Credit risk management a case study of BIDV

This thesis makes a brief look on Credit risk management practice of Bank for Investment and Development of Vietnam BIDV and further probes into risk exposure, assessment, management and

MIISTRY OF EDUCATIO AD TRAIIG UIVERSITY OF ECOOMICS HOCHIMIH CITY

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MAI XUÂ VIỆT

CREDIT RISK MAAGEMET:

A CASE STUDY OF BIDV

MASTER THESIS

HoChiMinh City - 2011

MIISTRY OF EDUCATIO AD TRAIIG UIVERSITY OF ECOOMICS HOCHIMIH CITY

-

MAI XUÂ VIỆT

CREDIT RISK MAAGEMET:

A CASE STUDY OF BIDV

MAJOR: BAKIG MAJOR CODE: 60.31.12

MASTER THESIS ISTRUCTOR: DOCTOR HỒ VIẾT TIẾ

HoChiMinh City - 2011

ACKOWLEDGEMET

I would like to express my deepest gratitude to my research Instructor, Dr Ho Viet Tien for his precious guidance, intensive support, ceaseless encouragement and highly valuable suggestions during the course of my research

I would like to extend my sincere thanks to Dr Truong Tan Thanh for his instruction and advice during the course of my thesis

I would like to express my sincere gratitude to all of my teachers at Faculty of banking and finance and Postgraduate Faculty, University of Economics Ho Chi Minh City for their teaching and guidance during my MBA course

I would like to express my sincere thanks to all of my classmates, my friends for their support and encouragement

I would also like to avail this opportunity to express my appreciation to Dr Nguyen Minh Kieu for his proposal of organizing the MBA program in English Finally, I would like to thank my boss and all of my colleagues for their help

in knowledge, experience of banking practice and data collection during the course

of my research

ABSTRACT

Along with the development of the economy, the Vietnam banking system has developed rapidly It brings about comfort to businesses with a lot of modern banking services, financing the economy, giving citizens and businesses a channel for investment Banking business brings about huge profit However, the banking business has a lot of potential risk, especially credit risk Credit risk may bring severe consequences to a bank and to the whole banking system, it increases expense of banks, causing loss to banks, or even worse, it may bring about a collapse in the banking system Many collapses in human history prove the bad consequences of poor credit risk management practices

Vietnamese bankers now are paying much attention to risk management in general and credit risk management in particular This is a part of their business strategy Banks are trying to improve their credit risk management capacity and practice

A case study of BIDV is performed to explore and evaluate the performance

of credit risk management in banking sector and find out some solutions for credit risk management practice

The result of this study will help the Vietnam banking system in the performance of its credit risk management policy and practice

TABLE OF COTETS

Acknowledgment i

Abstract ii

Table of contents iii

List of tables viii

List of abbreviations ix

Chapter 1: Introduction 1

1.1 Introduction 1

1.2 Research background 1

1.3 Statement of the problem 3

1.4 Research objectives and questions 4

1.4.1 Research objectives 4

1.4.2 Research questions 4

1.5 Scope and limitation 4

1.6 Research methods 5

1.7 Structure of the study 6

Chapter 2: Theoretical framework 8

2.1 Introduction 8

2.2 Risk and risk management in banks 8

2.3 Credit risk and credit risk management banks 10

2.3.1 Credit risk 10

2.3.2 Credit risk management 12

2.4 Standards of credit risk management of BCBS 17

2.4.1 Establishing an appropriate credit risk environment 17

2.4.2 Operating under a sound credit granting process 18

2.4.3 Maintaining an appropriate credit administration, measurement and monitoring process 19

2.4.4 Ensuring adequate controls over credit risk 19

2.5 Regulations of the State Bank of Vietnam on credit risk management 20

2.5.1 Regulations on classifications of debts and loss provisioning in banking operation of credit institutions 20

2.5.2 Credit rating for customers 23

2.6 Some knowledge on credit risk management 24

2.7 Conclusions 25

Chapter 3: Research Methods 26

3.1 Introduction 26

3.2 Business research 26

3.3 Research Design 27

3.4 Data collection 29

3.4.1 Document Collection 29

3.4.2 Depth Interviews 30

3.5 Reliability 32

3.6 Conclusions 33

Chapter 4: Introduction to BIDV 34

4.1 An overview of BIDV 34

4.2 Business performance of BIDV in the period 2006-2010 37

4.2.1 Business environment in the period 2006-2010 37

4.2.2 Total assets 37

4.2.3 Capital 39

4.2.4 Profitability 40

4.3 Credit activities in the period 2006-2010 41

4.3.1 Credit growth 41

4.3.2 Credit structure 42

4.3.3 Credit quality 44

4.4 Strategic objectives in the time to come 47

Chapter 5: Data analysis and findings 48

5.1 Introduction 48

5.2 Regulations on credit risk management of the bank 48

5.2.1 Documents related to credit risk 48

5.2.2 Credit risk management policy 50

5.2.3 Regulations on lending 51

5.2.4 Credit policies 54

5.2.5 Policies on security transactions 55

5.2.6 Credit risk management information system 56

5.2.7 Credit extension limits and credit restrictions 57

5.3 The credit risk management system and organization 58

5.4 Measurement of and controls over credit risk 59

5.5 Classification of Debts, Loss Provisioning and using provisions to compensate for credit risk 60

5.5.1 Classification of debts and loan loss provisioning 60

5.5.2 Using provisions to compensate for credit risk 62

5.6 The compliance with standards of Basel Committee on Banking Supervision and regulations of the State Bank of Vietnam 63

