different types of borrowers Inthe case of individual customers, there are a wide range of reasons why they areunable to service their debts For example, the borrower loses his/her job andthen has no financial resource to pay off a debt, or the debtor has to face

unpredictable problems such as an accident, service illness and other healthproblems A customer’s delinquency can also result from his/her failure inmanaging personal finance or using the lending fund properly.

In the case of corporate customers, causes for a bank’s credit risk are morecomplicated In running their business, these enterprise clients usually have toencounter serious financial difficulties which take root from the nature of supplyand demand For instance, when the price of raw material goes up, amanufacturer will have to run the risk of either higher operation cost or lowerprofit rate Besides, if the supply of material in the market is inadequate, thecompany will hardly meet the demand for products of consumers as well assatisfy the ordered amount according to its business contracts This willconsequently effect the company’s reputation and competitiveness In addition,

an enterprise may have to deal with other non-financial problems, such as weakmanagement skill of its directors, depression of the economy as a whole, anddecreased purchasing power Generally speaking, all of the mentioned exampleswhich often lead to a big decline in business’ profits and pose obstacles for them

to fix their debts can be considered the direct causes for credit risk of acommercial bank

b From lending risks.

Credit risks can be resulted from the activities of a commercial bank itself Lack

of responsibility and qualification is the common cause of credit risks If thebanking officers are poor qualified, they cannot recognize the warnings signs ofdelinquency as well as conduct transactions in the most beneficial way to theirbank Besides, some are careless in making hastily loan decisions without properassessment or through non-observance of credit guidelines, which often leads toserious dangers For example, it is believed that many bad debts have beencaused by lending to customers who use the advance for speculative purposes, orones in weak financial position without proven reliability

Lack of information is another cause The result of incomplete knowledge ofcustomer’s activities is that the true nature and purpose of borrowing is notknown This, of course, should never arise It is necessary to make inquiries at

the beginning to obtain as much as information as possible regarding theborrower’s background and find out the borrower’s financial standing.

In addition, staffs’ immorality and disobedience to banking principles often lead

to negative consequences to commercial bank

1.2.5 Criteria for evaluating credit risks

1.2.5.1 Banking criteria

The ultimate goal of credit risks management is to minimize potential creditrisks at an acceptable level to the bank In order to assess risks properly,commercial banks must have to the ability to measure risks there are oftenhelpful ratios used to measure credit risks

a Overdue debt ratio

Overdue debt ratio = TotalTotaloustandingoverduedebtdebts

Overdue debts are debts of which part or the whole principle and interest areoverdue Indeed, the higher this overdue debt ratio is the greater credit risks abank has to face In this case, the bank may suffer from increasing cost ofsupervising and controlling debt collection, and more importantly, the loss ofother loans to customers who have better payment ability

b Bad debt ratio

Bad debts ratio = TotalOutstandinoustandinggbaddebtsdebts

The higher the bad debt ratio is, the risks the bank’s credit is

c Default debt ratio

Default debt ratio = OutstandinTotaloutstandingdefault gdebtsdebts

Outstanding default debts include loans which have the probability of default.Thus, banks will run the serious risk of credit activities if this default debt ratio ishigh

d Risk provisions ratio

A risk provision is the additional amount ò money reserved for the purpose òdealing with loses caused in credit activity

Risk provision ratio = Theamount Totalofoustandingmoney reserveddebtsfor losses

If a bank spends too much on this reserved fund for risk, its operational cost willprobably increase, thus reducing its profit The high rate of risk provisions ratiomay indicate the bank’s poor quality in credit activity

1.2.5.2 Borrower criteria

Commercial bank often use quantitative models to assess credit risks,particularly the probability of default of the borrower One of the mostcommonly used is the liner discriminant model which is known as a part of Z –credit scoring models The model will help risk managers either calculate a “score” representing the borrower’s probability of default or sort those intodifferent default risk classes

a Linear discriminant model – “ Z – credit scoring model”

In order to employ this scoring model, the banker must identify objectiveeconomic and financial measures of risk for any particular class of borrowers.For customer debt, the objective characteristics may include income, assets, age,and occupation For commercial debt, cash flow information and financial ratios,such as the debt to total assets ratio which measures the percentage of the firm’sassets that are financed with debt and total asset turnover ratio which measureshow efficiently a firm utilizes its assets, are usually key factors

