bank risk management liquidity risk management in vietnam commercial banks

Out of the many risks that commercial banks have to face, liquidity risk might be the most specific risk and have huge impact on the bank’s performance.. DEFINITION For commercial banks,

I RATIONALE OF STUDY

Evidently, commercial bank is very crucial to every country’s economic growth In recent years, Vietnam commercial bank has succeeded in fighting inflation, securing monetary stability, boosting economic growth, etc.However, in the trend of economic integration, commercial banks

in Vietnam are facing more and more risk due to the fierce competition of other foreign credit institution Hence, the bank’s risk management is becoming more and more important and

requires immediate attention from commercial bank’s managers as well as bank’s operator Out of the many risks that commercial banks have to face, liquidity risk might be the most specific risk and have huge impact on the bank’s performance

II STRUCTURE OF STUDY

This report will consist of 3 parts: Literature review, Findings and analyses of liquidity risk and liquidity risk management and finally reach the conclusion and giving some recommendations for the concern

Due to the limited time and resources, the research might have many shortcomings, so we are looking forward to Dr Nguyen Thu Thuy’s comments and recommendations to be able to

improve our knowledge and skills for further research

B LITERATURE REVIEW

I DEFINITION

For commercial banks, liquidity risk is very typical, the reason is that the vast majority of bank capital is mobilized capital that can be withdrawn before maturity date Liquidity risk happens when the changes in secondary market become a problem for the transformation of the bank’s asset into cash to meet financial demands and this can be caused by the increase in the cost or time

of the transactions The loss that the bank has to suffer is the additional cost for finding other sources of fund If the bank cannot make immediate payments, it will lead to the decrease in the number of depositors or even worse, bankruptcy Lending is the primary investment activity of the bank so as a financial intermediary, it needs to maintain its ability to make payment or in other words, maintain its liquidity

We would like to list some detailed examples of liquidity risk:

+ In the 1970s, the commercial banks in developed countries lended hundreds of billions

of dollars to developing countries In the 1980s, those loans became insolvent Debt crisis took place in many countries, especially Latin America Consequently, many of those banks were unable to pay the depositors, suffered losses and then went out of business

+ In the 1990s, Japanese securities firms were in a dilemma due to the collapse of real-estate market and security market The commercial banks that supplied funds for those firms could not reclaim the loan and pay the depositors During the same period, some credit unions suffered losses and caused bank run, which led to continuous collapses

II CHARACTERISTICS

Liquidity risk is the most typical risk faced by commercial banks There are three main

reasons:

+ The capital the banks raise has high degree of liquidity The main source of bank’s capital is from call deposit The withdrawal date and the amount to withdraw can be an obstacle in banking’s management

+ The bank’s asset usually has lower degree of liquidity than the bank’s liabilities The asset of the bank comes from loans The quantity and due date are usually agreed and fixed in credit contracts and it is very rare for the bank to receive the payment before the due date

Moreover, if the customers are in need of capital and their projects are workable, the banks will make loans When an immediate demand for cash arises, the banks usually have to bid their asset The asset with higher liquidity often brings lower revenue and is rarely in the possession of banks Meanwhile, the banks do not want to bid the one with huge revenue due to difficulties in

transaction and exposure to high risk In addition, the market for bank’s asset does not develop

+ Banking activities is often based on credibility Basically, all banks can offer the same services However, choices of banks to deposit or to take out a loan or to use payment services rely much on their “name” Hence, if there is any rumor which can hurt the bank’s reputation, illiquidity risk is likely to happen

III MEASUREMENT OF LIQUIDITY

The criteria to evaluate the liquidity risk comes from liquidity measurement It include: Asset liquidity rate, deposit liquidity rate, liquidity gap, and payment index

a Liquidity rate

These rates are used to compared the liquidity of current asset, short-term deposit & loan and credit The higher rate there is, the lower liquidity rate for commercial bank There are many indexes that the bank can use to evaluate its liquidity and liquidity risk

- Asset liquidity rate 1:

ALR1= TLA

TA =

PR+SR TA

In which:

+ ALR 1: Asset liquidity rate.

+ TLA : Total liquidity assets.

+ TA : Total assets.

+ PR: Primary reserve

+ SR: Secondary reserve.

