Impact of monetary policy on bank’s loan supply bank’s balance sheet approach

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES VIETNAM – NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS IMPACT OF MONETARY POLICY ON THE SUPPLY OF BANK LOAN: BANK’S BALANCE

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM – NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

IMPACT OF MONETARY POLICY ON THE SUPPLY OF BANK LOAN: BANK’S BALANCE SHEET APPROACH

BY

Ms NGUYEN NHU Y

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, DECEMBER 2013

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM – NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

IMPACT OF MONETARY POLICY ON THE SUPPLY OF BANK LOAN: BANK’S BALANCE SHEET APPROACH

The thesis submitted in partial fulfillment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

Ms NGUYEN NHU Y

Academic Supervisor:

DR NGUYEN HOANG BAO

HO CHI MINH, DECEMBER 2013

Thirdly, I would like to express my sincere thanks to Dr Truong Dang Thuy for the econometric guidance and advices

Fourthly, I am very grateful to all lecturers of the Vietnam-Netherlands Programme for giving me knowledge and guidance to fulfill the thesis Besides, I would like to thank all the academic and technical support from the staffs of Vietnam – Netherlands Programme during the course

Finally, I would like to thank my friends and people, who have any help and support for my thesis but are not above-mentioned

ABSTRACT

This study researches the impact of monetary policy onthe supply of bank loan in Vietnam during the period from 2008 to 2012 The impact is examined by using the Generalized Methods of Moments (GMM) approach The estimation results indicate that monetary policy change has negative impact on the supply of bank loan and the magnitude is different among banks Bank characteristics i.e asset size, liquidity, and capitalization depress the negative impact of monetary policy change on the supply of bank loan The purpose of this study is to hope policy maker take into consideration when using monetary policy to regulate the supply of bank loan in the context that different bank react and absorb the monetary transmission differently

Key words: Monetary policy, supply of bank loan, bank characteristics, GMM, Vietnam

LIST OF FIGURES

Figure 2.1: The bank – lending channel mechanism .23

Figure 4.1: Analytical framework .50

Figure 5.1: The correlation among dependent variable and independent variables .55

Figure 5.2: The correlation among independent variables and cross-term variables .56

Figure A.1: Overview of the transmission mechanism (Égert & MacDonald, 2006) .92

LIST OF TABLES

Table 3.1: The short-term three months interbank deposit offer rate from 2008 to 2012 .34

Table 4.1: Variables definition and sources 36

Table 4.2: Expected signs of variables in equation (21) .44

Table 5.1: Summary statistics of the variables used in the regressions .54

Table 5.2: The empirical regression results of GMM estimation .59

Table A.1: The base rate of VND in the year 2008 74

Table A.2: The base rate of VND in the year 2009 75

Table A.3: The base rate of VND in the year 2010 76

Table A.4: The required reserve rate of VND in the year 2008 .77

Table A.5: The required reserve rate of VND in the year 2009 .77

Table A.6: The required reserve rate of VND in the year 2010 .78

Table A.7: The required reserve rate of VND in the year 2011 .78

Table A.8: List of commercial banks .79

Table A.9: Correlation matrix .81

Table A.10: The empirical regression results of GMM estimation .85

Table A 11: Wooldridge test for autocorrelation in panel data .87

Table A 12 : White’s test for Heteroskedasticity in panel data .87

Table A 13 : Test the relevance of instrument varible .87

Table A.14: Summary of empirical literature reviews .88

TABLE OF CONTENTS

CHAPTER 1: INTRODUCTION 9

1.1 Problem statement 9

1.2 Research objective 11

1.3 Research questions 12

1.4 Research methodology 12

1.5 Structure of thesis 13

CHAPTER 2: LITERATURE REVIEW 14

2.1 Theoretical literature 14

2.2 Empirical studies 24

CHAPTER 3: STYLIZED FACT ON VIETNAMESE MONETARY POLICY AND BANKING SYSTEM 28

3.1 Monetary policy system 28

3.1.1 Legal framework 28

3.1.2 Monetary policy strategy 29

3.1.3 Monetary policy instrument 30

3.2 Monetary policy and the supply of bank loan change in the period 2008 – 2012 31

CHAPTER 4: METHODOLOGY, MODEL SPECIFICATION AND DATA RESOURCES 36 4.1 Data and econometric model 36

4.1.1 Data and variables 36

4.1.2 Econometric model 40

4.2 Analytical framework 50

CHAPTER 5: FINDINGS 53

5.1.1 General picture of data for variables of empirical model 53

5.1.2 General relationship among variables 55

5.1.3 Data analysis discussion 58

5.2 Econometric results 59

CHAPTER 6: CONCLUSION 66

6.1 Summarize of methodology 66

6.2 Summarize of major findings 66

6.3 Policy implications 68

6.4 Shortcomings of the study 69

6.5 Suggestions for further study 69

REFERENCES 70

APPENDIX 74

CHAPTER 1: INTRODUCTION

This chapter begins the thesis research by introducing the research topic and states the research problems in terms of social and scientific point of view This chapter also includes research objective which is what the paper intends to study and states the research questions The next part is research methodology, which presents briefly the method will be used in the paper to solve the research objectives and obtains the answers for research questions The final part of this chapter presents the organization

of the thesis

1.1 Problem statement

Banking system plays a significant role in economic development process in Vietnam Banks are considered the capital transmission channel of the economy and its activity covers all economic and social activities Banks are financial intermediaries between savers and borrowers It provides capital for the economy and bridges the companies with market Therefore, it will be an effective tool for government to regulate the economy The government manages the macro-economy by implementing monetary policy, fiscal policy, foreign capital control policy, and trade policy Among the above policies, the study focuses on the monetary policy and its effect on banking system Banking system leads the market through credit operations and payments between commercial banks in the system following the government regulation Thereby, the banking system expands the volume of money supply in circulation by supplying credit

to sectors in the economy and controls them effectively One of the most important functions of banking system is financial intermediary For the economy, this function has an important role in promoting the economic growth by satisfying capital needs for the continuity of production process and production expansion With this function, the