The discriminant model divides borrowers into high or low default risks classesdepending on their observed characteristics ( Xj)

The following example considers the discriminant model developed by E I.Altman for publicly traded manufacturing firms in the Unites States Theindicator variable Z measures the default risk classification of a commercialborrower as a whole This is contingent on the values of various financial ratios

of the borrower ( Xj) and the importance of these ratios in deciding the defaultprobability of the borrower These values in turn are estimated by the pastobserved experience or defaulting versus non-defaulting borrowers which arederived from a discriminant analysis model The formula of Altman’sdiscriminant model ( credit-classification model) is:

Z = 1.2X1 + 1.4X2 + 3.3 X3 + 0.6X4 + 1.0X5

Where: X1 = working capital ratio ( working capital/total assets)

X2 = retained earnings to total assets ratio

X3 = earnings before interest and taxes to total assets ratio

X4 = market to book value ratio ( market value of equity/book value oflong-term debt)

X5 = total asset turnover ratio ( sales/total assets)

According to this model, the higher the value of Z, the lower the default riskclassification of the borrower Therefore, low or negative values of Z may beevidence of relatively high default risk class of borrowers Besides, discriminantanalysis model produce a switching point, Z =1.81, which is the averagedifference between the Z scores of a defaulting firm and a non-defaulting one This discriminant model is straightforward and its calculation is made simply.However, there are several shortcomings remaining The first weakness is thatthe model only reflects two extreme cases of a borrower: default and no default,but there are a variety of risks in the real world The second problem is thatconstant variables estimated in the model are no always the same due to changingreal financial conditions of borrower as well as the economy In addition, themodel has ignored important, hard-to-quantify factors, such as reputation of theborrower and long-term relationships between banks and their debtors, whichmay play a crucial role in the default or no default decision

b The policy on customer rating of CCF

Besides linear discriminant model, there are also various methods forcommercial banks to estimate or “ score” their customers’ creditworthiness Aspecific example of those methods is the CCF's policy on customer rating

From December 1st 2006, all of the branches and transaction departments of CCF,including Hatay branch, have followed this customer rating policy in order toimplement diversified customer policies adapted to a variety range of clients ofCCF The policy based on 60 criteria including financial and non-financial ones.

Financial criteria contain:

- Profitability ratios which comprise of gross Profit Margin, Operating ProfitMargin, Net Profit Margin, Return on Assets and Return on Equity measurehow a firm’s returns compare to its sales, asset investments, and equity

- Liquidity ratios which consist of Current ratio and Quick Ratio measure theability of the borrower to meet its short-term obligations

- Asset activity ratios which include Inventory Turnover ratio and Total AssetTurnover measure how efficiently a company uses its assets

- Debt ratios include debt to total Assets ratio, Debt to Equity ratio and EBIT /Interest expense ratio

- Besides, there are also several non- financial criteria including:

- Management expertise, professional knowledge and experience of the board ofdirectors who involve directly in day-to-day activity of a company

- Human resources of the firm; its vision and business strategies in the five-yearperiod; its average growth rate during the past 3 years

- Customer’s reputation and his credit relationship with the bank over the last 12months

- External factory, such as industrial potential, a new enterprise’s ability to enterthe market, the stability of input materials ( in both quantity and price),government’s subsidies

After considering all of these criteria, the branch will be able to “ score” itscustomers in accordance with their credits According to CCF’s internal ratingsystem, customers’ credits van be divided into ten following rating groups:

No Rating

groups Meaning

1 AAA Best group of customers with the best credit quality Their

ability to pay off their debts is extremely reliable

2 AA Customers rated AA are also very reliable

3 A Customers rated A are more susceptible to negative impacts

of external factors and economic conditions than the AAAand AA ones, but their ability to pay off debts is still highlyevaluated

4 BBB BBB-rated-customers have adequate conditions to pay back

all debts However, economic and external changes havemore influence on the customer’s ability to fix their debts

5 BB Caution is necessary for this group of customers Although

they are not likely to run the risk of default like those from B

to D group, they are facing potential risks which affect theirability to liquidate their debts

6 B These customers are more vulnerable to changes in economic

and financial conditions, but they are currently showing theability to meet their obligations

