Credit risk management tools in vietnamese joint stock commercial banks in vietnam

4 Change in loan class model 226 Non - performance Loan ratio formulation 28 7 Rate of interest income from credit formulation 29 8 Profitability rate of credit activities formulation 29

FOREIGN TRADE UNIVERSITY FACULTY OF BUSINESS ADMINISTRATION

-*** -GRADUATION THESIS

Major: International Business Management

CREDIT RISK MANAGEMENT TOOLS IN

VIETNAMESE JOINT STOCK COMMERCIAL BANKS

HANOI, 6/2012

TABLE OF CONTENTS

LIST OF TABLES AND GRAPHS v

LIST OF EQUATION vi

LIST OF ABRREVIATIONS vii

ABSTRACT 1

CHAPTER 1: INTRODUCTION 1

1.1 Research background 1

1.2 Research question 1

1.3 Research objective 2

1.4 Layout of study 3

CHAPTER 2: LITERATURE REVIEW4 2.1 Credit risk management (CRM) 4

2.1.1 Overview about CRM in banking performance 4 2.1.1.1 Banking credit 4

2.1.1.2 Credit risk 4

2.1.2 Vietnamese Join - stock Commercial Banks and Basel Accord II 6 2.1.2.1 Vietnamese Joint - stock Commercial Banks 6

2.1.2.2 Basel Accords II 9

2.2 Credit risk management tools 10

2.2.1 Traditional approaches 10 2.2.1.1 Expert Systems 10

2.2.1.2 Credit rating systems (Internal/External) 10

2.2.1.3 Limit systems (credit scoring systems) 10

2.2.2 Value at risk analysis-VAR (risk based scientific pricing) 11 2.2.3 Portfolio management 12

2.2.3.1 Asset-by-asset Approach 12

2.2.3.2 Portfolio Approach 12

2.2.4 Supervisory authority of bank credit risk management (KCSA and KRI) 14 2.2.5 Risk rating models 18 2.2.5.1 Z-point model 19

2.2.5.2 RAROC model 20

2.2.6 Managing credit risks by using financial ratios 21 CHAPTER 3: HYPOTHESIS TESTING 23 3.1 Research design and methodology 23

3.2 Analyzing and data description 23

3.2.1 Financial criteria 24 3.2.1.1 Overdue loans 24

3.2.1.2 Bad debt –NPL 25

3.2.1.3 Credit profitability 28

3.2.1.4 Capital efficiency 29

3.2.1.5 Provisions 31

3.2.2 Regression model represents the relationship between ROE(ROA) and loan losses (Non-performance loans/Total loans) 33 3.2.2.1 Suggesting the relationship between ROE (ROA) and NPL/TL 33

3.2.2.2 Forming the model 35

3.2.2.3 Testing and evaluating the hypothesis 37

3.2.2.4 Data description for 10 VJCBs 38

3.2.2.5 Summarizing the analytical results 39

3.2.2.5.2 Group 2 (CTG, MBB, EIB, VIB and EAB) 41

CHAPTER 4: RECOMMENDATIONS AND SUGGESSTIONS 47

4.1 Suggestions for Banks 47

4.1.1 Credit risk management strategies and policies 47 4.1.1.1 Strategy 47

4.1.1.2 Policy 48

4.1.2 Credit procedures and delegation of Authority 49 4.1.2.1 Credit procedures 49

4.1.2.2 Delegation of Authority 49

4.1.3 Credit risk management process 50 4.1.3.1 Credit grating 50

4.1.3.2 Risk mitigation 52

4.1.3.3 Credit monitoring 52

4.1.3.4 Credit review 53

4.1.3.5 Classification and Provision 54

4.1.3.6 Problem credit 55

4.1.5 Credit portfolio risk management 56 4.1.5.1 Portfolio Management Approach 57

4.1.5.2 Value at Risk 58

4.2 Conclusions 58 LIST OF REFERENCES 59

ANNEXES 62

LIST OF TABLES AND GRAPHS

risk

14+15

Table 5 A typical example of complete risk map 19Table 6 Some of the frequently used ratios in credit analysis 23Table 7 Overdue loans ratios in VJCBs 2007-2011 25

Graph 1 The relationship between ROE and NPL/TL 36Graph 2 The relationship between ROE and NPL/TL 37

4 Change in loan class model 22

6 Non - performance Loan ratio formulation 28

7 Rate of interest income from credit formulation 29

8 Profitability rate of credit activities formulation 29

9 Mobilizing capital efficiency formulation 31

10 Assets efficiency for loans formulation 31

11 Credit risk provisions ratio formulation 33

LIST OF ABRREVIATIONS

VJCBs Vietnamese Joint – stock Commercial Banks

VIB Vietnam International Bank

CRM Credit risk management

BCBS Basel Committee on Banking Supervision

KCSA Key Control Self-Assessment

KRI Key Risk Indicator

RAROC Risk-Adjusted Return on Capital

EBIT Earnings before tax

P/E Price to Earnings

NPL Non- performance Loan

CRP Credit Risk Provisions

With the longstanding history and development, the banks are always thetrusty partners of enterprises in the economic promotion process of nations andgrow together in a close relationship, which is represented by the relation betweenlender and borrower (credit transaction) and credit operation is the most profitable

of the bank In other words, all activities of banks are concerned about one word

“credit” However, the banks would produce negative results because of the heavydependence on credit work, which is able to create the risks from lending andraising funds In accordance with managerial point of view, if the bank wants toimprove the quality of credit activity, it should focus on and consider the credit riskmanagement as the most necessary and serious issue