capital,and promotes business growth.The supply of bank loan represents for the financial intermediary function of the bank The amount of the supply of bank loan indicates how much money relatively goes into the economy Theoretically, the loan supply of bank is influenced by several factors as capital input cost, monetary policies, economic situations, loan demand, etc Within the boundary of the study, the impact of monetary policy on loan supply will be solely discussed in detail Understanding the mechanism and factors, which determine the loan supply of a bank has important implications for strength and distributional effects of monetary policy Understanding how monetary policy influent the loan supply also strengthens the link between stabilization and regulatory policy from the government and the state bank of Vietnam

as well as business decision of bankers

B S Bernanke and Blinder (1989)suggested bank intermediation is seen to be especially crucial in a situation of asymmetric information and moral hazard since only bank specializes in monitoring their borrowers Moreover, bonds and bank loans are assumed not perfectly substitute so then many firms would turn into bank dependent Thus, the existence of bank lending channel becomes importance in monetary transmission mechanism In this case, monetary policy affects bank assets and bank liabilities It is not only shift the supply of deposit but also the supply of bank loan The importance thing isthat bank relies on deposit financing and adjustsits loan supply schedules following changes in bank reserves as monetary policy shock In this way, monetary policy shocks change the supply of bank loan.The existence of bank lending channel means that with monetary contraction, banks will cut back their loans supply and weak, undercapitalized bank will responds more than large and well-capitalized banks There are also several empirical studies on the field Kashyap and Stein (1995); Kashyap and Stein (1997) and Kashyap and Stein (2000)analyzed disaggregated data

of banks and find that large banks are better able to neutralize monetary shocks than

small banks Kishan and Opiela (2000) and Alcoforado Farinha and Robalo Marques (2001) found that small and undercapitalized banks are significantly affected by monetary policy Loupias et al (2002) suggested that the effects of monetary shock are more for illiquid banks as compared with liquid banks In order words, bank balance sheet items determine the magnitude of monetary policy shock on the supply of bank loan To clarify those above arguments for the case of Vietnam, this study intend to test the respond of Vietnamese banking systemin the supply of bank loanto the change in monetary policy shock by using the Generalized Methods of Moments (GMM) approach for dynamic panel data model The underlying idea is that adjustment of banks’ credit supply might depend on bank different characteristics

1.2 Research objective

This study intends to estimate the response of the supply of bank loan toward change in monetary policy with the sample of 20 Vietnamese commercial banks within the period from 2008 to 2012 Whether there exist important differences in the magnitude in which Vietnamese banks with varying characteristics in terms of asset size, capitalization, and liquidity respond differently to changes in the stance of monetary policy (the change of short-term interbank deposit offer rates)

Following the main objectives, the study firstly verifies the impact of change in interbank deposit offer rate to the supply of bank loan Secondly, the study tests whether bank asset size, capitalization, and liquidity affect the supply of bank loan Finally, the study examines whether bank asset size, capitalization, and liquidity affect the impact of monetary shocks on the supply of bank loan

1.4 Research methodology

The paper bases on the credit channel approach of B S Bernanke and Blinder (1989);

B Bernanke (1990); B S Bernanke (1993); Kashyap and Stein (1994); Kashyap and Stein (1995); B S Bernanke and Gertler (1995);Kashyap and Stein (2000) and empirical studies about bank lending and the impact of bank characteristics and monetary policy change on the supply of bank loan

The approach of this study is similarly withHernando and Martínez Pagés (2001);Golodniuk (2006) and Gambacorta and Marques‐Ibanez (2011) This study usesdynamic panel data model andcollected data from the balance sheet statement of

20 Vietnamese commercial banks in the periods of five years from 2008 to 2012 There are several advantages of using panel data in banking and finance field As balance sheet data are highly correlated among each other, panel data provides more information on variability, facilitates less collinearity among variables, increases degrees of freedom, and overall can produce better statistical fits In other hand, by controlling for individual heterogeneity, panel data minimizes bias in the results and

are able to explain the dynamics of change in a better way as compared to purely series or purelycross-sectional analysis.According to Anderson and Hsiao (1982) suggestion for suitable econometric approach for dynamic panel data, this study uses Generalized Method of Moments (GMM) with lag two of dependent variable as instrument The econometric approach will be discussed in detail in chapter four as well as demonstrating of the variable anddata

time-1.5 Structure of thesis

The paper is organized as follows.Chapter two provides the base theoretical studiesand link them with existing empirical literatures about bank lending channel.Chapterthree gives some stylized facts about Vietnamese monetary policy and banking system in Vietnam.Chapter foursets out the methodology for the study, describes the model specifications and data sources Chapter five discusses the results of dynamic panel regressions Chapter sixgives the conclusion and policy implication of the finding

CHAPTER 2: LITERATURE REVIEW

This chapter introduces two parts Part onepresents the theoretical literature of bank lending channel, the connection among the supply of bank loan and bank characteristics in the context of changing in monetary policy Part two summarizes the empirical literatures review about the supply of bank loan Based on relevant contents, the testing and resultsare introduced in the chapter four and five

2.1 Theoretical literature

This section introduces the theoretical literature about bank-lending channel The mainstream theory of monetary policy change affects the supply of bank loan, which is this study bases on The literature describes the mechanism of generating bank loan of

a representative bank model and its reaction to change in monetary policy The theory also illustrates the basic components of bank activities and the way each component interact The connection between the monetary policy and the supply of bank loan as well as how bank’s characteristics influence the bank’s response to monetary policy change will be discuss in this section

The conventional interest rate channel consider bank as a passive conduit for fund between the central bank and the economy The monetary policy change only lowers the deposit and the money supply in general The reduction of money supply and the increase of interest rate through tightening monetary policy directly depress the economy activities.Therefore, the reduction of bank loan demand typically results from weak economy