How to determine which is the primary and which is the secondary reserve relies on the financial situation and business ability of each bank and the regulation of every country

Normally, TLA, PR, SR can be calculated by the following formulas:

In which:

TLA=C+DD 1+TD 1+GSS+CSS+CLPR=C +DD 1+GSS

+ C: Cash

+ DD1: Demand deposit 1

+ TD1: Term deposit 1

+ GSS : Government short-term securities

+ CSS: Convertible short-term securities

+ CL: Convertible loans

- Asset liquidity rate 2:

Asset liquidity rate 2 is based on the the primary reserve of the bank

ALR 2= PR

TA

In which:

+ ALR: Asset liquidity rate

- Deposit liquidity rate

This rate is based on the short-term deposit and borrowing of the bank

DLR= C+DD 1+TD 1+CSS

SD+SB

In which:

+ DLR : Deposit liquidity rate

+ SD: Short-term deposit

+ SB: Short-term borrowing

This rate reflects the liquidity rate of short-term deposit and borrowing

- Credit liquidity rate

CLR= PR

O

In which:

+ CLR: Credit liquidity rate

+ O: Outstanding loan

This rate shows the liquidity per unit of credit that the bank provides

b Liquidity gap

Liquidity gap shows the gap between the liquidity supply and liquidity demand Negative liquidity gap indicates liquidity risk

Liquidity gap is calculated by a formula:

LG=LS−LD

In which:

+ LG: Liquidity gap

+ LS: Liquidity supply

+ LD: Liquidity demand

When Liquidity supply is higher than liquidity demand, which means that Liquidity gap is positive, the bank has more cash than required therefore the bank is able to make payment and the liquidity risk is quite low

On the other hand, when the liquidity supply is lower than the Liquidity demand, Liquidity gap is negative, the bank does not have enough cash to make payment and therefore, the liquidity risk is very high

Besides the above rates, banks can use other rate to evaluate its liquidity Many banks estimate the liquidity demand based on solely experience and the industry average ratio So some other rates can be used in liquidity management:

+ Cash status ratio= Cash+ Deposits Totalassets The higher rate means that the bank has better ability in making immediate payment

+ Lending Capability Index= Lending+Net leasing

Total assets The higher this ratio, the lower the liquidity

IV LIQUIDITY RISK MANAGEMENT

a Management of liquidity demand

The liquidity demand includes:

organizations

 Loan payment when it is due.

The liquidity demand should be estimated beforehand based on some factors that can affect the liquidity demand in short run and liquidity trend in long run

 The rumor that can badly affect bank’s reputation

 Information about depositor’s income,savings and consumption

 The policy and interest rates of other credit institutions

 The reputation of the bank itself

b Liquidity risk management by applying liquidity management theories.

- Commercial loan theory:

The commercial loan theory states that the liquidity of a bank can be maintained by

focusing on short-term self-liquidating productive loans to business organizations Basically these loans are working capital used to expedite the process of money making for those organizations Short-term productive loans mean higher debt recovery ability for debt collector because the borrower always have stable income or revenue so there is little risk of bad debt

However, the are some noticeable defects of this theory:

+ Short-term loan comes with lower interest rate which means lower revenue for banks

+ Undiversified loan maturity could threaten the customer’s loyalty as they can turn to another bank for more diversified services If all bank pursue the same rules, then it may reduce the money supply, making it impossible for existing debtors to repay the debt at maturity

+ Do not consider the relative stability of bank deposit This characteristic can allow commercial bank to expand its capital for a long period of time without losing liquidity

- Shiftability theory

The theory states that the liquidity of a bank can be maintained if the bank continue a substantial amount of assets that can be moved to other banks for cash without any loss of

material These assets can include: stock of company with good financial and business situation, government bonds, good quality loan (Mortgage loan)

This theory has positive elements of truth and can motivate term lending by banks

However, this theory fail to consider some other factors like the economic conditions or when there is a run on the bank, etc

- Anticipated income theory:

The liquidity of a bank is not only measured by the transformation of its asset After many analysis of the bank liquidity on the viewpoint of cash flow, it is concluded that the repayment of the borrower does not occur when the debt matures but rather during the entire time of borrowing The medium or long term loan often comes with a mortgage from a customer and the mortgage will be used and depreciated If the borrowers borrow money for long-term good, the loan should

be repaid by the future earnings of the borrower in installments rather giving lump sum at the maturity of the loan in order to increase the liquidity of the asset