The main purpose of this study is to have a clearer picture of how banksmanage their credit risk In this light, the study in its first section gives abackground to the study and the second part is a detailed literature review onbanking and credit risk management tools and assessment models The third part ofthis study is on hypothesis testing and use is made of a simple regression model.This leads us to conclude in the last section that banks with good credit riskmanagement policies have a lower loan default rate and relatively higherprofitability

CHAPTER 1: INTRODUCTION 1.1 Research background

In terms of management, an adequate system for assessing credit risks infinancial institutions is essential for the survival and growth of them In the case ofbanks, the issue of credit risk is even a greater concern because the higher levels ofperceived risks resulting from some of the characteristics of clients and businessconditions that can help banks control their performance more accurately and moreeffectively

In fact, credit creation is the main income generating activity for the banks,but this activity involves huge risks to both the lender and the borrower The risk of

a trading partner, who does not fulfill his or her obligation as per the contract on duedate or anytime thereafter, can greatly threaten the smooth functioning of a bank’sbusiness On the other hand, a bank with high credit risk has high bankruptcy riskthat puts the depositors in jeopardy Additionally, credit risk is also one of greatconcern to most bank authorities and banking regulators because credit risk is therisk that can easily and most likely prompts bank’s failure

In recent years, the world economic situation has a lot of unexpected changesand the probability of a credit crisis booming rise increasingly Vietnam which has

an open economy cannot avoid the effects of world economy To face with thatcondition, it is certain to require that VJCBs must improve the process of managingcredit risk to limit the potential possibilities which cause the risk at the lowest level

As a result, the subject “Credit risk management tools in Vietnamese joint

-stock commercial banks in Vietnam” is implemented to research the credit

business situation in reality and the effectiveness of credit assessment methods inVietnamese joint - stock commercial banks from which identifying the signs,finding the causes and proposing useful solutions for managing credit risk incommercial banking system

1.2 Research question

The following questions will illustrate for us the problems of credit riskmanagement in Vietnamese joint - stock commercial banks of which this article willlook for the answers

- What is a credit risk? How do banks control it? Which tools banks shouldapply to deal the problems of credit risk?

- Why do most VJCBs suffer weak risk management? It is shown clearly fromthe Mergers and Acquisitions tendency in Vietnamese banking system inrecent years

- A few banks have the adequate and effective system to manage credit risk?Why? How did they use the credit risk management tools? What lessonswere learned?

- How to improve this situation and what new solutions are available in theworld that Vietnam has adopted it yet?

1.3 Research objective

The main objective of the study is to have a whole scene of how banksmanage the credit risks in their performance, thus focusing on some followingaspects:

- Ascertaining why and how credit risk exposure in VJCBs is evolvingrecently

- Ascertaining and evaluating how VJCBs use the credit risk management andassessment tools to mitigate their credit risk exposure

- Approaching the process of credit risk management, including: identifyingand developing a control system, analyzing financial information and how tomitigate the risks

- Determine the relationship between the theories, concepts and models ofcredit risk management and what needs going into a reality

- Determine how and what should apply or improve effectively for managingcredit risk in VJCBs at the moment and in near future

However, this research will only give about information about top 10 biggestbanks in terms of total assets from 2007 to 2011 because these can cover andrepresent for 37 VJCBs, namely: Asia Commercial Bank (ACB), Vietinbank(CTG), Vietcombank (VCB), Eximbank (EIB), Sacombank (SCB), Military Bank(MBB), Techcombank (TCB), Maritime Bank (MSB), Vietnam International Bank(VIB) and Earth Asia Bank (EAB) (Sourced by: Vnr500.com.vn)

1.4 Layout of study

This study is divided into four sections:

- The first section is on background to the study and cuts across a generalintroduction, research question, research objective, and layout of the study

- Section two is on literature review on commercial banking and credit riskmanagement

- Section three is on hypothesis testing using a simple linear model on E-view.Here we also interpret the findings of the tests

- Section four concludes the study with a summary and some usefulsuggestions

CHAPTER 2: LITERATURE REVIEW

2.1 Credit risk management (CRM)

2.1.1 Overview about CRM in banking performance

2.1.1.1 Banking credit

It is the agreement of the bank to allow the customers can use an asset (cash,real property or reputation) with the principle of reimbursement by individuallending, discounting (rediscounting), financial leasing, bank guarantees and otheroperations

In addition, banking credit has its own characteristics and one of which ishigh potential risk to the bank (credit risk) and a separate management mechanism(banking credit risk management)

2.1.1.2 Credit risk

It is an investor's risk of loss arising from a borrower who does not makepayments as promised.Such an event is called a default Investor losses include lostprincipal and interest, decreased cash flow, and increased collection costs, whicharise in a number of circumstances:

- Potential losses due to an inability/unwilling of partner in meeting obligation+ Before, during or after the due date

+ Partner presses to perform all obligations

+ The impact of government or political effects

- Potential losses because of the borrower unable to repay

+ Borrower lacks of liquidity

+ Cannot get a refund

2.1.1.3 Credit risk management

It is a structured approach to managing uncertainties through risk assessment,developing strategies to manage it, and mitigation of risk using managerialresources The strategies include transferring to another party, avoiding the risk,reducing the negative effects of the risk, and accepting some or all of theconsequences of a particular risk Some traditional risk managements focused onrisk stemming from physical or legal causes (such as natural disasters or fires,accidents, deaths and lawsuits) Financial risk management on the other handfocuses on risks that can be managed using traded financial instruments Theobjective of risk management is to reduce the effects of different kinds of risksrelated to a preselected domain to the level accepted by society It may refer tonumerous types of threats caused by environment, technology, humans,organizations and politics On the other hand, it involves all means available forhumans, or in particular, for a risk management entity (person, staff, andorganization).