Among other proponents of the credit view, B S Bernanke and Blinder (1989) and B

S Bernanke and Gertler (1995) suggested that the change of aggregate demand of the economy cannot be entirely explained by the movement of interest rate They underline

the role of financial intermediaries and agent costs in monetary policy transmission They add balance sheet channel and bank lending channel into the theoretical discussion of the credit view about monetary policy transmission.Reader can take a look at figure A.1 in appendix for more information about the monetary transmission According to credit view, the monetary shock, which is policy change from the state bank that produces a significant change within an economy, can affect the real economy activities by two dimensions The first dimension is that monetary shock influents the financial position of the borrower firms The higher net worth of firm’s balance sheet, the easierfirm gets financial support from the capital market The second dimension is that monetary shock reduces the external source of fund to firm by reducing the supply of bank loan to bank-dependent firms

B S Bernanke and Blinder (1989) and Kashyap and Stein (1994)indicatedthe asymmetric information problem and adverse selection problem in the balance sheet channel In this channel, firms have few substitute sources of fund beyond bank borrowing so that tightening monetary policy indirectly deteriorate borrower’s balance sheet through the rise in interest rate This deterioration raises the cost of credit intermediation and the requirement of additional collateral.Moreover, asymmetric information problem between bank and borrower also causes a wedge between internal and external cost for firm A reduction of the supply of bank loan directly raises the external finance premium of bank-dependent firms

B S Bernanke and Gertler (1995)describedbank-lending channel as a set of factors that amplify and propagate conventional interest rate.In the bank-lending channel, monetary shock transmits into the economy through adjustment to the asset side of bank’s balance sheet This channel suggests that monetary policy can affect the aggregate demand of the economy not only through the traditional interest rate but also

channel are that bank borrowers must not be able perfectly substitute bank loan with other alternative financial methods and it is costly for bank to use non-reservable financial source of fund like bond and securities to rebalance its asset portfolio after the change in reserve.Moreover, the bank-lending channel also bases on the asymmetric information and agency cost problem between banks and their borrowers, which associated with financial transaction Bank do not have perfect substitute for deposit A tightening monetary policy limits bank access to other form of financial source that do not subject to reserve requirement without cost and theycannot obtain sufficient liquidity through the sale of bond Therefore, a tightening monetary policy draws down the bank money reserve that limit bank to access to loanable fund, which means bank have less money to make loan As the result, the supply of credit falls

The assumptions and mechanism of bank lending channel are presented by B S Bernanke and Blinder (1989) He developed a simple model for bank lending channel

by expanding the conventional IS-LM model to include the loan market and drop the assumption of perfect substitutability between bank loan and bond This simple model becomes a benchmark for future study of monetary transmission in credit view

The two typical way that bank reacts to monetary shock to adjust its net money creation is described by Van Ees et al (1999) The first way is selling securities in domestic capital market or issuing long-term liabilities like bond The second way is changing domestic loan supply In the two typical way that Van Ees et al (1999) suggested, B S Bernanke and Blinder (1989) and B S Bernanke and Gertler (1995) emphasized the imperfect substitution between bank loan and bond in the context that tightening monetary policy reduce the aggregate demand of the economy and the bank money reserve drain out of the system When deposit fall, the need for alternative source of fund for maintaining the level of loan arise In the case that the alternative

financial source of fund is scare or limited, the only solution for bank is reducing the supply of loan

Moreover, there are two main conditions for the bank-lending channel to operate The first condition is that some firms must be dependent on bank loan Van den Heuvel (2002) and Christiano (2005) suggested that small firms are bank dependent Bank has comparative advantage in obtaining information about customers at lower cost in compare with investors Small firms have limited access to capital market They do not satisfy the required regulationto issue securities on stock market to mobilize capital This problem especially crucial in country has underdeveloped capital market The second condition is that the central bank must be able to shift bank’s loan supply schedules In this context, B S Bernanke and Gertler (1995) pressed the financial market imperfections problem to bank reaction toward monetary shocks The asymmetric information makes it difficult and costly for bank to raise funds by other financial instrument rather than deposits When the central bank drains out money reserve from the economy through tightening monetary policy, it raises the opportunity cost of holding deposit In this context, bank has to alter deposit by other financial instrument, which is typically expensive and risky It raises the cost of loanable fund and force bank to curtail the supply of bank loan.B S Bernanke and Gertler (1995) also found that tightening monetary policy force bank to shed their deposit on the liabilities side of bank balance sheet and sell securities on the asset side in short term periods Over some periods, bank gradually rebuild its securities portfolio and reduce loan along with a decline in real economy activities In other word, reduction of the supply of bank loan results from the fall of demand for bank loan from a weak economy

Bank specific characteristics accentuate the asymmetric information and agency cost

Kashyap and Stein (1995); Kashyap and Stein (2000); Kishan and Opiela (2000); Westerlund (2003); Alfaro et al (2003); Gambacorta and Mistrulli (2004); Bichsel and Perrez (2005) andEzema (2009) suggested that small banks find it hard to raise fund and have to reduce their loan supply more than large bank in the periods of tightening monetary policy Other aspect is the liquidity standing of bank.Kashyap and Stein (2000);Alfaro et al (2003); ; Gambacorta and Mistrulli (2004); Gómez-Gonzalez and Grosz (2007) and Ezema (2009)suggested that liquid bank can draw down their liquidity assets to shield its loan portfolio in the period of tightening monetary policy Another aspect is bank’s capitalization level B S Bernanke and Gertler (1995); Kishan and Opiela (2000); Altunbaş et al (2002);Van den Heuvel (2002); Westerlund (2003); Alfaro et al (2003);Gambacorta and Mistrulli (2004); Bichsel and Perrez (2005); Golodniuk (2006);Gómez-Gonzalez and Grosz (2007) andGambacorta and Marques‐Ibanez (2011)suggested that bank with bigger capital to asset ratio is regarded

as being less risky Less capitalized banks find it more costly to access external finance

