Systemic risks in vietnam,s financial system and macroprudential implications

Meanwhile, after the global financial crisis, a new line of research related to systemic risks and macroprudential policy had taken center stage with various implications.. This study ex

FULBRIGHT ECONOMICS TEACHING PROGRAM

- – & — -

a thesis for THE DEGREE OF MASTER IN PUBLIC POLICY

SYSTEMIC RISKS IN VIETNAM’S FINANCIAL

SYSTEM AND MACROPRUDENTIAL

FULBRIGHT ECONOMICS TEACHING PROGRAM

- – & — -

LE XUAN HUNG

SYSTEMIC RISKS IN VIETNAM’S FINANCIAL

SYSTEM AND MACROPRUDENTIAL

MASTER IN PUBLIC POLICY THESIS

CODE: 60340402

supervisors JAMES RIEDEL

DO THIEN ANH TUAN

Ho Chi Minh city, 2015

The views stated in the thesis are of my own and do not necessarily reflect the views of the

Ho Chi Minh City Economics University or Fulbright Economics Teaching Program

Author

Lê Xuân Hùng

I would like to thank all teachers and staffs in Fulbright Economics Teaching Program (FETP), who have transferred much of their knowledge and experience to me I truly appreciate FETP’s founders for creating such an inspiring program that opened up to me a whole new horizon of knowledge

Last but not least, I would like to express my thanks to all of my friends and colleagues, who helped and encouraged me during my time at FETP

Author

Lê Xuân Hùng

ABSTRACT

Vietnam is addressing financial instabilities by strengthening its grip onto the banking

sector and financial system in general It is done via improving financial safety measures,

addressing cross-ownership relations and restructuring non-perform loans Meanwhile,

after the global financial crisis, a new line of research related to systemic risks and

macroprudential policy had taken center stage with various implications This study

explores the application of these implications in reducing systemic risk of Vietnam

financial system using qualitative analysis; via (1) formulating the implications of

macroprudential approach with emphasis on network theory; (2) identifying the systemic

risks in Vietnam financial system during 2009 – 2011 and (3) assessing recent reforms’

ability to reduce systemic risks in the financial sector The results indicate that there are

four groups of systemic risks in Vietnam financial sectors: expansionary macro

environment, weak currency position, sector-wide degradation of capital quality, and

structural weakness at institutional and systemic level Recent reforms are positive in

addressing those risks, but only from microprudential perspective Yet, the coverage of

macroprudential policies is low and incomplete The study suggests that a more holistic

approach is needed in improving financial stability, with specific recommendations

including (1) embrace the networked and dynamic nature of financial system; (2) facilitate

development of non-bank financial institutions; (3) address regulation transparency and

data availability; (4) construct a dependable set of indicators that reflect phases of risks

build-up and roll-out and; (5) further consolidate supervision structure

TABLE OF CONTENT

Certification i

Acknowledgements ii

Abstract iii

Table of Content iv

Table of Abbreviations vii

List of Figures ix

List of Tables x

Chapter 1: 1.1 Instabilities of Vietnam’s financial system 1

1.2 Objectives and scope 2

1.3 Research method 3

1.4 Analysis framework 3

1.5 Thesis structure 4

Chapter 2: 2.1 Financial crises 6

2.2 Principles of financial regulation 7

2.3 Systemic risks and macroprudential policy 8

2.3.1 Externalities of systemic risks 9

2.3.2 Phases of instabilities 11

2.4 Network anatomy of systemic risk 13

2.5 Macroprudential regulation 16

2.5.1 Development of macroprudential approach 16

2.5.2 Macroprudential policy 17

2.5.3 Macroprudential toolkit 19

2.6 Policy implications 22

Chapter 3: 3.1 Context 24

3.2 Risks build-up 25

3.2.1 Capital inflow 25

3.2.2 Credit growth 27

3.2.3 Biased banking sector 29

3.2.4 Quality of capital 31

3.2.5 Exploitive cross-ownership 32

3.3 Systemic stress materialization in financial sector 33

3.3.1 Liquidity shortage 33

3.3.2 Non-performing loans 35

3.3.3 Real-economy spillovers 37

3.4 Remarks 38

Chapter 4: 4.1 Shock absorption capability of credit institutions 40

4.2 Contagions and network structure 42

4.3 Information and regulation framework 46

4.4 Remarks 46

Chapter 5: 5.1 Key findings 48

5.1.1 Systemic risks in Vietnam’s financial system 48

5.1.2 Applications of macroprudential policy 49

5.1.3 Benchmark of recent reforms 50

5.1.4 Notes on macroprudential policy implementation 51

5.2 Policy recommendations 51

5.3 Further study 53

5.4 Finale 53

List of References 55

List of Regulations 61

Appendix 62

Appendix 1: Seismic anatomy of financial crises 62

Appendix 2: Financial accelerator effects and macro-financial linkages 62

Appendix 3: BICRA (Banking Industry Country Risk Assessment) score 63

Appendix 4: Theory of financial instability 63

Appendix 5: Network model of systemic risks 64

Appendix 6: Group of 30’s set of macroprudential tools 65

Appendix 7: Motivations for macroprudential policy adoption 66

Appendix 8: Cost of prudential regulations 69

Appendix 9: Capital inflow and the potential build-up of vulnerability 71

Appendix 10: Cross shareholdings, interbank lending and investment vehicles 72

Appendix 11: Shareholding structure in Vietnam’s banking sector 73

Appendix 12: Indicators for identifying global SIFIs 74

Appendix 13: Financial soundness indicators 75

Appendix 14: Macroprudential instruments reference 76

TABLE OF ABBREVIATIONS

LTI - Loan-to-income ratio

LIST OF FIGURES

Figure 2.1: Loss and margin/haircut spiral that arise due to leverage and maturity mismatch 7Figure 2.2: Build-up of Systemic Risk: Sources and Channels 12