5.7 The effectiveness of credit risk management policy of BIDV 64

5.8 Conclusions 65

Chapter 6: Conclusions and Recommendations 66

6.1 Introduction 66

6.2 Conclusions related to research questions 66

6.3 Recommendations 67

6.3.1 Regulations on credit risk management 67

6.3.2 Credit staff 67

6.3.3 Credit policies 67

6.3.4 Technology 68

6.4 Limitations of the research 68

References 69

LIST OF TABLES

Table 4.1: Total assets of BIDV in the period 2006-2010

Table 4.2: Total assets of BIDV in comparison with some big commercial banks in Vietnam in 2010

Table 4.3: Loans and advances to customers (net of allowance for impairment losses)

Table 4.4: Owner’s equity over 2006-2010 period

Table 4.5: Owner’s equity in 2010 compared to some Vietnamese commercial banks

Table 4.6: CAR at the end of 2010 compared to some big Vietnamese commercial banks

Table 4.7: BIDV’s profitability over the 2006-2010 period

Table 4.8: BIDV’s profitability in 2010 compared to some other commercial banks Table 4.9: Credit growth of BIDV over the period 2006-2010

Table 4.10: Credit structure by types

Table 4.11: Loan classification

Table 4.12: The percentage of loan classes

Table 4.13: NPLs of BIDV in 2010 in comparison with some other big commercial banks

Table 5.1: Internal credit rating system of BIDV

Table 5.2: Internal credit rating and debt classifications of BIDV

LIST OF ABREVIATIOS

Vietnam

Bank

Vietnam

and Trade

CHAPTER 1 ITRODUCTIO

1.1 Introduction

This chapter provides a general introduction to the current study, by drawing a picture of the following chapters and the study as a whole, beginning with a general introduction in section 1.1, section 1.2 examines the research background, section 1.3 makes a statement of the problem, and section 1.4 specifies research objectives and defines the research questions

In addition, section 1.5 discusses scope and some limitations of the study; section 1.6 briefly discusses the general aspects of research methods such as research types and research design; Section 1.7 introduces the structure of the study

1.2 Research background

Credit is always a source of benefit to banks, profit from credit always accounts for a big amount in total earnings However, credit is also a source of risk Adequately managing credit risk in banks is critical for the survival and growth of banks The issue of credit risk is of great concern because of the high levels of perceived risks resulting from some of the characteristics of clients and business conditions that they find themselves in

Banks are in the business of safeguarding money and other valuables for their clients They also provide loans, credit and payment services such as checking accounts, money orders and cashier’s checks Banks also offer investment and insurance products and a wide range of other financial services

Credit brings main income to banks, but this activity involves huge risks to both the lender and the borrower The risk of borrowers not fulfilling their

obligations as per contract on due date or anytime thereafter can terribly jeopardize the smooth functioning of a bank’s business On the other hand, a bank with high credit risk has high bankruptcy risk that puts the depositors in jeopardy

Among the risk that faces banks, credit risk is one of great concern to most bank authorities and banking regulators This is because credit risk is the risk that can easily and most likely prompt bank failure

Credit risk management is a structured approach to managing uncertainties through risk assessment, developing strategies to manage it, and mitigation of risk using managerial resources The strategies include transferring to another party, avoiding the risk, reducing the negative effects of the risk, and accepting some or all

of the consequences of a particular risk (Takang Felix Achou & Ntui Claudine Tenguh, 2008)

Traditional risk managements focus on risks stemming from physical or legal causes Financial risk management on the other hand focuses on risks that can be managed using traded financial instruments

The objective of risk management is to reduce the effects of different kinds of risks to the level accepted by the society It may refer to many types of threats caused by environment, technology, humans, organizations and politics On the other hand, it involves all means available for humans, or in particular, for a risk management entity

This thesis makes a brief look on Credit risk management practice of Bank for Investment and Development of Vietnam (BIDV) and further probes into risk exposure, assessment, management and control of the bank An attempt will be made to discover the use of some risk management, evaluation, assessment tools and techniques of the bank at the moment The way the bank manages credit risk will be explored

1.3 Statement of the problem

The major risk in banking business is credit risk This is the risk banks have to measure, manage and accept Banking business is so sensitive because most of banks’ liabilities are deposits from depositors Banks use these deposits to lend their borrowers Lending is a revenue generating activity for banks This process exposes banks to high default risk that may lead to financial danger including bankruptcy However, banks must make loans to their clients to make money, to grow and develop