Table 1: Credit risk management model in banks

(Source: Report of risk management department of Vietinbank)

2.1.2 Vietnamese Join - stock Commercial Banks and Basel Accord II

Capital Allocation Pricing Provisioning Grooming

Credit risk management model in banks

Loss Given Default Probability of Default

CR Management

2.1.2.1. Vietnamese Joint - stock Commercial Banks

In the most basic terms, commercial banks take deposits from individualsand institutional customers, which they then use to extend credit to other customers

They make money by earning more in interest from borrowers than they pay ininterest to those whose deposits they accept They are different from investmentbanks and brokerages in that those kinds of institutions focus on underwriting,selling, and trading corporate and municipal securities (Sourced by: Wikipedia)

Table 2: The structure of Risk Management system in VJCBs

(Source: Annual reports of VJCBs)

Board of Risk Management is directed under the Board of Management It shall

supervise all kinds of risks in the bank in order to have overall information aboutthe risk, which results to find out the most effective, reasonable and synchronouspolicies Board of Risk Management has some following functions:

Board of Management Board of Risk Management

Executive Board

Market Risk Committee

Operation Risk

Committee

Credit Risk Committee

The Structure of Risk Management System in VJCBs

- Ensure that the statements of risk policy on each type of risk are prepared forBoard of Management approval.

- Ensure that the risk policies have been implemented strictly

- Manage a bank capital

- Guarantee for the forming of market and credit risk limitations

- Manage the reports of general risks in operation process in each of businesssegments

- To revise the performance of the risk management committee

Risk Management Committee is directed under the Executive Board It shall have

a responsibility to monitor regularly the risk management process within the bankand draw up a risk management framework Members of Risk ManagementCommittee include: CEO (chairman), Director of Risk Management Departmentand other related departments Committee acts through regular or unusualmeetings

Risk Management Division at Head Office shall have a responsibility to help

leaders

Implement the risk management tasks as below:

- To support the Executive Board to demonstrate to the administrative,auditing and other higher level authorities that the risk managementperformance was done;

- To be a center where actively deploys the policies into practice, branches,units and functional departments in the process of Risk Management at thebank

Risk Management Division at Branch shall assist the Board of Directors at branch

to implement the risk management process and make the reports about riskmanagement It is also to deploy the risk management activities at branch under thedirection and supervision of the Risk Management Division at head office

Internal Audit Department has an independently auditing function with the

process of managing risk to assess the effectiveness of risk management policy andframework Audit Department should review the process and measurement methods

of risk management to ensure the compliance of the risk management process, andthe quality and content of method and results of those methods.

Board of Management and Senior Leadership

- Usually, one of the most important interfaces between the Board ofManagement and Senior Leadership is through Board of Risk Management

- Board of Risk Management often includes the main members of the Board ofmanagement and has a responsibility to direct the risk strategy

- Senior Leadership is responsible for implementing the operation process ofthe risk appetite framework which has been approved by the Board ofManagement

Table 3: The functional model of risk management in

Manage Risk appetite & Bank capital

Senior Leadership - Evaluate operational results &

Direct the capital management strategy

Transaction Department

Optimize Relationship Structure Risks Target Marketing Early warning / noticing Exit relations

Risk Committee Form main policies, procedures & tools Responsible to implement

“Assess & Balance”

The Basel Accord(s) refers to the banking supervision accords(recommendations on banking laws and regulations), Basel I (first published in

1988 and enforced by law in 1992 by the G-10 countries) and Basel II (published inJune 2004) issued by the Basel Committee on Banking Supervision (BCBS) Theyare called the Basel Accords as the BCBS maintains its secretariat at the Bank ofInternational Settlements in Basel, Switzerland and the committee normally meetsthere The Basel Committee consists of representatives from central banks andregulatory authorities of the G10 countries, plus others (specifically Luxembourgand Spain) The committee does not have the authority to enforce recommendations,although most member countries (and others) tend to implement the Committee'spolicies This means that recommendations are enforced through national (or EU-wide) laws and regulations, rather than as a result of the committee'srecommendations - thus some time may pass between recommendations andimplementation as law at the national level

Tier 1 capital is the core measure of a bank's financial strength from a

regulator's point of view It consists of the types of financial capital considered themost reliable and liquid, primarily Shareholders' equity Examples of Tier 1 capitalare common stock, preferred stock that is irredeemable and non-cumulative, andretained earnings Capital in this sense is related to, but different from, theaccounting concept of shareholder's equity Both tier 1 and tier 2 capital were firstdefined in the Basel I capital accord The new accord, Basel II, has not changed thedefinitions in any substantial way Each country's banking regulator, however, hassome discretion over how differing financial instruments may count in a capitalcalculation This is appropriate, as the legal framework varies in different legalsystems

Tier 2 capital is a measure of a bank's financial strength with regard to the

second most reliable form of financial capital, from a regulator's point of view Theforms of banking capital were largely standardized in the Basel I accord, issued bythe Basel Committee on Banking Supervision and left untouched by the Basel IIaccord Tier 1 capital is considered the core capital and more reliable form ofcapital