in compare with well-capitalized banks

The credit approach suffers the identification problem or so-called simultaneity problem Tightening monetary policy reduces the bank deposit and drainsout the supply of loan due to the effect of high interest rate on the aggregate demand The difficulty is distinguishing the shift in loan supply between demand side and supply side On the supply side, a tightening monetary policy causes bank deposit fall The loanable funds of bank reduce so bank has to shield its loan supply On the demand side, a tightening monetary policy cause interest rate increase and reduce investment in the economy In the context of low growth of real economic activities, the demand for loan from firms falls Therefore, bank reduces itsthe supply of bank loan To overcome this problem, researcher focus on cross section data or so-called bank – level data to capture asymmetric in loan supply behavior by examining the reduced form equation

linking bank loans to monetary policy measures Several previous studies such as Kishan and Opiela (2000); Altunbaş et al (2002); Westerlund (2003); Alfaro et al (2003); Golodniuk (2006); Kashyap and Stein (2000); Gambacorta and Mistrulli (2004); Kashyap and Stein (1994); Brissimis and Delis (2009); Bichsel and Perrez (2005); Ezema (2009); etc useddisaggregate data on bank balance sheet for their study about the supply of bank loanto disentangle demand from supply side effects to prevent

a proper identification of the bank lending channel

Bank lending channel emphasizes the role of changes in banks’ balance sheet items, i.e., in deposits and loans as conduits for monetary policy transmission B S Bernanke (1983) denoted that when federal funds rate increase, tightening monetary policy downsize the bank activities and decrease the level of loan supply

M ↓ ⇒ (Bank Deposits) ↓ ⇒ (Bank Loans) ↓

According to B S Bernanke and Gertler (1995), bond and loans are not perfectly substitute and banks are not able to offset the decrease in deposits from the monetary shock Tightening monetary policy as raising the reserve requirement and reduce bank’s core deposit base forces banks raise funds from other sources than deposit base finance This reaction will increase the relative cost of bank’s fund and push the bank reduce the supply of loans after the fall in reserves by the monetary shock as B S Bernanke and Blinder (1989) and B S Bernanke and Gertler (1995) suggestion

In addition, Kashyap and Stein (1994) mentioned about bank’s behavior toward change

in monetary policy in their paper In the case that tightening monetary policy raise the bank’s reserve requirement and reduce bank’s deposit core finance, the bank may offset the reduction of funding by selling T-bills or raise non-deposit financing, i.e., long term debt, certificate of deposits, equity, etc or cutting back their loans However,

opportunity cost when holding too much T-bill that yield lower return than loans The bank may also borrow money from public by issuing its own debt certificate but this is problematic for small banks due to asymmetric information In the end, they concluded that average bank would cut back their loans in respond to monetary shock The strong and well-capitalized banks may respond less to policy change by raising external finance Pandit et al (2006) also strengthen this argument The study tests the lending behavior between small and big bank under the asymmetric information assumption They estimate the loan supply function of a panel data from 57 banks in India from

1996 to 2002 They conclude that the different characteristics the banks are the different lending behavior of big and small banks in respond to monetary shock Small banks are more sensitive to policy change than big banks

Following Kashyap and Stein (1995), Kishan and Opiela (2000)present a representative bank model in their study The model, which is modified from J Peek and E Rosengren (1995)is used to demonstrate the bank structure and its behavior toward monetary policy change The model present three typical bank’s assets as required reserve (RR), securities (SEC), and loans (LN); and three liabilities as demand deposits (DD), large time deposits (TD), and capital (K) Then the balance sheet will be:

The demand deposits (DD)are theoretically inversely related to market interest rate, i.e., the federal fund rate (𝑟𝐹𝐹) Bank customers will shift to interest paying asset instead of holding demand deposits when the market interest rate increases Bank is also assumed to hold market power in large time deposits (TD) market that they can control the TD amount by changing its rate (𝑟𝑇𝐷) in comparison with the market mean rate (𝑟̅𝑇𝐷) The bank may raise its TD by raising its rate above the market rate

DD = 𝑎 0 - (𝑎 1) 𝑟𝐹𝐹 (2)

The required reserve (RR) is an amount of money that bank hold as a fraction of demand deposit (DD) as regulations SEC as securities are a fixed proportion of demand deposit DD Bank loan market is assumed imperfectly competitive Each bank may raise its loans by setting their loan rate below the mean market rate (𝑟̅𝐿𝑁)

on securities, minus interest rate paid for demand deposit and term deposits Equation (10) is maximized with respect to time deposit (TD) after eliminating RR, DD, LN, SEC,𝑟𝐷𝐷, and𝑟𝐿𝑁 and first order condition are solve for TD The same process is used

find it hard to raise time deposit (TD) and more sensitive to policy change than large and well-capitalized bank To test these hypotheses, we take the derivative of LN, TD and SEC equation with respect to the federal fund rate

of big firms with respect to loan rate is elastic than small firms

Substitute (14), (15) into (11), (12), then take derivative with respect to assets and capital:

𝜕[𝜕𝐿𝑁/𝜕𝑟𝐹𝐹]/𝜕[𝐴] = 𝜕[𝜕𝑇𝐷/𝜕𝑟𝐹𝐹]/𝜕[𝐴]

=[𝑎1(1 − 𝑐1)(𝑏1𝛿1− 𝑑1𝛽1)]/[𝑏1+ 𝑑1]2 ≤≥ 0 (16)

𝜕[𝜕𝐿𝑁/𝜕𝑟𝐹𝐹]/𝜕[𝐾] = 𝜕[𝜕𝑇𝐷/𝜕𝑟𝐹𝐹]/𝜕[𝐾]= [𝑎1𝑑1𝛽2(1 − 𝑐1)]/[𝑏1+ 𝑑1]2> 0 (17) The net effect of bank assets size on the changing of loan (LN) and time deposit (TD)

to monetary policy change is indeterminate Because large and well capitalized bank may easily raise funds and use these funds to grant loans under commitment They can continue to disburse for commitment loans and may meet the new loans demand with acceptable cost Thus, they are less sensitivity to tightening monetary policy than small bank In other hand, they also lose loan when the interest rate rise as it reduce or constrain the loan demand by increasing the cost of borrowing and effectively reduce its attractiveness Besides, the capitalization of a bank has positive effect on the bank loans supply to the change in fed fund rate The more well capitalized the banks are, the more positive the 𝜕𝐿𝑁/𝜕𝑟𝐹𝐹 becomes