Figure 2.3: Transmission Channels of an Exogenously Induced Credit Supply Shock 13

Figure 2.4: Macro-financial linkages between real and nominal (i.e financial) economy 15Figure 3.1: Exchange rate from 1/1/2007 – 2012 26Figure 3.2: Share of credit to the economy by group of credit institutions and total credit to GDP 27Figure 3.3: Growth of credit, deposits and GDP during 2000 – 2010 28Figure 3.4: Market share in banking sector 29Figure 3.5: Net credit between CIs Showing large SOCBs acted as credit providers to JSCBs 34Figure 3.6: NPLs ratio of commercial banks Showing adjustments after Circular 13 in effect 36Figure 4.1: Understanding network topology is key in macroprudential policy 45

LIST OF TABLES

Table 2.1: Classification of FIs based on their systemic risk contribution 9

Table 2.2: Externalities and Macroprudential policies 10

Table 2.3: Comparison of macro- and micro-prudential perspectives 18

Table 2.4: The macroprudential toolkit 20

Table 2.5: Classifies the set of potential tools 21

Chapter 1: INTRODUCTION

1.1 Instabilities of Vietnam’s financial system

Vietnam’s macro environment is relatively stable in the 1997-2006 period, with low inflation, a higher growth rate – 7% to 9% annually – and a moderate level of trade deficit

in public and private sector began to experience structural problems, rising inefficiency, and waste of resources Problems exhibited via macro indicators, including: reduced GDP

banking sector, stagnated stock market, etc

Area that received the most media coverage was financial sector with banking system at the epicenter Vietnam’s banking sector expanded rapidly during this period and its troubles were pronounced indication of fundamental weaknesses in financial system In this period, we can see many kinds of issues - at different severities: liquidity shortage,

regulation circumventions, cross-ownership, prevalent Non-performing loans, etc

To be fair, it is not all bad as the economy is still growing, and the government succeeded

at re-gaining control of the economy with steady single digit inflation rates and above 6% growth for the first quarter of 2015

Optimistic as it sounds, it is also a point for debates Was these macro issues remedied by

these problems are consequences of long-standing structural problems nested inside the economy: misallocation of resources, ownership structure, inefficient public spending,

local credit-fueled growth, and other factors With TPP entrance in sight, will history be

repeated?

In the wake of 2007 – 2008 global crises, the idea of systemic risk has risen as a prevalent approach to analyze instabilities in financial system The macroprudential approach - as a way to reduce systemic instabilities - has emerged as a recommended practice in supervising financial systems Studies also indicated that the application of these theories

is not limited to developed economies but also highly applicable for emerging economies (Mihet, 2013)

In Vietnam during 2006 – 2011, besides external factors, a major source of financial instabilities came from wrongdoings of FIs and shortcomings of regulations (VELP, 2012) The negative consequence was not limited in those faulty FIs or within financial sector but also affected negatively other well-behaved FIs and the rest of the economy It is questioning that will and how macroprudential approach (1) help with understanding and (2) provide regulators with tools to mitigate these problems of Vietnam?

1.2 Objectives and scope

This study argues that macroprudential approach is beneficial for Vietnam by taking into account the instabilities of Vietnam financial system and general economy during period of

2006 – 2011 It focuses on aspects of systemic risk and indications of microprudential supervising approach’s deficiencies The study also briefly reviews new regulations (since 2012) against macroprudential recommendations

To meet those objectives, the research questions are:

1 What are the aspects of systemic risks in Vietnam financial system during 2006 – 11?

2 How macroprudential policy can prevent/mitigate those risks in the context of Vietnam?

3 How does recent financial reforms compare against the recommendations?

The main research subjects are: (1) mechanism of systemic risk and financial instabilities; (2) motivations, tools and indicators of macroprudential approach in financial system

supervision; (3) systemic risks of Vietnam’s economy and financial system during the period of 2006 – 11; (4) current financial reforms

Vietnam has a bank-based financial system, thus, this literature is strongly biased towards reviewing the effects of macroprudential policy on banking sector Other types of financial institutions (FIs) are only referred when needed When mentioning FIs in the context of Vietnam, we may use credit institutions (CIs) as an interchangeable term to conform to local literatures

This study by no mean is going to exhaust the problem of applying macroprudential approach into supervising Vietnam financial system Instead, it put Vietnam financial instabilities in the context of systemic risk and macroprudential policy to devise related high-level implications for financial reforms