2.2. Credit risk management tools

2.2.1 Traditional approaches

It is hard to distinguish between the traditional approach and the new one as

a lot of core ideas of traditional models are used in the new ones The traditionalapproach is comprised of three classes of models

2.2.1.1. Expert Systems

In the expert system, the branch lending officer has a wholly right to making

a credit decision The judgment of the credit expert and weightiness of certainfactors are the most important determinants in the decision to grant loans The loanofficer can examine as many points as possible but must include “6Cs”: character,credibility, capital, collateral, cycle (economic conditions) and control In addition

to “6Cs”, an expert may also take into consideration the interest rate

2.2.1.2. Credit rating systems (Internal/External)

These enable the banks to evaluate the credit worthiness of an issuer ofspecific types of debt, specifically, debts which are issued by a business enterprisesuch as a corporation or a government Credit ratings are determined by creditratings agencies that capture all relevant information about the borrower and assign

a grade through a risk rating process For example, Standard & Poor ratedbonds/debentures from excellent to poor as AAA, AA+,…, D

2.2.1.3. Limit systems (credit scoring systems)

A credit score is a number that is based on a statistical analysis of aborrower’s credit report, and is used to represent the credit worthiness of that person

or group Lenders, such as banks use credit scores to evaluate the potential riskposed by rating linked exposures, industry level caps and delegation of power.Using credit scores, financial institutions determine who are the most qualified for aloan, at what rate of interest, and to what credit limits (Sourced by: Wikipedia)

2.2.2 Value at risk analysis-VAR (risk based scientific pricing)

VAR is generally defined that this a technique used to estimate theprobability of portfolio losses based on the statistical analysis of historical pricetrends and volatilities

VAR is commonly used by banks, security firms and companies that areinvolved in trading energy and other commodities VAR is able to measure riskwhile it happens and is an important consideration when firms make trading orhedging decisions (Sourced by: Investopedia)

In fact, using VAR analysis in banks has a purpose that they can distributereasonably their sources (assets, liabilities and capital) to ensure the banks’ profitsand mitigate the risks because VAR is a effective tool to identify causes of risks andwhich policy should be apply to mitigate the risks (State Bank’s provide)

Some specialists described that VAR is the new science of risk managementand there were many ways to use VAR However, this part will illustrate a basicformulation of VAR relied on 3 basic methods of calculating it The more importantthings, in here, are the results of VAR calculation show what, and how tounderstand and apply it easily and practically after we knew the formulation

Basically, VAR is represented by:

VAR = (dollar value of position) x (price sensitivity) x (potential adverse move

in price/ yield) (1)

As can be seen from this formulation, VAR is a specific value whichrepresents for a maximum money of the portfolio that may be lost in assumingperiod of time with particular confident interval For example, a bank has a portfoliowith 100mVND and it could calculate that the VAR value is -3% (daily return) overnext 252 trading days with 95% level of confidence This means the bank expectsthat the maximum money can lose is just over 3m VND and it will only happen in

13 days of this period As a result, VAR is used to answer the question “What is myworst case scenario?” or “How much could I lose in a really bad month?”

To be more specific, a VAR statistic has three components: a time period(day, month, and year), a confidence level (typically 95% and 99%) and a lossamount (or loss percentage) In the case of VJCBs, the SBV requires VJCBs must

calculate VAR in 10 days with 99% level of confidence and the SBV will assessthis result by Backtest testing to evaluate the banks’ performance.

2.2.3 Portfolio management

The need for credit portfolio management emanates from the necessity tooptimize the benefits associated with diversification and to reduce the potentialadverse impact of concentration of exposures to a particular borrower, sector orindustry Stipulate quantitative ceiling on aggregate exposure on specific ratingcategories, distribution of borrowers in various industry, business group andconduct rapid portfolio reviews The existing framework of tracking the non-performing loans around the balance sheet date does not signal the quality of theentire loan book There should be a proper & regular on-going system foridentification of credit weaknesses well in advance Initiate steps to preserve thedesired portfolio quality and integrate portfolio reviews with credit decision-makingprocess

2.2.3.1. Asset-by-asset Approach

Traditionally, banks have taken an asset-by-asset approach to credit riskmanagement While each bank’s method varies, in general this approach involvesperiodically evaluating the credit quality of loans and other credit exposures,applying a credit risk rating, and aggregating the results of this analysis to identify aportfolio’s expected losses The foundation of the asset-by-asset approach is asound loan review and internal credit risk rating system A loan review and creditrisk rating system enable management to identify changes in individual credits, orportfolio trends in a timely manner Based on the results of its problem loanidentification, loan review, and credit risk rating system management can makenecessary modifications to portfolio strategies or increase the supervision of credits

in a timely manner

2.2.3.2. Portfolio Approach

While the asset-by-asset approach is a critical component to managing creditrisk, it does not provide a complete view of portfolio credit risk, where the term risk

refers to the possibility that actual losses exceed expected losses Therefore to gaingreater insight into credit risk, banks increasingly look to complement the asset-by-asset approach with a quantitative portfolio review using a credit model.