The representative bank model discuss above can be graph as below:

Figure 2.1: The bank – lending channel mechanism

Market interest rate (𝑟̅𝐿𝑁)

Bank’s balance sheet

Bank’s asset side Bank’s liability side

Source: A representative bank model by J Peek and E S Rosengren (1995)

The figure 2.1 indicates that the adjustment in monetary policy change the market interest rate The change in market interest rate affects the bank balance sheet items in both assets and liabilities side In the liabilities side, market interest rate have directly negative effect on demand deposit (DD) and directly positive effect on time deposit (TD) as people switch to interest paying assets when market interest rate increase Moreover, market interest rate also has direct negative effect on the supply of bank loan (LN) This negative effect come from both supply side and demand side of monetary policy on loan supply as discuss in the identifications problem of credit channel Neither the reduction of loan supply comes from weak loan demand from firms or the decrease in supply of loan from banks Besides the direct effects of change

in market interest rate on bank balance sheet items, there are also some indirect effects The time deposit (TD) and capital (K) have positive effect on loan (LN) The hypothesis describe in equation (11) and (17) indicate that monetary policy have negative effect on loans and the bank capital reduce the magnitude of the effect Moreover, hypothesis mentioned in equation (12) and (17) indicate that policy increase the time deposit (TD) and the loan supply is depend on the bank ability to raise alternative funds Besides, the equation (16) indicates that the impact of asset side on loan supply is indeterminate

2.2 Empirical studies

This section presents the previous empirical studies about the reaction of the supply of bank loanto monetary policy change Each empirical literature review contains its researching countries and periods, methodology, and empirical findings There are many studies of the supply of bank loanon the field However, the most significant and

relevant to this study will be collected and present in this section.In order to give the reader a brief look about credit channel approach, which discuss on the theoretical literature section, a table summarizes the previous empirical literatures review about the interaction between the supply of bank loan and bank characteristics is presented There are several empirical studies about the supply of bank loan reaction toward monetary policy change on the fields Kishan and Opiela (2000) employed the quarterly data of 13,042 US commercial banks from 1980:1 to 1995:4 to test for the shift in supply of bank loan According to bank asset size and capital leverage ratio, the study divides banks into six assets categories and three capital adequacy groups The author using OLS to regress the growth rate of loans on its lagged values, change in the federal fund rate lagged values, current growth in term deposit and securities as a control for loan demand movement, GDP, and seasonal dummy variables They found that monetary policy change significantly influences the loan growth of small and undercapitalized banks Small banks are unable to raise fund to finance loans during the tightening monetary policy

Altunbaş et al (2002) applied the same methodology approach as Kashyap and Stein (1994), De Bondt (1998) and Kishan and Opiela (2000) to investigate the bank lending channel of 11 European Monetary Union countries and the banking system of Germany, France, Italy, and Spain from 1991 to 1999 The study using random effect panel data estimator to regress the growth of supply of bank loan on its lagged valued, short-term money market values and its lagged, bank securities values and its lagged, interbank deposit growth rate value and its lagged, GDP growth rate and its lagged The author also estimate the same model for deposit, securities and interbank borrowing to find out which balance sheet items will be affected by monetary policy They found that in the case of European Monetary Union, undercapitalized banks no

matter what size, they tend to react more to policy change There are banking channel only for Italy and Spain in the case of four individual countries testing

Westerlund (2003)also use the same approach to test the hypothesis that monetary policy may change the supply of bank loan for the case of 12 Swedish banks from 1998:M1 to 2003:M6 The study using the Autoregressive distributed lag to regress the growth rate of loans on its lag value, change in monetary policy instrument, bank balance sheet variables, certificate of deposit, and securities as a proxy to capture the loan demand movement The study yieldssimilar results with those mentions above Small and undercapitalized banks are sensitive and strongly react to monetary policy change Another empirical study that using the same approach to test the respond of supply of bank loan to monetary policy change is Alfaro et al (2003) The study use the same methodology with Westerlund (2003) The difference is that Westerlund (2003) used certificate of deposit and securities holding to capture the loan demand movement and Alfaro et al (2003) used annual GDP growth and depreciation of the real exchange rate as loan demand control variable The study found that small, less liquid and less capitalized banks have to compress their loan supply during the period

of monetary policy shock

Golodniuk (2006) using Generalized Methods of Moments procedure to estimate a model likely the same with Westerlund (2003) for 149 Ukrainian banks from 1998 to

2003 The study segregates banks by theirs asset size, capitalization, and liquidity to test whether lending responses differ depending on the strength of a bank The paper concludes that undercapitalized bank face serious problem in maintaining the supply of bank loan in tightening monetary policy period In addition, liquidity standing is likely not importance in the explaining the respond of supply of bank loans to policy change

in this case

To summarize, this literature chapter suggests that the response of banks to monetary policy change through bank lending channel is different among banks The differences depend on their individual characteristics such as assets size, liquidity standing, and capitalization The monetary change has negative impact on the supply of bank loan However, banks with more assets and/or high liquidity ratio and/or high capitalization are less affected then others.The consensus is that these characteristics help to identify the effect of monetary policy change on the supply of bank loan between the supply side of bank lending channel and the demand side of interest rate channel Readers may find more information about empirical reviews in table A.14 in Appendix section