1.3 Research method

In this study, there is not a concrete hypothesis or theory that should be tested, so we used

an inductive approach An inductive approach develops a theory from data that is first being collected The collected data - including the studies related to financial crises, systemic risks and macroprudential policies - would be used to devise the need of a macroprudential approach for Vietnam From the constructed framework, we will deduct the position of Vietnam in term of macroprudential principles’ application

Macroprudential and systemic analysis is a relative new area in Vietnam financial policy study There is a lack of both data and resource for quantitative research Therefore, the study employs a high-level qualitative approach that builds on verbal communication and soft data

Using qualitative analysis methods on macro indicators and policy summaries, the study analyzes systemic risks of Vietnam and predicts the effectiveness of macroprudential policies as a supplemental for current supervising tools

1.4 Analysis framework

The body of research for macroprudential policy take roots from theories related to instabilities inside financial systems The prevailing perception of crisis formation after the global financial crisis (2008) is the theories of financial fragility, which developed by

Hyman Minsky and Robert Shiller (Pilkington, 2010)3 The inherent unstable nature of financial system requires that it must be regulated to protect well-being of the economy as

a whole Brunnermeier et al (2009) outlined the foundation for these regulations in “The

Fundamental Principles of Financial Regulation”

The macroprudential approach based on the realization that the accumulated effect of

externalities related to behaviors of financial institutions Nicolò et al (2012) summarized these externalities as strategic complementarities, fire sales & credit crunches, and interconnectedness [2.3.1] To further explain the underlying mechanism of these externalities, the study employed the view of financial systems as complex networks of adaptive agents (Haldane, 2009)

Most major financial institutions – including BIS, IMF, ECB and OECD members’ state banks – have studies related to macroprudential tools and applications Even though the exact specifications are different, the primary approaches are quite similar Accordingly, the set of macroprudential tools is a mix of existing microprudential and newly devised tools to address macroprudential specific problems The new tools are summarized and classified by different criteria (purpose, requirements, models, etc.) to provide a foundation for reasoning about Vietnam’s stance regarding macroprudential policy The problem of implementation details is out of scope of this study

1.5 Thesis structure

This thesis consists of 5 chapters Chapter 1 outlines the foundation, the context and introduces the symptoms in Vietnam financial system that raises the need for macroprudential analysis Chapter 2 reviews other studies and formulates the analysis framework for macroprudential regulations Chapter 3 addresses research question 1 and 2

by diving into the details of systemic risks in Vietnam financial system and macroprudential implications in each case Chapter 4 targets the last question by giving a brief summary of recent regulations against mainstream macroprudential toolset and implications Chapter 5 summarizes the findings and proposes related policy recommendations

Chapter 2: MACROPRUDENTIAL REGULATION FRAMEWORK

In this chapter, the study explores the foundations of financial stabilities and the externalities that demand financial regulations On that basis, it identifies the need for systemic risk management as a financial regulations component and formulates the analysis framework for macroprudential regulations Here, the study puts an emphasis on network theory with implications that are hardly devised from traditional analysis

2.1 Financial crises

According to Hyman Minsky’s hypothesis [Appendix 4], failures of financial systems are inevitable due to their inherent nature On the good side, each one shed more light on how they work and how they interact with real economies This is valuable knowledge for

does light up an important ideas: to prevent financial crises, ensuring the financial health of individual financial institution (FI) is not enough Instead, to keep certain FIs from triggering cascading failures – that affect both real economy and financial system – we need a holistic approach to monitoring the economy’s health, creating incentive structures and setting up regulatory boundaries

Brunnermeier (2009) states that financial crisis is the situation when FIs are facing low

funding liquidity and low market liquidity 6 Both forms of liquidity are influenced by the soundness of other FIs via: (1) liquidity spirals, (2) hoarding of funds, (3) runs on FIs and (4) network effects via counterparty credit risk For example, one bank’s microprudential

5 The crisis estimate costs Americans about USD 19.2 trillion in lost household wealth Source: US Department of Treasury (2012).

6 “Funding liquidity describes the ease with which investors and arbitrageurs can obtain funding Funding liquidity is high — and markets are “awash with liquidity” — when it is easy to raise money because collateral values are high (and/or rising), and haircuts and margins are low Market liquidity is high when it is easy to raise money by selling one’s assets at reasonable prices Conversely, market liquidity is low when selling the asset depresses the sale price considerably

When market liquidity is low, it is very costly to shrink a firm’s balance sheet.” — Source: Brunnermeier (2009)

behavior to cut back its funding to others may lead to liquidity spirals [Figure 2.1] Other factors (psychology, political, global markets, etc.) accelerate the process further so when risk stacks up and every FI acts on it own interest, it can lead to widespread collapses across the economy

Figure 2.1: Loss and margin/haircut spiral that arise due to leverage and maturity mismatch

Source: Brunnermeier and Pedersen (2009)