Banks increasingly attempt to address the inability of the asset-by-assetapproach to measure unexpected losses sufficiently by pursuing a portfolioapproach One weakness with the asset-by-asset approach is that it has difficultyidentifying and measuring concentration Concentration risk refers to additionalportfolio risk resulting from increased exposure to a borrower, or to a group ofcorrelated borrowers

Table 4: Strategies for reducing and coping with portfolio credit risk

Geographic

Diversification

External shocks (climate, price, natural disasters, etc.)are not likely to affectthe entire portfolio if there is spatial

diversification

If the country is small

or the Institution is capital constrained, it may not be able to apply this principle Itwill become

vulnerable to covariate risk, which

is high in agriculture

Loan Size Limits

(Rationing)

Prevents the institution from beingvulnerable to

nonperformance on a few large loans

Can be carried to the extreme where loan size does not fit the business needs of the client and results in suboptimal use and lower positive impact

by client

Client could become dissatisfied

Protects asset quality in the short-run but creates clientretention problems

in the long run Inimical to relationship banking

Over Assures the Excludes poor, low- Not a recommended

Collateralization institution that

enough liquidation value will exist for foreclosed assets

income clients who are the vast majority

of the market

technique if goal is

to better serve the low and moderate income clients.Credit Insurance Bank makes clients

purchase credit insurance In event ofdefault, bank collects from insurer

Databases and credit bureaus may not exist

to permit insurer to engage in this line of business in cost -effective manner

Portfolio

Securitization

Lender bundles and sells loans to a third party

Transfers default risk and improves

liquidity so that it cancontinue to lend

Allows lender to develop expertise in analyzing credit worthiness in one sector or niche

Requires well documented loans andlong time series of performance data to permit ratings and reliable construction

of financial projections

Requires a well developed secondarymarket, standardizedunderwriting

practices, and existence of rating companies

(Source: Publication of the Inter-American Development Bank)

2.2.4 Supervisory authority of bank credit risk management (KCSA and

KRI)

Credit assessment is not clearly a non-scene work; in contrast, it is anecessary step to form the lending policies of banks in a healthy manner It not onlyhelps managers identify problems quickly, but also works regularly checking howthe credit officers to abide by the lending policies of banks As a results and alsoincreasing the objectivity of the credit assessment, most of major banks usually set

up a “credit assessment division” separated with “credit department” Additionally,credit checking activities help the Board of Management and the directors can

assess all potential risks to the bank, so as to give out preventive solutions such asorientating the policy “risk provisions fund” and strategy “increasing the equity’scapital of the bank in the future” Nowadays, many banks use different processes toassess the credit operation However, the general principles are applied in mostbanks including:

Principle 1 : inspect regularly all types of credit in specific terms For example,

small and medium loans should be checked periodically in 30, 60, 90 days whereasthe greater ones must be checked more common

Principle 2 : Developing a plan, program and content of inspection process

adequately and carefully to ensure that the most important aspects of each creditaccount are checked including:

- Repayment plan of customers which ensures that customers do not delay inrepayment schedule

- Quality and condition of the insurable properties

- The completeness and validity of a credit contract which ensure that the bankwill have fully legal authority to own the collateral credit for borrower undercourt of justice if this is necessary

- Assessing how to the financial condition and the forecasts of the borrowerschange, which leads to review the credit demands of the borrowers

- Assessing whether the credit accounts comply with the lending policies ofbanks and the standards of the higher management offices

Principle 3 : Checking the large credit account usually because if the giants are in

default, it will seriously affect the financial conditions of the bank

Principle 4 : Managing seriously and regularly the credit accounts which often have

problems; strengthening the supervision and inspection activities to detect early thenegative notices related to credit account of the bank

Principle 5 : Enhancing the credit assessment activities when the economy has

downward trend or the business lines that constitute a major part of credit accounts

of the bank have serious problems in development such as the appearance of newcompetitors or the application of new technologies which requires new products andnew distribution methods

In particular, State Bank provide 2 technical tools for Supervisory Department inVJCBs to assess the banking transactions and activities.

2.2.4.1. KCSA (Key Control Self-Assessment)

It is a tool that aims to:

- Early detect the unidentified and unacceptable risks

- Better evaluate the acceptable ability for the risks have been identified

- Develop the control measurements more effectively for the unacceptablerisks

- Implement earlier and better the risk mitigation actions

- Support the senior managements identify the significant risk issues

- Improve the awareness and culture of risk management

KCSA can be done through questionnaires or interviews or conferences sothat the bank can establish the risk control matrixes to easily evaluate theeffectiveness of risk management tools which are applied

Term of KCSA implementation is at least once a year If a business area islikely to occur at higher risk, the number of tests will be performed more regularly(quarterly, monthly) Date of KCSA implementation is spread over the whole year

2.2.4.2. KRI - Key Risk Indicator

It is a quantitative assessment tool used to check / evaluate a level of risk in

an operational area or a working process Therefore, it can measure the risk level in

a specific activity The main characteristic of KRI is the set of quantitative,forecasting and trendy analysis

There are 2 types of KRI:

- General KRI: is general principles which relate to the applicableregulation / policy to all functional departments and employees (E.g.Termination rates or regulation of structure)

- Specific KRI: is a set of rules coordinates the performance of a specificfunctional department which forms these rules for themselves (E.g Thenumber of transactions is delayed or canceled in a month)

KRI reports are tabular form that indicates some key risk indicators based onthe predetermined criteria and standard to reflect clearly all operations processes.The objective of the report is warning early and detecting timely any changes incontrol to help managers focus on risk management activities within thepredetermined and acceptable target or limitation or other quality norms.