Risk management in general and credit risk management in particular always draw great attention of bankers In order to survive, banks have to manage risks well Bankers now pay more attention to credit risk management Every bank now has its credit risk management department with main task of issuing credit policies and credit procedures so as to simultaneously serve customers well to earn profit and to mitigate risks

Credit risk management is always an activity of great concerns of Board of Management, Board of Directors and every credit officer of BIDV BIDV has established a credit risk management Department in order to monitor credit activity,

to manage and mitigate credit risk Besides, BIDV has issued a system of policies, procedures and regulations for lending activity As a result, credit risk is mitigated significantly, loans are well controlled and non-performing loans are in acceptable limitation

The purpose of this study is to explore the way BIDV manages credit risk and

to make an assessment of credit risk management practice of BIDV, its policy and procedures compared to standards of Basel Committee on Baking Supervision and regulations of the State Bank of Vietnam in order to help improve its credit risk management practice Besides, the result of the study may have an implication on other banks and the banking system as a whole

1.4 Research objectives and questions

1.4.1 Research objectives

The research objective is the researcher’s version of the business problem These objectives explain the purpose of the research in measurable terms and define standards of what the research should accomplish (Zikmund 1997)

In order to solve the research problem, the research objectives of this study are

to explore and evaluate the credit risk management practice of BIDV in order to strengthen the effectiveness of its credit risk management system

1.4.2 Research questions

A research question is the researcher’s translation of the business problem into

a specific need for enquiry (Zikmund 1997) In order to get the above-mentioned research objectives, this study should answer the following questions:

- How does BIDV manage credit risk?

- How effective is credit risk management policy of the bank?

1.5 Scope and limitation

Banking business is affected by many factors; banking profitability is affected

by many banking risks that need to be managed and controlled Risk management in banks involves many kinds of risks arising from daily banking activities including market risk, interest rate risk, foreign exchange rate risk, liquidity risk and credit risk This study focuses on credit risk only and it takes the case of BIDV, which does not represent the whole banking industry in Vietnam Its findings therefore may not be applied to other kinds of risks and may not be applied to the whole Vietnam banking system

1.6 Research methods

The nature of the problem influences the types of business research According

to Zikmund (1997), based on the purpose of research, there are three types of business research: exploratory, descriptive and causal research

- Exploratory research is the initial research conducted to clarify and define the nature of a problem

- Descriptive research is the research designed to describe characteristics of a population or a phenomenon

- Causal research is the research conducted to identify cause-and-effect relationships among variables where the research problem has already been narrowly defined

This research is designed to explore and evaluate the credit risk management practice of BIDV in order to enhance the effectiveness of its credit risk management system So, exploratory research is the most appropriate research type for the study and case study method is the exploratory research technique used to obtain information to the research problem

A case study is conducted at BIDV, qualitative approach is used, both primary data and secondary data are collected A survey is chosen to investigate and describe the practice of credit risk management of BIDV A questionnaire is designed and asked directly to interviewees to collect data related to credit risk management practice of BIDV

Secondary data is used to investigate the policy, strategy and procedures of BIDV in credit granting and credit risk management It is used to evaluate the compliance with international standards and regulations of the State Bank of Vietnam Secondary data is in documents relative to credit and credit risk of BIDV This data is collected from BIDV branches and the website of BIDV

1.7 Structure of the study

This research consists of six chapters The structure of this research is presented as follows:

Chapter 1: Introduction

This chapter provides the background to the research, the contribution of the research, research methods and outlines the limitations of the research

Chapter 2: Theoretical framework

This chapter presents a theoretical framework relating to the subject of this thesis It includes some theoretical concepts and definitions relating to credit risk management Besides, it shows the standards for credit risk management recommended by the Basel Committee on Banking Supervision and regulations of the State Bank of Vietnam that govern the lending activity and credit risk management

Chapter 3: Research methods

This chapter discusses the methodological approach used for the thesis It presents the reason why a case study is chosen and how data, information and literature are collected

Chapter 4: An introduction to Bank for Investment and Development of Vietnam (BIDV)

This chapter makes an overview of Bank for Investment and Development of Vietnam (BIDV), its activities over the period 2006-2010 It makes a brief assessment of banking practice of BIDV by showing main indicators over years and comparing the indicators with those of some other leading banks in Vietnam banking market

Chapter 5: Data analysis and findings

This chapter analyzes credit and credit risk policies, credit organization and practice of BIDV, the way BIDV manage credit activities and credit risk arising from the activities, the efficiency of credit policies of BIDV From that an assessment will be made

Chapter 6: Conclusions and recommendations

The conclusions about the whole thesis and the recommendations upon the problems identified will be discussed in this chapter

CHAPTER 2 THEORETICAL FRAMEWORK

2.1 Introduction

This chapter mentions theoretical framework relating to risk management in general and credit risk management in particular The chapter consists of six sections The first section makes an introduction to the chapter, the second section presents an overview of risk and risk management in banks, the third section refers

to credit risk and credit risk management in banks, the fourth section reviews standards of credit risk management of Basel Committee on Banking Supervisions, common practices of credit risk management in banking, the fifth section presents regulations of State Bank of Vietnam on credit risk management, the six section presents some knowledge on credit risk management, the last section provides some conclusions to the chapter