2.2 Principles of financial regulation

Similar to Adam Smith's invisible hand for the general economy – in financial markets, it

implicitly assumes that we can make the system as a whole safe by simply trying to make

sure that individual FI is safe However, in practice it represents a fallacy of composition,

where some parts of the whole are true does not mean that the whole is true

Brunnermeier et al (2009) suggests that there are three main purposes for regulations, according to traditional economics principles: (1) limit the use of monopoly power (i.e prevent serious distortions to competition) and maintain market integrity; (2) protect the essential benefits of ordinary people in cases where information is hard or costly to obtain, and mistakes could greatly reduce welfare (i.e information asymmetry); and (3) adjust externalities where they are sufficiently large that the social, and overall, costs of market failure exceed both the private costs of failure and the extra costs of regulation

Initial

Losses

(e.g credit)

Funding problems

Reduced Positions

Prices move away from Fundamentals

Reduced Positions

Higher margins

Losses on existing positions

The third principle suggests that managing crises is an important aspect of regulations Crisis prevention and management component of regulations must act as a countervailing force to the natural decline in measured risks in a boom and rise in measured risks in the subsequent collapse (Brunnermeier, 2009) The main obstruction for such regulation is the

politics of boom When in a boom, lending, leverage and reliance on short-term liquidity

become mutually reinforcing and excessive (Brunnermeier, 2009); it has addictive effect

from economics, political, and social perspectives altogether

2.3 Systemic risks7 and macroprudential policy

Systemic risk and macroprudential has been used as a pair of catchall term for a new approach to financial regulation In “Systemic Risk Monitoring Toolkit – A User Guide”, Blancher et al (2013) defined systemic risk as follow:

“Systemic is defined as risk that originates within, or spreads through, the financial sector (e.g., due to insufficient solvency or liquidity buffers in FIs), with the potential for severe adverse effects on financial intermediation and real output.”

European Central Bank has a different definition that omitted real output, yet included a

“negative” factor that differs it from ordinary market adjustments

“Systemic risk refers to the possibility that a triggering event such as a bank failure or a market disruption could cause widespread disruption of the financial system, including significant difficulties in otherwise viable institutions or markets.” 8

Nicolò and Lucchetta (2010) divided the term into two aspects: financial and real In

which, systemic financial risk (a) is “the risk that a shock will trigger a loss of economic

value or confidence in, and attendant increases in uncertainty about, a substantial portion

of the financial system” and systemic real risk (b) is “the risk that a shock will trigger a

significant decline in real activity” Thus, to consider whether a financial shock is a

systemic shock it explicitly requires that the negative externalities of the shock extend to the real economy Other kind of financial markets turbulences (e.g increases in volatility and/or failures of financial intermediaries) that are missing of real effects are not classified

as systemic

A notion that commonly used considers systemic risk is the aspect of self-prudent behaviors of large financial hub and herds of leveraged FIs can trigger widespread damage

to the financial system and the real economy [Table 2.1]

Table 2.1: Classification of FIs based on their systemic risk contribution

Macro-prudential

prudential

Micro-“Individually

systemic”

Large and interconnected banks and insurance companies that cause risk spillovers

"Non-systemic" Pension funds and insurance companies

that are not highly levered

Source: Brunnermeier (2009)

The primary way to tell whether a risk - or a shock stemmed from it - is systemic is based

on its definitions as discussed However, these definitions only outline the criteria without mentioning how to assess/measure them Therefore, this section discusses further how such risks can manifest into instabilities and the models used for assessing them

2.3.1 Externalities of systemic risks

To formulate policies to address systemic risk, it is needed to identify the market failures that lead to the problem Nicolò et al (2012) highlighted three main sources of externalities (i.e market failures) that contribute to systemic risk unless internalized

properly: (1) strategic complementarities, that arise from the strategic interactions of banks

and other FIs and agents – which causes the build-up of vulnerabilities during the

expansionary phase of a financial cycle; (2) fire sales and credit crunches, that arise from a

generalized sell-off of assets causing a decline in asset prices, a deterioration of balance sheets indicators, and a drying up of financing, especially during the contractionary phase

of a economic cycle; and (3) interconnectedness, caused by the propagation of shocks (i.e

contagions) from systemic institutions or through financial networks In the three groups

of externalities, interconnectedness is a relative new aspect of systemic risk that triggered the rejuvenation of macroprudential ideas It is discussed further in section [2.4]

Table 2.2: Externalities and Macroprudential policies

Can be addressed by

Capital Requirements (Surcharges)

Liquidity Requirements

Restrictio

ns on activities, assets, or liabilities

Source: Nicolò et al (2012)

with Nicolò’s classification Accordingly, there are time-series natured externalities and cross-sectional natured externalities The former group of externalities gives rise to procyclicality in good and bad times; it is corresponding to Nicolò’s externalities as: (1) – good time, (2) – bad time The latter group is corresponding to Nicolò’s group (3) – due to interconnectedness of financial entities

9 Group of 30 An international private, non profit body of leading financiers and academics.

2.3.2 Phases of instabilities

A failure in financial systems may seem to appear unexpectedly but in reality gradually via different phases At each phase – with different urgency and level of stress – systemic risks manifest themselves differently It even becomes more complex as systemic risks combine with other types of risk that are characterized by particular institutions and countries Different indicators prove useful at different phases and help understanding different

as outlined by Blancher et al (2013):

Build-up phase Systemic risks accumulate due to high exposure to an overheating sector

(e.g real-estate, securities), or subject to procyclical behaviors Growing cross-border exposures and funding sources (i.e capital flows) also accelerate this phase In this phase,

it is important to assess the likelihood of a systemic crisis (e.g forecasting, early warning, stress-tests, etc.) and strengthen counter-cyclical buffers designed to absorb financial shock [Figure 2.2]

10 We are not considering the recovery phase of the financial system but focusing on the way a crisis gets to its trough We also skip the case when a crisis has multiple troughs, which can be divided into many smaller ones.