KRI reports periodically about key risk ratios by daily / weekly / monthly,which is done by all the functions of business units Each operating unit shouldmake a report about the key risk indicators suited for their requirement The reportabout key risk indicators is established by the different levels Each level must bemanaged differently to ensure a conciseness, access easily and focus on the notableareas In addition, it not only concerns about the control but also represents thechange and improvement of each indicator to provide the early warning signs

2.2.4.3. Risk map

It is established relies on the risks that were identified through theassessment process using the management tools (KRI or KCSA)

The classification of risk on the risk map bases on two factors:

- The degree of impact - the impact of risk factors before making apreventive method to reduce the severity of such factors

- The probability - predicting the possibility of risk factors can occur evenwhen a preventive plan has

Comments about risk and the suitable management policies are based onadequate information on the risk map

Table 5: A typical example of complete risk map

LOW(1.5)

LOW(2,5)

MEDIUM(3,5)

HIGH(4,5)

HIGH(5,5)LOW

(1,4)

LOW(2,4)

MEDIUM(3,4)

HIGH(4,4)

HIGH(5,4)LOW

(1,3)

LOW(2,3)

MEDIUM(3,3)

MEDIUM(4,3)

HIGH(5,3)17

LOW(2,2)

LOW(3,2)

MEDIUM(4,2)

MEDIUM(5,2)LOW

(1,1)

LOW(2,1)

LOW(3,1)

LOW(4,1)

LOW(5,1)

NOTE: from 1 to 5 is the lowest level to the highest level of probability (or impact)

2.2.5 Risk rating models

Credit Audit is conducted on site, i.e at the branch that has appraised theadvance and where the main operative limits are made available However, it is notrequired to risk borrowers’ factory/office premises As observed by RBI, CreditRisk is the major component of risk management system and this should receivespecial attention of the Top Management of the bank The process of credit riskmanagement needs analysis of uncertainty and analysis of the risks inherent in acredit proposal The predictable risk should be contained through proper strategyand the unpredictable ones have to be faced and overcome Therefore any lendingdecision should always be preceded by detailed analysis of risks and the outcome ofanalysis should be taken as a guide for the credit decision As there is a significantcorrelation between credit ratings and default frequencies, any derivation ofprobability from such historical data can be relied upon The model may consist ofminimum of six grades for performing and two grades for non-performing assets.The distribution of rating of assets should be such that not more than 30% of theadvances are grouped under one rating The need for the adoption of the credit risk-rating model is on account of the following aspects:

- Disciplined way of looking at Credit Risk

- Reasonable estimation of the overall health status of an account capturedunder Portfolio approach as contrasted to stand-alone or asset based creditmanagement

- Impact of a new loan asset on the portfolio can be assessed Taking a freshexposure to the sector in which there already exists sizable exposure may

IMPACT

simply increase the portfolio risk although specific unit level risk isnegligible/ minimal.

- The correlation or covariance between different sectors of portfolio measuresthe inter relationship between assets The benefits of diversification will beavailable so long as there is no perfect positive correlation between theassets, otherwise impact on one would affect the other

- Concentration risks are measured in terms of additional portfolio risk arising

on account of increased exposure to a borrower/group or co-relatedborrowers

- Need for Relationship Manager to capture, monitor and control the overallexposure to high value customers on real time basis to focus attention onvital few so that trivial many do not take much of valuable time and efforts

- Instead of passive approach of originating the loan and holding it tillmaturity, active approach of credit portfolio management is adopted throughsecuritization/ credit derivatives

- Pricing of credit risk on a scientific basis linking the loan price to the riskinvolved therein

- Rating can be used for the anticipatory provisioning Certain level ofreasonable over provisioning as best practice

Some of the risk rating methodologies used widely are briefed below:

2.2.5.1. Z-point model

Prominent amongst the credit scoring models is the Altman’s Z-Score The

Z-score formula for predicting Bankruptcy developed by Dr Edward Altman (1968)

is a multivariate formula for measurement of the financial health of a company and

a powerful diagnostic tool that forecast the probability of a company enteringbankruptcy within a two year period with a proven accuracy of 75-80%

The Altman’s credit scoring model takes the following form;

Z=1.2X1+ 1.4X2 + 3.3X3 + 0.6X4+1.0X5 (2)

Where, X1 = Working capital/ Total assets ratio

X2 = Retained earnings/ Total assets ratio

X3 = Earnings before interest and taxes/ Total assets ratio

X4 = Market value of equity/ Book value of long-term debt ratio

X5 = Sales/ Total assets ratio

The higher the value of Z, the lower the borrower’s default riskclassification According to Altman’s credit scoring model, any firm with a Z-Scoreless than 1.81 should be considered a high default risk, between 1.81-2.99 anindeterminate default risk, and greater than 2.99 a low default risk

Use of this model is criticized for discriminating only among three borrowerbehaviors; high, indeterminate, and low default risk Secondly, there is no obviouseconomic reason to expect that the weights in the Z-Score model or, more generally,the weights in any credit scoring model will be constant over any but very shortperiods Thirdly the problem is that these models ignore important, hard to quantifyfactors (such as macroeconomic factors) that may play a crucial role in the default

or no-default decision

2.2.5.2. RAROC model

An increasingly popular model used to evaluate the return on a loan to alarge customer is the Risk-Adjusted Return on Capital (RAROC) Model Thismodel, originally pioneered by Bankers Trust (acquired by Deutsche Bank in 1998)

is now adopted by virtually all the large banks in Europe and the US, although withsome differences among them (Saunders and Cornett, 2007) The essential ideabehind RAROC is that rather than evaluating the actual promised annual cash flow

on a loan as a percentage of the amount lent or (ROA), the lenders balance theloan’s expected income against the loan’s expected risk

The RAROC Model is basically represented by:

RAROC = (one year net income on loan)/ (Risk adjusted assets) (3)

For denominator of RAROC, duration approach can be used to estimate worst caseloss in value of the loan:

DLn = - DLn x Ln x (DR/ (1+R)) (4)

Where:

- DR is an estimate of the worst change in credit risk premiums for the loanclass over the past year

2.2.6 Managing credit risks by using financial ratios

Ratio analysis (financial and accounting ratios) is a measurement system toanalyze the strength, weakness, opportunity and threats (SWOT Analysis) of afinancial institution

Table 6: Some of the frequently used ratios in credit analysis

Liquidity Current ratio= Current assets/ Current liabilities

Quick ratio= Quick assets/ Current liabilitiesNet working capital= Current assets= current liabilities)Financial leverage Total debt ratio= (Total assets- Total equity)/ Total assets

Debt-equity ratio =Total debt/ Total equityEquity multiplier Total assets/ Total equityLong term debt ratio= Long term debt/ (Long term debt +Total equity)

Interest coverage ratio= EBIT/ InterestCash coverage ratio = ( EBIT+ Depreciation)/ InterestTurnover Total asset turnover = Total operating revenue/ Total assets

Receivables turnover = Total operating revenue/Receivables

Average collection period= Days in period (360)/Receivables turnover

Inventory turnover= Cost of goods sold/ InventoryDay in inventory= Days in period (360)/ Inventory turnoverProfitability Net profit margin= Net income/ Total operating revenue

Gross profit margin = EBIT/ Total operating revenueROA= net income/ Average total assets or EBIT/ Averagetotal assets

ROE= Net income/ Total equityMarket value P/E= Price per share/ Earnings per share of common stock

Dividend Yield= Dividend per share/ market price pershare

Market-to-Book Value= market price per share/Book valueper share

(Source: Giáo trình “ Ngân hàng thương mại”

CHAPTER 3: HYPOTHESIS TESTING

3.1 Research design and methodology

Analyzing banks’ performance based on financial ratios and a regressionmodel which represents the relationship between ROE (ROA) and Bad debts ratio,and evaluating it relied on the association of 2 ones The process includes:

- Step 1: Predicting the viability of the coefficients and the model will be

applied in the process of analyzing and evaluating data As these ways werepresented in the previous research and teaching curricula, thus they would behighly feasible

- Step 2: Collecting data All data are taken from annual reports, internal

auditing and accounting reports, statements of shareholders of the banks

- Step 3: Testing and selecting data All data were collected from secondary

sources which were audited and therefore should have high accuracy Tofurther ensure them, I have recalculated the figures, and then these aremoved into the research data The figures in this article are only taken in theperiod from 2007 to 2011 of 10 Vietnamese Join – stock commercial banks

as above description

- Step 4: Threading and entering data into the models The data have been

processed and summarized in short tables to help putting it in E-viewsoftware more easily and more accurately After that, the data wereprocessed continuously by E-view software when setting up a linearregression model and tested in parallel with personal computing Allcalculation results are stored in the data of the E-view The calculationformulas or commands are taken from textbooks of econometrics and riskmanagement

- Step 5: Testing results and forming models automatically by E-view

software Combined with the economic theory to make final conclusionsabout the rationality of the results

3.2 Analyzing and data description

3.2.1. Financial criteria

3.2.1.1 Overdue loans

Overdue loans arise when loans become due, but the customer does not repaythe whole or part of principal or interest payments Delinquency is often anexpression of financial weakness of customers or a sign of credit risk for banks Incredit activities of banks, the appearance of overdue loan is inevitable, but if thedelinquency ratio exceeds an allowable number, it will lead to lack the solvency ofthe bank (usual limitation for this ratio from 3% to5%)

Overdue loans ratio = Overdue loans (loans group 2-5)/ Total loans x 100% (5)

Overdue loans ratio reflects the balance of principal and interests wereoverdue but not yet recovered This ratio shows that the how many the currentbalance in 100 lending units has expired Therefore, it is a basic indicator for thecredit quality of the bank High delinquency rate represents for lower credit qualityand vice versa

Table 7: Overdue loans ratios in VJCBs 2007-2011

(Source: Own inquiry, 2012)

As can be seen from the above table, the rate of overdue loans at VJCBs haddifferent changes and various characteristics year by year However, the mostnoticeable thing should be mentioned that is a group of banks (ACB, SCB, EAB), ofwhich the overdue loan ratios were quite low and less than the standard value forbanks (5%) over five consecutive years This partly reflects that the riskmanagement performance of these three banks was implemented well and seriously

in curbing the affects of delinquency to the operation of bank

Several other banks also showed somewhat the fairly complete credit riskmanagement of them such as: CTG, MBB, EIB and VIB where the delinquencyratios were maintained at the safe level below 5% and these figures were only out ofcontrol in the year of economic volatility as 2008 and 2011 (2 years had the average

of overdue loan ratio over 5%: 5.25% and 5:53% respectively)

Besides, there were many limitations existed in the credit risk managementactivities of two major banks (VCB and TCB) that were the high delinquency ratios

over 5 years (always greater than 5%) This is obvious a big question for credit riskmanagement activities of the two banks To conclude, I strongly claim that theprocess of credit risk management in the Vietnamese joint-stock commercial banks

is still limited and the average of overdue loan ratios still stood at high rate in recentyears (greater than 3%) Therefore, if the banks want credit operation to runsmoothly, they must have more effective measures for managing credit risk to makemore positive numbers (less than 3%)