2.2 Risk and risk management in banks

According to Shelagh Heffernan (2005), banking risk is the volatility of net cash flows of a branch, a division of a bank or the whole bank The objective of a single bank is to add value to its equity by maximizing the risk-adjusted return to shareholders Banks accept risk to make profit For a bank, risk-adjusted return depends severely on risk management policy and practice Risk management is the core operation any bank

There are a lot of risks in banking practice that affect the profitability of banks Gup (Commercial banking, 2005, P 12) lists nine risks needing to be supervised, namely credit, interest rate, operational, liquidity, price, compliance, foreign exchange, strategic and reputation risks

Credit risk is the risk to earnings and capital that banks have to absorb due to

the borrower is unable to or unwilling to pay its debt This affects the lender holding the loan contract, as well as other lenders to the debtor Therefore, the creditworthiness of the debtor as well as the market value of the collateral is of great interest to the bank Credit risk is the gap between the performance and expected value Accordingly, it can be diversifiable, but cannot be eliminated completely This is because a part of credit risk stems from market risk This arises to banks that

do business in local markets and take on highly illiquid assets In such cases, banks are of difficulty in transferring credit risk and estimating potential loss

Interest rate risk is the risk to earnings and capital due to the movements of

interest rates Banks and borrowers bear interest rate risk Banks have the risk of reduced revenues due to the decline in interest rates Borrowers suffer higher costs due to interest rates increasing However, interest rate exposure produces chances of gains as well

Operational risk is the risk to earnings and capital arising from malfunctions

of the information system, reporting systems, internal risk-monitoring rules and internal procedures designed to take timely corrective actions, or the compliance with internal risk policy rules (Joel Bessis, 2002) Operational risk relates to the problems of accurately processing, settling, and taking or making delivery on trades

in exchange for cash This is the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events

It also arises in system failures and compliance with banking regulations

Liquidity risk is the risk to earnings and capital that a bank cannot meet its

obligations to depositors and the needs of borrowers by turning asset into cash quickly, being able to borrow fund when needed This is often associated with an unexpected event, loss of confidence, or a crisis of national balance of payments

such as a currency crisis In some cases, a low liquidity ratio may lead banks to bankruptcy

Price risk is the risk to earnings and capital stemming from market value

variation, especially the fluctuation of exchange rate This risk can be hedged, but cannot be diversified away It appears in various forms For banks, price risk arises from the fluctuations of interest rates and the value of currencies

Compliance risk is the risk to earnings and capital arising from violations of laws, rules, regulations, and so on Compliance risk may arise from activities of an

institution's management or employees Fraud, violations of laws and regulations may lead to huge loss

Foreign exchange risk is the risk to earnings and capital arising from changes

in foreign exchange rates

Reputation risk is the risk to earnings and capital stemming from negative

public opinion of the bank Negative public opinion may arise from poor service, failure to serve credit needs, and for other reasons This may lead to a loss of market share

Every bank faces these kinds of risks to a particular extent The banking industry regards the issue of risk management as the need to control the risks which make up most of their risk exposure Consequently, the main tasks of banking risk management are to manage these kinds of risks

2.3 Credit risk and credit risk management in banks

2.3.1 Credit risk

There are many definitions of credit risk Basel Committee on Banking Supervision (2000, p 1), defines credit risk as the potential that a bank borrower or

counterparty will fail to meet its obligations in accordance with agreed terms Benton E Gup (2005, P 12) states that credit risk is the risk to earnings and capital that an obligor may fail to meet the terms of any contract with the bank Credit risk

is the primary cause of bank failures, and it is the most visible risk facing bank managers

According to Decision 493/2005/QĐ-NHNN dated 22/04/2005 of the State Bank of Vietnam, credit risk is the probability that a default event occurs in banking practice of a credit institution due to the borrower is unable to or unwilling to meet its obligations as committed

For most banks, loans are the largest and most obvious source of credit risk However, there are many other sources of credit risk in banking activities both on and off the balance sheet Banks are facing credit risk in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions In this thesis, credit risk is narrowed down to main credit activities namely loans and guarantees

Credit risk arises from the possibility that a counterparty is either unwilling to perform on an obligation or its ability to perform such obligation is deteriorated causing financial losses to the bank Losses originate from total default due to inability or unwillingness of counterparty to meet commitments relating to lending, trading, settlement and other financial transactions, losses may also stem from reduction in value due to deterioration in credit quality Credit risk arises from a bank’s dealing with individuals, businesses or financial institutions Credit risk may originate from activities on or off the balance sheet

Credit risk results in direct accounting losses In addition, it causes economic exposures consisting of opportunity costs, transaction costs and expenses relating to

non-performing assets Credit risk may also expose banks to liquidity risk Credit risk is the most substantial risk in terms of losses It is the principal cause of bank failures