Figure 2.2: Build-up of Systemic Risk: Sources and Channels

Source: Blancher et al (2013)

Shock materialization In this phase, imbalances start to roll out Two conditions for this

system (as the accumulated result of excessive risk-taking during build up phase) In this phase, the priority is assessing of potential loss in financial system and real economy

Amplification and propagation In most crises, shocks are not contained within financial

system but transmitted to the broader system, including other sectors (and potentially other countries’ financial systems) In this phase, the priority shift to understanding transmission

11 The shock can be endogenous or exogenous and larger than a certain threshold e.g., GDP or fiscal shocks, exchange rate or housing price shock, failure of a systemically important FI (Blancher et al., 2013)

and amplification mechanisms (e.g linkages topology, fire-sales, contagions, adverse feedback loops [Figure 2.3], etc.)

Figure 2.3: Transmission Channels of an Exogenously Induced Credit Supply Shock

Source: Beneš, Ötker-Robe, Vávra (2009) Author’s adaptation

2.4 Network anatomy of systemic risk

The essence of the financial system itself and its relation to the real economy can be naturally captured as a network [Figure 2.4], which can be sub-divided into smaller ones

aspect we want to study For example, banking systems can be modeled by agents that are connected directly through mutual exposures in the interbank market and indirectly through holding similar portfolios or sharing the same mass of depositors The network view provides implications that can hardly be devised from the traditional view of financial systems

12 e.g liability-asset connection – where liabilities of an institution are assets of others; information connection – where institutions share certain information and behave in a coordinated way (e.g invest in the same assets, have the same owner); regulation connection – where institutions are under the same operation restrictions; etc

13 Financial entities are used as a broader term than financial institutions, which include all agents that participate in financial transactions.

of foreign markets

funds more expensive funds less available tightening of bank lending standards

reduced lending to households and corporates

and/or

reduced demand for loans under certain economic prospect and higher borrowing costss

reduced consumption and investment spending

borrower debt service problems/

declining asset quality domestic bank problems further tightening of lending standards

economic slowdown in home

country

Feedback loop between bank problems and the real economy

reduced export to foreign countries

When looking under the lens of network theory, the externalities that caused systemic risks can be described as different kinds of contagion in financial networks According to Cont (2012), these contagions can be of following types:

Correlation Homogeneity behavior of FIs creates large exposures to common risk factors,

which in turn lead to simultaneous losses across FIs

Counterparty Risk/Balance sheet contagion The default of an FI may lead to the

write-down of assets held by its counterparties and consequently, leads to its insolvency

Spirals of illiquidity Market moves and credit events may lead to margin calls, which lead

to the default of institutions that lack sufficient short-term funds

Procyclical feedback effects Fire sales of assets due to deleveraging can further depreciate

asset prices and lead to losses in other portfolios, generating endogenous instability

network

14 In network theory, cascading failures usually begin when one part of the system fails When this happens, nearby nodes must then take up the slack for the failed component This in turn overloads these nodes, causing them to fail as well, prompting additional nodes to fail one after another in a vicious circle.

Figure 2.4: Macro-financial linkages between real and nominal (i.e financial) economy

Source: Galati and Moessner (2011)

Haldane (2009) noticed the similarity of global financial system – and the global crisis happened within – with various social and natural phenomenons Using network theory, he explained the emergence of complexity and homogeneity as two primary characteristics of modern financial networks This intuitive work of Haldane has laid the ground for many macroprudential and systemic risk studies later on

Acemoglu et al (2013) established a stylized network model [Appendix 5] that confirmed main ideas of Haldane (2009) In which, for small negative shocks, a more densely connected financial network (corresponding to a more diversified pattern of interbank liabilities) enhances financial stability Beyond a certain threshold, larger shocks are amplified by such densely connected network leading to more fragile system Therefore, factors that improve resilience under certain conditions can be a source of systemic risks under others

Galati and Moessner (2011) restated these findings by referring to the research of Gai and Kapadia (2008) and Nier et al (2008) They constructed artificial homogeneous networks

of banks and analyzed the effect of an idiosyncratic shock on the resilience of the network Both found non-linear effects of net worth (i.e size of the bank) and network connectivity (the probability that one bank has lent to another bank) on contagion These results

illustrate that the financial system is likely to have a robust-yet-fragile tendency – while

the likelihood of contagion may be reduced by greater connectivity; the potential impact of

a shock has a much larger scale

Along the network interpretation of financial systems, the notion of too-big-to-fail may not

fully describe institutions that have high network importance The current term to describe those institutions is systemic important financial institutions (SIFI) The new term

incorporates too-interconnected-to-fail financial institutions as well as

too-intercorrelated-to-fail financial structures In which, too-interconnected-too-intercorrelated-to-fail refers to FIs with

large/complex bilateral exposures and too-intercorrelated-to-fail financial structure refers

government have to insure the safety of the whole sector (e.g banking, stock market)