7 CCC CCC-rated-customers are currently being put at risk of a

default Their ability to pay off debts depends on favorableeconomic conditions

8 CC Customers rated CC are highly vulnerable to a payment

default

9 C C-rated-customers have close to or already declared

bankruptcy, but their payment on the financial obligations iscurrently continued

10 D This is the worst group in which customers actually face a

1.2.6 The impact of credit risks on banking activities

It is widely known that profit and risk are parallel factors in any businessactivities, particularly in trading currencies Business entities which can earn ahuge profit, such as commercial bank and credit institutions, in turn have to takeconsiderable credit risks

 Credit risks decrease banks’ profit

The main source of Vietnam bank’s earnings is from credit activities.Therefore, when any type of credit risks occurs ( ex A borrower’s default), itwill directly affect banks’ benefits For example, banks may have difficulties incollecting debts from overdue credits but at the same time they still have to payinterest foe mobilized capital from customers’ deposits or savings It is alsounderstood that greater risks in credit activities will lead to banks’ lowercompetence in making payment On the other hand, if a bank is able to manageand control credit risks, it will have an adequate source of money to meet itsoperational cost as well as additional expense and even to expand its businessscale

 Credit risks damage banks’ prestige

A bank with high level of credit risks is said to have ineffective operation andlimits capability for providing banking products and services Once a bank hasbad reputation as unsuccessful credit risk manager, it probably losses people’sconfidence and becomes an unreliable business partner for both domestic andinternational banks Consequently, it will be hard for that bank not only to attractcapital from the public but also to maintain its competitiveness in the market

 Credit risks may be the main cause of a bank’s insolvency

When the level of credit risks dramatically increase beyond the bank’ sexpectation, a threat of bankruptcy is unavoidable

1.3 SOME EXAMPLES OF GOVERNMENT REGULATIONS IN CONTROLLING RISKS OF CREDIT INSTITUTIONS

Regulatory policies play a fairly important role in reducing risks andenhancing risk management operation Vietnam is not a member of the BaselCommittee on Bank Supervision and therefore, has not adopted Basel Accordsyet However, the State Bank of Vietnam is trying to issue policies that requirethe banks to direct their operations more and more closely to internationalstandards Indeed, Vietnamese bank are doing their best in that direction

For the scope of this thesis, there is not enough time to mention all policies butonly to analyze the most basic ones

1.3.1 Provision on lending by credit institutions

On 31.12.2001, the Vietnamese central bank issued the Decision No.1627/2001/QD-NHNN on the provision lending by credit institutions to clientsRecently, Circular No 13/2010/TT-NHNN dated 20.05.2010 revised theregulations on lending activities:

 Loan interest rate:

This interest is agreed between the credit maker and its customer in accordancewith regulations of the SBV Importantly, the interest rate for overdue debts must

be fixed by the credit institution and stated in the credit contract and must notexceed 150% of the interest rate applicable during the loan term

 Credit limits:

Fundamentally, the credit institution decides the limits on its own, based on theborrowing requirements of clients and their ability to repay and on its availablecapital sources

“The total outstanding loans to a single client may not exceed 15% of the equity

of the credit institution, except in cases of loans funded by capital sources entrusted by the Government, by organizations or by individuals.

“The total outstanding debts of a credit institution for a group of related clients must not exceed 50% of its own capital, in which the total outstanding debts for a single client must not exceed 15% of its on capital”

To prevent inadequate lending practices, a credit institution is required not toprovide loans to:

(a) its affiliated companies being securities trading businesses;

(b) members of the board of management or inspection committee, the generaldirector or deputy general director of the credit institution;

(c) staff of the credit institution who carry out loan evaluation and approval; (d) parents, spouses or children of the members of the board of management orinspection committee, the general director or deputy general director

(Vietnam Embassy in the USA 2002, Thu vien phap luat 2010)

Decision 1627 and Circular 13 specify very clearly the lending limits andother important provisions on an adequate loan process They will act as usefulguidelines for the credit providers in order to improve the soundness of thelending decisions

1.3.2 Regulations on Classification of Debts and Loss provision

The rules concerning debt classification and loan loss reserve are covered bythe Decision No 493/2005/QD-NHNN dated 22.04.2005 and Decision No.18/2007/QD-NHNN issued on 25.04.2007 The systematic categorization ofdebts or loans makes it easier for banks to calculate non-performing loans andloss provision

 Local people credit funds shall be obliged to carry out debts classification toapplicable groups as follows:

Group 1 includes: good debts which are paid within maturity

Group 2 includes: noticing debts including those are overdue for nearly 90 days.Group 3 includes: debts overdue from 90 to 180 days

Group 4 includes: suspicious debts which are overdue from 181 to 360 daysGroup 5 : defaults debts which are overdue for more than 360 days

 Loss provision is utilized when the borrowers are unable to repay the debt.Two types of loss provision specified in the decision are general and specificprovisions:

General provisions are the guard against losses inherent in a credit

institution’s loan portfolio General provisions are equal to 0.75% of the totaldebt classified from category 1 to category 4

Specific Provision : The minimum specific provision made for each customer

in a debt category is calculated as follows:

R = Σ Ri

Ri = max {0, (Ai - Ci)} x r

In which:

R: Total specific provision made for each customer;

Ri: Specific provision made for this outstanding principal;

Ai: this outstanding principal;

Ci: Discounted value of collateral for Ai;

r: Ratio for specific provisioning of the debt category

Under this formula, the credit provider needs to consider both the loan and thecollateral amount It is essential that collateral is accurately valued

Ratio for specific provisioning of each debt category is as follows:

In order to further understand how the objectives of this study will be

achieved, three following research questions are introduced:

1 Which types of credit risks could pose potential dangers to CCF Hatay branch?

2 How effective are credit risk management practices in the CCF Hatay branch? What is their strength and weaknesses?

3 What could CCF Hatay have done in order to prevent or at least lessen the badimpact of credit risks happening?

2.2 SUBJECTS OF THE STUDY

2.1.1 History and development of CCF Hatay branch

Vietnam is a special case among studies of the restructuring and reform offinancial institutions The primary act of reform consisted in closing the oldsystem of rural credit cooperatives and replacing it with a new system under anew name: People’s Credit Funds (PCFs) SBV has been in charge of designingnew system The PCF-system comprises three managing levels: the Local creditfunds (LCF), the Central People’s credit fund (CCF) and Vietnam Association of

People’s Credit Funds (VAPCF) ( See Figure 1)

Central people’s credit fund (CCF) is a cooperative credit institutionestablished according to the Document No 6901/KTTH dated on February 9,

1994 by Government’s Prime minister and the Decision No 162/QD – NH5 dated

on June 8, 1995 by Governor of the state bank Its headquarter is located inHanoi

It is considered as the apex cooperative financial institution of the PCFnetwork There was no equivalent in the old credit cooperative system The CCF

is a joint stock credit institution under the law of cooperatives, the law of creditinstitutions; it is supervised by SBV

The CCF’s initial equity is over VND 110 billions , it is estimated that up to

2011 the equity would be increased to VND 3000 billions that expected to betransformed into a commercial bank

CCF provides financial services to LCFs and the general public, includingSMEs, farmers and CCF staff The CCF’s operating network covers 53provinces, cities with 24 branches that directly take care, intermediate fund fornearly 1000 LCFs through the country to strengthen the linking network

The key target is mutual help within the network, help LCFs in communesdeveloping firmly In addition it provides technical assistance to LCFs and hasbeen acting as focal point for the network in its relations with SBV, domestic andinternational organizations Its annual report comes out in two languages,Vietnamese and English, and reports on CCF, the PCFs and VAPCF It is audited

by Deloitte

Since 2004 CCF is an active member of the Asian Confederation of CreditUnions (ACCU), which is part of the World Council of Credit Unions(WOCCU).

Figure 1: Apex structure of the People’s Credit Fund network

2.1.1.2 The development of CCF - Hatay branch

In 1994, Hatay province started the pilot establishing 12 People’s creditfunds under the steering Committee and CCF

Central people’s credit fund Hatay branch (CCF Hatay Branch) is establishedaccording to Decision No 2072/QD – NH5 dated on March 20, 2001 byGovernor of the State bank

The main function of CCF- Ha Tay branch is intermediating fund within thenetwork; providing services, taking care, consulting member’s LCFs in 3provinces: Hanoi (old Hatay area), Hoa Binh and Son La province, doingmonetary business, credit and banking services, implementing some tasks oflinking PCF’s network regulated by the Governor of State bank

In the recent year, Ha Tay branch had to face many difficulties Forexample, the branch was located in the same place with more than 5 commercial