Credit risk may be divided into three types: default risk, exposure risk and recovery risk Default risk is the risk arising due to a default by the counterparty, which declares bankruptcy, goes into liquidation or otherwise defaults on the loan; exposure risk is the risk that exposure at default is greater than the amount originally expected; recovery risk is the risk that the recovery rate actually recorded after the liquidation of the insolvent counterparty’s assets is less than the amount originally estimated, because the liquidation value was lower than estimated or simply because the recovery process took longer than expected

Because credit expansion is the principal of banking operation, the major part

of banking risk management is credit risk management It applies to bank loans and investment portfolio Credit risk management combines decision making, monitoring and reporting process Loans in default or close to default become non-performing Usually, loan becomes non-performing after being default for three months Non-performing loan rate shows the proportion of the default or near to default loans to the actual performing loans It indicates the efficiency of the credit risk management employed in the bank A low non-performing loan rate shows an effective credit risk management policy

2.3.2 Credit risk management

Credit risk management is the process of credit risk approach in a scientific, comprehensive and systematic manner to identify, control, prevent and mitigate the damage, loss, adverse effects of credit risk

of return by maintaining credit risk exposure within acceptable parameters Banks

need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions Banks should also consider the relationships between credit risk and other risks The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential

to the long-term success of any banking organization (BCBS, 2000, P.1)

Retail lending approach is different from that of corporate lending because corporates have financial reports that generate financial ratios while individuals don’t This makes retail lending more difficult than corporate lending due to lack of information However, lending to corporations involves large sums of money and every failure may lead to serious consequences whereas retail loan defaults rarely have severe adverse effects on a bank

Credit risk is managed in various ways Tony Van Gestel (2009, P 42) introduces four techniques for credit risk management as the followings:

Limitation restricts the exposure of the bank to a particular customer; it prevents the bank from insolvency due to losses of lending to one customer or a group of customers The State Bank of Vietnam regulates that the total outstanding credit of a commercial bank extended to a single client must not exceed 15% of its

own capital and the total outstanding credit of a commercial bank extended to a single client and affiliated persons must not exceed 25% of its own capital (article

128 of the Law on Credit Institutions) Each bank makes a credit extension limit to

a single customer based on financial capacity and demand for business activities of the customer Besides, the bank limits the authority of each credit officer and committee Large loans must be verified by many levels of credit authority

Diversification offsets the volatility created by an increase in the number of risky loans Diversification strategy spreads credit in order to avoid a concentration

on credit risk The bank diversifies its credit portfolio by making loans to various borrowers of different types, industry sectors and geographies in order to reduce the overall riskiness of the loan portfolio with assets of negatively correlated

In order to mitigate credit risk, banks may use credit protection by buying credit derivative products or credit insurance Besides, with higher credit risk counterparts, banks also require more collateral Collateral is the second source of repayment Collateral helps to reduce recovery risk

Default risk of individual loans is assessed by qualitative and quantitative methods Qualitative method is used when the bank is unable to obtain information

on a potential borrower, quantitative method uses financial data to measure and predict the probability of default of a borrower

Qualitative approach use checklists to take account of specific issues of the borrower Shelagh Heffernan (2005) uses the following checklist to evaluate credit risk:

- Whether borrower earnings are volatile

- Employment history

- Length of time as a customer at a bank

- Length of time at a certain address

- Whether or not collateral or security is part of the loan agreement

- Whether a future macroeconomic climate will affect the applicant’s ability to repay

With the above-mentioned checklist, the bank will have an evaluation of the customer’s creditworthiness and the ability to pay debt in the future when the economic conditions change

For the management of credit risk, Benton E Gup (2005) uses the 6 C’s of credit in a qualitative assessment of credit risk:

- Character: Personal characteristics of the borrower, honesty, and attitudes about willing and commitment to pay debts

- Capacity: the borrower’s success in running a business

- Capital: the financial condition of the borrower

- Collateral: pledged assets

- Conditions: economic conditions

- Compliance: compliance with laws and regulations

Today, many credit officers use these 6 C’s of credit to evaluate credit risk They are important to assess credit risk of new established corporates and individuals

Quantitative approach uses credit scoring models to assess the creditworthiness of customers Credit scoring is the use of statistical models to determine whether a prospective borrower will default on a loan The credit score is

a number calculated by the lender or credit scoring company that is used in making

credit decisions and other purposes According to Benton E Gup (2005), credit scoring models can be used for:

- Controlling risk selection

- Managing credit losses

- Evaluating new loan programs

- Improving loan approval processing time

- Ensuring that existing credit criteria are sound and consistently applied

- Improving compliance with the laws and regulations

Besides managing credit risk of making loans to individuals and corporations, banks have to manage their aggregate credit exposure A heavy concentration of loans in one sector may lead the bank to huge risks According to Shelagh Heffernan (2005), there are four factors influencing the assessment of aggregate credit exposure:

- The expected loss levels over a given time horizon, for each loan and for the portfolio as a whole

- The unexpected loss for each loan

- The volatility of expected loss for the portfolio as a whole

- The probability distribution of credit loss for the portfolio, and the capital required, for a given confidence level and time horizon, to absorb any unexpected losses