[Overview A] Lastly, it is worth mentioning too non-traditional to fail principle, where

non-interest activities may lower the risk for individual banks yet increase the systemic risk level (More & Zhou, 2014)

2.5 Macroprudential regulation

In simplest form, macroprudential regulations are policies aimed towards limiting systemic financial risk (Blancher et al., 2013) This is not to suggest that the present microprudential measures are unnecessary or wrongly designed for this purpose, but just insufficient on their own Indeed, when an institution, or market, is sufficiently large or strategic – that its failure by itself would cause externalities – then it needs individually targeted microprudential controls (Brunnermeier et al., 2009)

2.5.1 Development of macroprudential approach

The term macroprudential appeared the first time in public literature back in 1986 in a document regarding innovations in international banking from BIS Initially, it was defined

as a policy that promotes “the safety and soundness of the broad financial system and

payments mechanism” In subsequence years, it evolved slowly, and its meaning

converged to the use of prudential tools with the explicit objective of promoting the

15 Can be considered as a form of moral hazard

stability of the financial system as a whole It is often defined in contrast to its antonym,

“microprudential” – which emphasizes the safety of the individual institutions within (Clement, 2010) After the global financial crisis (2008) the term was put in spotlight as a preferable way to avoid such crisis in the future Since then, its usage has risen rapidly along with the number of related studies

The surge of research after the global crisis helped exploring more intricate details of macroprudential policy For example, indicators of financial distress based on balance sheet and market indicators, early warning indicators, financial contagions, macro stress tests, SIFIs classification, macro-financial linkages, interaction with other policies (monetary & fiscal), etc (Galati and Moessner, 2011) International financial institutions and research bodies also issued guidelines, indicators (e.g IMF’s financial soundness indicators and ECB’s macroprudential indicators (Agresti, Baudino and Poloni (2013)) and executive reviews to broaden the application of macroprudential policy in both domestic and international context

Until lately that macroprudential policy is considered as an integrated approach However, from early 2000s countries already applied macroprudential tools and principles; with varied levels of application and success; to address stability issues of their financial system [Appendix 7] Recently, Cerutti, Claessens and Laeven (2015) reviewed the usage of 12 macroprudential policies on a sample of 119 economies (both emerging and developed) over the 2000-13 periods The results suggest that macroprudential policies have a significant effect on credit development yet its effectiveness varies by countries and

successful implementation of macroprudential policy

2.5.2 Macroprudential policy

As a policy framework, macroprudential approach protects systemic safety by utilizing a top down view of the financial system and considering the correlation and common exposure across institutions It also differs from microprudential approach by emphasizing the endogenous nature of systemic risk instead of considering it as exogenous

Table 2.3: Comparison of macro- and micro-prudential perspectives

Ultimate objective Avoid macroeconomic costs

linked to financial instability

Consumer (investor/depositor) protection

Characterization of Risk “Endogenous” (dependent on

collective behavior)

“Exogenous” (independent of individual agents’ behavior)

Correlations and common

to dampen systemic risks contagions inside the financial system by reducing the tendency

of FI to acts in procyclical ways; (3) using tools of prudential supervision with the goal of

reducing systemic risks and increasing the resilience of the financial system to absorb such

risks

The process of macroprudential policy implementation should recognize complimentary

relationship with other areas of economic policy It must inform and be informed by

monetary, fiscal, and other government policy (G30, 2010)

There are three layers of defense that macroprudential policy can protect financial system’s stability when fully employed (De Nederlandsche Bank, 2010) First, it tries to identify and eliminate systemic risks in financial system (i.e identifier); second, smaller shocks are

disarmed automatically via improved resiliency of the system (i.e stabilizer); finally, when there are financial collapses, it prevents a cascading failure by improved absorption capability of individual FIs (i.e absorber)

2.5.3 Macroprudential toolkit

quantitative assessment of FIs’ behaviors therefore it is preferable that these indicators are backed with models that explain their channel of effect The models that can be used as foundation for macroprudential instruments are already described in [Appendix 14]

Macroprudential toolset is quite complex and still evolving (De Nederlandsche Bank 2010) It includes both existing microprudential tools and new instruments (Blancher et al

2013) Due to the wealth of tools that can be used for macroprudential purpose, it is

required that these tools to be classified according to their purpose, target, and application detail (i.e can be used under which circumstances) We shall not get into technical details

of each tool but stay on the conceptual level of its function An intuitive way to classify macroprudential tools and indicators is by projecting them against phases of crisis manifestation and their target – as done by Claessens, Ghosh and Mihet (2013) This classification indicates that each instrument/indicator can be useful to address certain combinations of risk types and phases of instabilities’ manifestation [Appendix 6]

16 In this study, there is a distinction between tools (i.e instruments) and indicators Tools are used actively whether by the mandate of regulations or voluntarily towards a specific purpose; while indicators are used passively for decision support and/or day-to-day operations.