State Bank of Vietnam

Membership

MembershipRefinance

banks; thus, it has suffered from fierce competition in attracting potentialcustomers In addition, its staffs at first lacked professional skills and experience.Being aware of these challenges, the directors as well as all staffs of Hataybranch had to try their best to overcome weakness, take full advantage ofstrengths and enhance positive image for the branch Thanks to conductinginnovation of many aspects of operation and applying policies suited for socialand economic conditions, CCF Hatay branch is gradually growing andachievingmany accomplishments By 30/06/2010, Hatay branch has 3 transaction offices, 1saving fund and manages 92 LCF members comprising of 81 LCFs members inHanoi, 4 ones in Hoa Binh and 7ones in Son La province.

Services offered

CCF gradually expanded products, services and continuously innovated andimproved serving quality for not only PCF network but also non-members toconfirm its position in banking system in particular and society-economy ingeneral

◙ Capital mobilization:

- Receiving capital from its members (LCF )

- Receiving demand deposit, term-deposit, deposit for settlement and other deposits of the institutions and individuals,

- Issuing deposit certifications, bonds and other valuable papers in

accordance with the SBV regulations

- Borrowing capital in the domestic money market and domestic and foreign financial credit institutions and other institutions and individuals according to thelaw

- Receiving sponsored capital, entrusted investment capital from

government, Internal, International organizations, individuals from inside and outside country

- Borrowing fund from SBV and Implementing other forms of mobilizing allowed by SBV

◙ Credit activities

- Lending short-term, medium term and long term fund PCF members, the institutions, individuals outside the network according to the capacity of fund of each period in the principle of giving priority with the members

- Co-financing PCFs and other credit institutions according to the SBV

regulations

- Discounting, re-discounting and pledging commercial paper and other short term valuable papers; bank guarantee and other credit activities stipulated by the SBV

- Setting and maintaining credit records, lending procedures, loan assessing, examining the use of loan, terminating loan, dealing with debts, adjusting debts and interest rates according to the SBV regulations

◙ Payment and treasury services

- Opening accounts

+ CCF opens its account with SBV and credit institutions

+ Open account for customers

- Implementing payment and treasury services for PCF members and

customers

+To provide means of payment

+ To provide domestic payment service, collecting and paying services + Other payment services

+To provide safekeeping services in respect of the maintenance of the precious assets and valuable papers

+ To provide services relating to the collection and payment of cash to customers

- To provide other payment services as stipulated by the SBV

2.1.3 Organization structure

CCF- Hatay branch is organized according to a modern banking system in conformity with the their business functions and scale

 The Branch Director is responsible for day-to-day activities of the bank

 The Bank’s department are divided into 5 office in accordance with their

functions

Figure 2: Organizational structure of CCF Hatay branch

Because the primary concern of the study is about credit activity and its risk,

I will mainly focus on the duties and responsibilities of Credit Department whichdirectly deal with the credit activities at Hatay branch

They are responsible for the development of the bank’s scale of credit activity

by attracting more long- term customers, and ensuring safety and efficiency ofcredit transactions as well as the bank’s benefits Besides, staffs in thesedepartments have duty to provide customers with full consultancy aboutchoosing the most suitable credit products and services and using them properly The department is directly deal with assessment and re-assessment ofprojects, loans, guarantees, and mortgages in accordance with regulation of theGovernment and the SBV Moreover, it is also responsible for processing and

Branch Director

Credit

Dept.

Budget Dept.

Transaction Dept.

Internal Management Dept.

Administrative Dept.

Saving funds

managing information from customers, conducting the credit managementsystem and ensuring the legal safety of Ha Tay branch’s credit activities.

2.1.4 Overview of activities at CCF Hatay branch

The fluctuation of Vietnamese economy over recent years has great effects oncredit institution, CCF Hatay branch is not an exception Although their financialcapacity, brand and competitiveness remain weaker than local commercial banks,CCF Hatay branch always achieve the strategic goals and planning Ha Taybranch established specific methods that ensure timely provision of capital toLCF member as well as general public In addition, the Branch has adopted aproper development strategy with focus on the service quality to provide itscustomer with the best service, such as making expansion scale, reducing risksand setting flexible market interest rate policy, simplifying procedures as well aschanging its staffs’ working style In return, CCF Hatay branch has step by stepimprove their prestige, competitiveness and brand name in banking market Thebranch has gradually become a reliable mainstay for people credit fund atgrassroots level in the area The capital sources provided by CCF help manybusiness, families and individuals in the area expand production and create jobs

to thousands of labor each year This is a proof of the effort to become atrustworthy companion of local people as well as business through capitalincrease substantially in recent years By 2010, the total capital of CCF’s Hataybranch amounted to 699.173 VND billion, which is major built up frommobilization and borrowing capital