2.4 Standards of credit risk management of Basel Committee on Banking Supervision

Since credit risk is still the main risk of banking practice, banks must identify, measure, monitor and control credit risk According to Basel Committee on Banking Supervision (1999), in order to manage credit risk well, banks must carry out the followings:

- Establishing an appropriate credit risk environment;

- Operating under a sound credit granting process;

- Maintaining an appropriate credit administration, measurement and monitoring process;

- Ensuring adequate controls over credit risk

2.4.1 Establishing an appropriate credit risk environment

An appropriate credit risk environment is a critical condition for the success of credit risk management In order to create a good credit risk environment, the following factors must be noticed:

- Credit risk strategy and policies;

- Credit risk inherent in all products and activities

In their business, banks have to accept risks to earn profit, to determine the acceptable risk/reward trade-off for their activities Every bank, regardless of size, must establish a strategy for selecting risks and maximizing return The strategy reflects the bank’s tolerance for risk and the level of profitability the bank expects

to achieve for incurring various credit risks The strategy helps the bank recognize the goals of credit quality, earnings and growth Based on the strategy, the bank will set up appropriate policies to get the goals The policies and procedures must

address credit risk in all of the bank’s activities and at both the individual credit and portfolio levels

With sound policies and procedures, the bank will be able to maintain sound credit granting standards; monitor and control credit risk; properly evaluate new business opportunities; identify and administer problem credits

Banks must identify and manage credit risk inherent in all products and activities The risks of products and activities new to them must be subject to adequate risk management procedures and controls before being introduced or undertaken

2.4.2 Operating under a sound credit granting process

The credit granting process is an important factor for credit risk management

A sound credit granting process will help the bank manage and reduce credit risk, a poor one will lead the bank to credit risk exposure The Basel Committee on Banking Supervision advises that banks must operate within sound credit granting process to reduce credit risk and maximize risk-adjusted profit This includes the following tasks:

- To establish a target market and understand the borrower, as well as the purpose and structure of the credit, and its source of repayment

- To establish overall credit limits at the level of individual borrowers and groups of connected counterparties that aggregate in a comparable and meaningful manner different types of exposures, both in the banking and trading book and on and off the balance sheet

- To establish a process for approving new credits as well as the amendment, renewal and re-financing of existing credits

- To grant credit on an arm’s-length basis Credits to related companies and individuals must be monitored with particular care

2.4.3 Maintaining an appropriate credit administration, measurement and monitoring process

Credit administration is a critical element in maintaining the safety and soundness of a bank To manage credit risk efficiently, the bank must have a system for the administration of their various credit risk-bearing portfolios, for monitoring the condition of individual credits, including determining the adequacy of provisions and reserves

A common way for the evaluation of individual credits in terms of credit risk

is the use of an internal risk rating system The rating system is established consistent with the nature, size and complexity of the bank’s activities Besides, an information system is in need to measure the credit risk inherent in all activities The management information system help provide adequate information on the composition of the credit portfolio, including identification of any concentrations of risk

The economic conditions have great effect on credit quality As a result, changes in economic conditions must be taken into account when assessing individual credits and their credit portfolios

2.4.4 Ensuring adequate controls over credit risk

Credit risk needs to be controlled in a sound manner Every bank needs a system of independent assessment of credit risk management processes in order that the board of directors and senior management can be provided with sufficient information to evaluate the performance of credit officers and the condition of the credit portfolio

The goal of credit risk management is to maintain credit risk exposure within levels consistent with prudential standards and internal limits The establishment

and enforcement of internal controls, operating limits and other practices will help ensure that credit risk exposures do not exceed levels acceptable to the individual bank Such a system will enable bank management to monitor adherence to the established credit policies Problem credits must be managed in a timely manner The way banks deal with problem credits need to be included in credit risk policies

2.5 Regulations of the State Bank of Vietnam on credit risk management

In order to ensure the safety of the Vietnam banking system, the State Bank of Vietnam has issued regulations on risk management including limits on lending and regulations on classification of debts and loss provisioning in banking operation of credit institutions

2.5.1 Regulations on Classification of Debts and Loss Provisioning in Banking Operation of Credit Institutions

In order to manage credit risk in the banking system, the State Bank of Vietnam has issued many regulations on credit risk management including Decision 493/2005/QD-NHNN dated April 22, 2005 issuing the Regulations on Classification of Debts and Loss Provisioning in Banking Operation of Credit Institutions applied to all credit institutions operating in Vietnam (excluding the Bank for Social Policies) The loss provisioning aims to compensate for credit losses of credit institutions The loss reserve is calculated on the basis of the principal of debt and is treated as operating expenses of credit institutions There are two kinds of loss reserve; those are specific provisions and general provisions Provisions established to absorb unidentified losses inherent in a credit institution’s loan portfolio are referred to as general provisions, and provisions established to absorb losses identified for specific loans are referred to as specific provisions Specific provisions depend on which category the loans belong to General provisions are equal to 0.75% of the total debt classified from category 1 to category 4