CHAPTER 3: STYLIZED FACT ON VIETNAMESE MONETARY POLICY AND BANKING SYSTEM

This chapter describes the Vietnamese monetary policy system, which include the legal framework, monetary policy, and monetary policy instrument This chapter also summarizes the Vietnamese monetary policy change in the period from 2008 to 2012 and gives some stylized fact on Vietnamese banking system The summarizing and describing section also contain comments on the impact of changesin monetary policy

on the banking system in the context of concerned variable

3.1 Monetary policy system

3.1.1 Legal framework

The financial sector reform in the late 1980s in Vietnam converted the mono-bank system to a two-tier banking system with the state bank of Vietnam being the central bank, four large state-owned commercial banks, one small state-owned commercial banks, thirty-six joint stock banks and an extensive system of people’s credit funds The Vietnamese banking system is dominated by four large state-owned commercial banks that account for 74% of total credit in 2004 Around 23-26% of state-owned commercial bank loan portfolio allocates to the agriculture aqua-cultural, 16-22% of total loan allocate to trade, and services sector with 60% were short-term credit The credit markets continue to be segmented as regulatory frameworks have been designed

to favor the state-owned commercial banks Government regards state-owned commercial banks as the key channel to fund state-owned enterprises, which is considered as the key engine for economic development in Vietnam In 2004, the largest share of state-owned commercial banks’ loan portfolio is lending to state-owned enterprises that make up 32% of their total loans Meanwhile, the joint stock banks and

other small banks serve the domestic private sectors In 2004, the joint stock banks account for 27% of total credit that 4% lend to state-owned enterprise and 23% lend to no-state owned sectors

The “Law on the State Bank of Vietnam”, which enacted in 1996 and amended in

2003, formed the state bank’s legal framework According to the law, the state bank of Vietnam is a government agency and the central bank of the Socialist Republic of Vietnam The state bank of Vietnam conducts the state management over the monetary and banking activities Its responsibility is stabilizing the value of the currency, safeguarding banking activities, and banking system within the context of the country’s social orientation According to the law, the instrument independence of state bank of Vietnam over monetary policy is limited The state bank of Vietnam operates more like

a government department rather than an independent central bank The law regards monetary policy as the responsibility of the National Assembly and the government The state bank of Vietnam has little control over the monetary policy As the result, the accountability for the management and supervision of the banking sector is confused due to the lack of operational independence of the state bank of Vietnam vis-à-vis other state bodies The National Assembly not only sets up the monetary policy include annual rate of expected inflation, credit, and money growth but also supervise the implementation of the policy In the case of Vietnam financial system situation and financial sector reform process, underdeveloped financial market limit the effectiveness of monetary transmission through interest rate and the bank lending is seen as a principal and better channel of the monetary transitions

3.1.2 Monetary policy strategy

The Vietnamese monetary policy follows the five-year plan on the Social and

Communist Party The state bank of Vietnam is in charge of formulating the action plan for the banking sector Normally, the state bank of Vietnam conduct two main component of the monetary policy strategy as an annual target for the depreciation of the dong and targets for total liquidity (M2) and credit to the economy In the case, a country just can pursue two of the following options: fixed exchange rates, domestic monetary autonomy, and capital mobility In addition, dollarization situation makes the scope for independent monetary policy in a fixed exchange rate regime become limit

3.1.3 Monetary policy instrument

Indirect monetary policy instruments have been used since the financial sector reform includes reserve requirement, refinancing and discount lending facilities, open market operation and foreign exchange intervention Reserve requirements are classified base

on the maturity of deposit, the favor economic sector of bank and the dominated currency deposit Reserve requirement for longer deposit period is lower than short period and lower for bank that serving the agriculture sector and for people’s credit funds Refinancing and discount lending facilities take form of an outright purchase of securities and repurchase agreement The discount rate is the lower rate and the refinancing rate is the upper rate for lending from the state bank of Vietnam These facilities are collateralized and are channel for commercial banks access to fund subject

to quotas Open market operations are instrument for controlling liquidity that takes form of outright sales and purchases of securities or repurchase agreement Eligible securities are government securities, state bank bills, or state bank of Vietnam’s selected securities In the situation of Vietnam, that financial market is thinness and segmented, the government and the state bank of Vietnam believe that indirect monetary instruments are not enough sufficient to control inflation They believe that inflation is driven by supply shock and other measures need to be used The state bank

of Vietnam uses the base interest rate as reference rates to affect interest rate and the

administrative instrument to control prices The base rate is regarded as the basic for determination by credit institutions of the lending interest rate in Vietnam dong and market participation take change in base rate as a signal of change in commercial bank lending rate

3.2 Monetary policy and the supply of bank loanchange in the period 2008 – 2012

In the period from January 2007 to August 2008, inflation rise continuously, peaking at 28.3% in August 2008 The high inflation record during this period is not entirely due

to the impact of international economic integration but the inflationary pressures from the previous year, when Vietnam priority objectives of economic growth and implement macroeconomic policies towards expansion In the first haft of 2008, the primary target for the economy is the inflation curbing In February 2008, the state bank of Vietnam increases the reserve requirement ratio by 1 percentage point to all term and both local and foreign currency They also expand the reserve requirement on deposits term within 24 months or more In March 2008, the state bank of Vietnam issues VND 20.300 billion of compulsory state bank of Vietnam bills with 364-day maturity at 8% Alongside with tightening monetary policy, the state bank of Vietnam also increase yearly base rate, refinancing rate, discount rate, and yearly interbank overnight rate The base rate has been increased from 8.25%/year to 12-14%/year, discount rate of 4.5%/year to 11-13%/year and interbank overnight rate of 10.8%/year

to 15%/year In early 2008, the VND mobilizing rate increase rapidly and the highest rate reach 13.8% per annum The interbank rate also rises due to the shortage of liquidity of credit institutions After the state bank of Vietnam Governor's Decision No 16/2008/QĐ - NHNN dated 16 May 2008 on regulatory mechanism of VND deposit base interest rate and the state bank of Vietnam Governor's Decision No 1098/QĐ - NHNN dated 16 May 2008 setting the applicable VND deposit base interest rate from

the interest rate and reserve requirement increases the relative cost of bank’s fund and push the bank reduce the supply of loans after the fall in reserves by the monetary shock In the respond of tightening monetary policy, the loan outstanding of the whole banking sector in 2008 increase by 25.43% muchlower than the growth rate of 53.89%

in 2007 The growth rate of credit decrease significantly in 2008 compared with 2007