Table 1: Capital structure at CCF Hatay branch

2.1.4.1 Total capital mobilization

Mobilizing capital is one of the most major activities in CCF Hatay branch It affects directly on scale and efficiency of credit activities and plays a very

important role on sustainable development of the Branch Over the last few

years, CCF Hatay branch highly concentrated on numerous forms, methods,

canals of capital mobilization from LCF members to general public such as

individual and corporate clients CCF- Hatay branch has step by step try to

increase the total mobilized capital each year

Table 2: Capital mobilization at CCF- Hatay branch

( Source: Credit Department – CCF – Hatay branch)

Although CCF Hatay branch is operated alongside the country’s globalizationwith a growing level of competition from local commercial bank, its mobilizedcapital has increased significantly In 2009, the branch’s total mobilized capitalamounted to VND 378.928 billion which increased by 22.62% and incomparision with that of the year 2008 The growth rate in 2010 was 195,28.There are several reasons for this dramatic growth in capital mobilization of thebranch Firstly, both board of directors and staffs of Hatay branch are aware ofthe importance of calling up idle capital from the public and PCFs, therefore,they have to tried to improve their products and services in order to best satisfy

their customers Fast remittance service has been expanded, transaction time hasbeen shortened and staffs’ working style has been much improved Besides, inperiod 2008-2009, Hatay branch has opened two more transaction, carried outmarketing strategy and adopted flexible interest rate policy To its best effort,there is an increasing number of customers opening accounts or leaving deposits

at CCF Hatay branch

In order to have a clearer understanding about capital mobilization of thecredit fund in recent year, it is necessary to analyze data in table 2 in moredetails

In terms of types of deposit, CCF Hatay branch's capital is mobilized fromeither PCFs or general public

On the one hand, deposits from LCF members is still a major proportion inthe total mobilized capital This capital sources ensures the sustainable andeffective activities at CCF Hatay branch Over recent year, however, this depositstrends to decrease highly In 2008, the deposits from LCFs was VND 145.616billion, account for 47.12 percent of the total mobilized capital The year 2009witnessed the strong decrease in the proportion of LCFs deposits which wereabout VND 152.403 billion making up just 40.22% of the whole mobilizedcapital Over the next year, however, there was a dramatic increase in the LCF’sdeposits which rose 171.48% in comparision with 2009 In order to achieve thispositive result, the CCF has timely adjustment by actively researching local LCFmember, encouraging their member fund to take deposit in the branch with aflavourable interest rate

On the other hand, deposits from general public proved more and moreimportant role in enhancing the CCF’s effective development In 2008, the creditfund attracted the amount of VND 163.399 billion from individual and SMEsclients, accounting for 52.88% of the total mobilized capital This percentage ishigher than the amount mobilized from LCF members During the next twoyears, deposits from the public continued rising up to VND 226.255 billion in

2009 and in 2010 respectively This significant growth proved that CCF Hataybranch had been able to gain considerably public’s trust It also opened a new

way for conducting business that the credit fund would probably raise its capital

by actively calling up public’s investment rather than depending passively on theLCF members

Thanks to gradually growth in the amount of mobilized capital, CCF Hataybranch could be always confident in enhancing development and expanding itsbusiness scale

2.1.4.2 Lending activities

CCF Hatay branch use a major proportion of capital sources in lendingactivities In an effort to contribute to their viability, The Branch has beenlending not only to LCF members but also to SMEs and individual clients As of