There are two methods of debt classification and loss provisioning, that is quantitative method and qualitative method

In quantitative method, the system classifies bank loans into five categories according to their inherent risks as standard, special mention, substandard, doubtful and loss, which is primarily based on the period that payments of principal and interest are overdue

- Category 1 (standard) consists of debts that are not due and the borrower is able to pay the principal and interest of debts in full and in a timely manner;

- Category 2 (special-mention) consists of debts which are overdue less than

90 days and rescheduled debts that are not due;

- Category 3 (sub-standard) consists of debts that are overdue from 90 to 180 days and rescheduled debts that are overdue less than 90 days;

- Category 4 (doubtful) consists of debts that are overdue from 181 to 360 days and rescheduled debts that are overdue from 90 to 180 days; and

- Category 5 (loss) consists of debts that are overdue more than 360 days, rescheduled debts that are overdue more than 180 days and debts that are subject to rescheduling arrangements as directed by the Government

However, loans may be subject to a worse rating if there are reasons to doubt the borrower’s ability to continue to service such loans

The qualitative method is based on the credit institution's internal credit rating system and provisioning policy as approved by the State Bank of Vietnam Debts are also classified as standard, special mention, substandard, doubtful and loss:

- Category 1 (standard): debts that the borrower is able to pay the principal and interest for in a full and timely manner;

- Category 2 (special-mention): debts that the borrower is able to pay the principal and interest for in full but there exists a sign of decreasing payment ability;

- Category 3 (substandard): debts that the borrower is not able to pay the principal and interest for in a timely manner and some loss of principal and interest is possible;

- Category 4 (doubtful): debts in relation to which the loss of principal and interest is highly probable; and

- Category 5 (loss): debts that are uncollectible

Under either the qualitative method or the quantitative method, the ratios of specific provisions for debts of categories from 1 to 5 are 0%, 5%, 20%, 50% and 100%, respectively

The formula for calculating specific provisions is as follows:

R = max {0, (A-C)} x r

In which:

R: a specific amount for loss reserve

A: the value of the loan

C: the value of the collateral

r: ratio for loss provisioning

The formula for calculating specific provisions shows that the loan loss reserve does not depend only on the value of the loan and the ratio of loss provisioning; it also depends on the value of the collateral The loan loss reserve will be zero if the value of the collateral (C) is higher than the value of the loan (A), and credit institutions do not have to set aside a specific loss reserve for such loan The value of the collateral set forth in the underlying security agreement will be the basis for calculating the loan loss reserve with respect to most types of collateral

Under the formula, credit institutions have to evaluate seriously the collateral

on the date of the security agreements However, the liquidity of the collateral is a problem The valuation of current assets, such as accounts receivable, materials, goods in process, etc will also be problematic

Loss reserves are used when organizational customers are bankrupt or dissolved or individual customers are dead or missing Loss reserves are also used when loans are classified in category 5 In such cases, specific provisions and the proceeds from collateral realization are used to compensate for the loss first General provisions are only used when the fund is not enough

2.5.2 Credit rating for customers

According to Decision No.493/2005/QD-NHNN dated April 22, 2005, credit institutions would have to establish internal credit rating system within 3 years from the validity date of the Decision (15/05/2005) to support debt classification, credit quality management in accordance with scope of activities, specific situation of every credit institution An internal credit rating system should include at least the followings:

- Legal bases relating to the customers’ establishment and business;

- General business figures relating to business, finance, assets, and the ability

to perform duties as committed;

- Prestige of the customers to credit institutions having relationship with previously;

- Criteria to evaluate customers specifically, in detail, systematically Based on that are specific ratings for each customer

Based on the regulations of the State Bank of Vietnam, each credit institution establishes the internal credit rating system for its own to support debt classification, credit granting, credit control and monitoring The internal credit

rating system helps to evaluate the creditworthiness of customers in credit granting process to mitigate credit risk for the bank

2.6 Some knowledge on credit risk management

Many researches so far have studied the sources of credit problem and factors affecting credit quality and tried to find ways to manage credit risk Ngoc (2010) stated four factors influencing credit risk management performance namely credit information, technology, credit staff, credit policy; to manage credit risk is to manage the four factors above

While Dieu (2008) presented five reasons of credit failure namely:

- Poor internal control;

- Poor credit policies;

- Credit staff;

- Poor monitoring and control after credit granting;

- High credit growth rate

To mitigate credit risk, banks have to strengthen internal control activity in order to timely uncover problematic credit and take measures to deal with it; besides, banks have to develop sound credit policies to help credit activities go smoothly; furthermore, banks need to intensify training credit staff, both in skills and professional ethics; moreover, banks need to strengthen monitoring and controls over credit after granted to see if the credit is used with right purpose or it can generate cash flow for credit reimbursement And finally, a high credit growth rate may lead banks to failure so banks have to keep the credit growth rate at the speed that can be managed and controlled