This theory did not deny the commercial loan theory or the shiftability theory but

emphasize on the potential of receiving debt payment with the borrower’s income rather than relying solely on the mortgage The theory does not affect how the bank wants to invest and

prevents the banking from having to face with the question of how to deal with the mortgage it is holding Overall, it significantly increase the liquidity of the bank

- The liabilities management theory:

This theory was formed in the mid-1960s of the 20th century, attached to the formation of

a new mobilization tool, the certificate of deposit and the CD market In addition to the traditional borrowing of central banks and other commercial banks, the CD allows large central banks to mobilize large amounts of capital at a short time, at a cheaper cost issuing medium and long term bonds In addition, the development of an international and regional interbank market allows banks around the world to borrow from one another on a large scale, with low transaction costs and less affected by the policy of Central bank of each country This operating environment increases the ability of commercial banks to borrow According to the authors, if a bank has a high ability to borrow, its liquidity is also high Bank managers can maintain a portfolio of assets that are more profitable than liquidity and use new deposits as the main method to meet liquidity needs

C FINDINGS AND ANALYSES

I OVERVIEW OF ASIA COMMERCIAL BANK (ACB)

Asia Commercial Joint Stock Bank (ACB) was established on 19 May 1993 and began

operations in June 1993 From that time, ACB has experienced a rapid rise and achieved many milestones ACB was actually the first bank in Vietnam to issue Mastercard and Visa international debit card In 1997, ACB implemented a two-year training program on banking operations

conducted by foreign bankers and banking specialists, to make sure that the bank was

well-equipped It also signed an agreement with the premier UK financial institution Standard

Chartered Bank to receive comprehensive technical assistance The bank has also been awarded two Labor Medals by the Vietnamese government (in 2006 and in 2008), as well as being

recognised by several prestigious institutions as a fine financial institution in Vietnam

The Bank provides consumer and corporate commercial banking services, including deposits, corporate and consumer lending, as well as trade financing It is also involved in capital and money markets at interbank level, along with treasury activities, commodities financing and international clearing and settlement Through its subsidiaries and affiliates, the Bank provides investment banking services, such as securities brokerage, custody and underwriting services, along with corporate advisory services Other activities include gold bar manufacturing and asset management

II ASIA COMMERCIAL JOINT STOCK BANK (ACB)’S CASE OF LIQUIDITY RISK

In early 2003, ACB was still in effective business The profit in the first 9 months of 2003 of this bank increased by 20% compared to that of the same period in 2002 (reaching approximately

170 billion) ACB was very popular and trusted by domestic customers and foreign ones trust when they deposit money Therefore, the rumor of "General Director of ACB, Pham Van Thiet escaped" caused a "shock" to people in Ho Chi Minh City, especially those who are depositors in the bank Here are some key developments of the incident:

- At the beginning of October 2003, the first rumor about the General Director of ACB began

to flee

- About a week later, on Sunday (October 12) and Monday (October 13), the rumor became widespread among people in Ho Chi Minh City

- On October 14, 2003, the tension reached its "peak" when thousands of people rushed to withdraw their money at the headquarters of ACB on Nguyen Thi Minh Khai Street and its branch

at 30 Mac Dinh Chi ( District 1 - Ho Chi Minh City) At these two locations, the population was

so crowded that it flooded the road,causing heavy traffic congestion hours Thankfully, the

appearance in front of a large number of people of the State Bank of Vietnam Governor Le Duc Thuy beside the General Director Pham Van Thiet and representatives of the City Government was the most powerful rejection of rumor

- Over the next day, October 15, despite the fact that great withdrawal continued, the press agencies together with the individuals and authorities simultaneously had news and articles with a view to rejecting the false information Therefore by the end of the day, the situation calmed down Customers started to send deposits back to ACB On October 16, the incident was almost eliminated

- After a week, everything was back to normal ACB restored all activities Even at that time, the number of depositors was much greater than that before the incident

It can be seen that the reason for placing ACB in the context of liquidity risk in this case stems from an external reason which is a “false rumor” (CEO of ACB fled) that led to a massive