31 December 2010, CCF’s loan portfolio stood at VND 601.557 million

Table 3: Lending capital structure at CCF Hatay branch

Unit: VND billion

2008 2009 2010

Total lending capital 383.743 17,59 452.316 17,86 601.557 84,34

As can be seen from the above table, total loan outstanding grew from VND383.743 million in 2008, to VND 365.980 million in 2009 and VND 601.557million in 2010, at annual growth rate of 17.86% and 84.34% respectively Noteshould be taken that with the spectacular increase in deposits the relative weight

of borrowings declined This is a proof that the branch has used more and moreown capital actively In the past, most lending capital is taken from borrowingssuch as ADB, DID Up to now, mobilized capital adapt almost lending activities.Mobilized capital made up from 80.53% in 2008 to 83.78% in 2009 and 82.25%

in 2010 of total outstanding loans

In term of types of deposits, lending to LCF members make up a majorproportion in the total lending capital Accordingly, the average lending rate forLCFs in the period 2008-1010 account for 80.26% of the total lending capital.78.82% of the portfolio is extended to LCFs, 21.18% to SMEs and otherindividual clients However, whereas the LCFs loan trends to be halted generalpublic’s loan is in contrast The loan for general public in 2010 rose 230.69%against 2009 whereas for PCF system just 64.78% The reasons to explain is thatCCF not only make assistance and support the PCF system but also carry outcommercial banking and development banking activities Expanding generalpublic loans is an indispensable need in the process of transforming intocommercial bank

In terms of time of loans, CCF Hatay branch focus on short-term loans In theperiod 2008-2010, the average lending rate was 82.52% for short term and17.48% for medium and long-term In 2010, 83.95% of loans were short-term,16.05% medium and long-term Accordingly, medium and long-term make amodest contribution to CCF’s profits Its is considered as the main characteristic

of CCF in general and Hatay branch in particular There are some reasons toexplain that Firstly, Offering short-term loans makes the speed of capitalturnover become faster Secondly, CCF Hatay branch provide a great deal ofrural credit for the poor who demand short term capital to run business andexpand agricultural production Several of medium and long term loans such asAIF, ICO, ADB are typically disbursed to LCF members in rural credit project

Lastly, this concentration on short maturities reflects the concern to avoid amismatch between maturities of loans and deposits and their efforts to reducecredit and interest risks Hence, this limited lending capital is paralleled by amodest in the percentage of medium and long term loan

2.1.4.3 Banking services

The PCF system in general and CCF Hatay branch in particular are infancy andstep by step access and develop banking products and services such as enhancingco-donor activities, expanding network of money transfer service to each LCFmembers, issuing Visa, Master Card, guarantee and providing other services asstipulated by the SBV

● Payment services

Over the last few year, the branch has implemented electronic paymentthrough opening accounts, researching demands of LCFs in order to expand e-payment services on the whole system In spite of much progress, the turnoverfrom payment services remains at low level revenue earned from this servicesfluctuated from VND 52 million in 2009 to VND 108 million in 2010 Theforthcoming goal of Hatay branch is to carry out specific modernization andexpansion of electronic money transfer services that make contribution toenhancing prestige and attracting more and more customer

● PCFs consulting services

Playing a consultative role for LCF members is considered as the priority taskwhich show linkage of the whole system Accordingly, CCF Hatay branchalways organize training courses to increase its member capacity and achievesustainable economic developments in the integration process The branch hasmade remarkable contributions to the sustainable development of the wholesystem

2.3 DATA COLLECTION INSTRUMENTS

In this thesis study, qualitative and quantitative methods are indeed employed totackle different aspects of the research problem Whereas the qualitative method is

used to gain understanding of the actual practices inside the credit fund, thequantitative one has served a smaller purpose of figuring more about the credit staffs(their characteristics like education, skills, experience, responsibilities, etc.).Nevertheless, the outcomes of each method do not separate from each other buttogether facilitate the research findings’ analyzes

In order to provide insightful analysis, it could be utilized by two kinds of datasource including secondary and primary data

Secondary data

Secondary source of information is collected from available information in referencebooks, company’s annually reports, SBV regulations, and official documents ofCCF, Internet and newspapers, thesis, and specially the results of financialperformance at CCF Hatay branch

Primary data

Besides, I use primary sources collected from the questionnaire survey and interviewfor the findings The researcher used quantitative and qualitative methods to findthese information aimed at answering three research questions in 2.1

● Qualitative Method

* In-dept interview question guideline: (Appendix 1)

Table 4 In-depth interview question guideline

Id Target group Quantity Purposes

1 Board of

Gathering details of the CCF’s creditpolicies; how the policies look like and ifthey contain fundamental information

Discovering how credit department inCCF Hatay branch work and whether itsoperation complies with the policies

Understanding how well the branch isperforming based on comparing historicaldata and figures from year to year