In 2009, inflation rate declines The average consumer price index in 2009 compared to

2008 increased by 6.88% much lower than the increase in 2008 From September 2009

to December 2009, come along with the impact of the stimulus measures by the government, the recovery of world prices, and the rising of VND/USD exchange rate, inflation index over the same period has increased again Come along with the loose monetary policy, the fund mobilizing of banking system increase of 29.88% much higher than the rate in 2008 The total loan outstanding of the banking system increases

by 37.53% due to the effect of stimulus policies In the first two months of the year, credit growth is low as follow the tendency of 2008 From March to September 2009,

as the result of stimulus policies and interest rate support from Government's, the credit growths hike up Following a loose monetary policy, the interest rate is lower and supply of bank loan increase The reaction of the supply of bank loan in the first two observed year is totally support the bank lending channel mechanism of B S Bernanke and Gertler (1995)

In the period from September 2010 to December 2011, the inflation hike up to 11.8% compared to December 2009 and reach 18.1% in December 2011 In the first 4 months

of the year 2010, the interest rate volatility is high due to the upward adjustment of the base rate and restricting the money supply from the state bank of Vietnam The interest rates in 2010 drop significantly compared to 2009 VND mobilizing interest rate and lending rate decrease around 1% per annum and VND lending interest rate drop about 1.3% per annum compared to 2009 In the two last months of the year, the capital

demand for consumption and investment of the economy increase lead to an increase of the lending rate, deposit rate and interbank money market rate Continuously, in 2011, according to the tightening monetary policy from state bank of Vietnam, the mobilizing interest rate and lending rate hike up during the first haft year In the end of June 2011, the average VND mobilizing interest rate was 15.6% per annum compare to 12.44% per annum in late 2010 The VND lending rate continues to increase due to rising funding costs and tightening monetary policy From September 2011, most of the commercial banks strictly implement the interest rate ceiling from the state bank of Vietnam (14%/year for term from 1 month or more, 6%/year for demand deposit and less than 1 month) An increasing in market interest rate slow down the growth rate of bank loan (B S Bernanke & Gertler, 1995) Total credit growth in the first four months grow slowly but start to increase in May 2010 due to the fall of interest rate by the Governor’s Resolution No.18/NQ-CP dated 20/04/2009 In September 2010, total credits of the banking system reach 31.19%, which lower than the rate 37.53% in 2009 During the two year 2010 and 2011, state bank of Vietnam applied tightening monetary policy to curb inflation In 2011, investment activities for economic development slowdown in all credit institutions even commercial banks Total mobilizing fund increases by 12.4%, which much lower than the rate in 2010 By composition, the share of state-owned commercial banks decrease and the share of other credit institutions increase sharply

In conditions of slow economic growth and low inflation rate in early 2012, state bank

of Vietnam has driven down the deposit and lending interest rates The key interest rates of the central bank are operating under the mechanism: "ceiling" is the refinancing rate and the "floor" is the discount rate, the amplitude + / - 2 % for market regulation Compared to the end of 2011, deposit rate with maturities of less than 12 months reduce from 14%/year to 8%/year The lending rate for agriculture, export,

industry, small and medium enterprise is 11-12%/year and other is 14-17%/year Total mobilizing fund increases by 12.4%, which much lower than in 2010 By composition, the share of state-owned commercial banks decrease and the share of other credit institutions increase sharply In 2012, the general interest rate is quite low but the total banks’ loan outstanding just slightly increase by 1.51% compared to 2011and there are sixty-nine banks have negative credit growth

The changing of the supply of bank loan from 2008 to 2012 as discuss above is significantly related to the mechanism of B S Bernanke and Gertler (1995) Tightening monetary policy as raising the interest rate and reserve requirement increase the relative cost of bank’s fund and push the bank reduce the supply of loans after the fall in reserves by the monetary shock and vice versa for loose monetary policy The impact of those monetary policy adjustment influence loan supply of the banking system Typically, raising market interest rate i.e base rate or interbank rate reduces the loan supply of banks and vice versa The mechanism of changing in market rate influence the bank balance sheet items is the same as discuss in figure 2.1 in chapter 2 Table 3.1 below describes each period of monetary policy change by year and the following fluctuation of the short-term three months interbank rate (Vnibor) The rate

is considered as instrument for monetary policy change by B Bernanke (1990)

Table 3.1: The short-term three months interbank deposit offer rate from 2008 to 2012

Monetary policy Tightening Loosening Tightening Tightening Loosening Vnibor

(% per annual) 17.31% 8.78% 11.74% 17.63% 10.05% Source: Global financial data, Ho Chi Minh City securities company (HSC)

The initial analysis about Vietnamese monetary policy and its impact on loan supply of the banking system gives reader a brief look at the interaction between market interest rate and the supply of bank loan The relationship is negative and significant for Vietnamese economy The next chapter presents more about the change in the supply

of bank loan of the Vietnamese banking system in the context of modeling and regressing the econometric model on the data of 20 Vietnamese commercial banks in the period from 2008 to 2012

CHAPTER 4: METHODOLOGY, MODEL SPECIFICATION AND DATA RESOURCES

This chapter includes two parts Part one is that the data and econometric model This part demonstrates the data, introduces the model and econometric approach, and gives comments about the variable generally Part two graphs the analytical framework which describe the relationship and connection among independent variable and dependent variables

4.1 Data and econometric model

4.1.1 Data and variables

The study uses the data of bank balance sheet from 20 Vietnamese commercial banks period from 2008 to 2012 The data was directly collected and calculated from each bank balance sheet statements List of commercial banks can be found in table A.8 in appendix section