Table 2.4: The macroprudential toolkit

related to borrower, instrument, or activity

Restrictions on financial sector balance sheet (assets, liabilities)

Buffer based policies

Other Taxation,

levies

Other (including institutional infrastructure)

- Mismatches (FX, interest rate)

- Reserve requirements

Countercyclica

l capital requirements, leverage restrictions, general (dynamic) provisioning

Levy/tax on specific assets and/or liabilities

- Accounting (e.g., varying rules on mark to market)

- Changes to compensation, market discipline, governance

Countercyclica

l capital requirements, general (dynamic) provisioning

Levy/tax (e.g., on non-core liabilities)

- Standardized products

- OTC vs on exchange

- Safety net (Central Bank/Treasury liquidity, fiscal support)

on (bilateral) financial exposures, other balance sheet measures

Capital surcharges linked to systemic risk

Tax/levy varying by externality (size, network)

- Institutional infrastructure (e.g., CCPs)

- Resolution (e.g., living wills)

- varying information, disclosure Enhancing resilience

Dampening the cycle

Dispelling gestation of cycle

Source: Claessens, Ghosh and Mihet (2013)

Bank of England (2011) took a different approach of classifying the tools by focusing on amplification channels and how each type of tools reduces risk on that aspect

Table 2.5: Classifies the set of potential tools

Leverage Intra-financial

system activity

Maturity transfor mation

Balance sheet

tools

(1) Countercyclical capital buffers (2) Restrictions on distributions (3) Maximum leverage ratios

(6)

Time-varying liquidity buffers

(4a) Sectorial capital

requirements targeted

at real-economy lending

(5) Time-varying

provisioning practices

(4b) Sectoral capital

requirements targeted at intra- financial system activity

(11) Disclosure requirements

Source: Bank Of England (2011)

For practical purpose, European Systemic Risk Board (ESRB, 2015a) gives a simpler classification that based on the primary goals of the tools There are four group of tools respective to the four primary goals of macroprudential (1) excessive credit growth and leverage; (2) excessive maturity mismatch and market illiquidity; (3) direct and indirect

exposure concentrations; (4) misaligned incentives with a view to reducing moral hazard The list of tools for each group and their descriptions are provided in [Appendix 14]

For regulators – with the purpose of issuing regulations – the problem expands into strategic, tactical and regulation/operation levels Each level reflects a different set of insights and concerns

On the top most, strategic level, the government should be guided by solid and consistent principles According to (Haldane, 2009) there are three areas that a government can do to limit systemic risk, they are: (1) data and communications - to allow a better understanding

of network dynamics following a shock and thereby inform public communications; (2) regulation - to ensure appropriate control of the damaging network consequences of the failure of large, interconnected institutions; (3) restructuring - to ensure the financial network is structured so as to reduce the chances of future systemic collapse

At tactical level, models, tools and, indicators, realize the above strategic recommendations The models help understand in-depth aspects of systemic risk such as capital buffers, identifying SIFIs, contagions, interlinkages, etc The models help establish the tools that regulators can use to control systemic risks The tools, which including indicators and instruments, must be based on actual available data Indicators can act as

“beacons” to guide FIs activities and the instruments are the ways that regulator exerts

their regulative power on FIs Besides, each set of tools should be employed differently depending on the state of the economy to address the issue at the moment At this level, the information provided in [2.5] - which includes the tools, their characteristics and selection criteria - are main concerns of regulators

At regulation/operation level, the indicators and instruments need to be formalized as documents/instructions that have precise meaning and simple adherence Financial institutions should expect to receive instructions in a consistent and precise manner They also need the support from regulators in the form of feedback and services

Chapter 3: FINANCIAL INSTABILITIES AND SYSTEMIC RISKS

This chapter enumerates factors that contributed to the accumulation of systemic risk in Vietnam’s financial system during the period of 2006 – 2011 In the end, it summarizes four groups of risks and related macroprudential instruments for each case Noticed that Vietnam did not face a full-blown crisis in this period; some symptoms are missing or not clearly exhibited (e.g default contagions)

3.1 Context

Along with impressive growth, Vietnam also transitioned through a period of financial turbulences during 2006 – 2011 The symptoms were prominent: liquidity shortage, high level of Non-performing loans, unconstrained interest and exchange rates These problems contributed to the considerable reduction of GDP growth rate from 7-8% range to 5-6% during the period of 2009 – 2011

The development of instabilities in the financial system can be roughly divided into three

phases [Overview B; section 2.3.2] In which, the build up phase is associated the rapid

expansion and collapse of the stock market; the materialization phase is marked with double digit inflation and high interest rates in 2009 – 2010; and the amplification and

deteriorate asset prices and helped form a large amount of NPLs across CIs It is noteworthy that because the instabilities in Vietnam’s financial system have not manifested into a full-blow crisis, the symptoms of each phase are less sharply separated

In this section, the study analyzes these systemic risk factors in financial sector The analysis is augmented with respective macroprudential policy implications for each risk factor