The Basel Committee on Banking Supervision states that the most common problems of credit are concentrations, credit processing, market and liquidity

sensitive credit exposures To manage credit risk is to deal with those problems The first is to diversify credit portfolio in order to reduce exposure to concentrations, the second is to improve credit processing process by means of credit rating and 6 C’s technique, and finally, a bank can reduce exposure to market and liquidity sensitivity by diversification and hedging

2.7 Conclusions

The theoretical framework gives us a general look on risk and credit risk management, components of credit risk and credit risk management Besides, it introduces standards of Basel Committee on Banking Supervision and regulations

of the State Bank of Vietnam on credit and credit risk management These standards and regulations are the guidance for the management of credit risk for each bank and the whole banking system They are also the basis for the researcher to assess the credit risk management practice of BIDV Moreover, it presents some knowledge on reasons of credit risk and bank failure and the way to manage credit risk This is a help for the researcher in doing this study

CHAPTER 3 RESEACH METHODS

3.1 Introduction

The previous chapter provides theoretical framework for the research This chapter provides an overview of business research and introduces appropriate research methods to be applied for the research

The purpose of this chapter is to describe, justify, and explain the research methodology used in the study It explains how research design, data collection and analysis utilized to answer the research questions outlined in chapter 1 This chapter

is structured into six sections

Section 3.1 makes an introduction to the chapter, section 3.2 presents business research, section 3.3 discusses and explains how the research design can be used in this research to answer the research questions, section 3.4 mentions methods of data collection, section 3.5 discusses reliability of data, section 3.6 provides some conclusions to the chapter

3.2 Business research

Business research is a management tool that companies use to reduce uncertainty; it is the systematic and objective process of gathering, recording, and analyzing data for decision making There are some ways to classify business research It can be classified based on characteristics of the data, source of the data, the purpose of research or the frequency of study

To classify business research on the basis of purpose allows us to understand how the nature of the problem influences the choice of research methods Based on the purpose of business research, there are three types of business research:

- Exploratory research: This is the basic level of research It is used to clarify ambiguous problems or to gain better understanding of the dimensions of the problems

- Descriptive research: The objective of descriptive research is to describe characteristics of a population or phenomenon It may be an extension of an exploratory research It is based on some previous understanding of the nature of the research problem

- Causal study: the major purpose of causal research is the identification of cause and effect relationships between variables In causal research, the emphasis is on studying a specific situation or a problem in order to explain the relationships between variables

Based on the characteristics of data needed and research purpose, either qualitative or quantitative approach or a combination of these can be used

3.3 Research design

Chapter 1 of this research has determined the objectives to be achieved This section enables us to select appropriate methods in order to meet objectives in the most efficient way

The research objectives of this study are to explore the way BIDV manages credit risk and to evaluate the credit risk management practice of BIDV in order to enhance the effectiveness of its credit risk management system

Chapter 1 states the main research questions as follows:

- How does BIDV manage credit risk?

- How effective is credit risk management policy of the bank?

In order to answer these questions, the researcher has to find out the information on credit activities and credit risk management system of BIDV, the

compliance of credit risk management practice of BIDV with standards of Basel Committee on Banking Supervision and regulations of the State Bank of Vietnam The information needed for this study includes the followings:

- Regulations on credit and credit risk management;

- Credit granting process;

- Credit extension limits and credit restrictions;

- Credit risk management organization system;

- The compliance with regulations of the State Bank of Vietnam and standards

of Basel Committee on Banking Supervision

The research aims to deal with the ambiguous problems of exploring and assessing credit risk management of BIDV Thus, an exploratory research is appropriate for the study One of techniques for the exploratory research is the case study method It is used to obtain information from one or a few situations that are similar to the researcher’s problem situation

In this research, both primary data and secondary data are used Secondary data is collected from regulations governing credit activities of BIDV or any documents related to credit granting process and risk management practice of BIDV However, secondary data is insufficient for the research As a result of that,

a survey is conducted to collect primary data It is more appropriate where there is a lack of secondary data Survey is used to investigate and clarify the credit risk management practice of BIDV To choose appropriate ways to communicate with respondents is very important in surveys This depends on the possibility of communicating with respondents, the advantages and disadvantages of the most typical surveys, and the budget allocated for the research In this thesis, depth interviews are conducted with twelve credit officers and managers to gain insight into daily credit activities of BIDV The interviews are conducted in different time appropriate for respondents and in many ways appropriate with the situations

There are two main sources of data: primary data and secondary data In this thesis, both primary and secondary data are collected Methods utilized in data collection are document collection, and in-depth interviews The interview results are primary sources of data whereas the documents collected for analysis are secondary sources of data Documents collected are credit risk management policy, policy on loss provisioning to compensate for credit losses, credit granting procedures, credit granting policy, and so on

3.4.1 Document collection

Secondary data is collected by means of documents Documents used in this study are regulations of BIDV relating to credit granting process and credit risk management They provide the researcher with needed and useful information for the research This information provides a deeper understanding of how credit risk management is performed by BIDV In addition, based on the information acquired, the researcher can assess the credit risk management strategy and policies of BIDV Documents collected include:

- Credit granting policies;

- Credit granting procedures;