Table 4.1: Variables definition and sources

balance sheet statement

ln𝐿𝑂𝐴𝑁𝑖𝑡(-1) One period lag of total loan of bank i in year t

Ln 𝐴𝑆𝑆𝐸𝑇𝑖𝑡 Total asset size of bank i in year t

Ln 𝐿𝐼𝑄𝑈𝐼𝐷𝐼𝑇𝑌𝑖𝑡 The liquidity ratio of bank i in year t

Ln 𝐾𝐴𝑖𝑡 Capitalization ratio of bank i in year t

ln𝑇𝐸𝑅𝑀 𝐷𝐸𝑃𝑂𝑆𝐼𝑇𝑖𝑡 Total term deposit of bank i in year t

Typically, the original figures on bank balance sheet cannot be imported directly into the model In order to satisfy the requirement of economic significant meaning of the model, each variable is chosen and calculated as follow The total loan is calculated as the bank total loans exclude provision for credit losses This is the original total amount

of loan, which banks loan out to customers in particular year This total number does not account for future credit loss and the total loan present for the volume of the supply

of bank loan The reason is that the way bank provisions for credit loss depend on how that bank defines risk Each bank has its own view on risk besides the regulator from the state bank of Vietnam Therefore, the data of total loan variable will reflect faithfully the supply of bank loan

The next variable is liquidity ratio of a bank Liquid assets for calculating the liquidity ratio of the bank include cash on hand and balance with the state bank of Vietnam plus balances and loans to other credit institutions Liquid asset is an asset that can be converted into cash quickly They have an established market, relative ease in transfer

ln

𝐼𝑁𝑇𝐸𝑅𝐵𝐴𝑁𝐾 𝐵𝑂𝑅𝑅𝑂𝑊𝑖𝑡

The interbank borrowing amount of bank i in year t

ln𝑖𝑡 Annualized, average weighted, short-term

(three month) SBV interbank deposit offered rate as measure of monetary policy shock – B

Bernanke (1990)

Global financial data, Ho Chi Minh city securities company (HSC)

assets to total assets The liquidity ratios calculate bank’s ability to pay off its term debt obligations The higher the rate, the better the bank manage its short-term obligations However, the more the liquid asset the bank holds the less profit the bank makes In reality, most of bank keeps this ratio at the regulation level as the margin of safety that the banks possess to cover short-term debts in an emergency

short-The interbank borrowingvariable using in the equation is equal to a borrowing amount due to the government and the state bank of Vietnam plus borrowings from other credit institutions Banks use interbank loans to cover liquidity requirement from the state bank in short-term periods Banks can borrow money from the state bank or other banks in the banking system

The asset size variable is the total asset of bank In accounting term, the total asset of bank includes liquid assets, trading and investment securities, loan, long-term investment, fixed assets and other assets

Capitalization ratio is calculated as the ratio of bank total capital to bank total asset Bank capital for calculating the capitalization of the bank is the total shareholder’s equity The total shareholder’s equity simply equals the total assets minus total liabilities In the case, some bank balance sheet statements do not present it separately then the way to calculate the figure equals to total liabilities and shareholders’ equity minus total liabilities and minority interest Shareholders' equity represents the amount

by which a company is financed through common and preferred stocks Shareholder’s equity includes capital, reserves, and retained profit, which is known as tier one capital

or core capital.The original source of shareholder’s equity is the capital which money was originally invested in the company Remain sources largely come from retained earnings, which accumulate over time through its operation In the second way to calculate the shareholder’s equity, the reason why the minority interest is excluded is that banks usually not only run its own businesses but also invest in other banks,

companies, and its subsidiary In accounting term, minority interest presents the ownership of bank to other institutions that banks invest The benefit from this investment is dividend received and minority passive position or net assets of a subsidiary attributable to shareholder’s equity

In other way, capitalization is the total value of bank’s share on stock exchange known

as market capitalization The capitalization ratio measures the debt component of the bank’s capital structure This ratio delivers the key insight into bank’s use of leverage

In this study, the capitalization is a ratio of tier one capital and total risk-weighted assets, which is known as tier one capital ratio This ratio presents the equivalence between bank core capital and total risk-weighted assets The level of bank capital adequacy is graded by the capitalization ratio follow the ranking as well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized.Kishan and Opiela (2000)pressed the important role of bank core capital in their study The bank core capital affects bank’s external rating as discuss above and provides signal about investors’ creditworthiness Moreover, raising fund from non-reservable funding i.e bonds or certificate of deposit is costly especially for low-capitalized banks Low-capitalized banks have less capacity to shield the credit relationship and are perceived as more risky by the market Van den Heuvel (2001)emphasized that low-capitalized banks forgo lending opportunities to lower the risk of capital inadequacy despite their capital are greater than regulatory capital requirement In this case, the bank capitalization influences the loan supply reaction to output shocks

The term deposit variable includes all kind of term deposit and saving A deposit held

at bank has a fixed term Term deposits are considered extremely safe for investor and highly stable for the banks The investors can get higher rate compared with demand

variable does not distinguish among different term of the term deposit due to the lack

of data It accounts for the general term deposit at the bank so that the variable may not delivery every different effect of each term deposit to the supply of bank loan

The last variable is the Vietnamese interbank deposit offer rate which is the rate of interest charged on short- term loans made between banks on the Vietnamese wholesale money market or interbank market In order words, the rate is the price of interbank borrowing to banks

All the data for variables in the equation (21) come from 20-selected bank’s balance sheet statements All statements are public and audited versions However, the three - month interbank deposit offer rate is not perfectly completed In 2008, the data from the beginning of the year to July 01 is missing For the year 2009, data from the beginning of the year to May 18 is missing The data from April 04, 2010 to the end of the year is missing Although the data of interbank rate from three year above are missing but the fluctuation of the rate during the year is not significant and not seriouslyaffect the average figure calculated for the year

4.1.2 Econometric model

This section presents the empirical model which is employed to answer the research questions mentioned in the first chapter The study intends to test the hypotheses that strong and weak banks react differently to change in monetary policy from the representative bank model in J Peek and E S Rosengren (1995); following by Kashyap and Stein (1995); and modifying by Kishan and Opiela (2000) The theory indicates that well capitalized and liquid bank will be less sensitive to monetary policy change However, the net effect of bank assets size to the supply of bank loan is indeterminate In reality, banks are different from each other at various aspects Each