17

Evidenced by the sharp decline in residential real-estate absorption rate from 105% to 85% from Q3/2009 – Q1/2010 (Ho Chi Minh city) Source: (Savills, 2015)

3.2 Risks build-up

The sources of instabilities were elevated risks inside the financial system, which include: excessive credit growth; fluctuation in assets prices (esp real estates, stocks bubbles.); exchange rates depreciation; and vulnerable position of CIs On time-series aspect, it showed an inherent bias toward procyclicality as CIs participated eagerly in assets bubbles

On cross-sectional aspect, ownership structure of CIs has grown out of prudent limits Meanwhile, the regulation framework for FIs and banks was weak and not prepared to deal with increased level of complexity in the financial sector

3.2.1 Capital inflow

The inwards capital flow (after joining WTO) led to the expansion of stock-market and real-estate bubbles [Overview B] Banks, which are major players in the field, are quickly drawn into the loophole As a consequence, commercial banks started neglecting the primary role of diffusing the exceeded capital to the real economy A large amount of credit was directed to these profitable areas Even with safety constraints from SBV, they are often bypassed; especially in smaller banks with closer ties to real estate and securities trading firm The trend has created initial vulnerabilities in the banking sector and the real economy

Meanwhile, Vietnam’s foreign-exchange position, measured by the stability of its foreign reserves, is weak Vietnam’s trade deficit has widened despite multiple VND devaluations [Figure 3.1] If it was not receiving a large amount of remittances ranging USD 6-8 billion each year (World Bank, 2015), Vietnam account balance should have broken already.Inwards capital flow may increase systemic risk [Appendix 9] Furthermore, cheap funding liquidity has high impact on financial stability because market liquidity and funding liquidity can be mutually reinforcing, leading to liquidity spirals (Brunnermeier, 2009)

As a direct consequence of inflow capital, double-digit inflation rate was exhibited in this period, with peak reached over 30% at certain periods High inflation and weak foreign exchange position are telltale signs of instabilities

The increased risk due to the surge of capital inflow requires that the government to increase counter-cyclical buffers, restrictions on prudent ratios (e.g LTV, LTI) and

sectoral requirements (e.g increase risk weight of certain sector) However, there is not many regulation updates in the first half of period, which can be considered as a sign of

boom politics

In hindsight, we can see that the ever-changing nature of cross border capital flow requires the government to have an adaptive policy Macroprudential policy recommends that regulators should employ a rule-based approach in this situation (Brunnermeier, 2009), where the prudent requirements are adjusted in a predictable manner

Limited sectoral lending can also be helpful Lending to certain sector should be restricted due to their risk profile and to limit asset bubbles It is not to confused with directional lending – which is also a kind of sectoral intervention – in the case of Vietnam where lending to certain sectors was encouraged (e.g SOEs)

Figure 3.1: Exchange rate from 1/1/2007 – 2012

Source: Author’s calculation Data: SBV, Vinacapital

3.2.2 Credit growth

Figure 3.2: Share of credit to the economy by group of credit institutions and total credit to

GDP

Notes:

JSCB – Joint stock commercial banks

JV & FFCB – Joint venture and fully foreign owned commercial banks

MC/GDP – Mobilized capital over GDP

Source: Author’s calculations Data: IMF

Vietnam’s bank lending was expanded by 33 percent year over year during these years It

is the strongest growth rate recorded by any ASEAN country, India, and China Such a robust expansion imposed a risk of accompanied parallel rise in non-performing loans as

be related to the build-up phase of crises where uncontrolled credit growth can help forming leverage traps across both the financial system and the real economy

Furthermore, credit growth is also higher than deposits and GDP growth According to a report by (VCBS, 2011), the average credit growth during 2000 – 2010 was 32% while the

average growth of deposits and GDP were 29% and 7.15% respectively The consequence

was the ratios of loans/deposits and loans/assets of Vietnamese banking sector reached

Total Credit/ GDP (RHS) MC/GDP (RHS)

130.7% and 76.6% respectively in 2010, which were the highest level in Asia Higher

credit growth (above 20% or more than three times GDP growth rate) can destabilize the economy by increasing liquidity risk

Figure 3.3: Growth of credit, deposits and GDP during 2000 – 2010

Source: VCBS, 2011

Due to strategic interactions of banks in expansionary periods, it is understandable why in considering period commercial banks formed homogeneity structure [3.2.3] and stacked up credit imbalances [3.2.4] This situation indicates complementary externalities that demand adjustment

Expansionary macro environment – showcased by the indicators in [3.2.1] and [3.2.2] – mandates the government to intervene with fiscal and monetary policies The most important macroprudential tools for this type of risk are countercyclical buffers and reserve requirements On the other hand, credit expansion also adds uncertainties in the form of sovereign risks – where the high probability of a policy or government act may alter the financial environment in an unfavorable way; e.g sudden foreign exchange de-appreciation, interest rate adjustments, etc Therefore, macroprudential policy requires that these types of risks must be assessed continuously, via tools like Debt Sustainability Analysis, Macro Stress Tests, Regime Switching Model, etc

In the period of heightening risk, macroprudential policy recommends regulators to employ forward-looking tools besides traditional backward-looking and prudent