- Overdue loans of less than 10 days

Group 2 (special mentioned) includes:

- Loans being overdue between 10 days to 90 days

- Loans having revised terms of repayments for the first time (if customers areassessed as being capable of repaying both principal and interest according tothe first revised terms of repayments for the case of enterprises andorganizational customers)

Group 3 (sub-standard) includes:

- Loans being overdue between 91 days and 180 days

- Loans having rescheduled terms of repayments for the first time except forthe loans with revised terms of repayments classified into the abovementioned Group 2

- Loans having exempt or reduced interest because customers are not able topay the interest according to contracts

Group 4 (doubtful) includes:

- Loans being overdue between 181 days and 360 days

- Loans having rescheduled terms of repayments for the first time and beingoverdue less than 90 days according to the first rescheduled terms ofrepayments.

- Loans having rescheduled terms of repayments for the second time

Group 5 (Loss) includes:

- Loans being overdue more than 360 days

- Loans having rescheduled terms of repayments for the first time and beingoverdue from 90 days or more according to the first rescheduled terms ofrepayments

- Loans having rescheduled terms of repayments for the second time and beingoverdue according to the second reschedule terms of repayments

- Loans having rescheduled terms of repayments for the third time

- Blocked loans, or loans awaiting for settlements

Non - performance Loan ratio = Loans group 3, 4, 5/ Total loans x 100% (6)

NPL ratio illustrates that how many in 100 units of loan balance consist ofbad debt; hence, it is a basic indicator to evaluate the credit quality of the bank.NPL reflects the difficulties in recovering capital; the bank's capital is no longer atnormal risk level that is a loss risk

As can be seen the table of overdue loan ratio, this rate also gives us a clearview about the credit quality of banks Nonetheless, the results from the abovetable will be more adequate, accurate and people interested than the rate of overduedebts In general, the NPL ratios of banks were controlled successfully;particularly, most of the numbers were lower than 3% (level works well) and only

a few banks have ratios less than 5% in results (level works moderately) (VCB:

2007 and 2008, EIB and EAB: 2008) This ratio was also stabilized over 5 yearswith the average values were less than 3%

This illustrates that the banks are really interested in reducing bad debt incredit activities to allow the flow of capital running smoothly and not to lose alarge amount of capital which affects the banks’ business However, if thesenumbers are compared with the corresponding results in the table of overdue loanratio, the next task of the banks after controlling possibly bad debts (debts group 3,

4, 5) is the debts of group 2 need to attend carefully to avoid the possibility ofspecial mentioned debt turned into bad debt because this risk is very high and easy;

it will affect the business activities in the future

3.2.1.3 Credit profitability

Rate of interest income from credit (P1) = interest income from credit activities/ Total interest income x 100% (7)

In addition to the criteria of overdue, bad debt , the credit quality must bereflected by the ratio of operating profit from credit activities This indicates that in

100 units of bank’s profits has how many units are brought by credit activities.Operating profit from credit proves that loans not only recover the principal but alsohave the interest to secure the loans

Profitability rate of credit activities (P2) = credit profits / total loans x 100% (8)

This indicator reflects the profitability of credit activities, it represents for theamount of interest income on 100 units of the loans balance The higher this rate, the better credit quality is

Table 9: Credit profitability ratios in VJCBs 2007-2011

(Source: Own inquiry, 2012)

It can be seen clearly from the above table that net income from loan andadvances to customers (P1) played an important role for the banks Depending oneach bank, income from credit activities will have different values, but generally,with the Vietnam Commercial Joint Stock Bank, it gave an average of 65-68% oftotal net income of banks and almost unchanged in recent years Furthermore, theprofitability of this activity (P2) also deserves attention In my opinion, in thedifficult economic period (2008 and 2011), it seems that the profitability of loans

for lending of banks would have higher rates than other years (12.19% and 14.27%compared with only 7-10%) Hopefully, in the near future, with more encouragingnumbers will appear the improvement in credit risk management.

3.2.1.4 Capital efficiency

Capital efficiency 1 (H1) = Total loans/ Total mobilizing capital x100% (9)

This indicator reflects the correlation between mobilizing capital and loansand advances to customers Mobilizing capital has low cost (cheaper borrowing)and stabilizes the balance and term, thus the lending capacity of commercial banks

is generally limited by the capacity to mobilize capital If this number is close to100%, it will demonstrate that the balancing ability between mobilizing capital andlending demand for customers is high However, in reality, this number may begreater than 100% or much less than 100% (40-50%) that is caused by the ability ofmobilizing capital or loan demand in the operation area is very low This makes theeffectiveness of bank performance decline due to higher costs for borrowing capital(deficit of mobilizing capital) or low interest for lending ( deficit of credit demands)

Capital efficiency 2 (H2) = Total loans/ Total assets x100% (10)

The H2 criterion demonstrates how many units of every 100 assets units areused to lend directly to customers As credit is mainly profitable item, thus H2criterion is higher, which results in the business activities of banks are moreeffective and vice versa However, if banks use capital for lending in excess ofexpectation, it will be influenced by liquidity risk Conversely, if H2 is too low, itproves that the bank is wasting capital and capital efficiency is not optimal Innormal conditions, H2 criteria of banks fluctuate from 70% -80%

Table 10: Capital efficiency VJCBs 2007-2011

2007 2008 2009 2010 2011 CTG H1=70.52%

ACB H1=47.56% H1=46.37% H1=57.21% H1=47.61% H1=43.75%