LV Thạc sĩ_Liquidity risk management at tienphong bank

SOLVAY-BRUSSELS SCHOOL OF ECONOMICS AND MANAGEMENT NATIONAL ECONOMICS UNIVERSITY Vietnam – Belgium Master Programmes MASTERS IN BUSINESS MANAGEMENT THESIS LIQUIDITY RISK MANAGEMET AT TIE

SOLVAY-BRUSSELS SCHOOL OF

ECONOMICS AND MANAGEMENT

NATIONAL ECONOMICS UNIVERSITY

Vietnam – Belgium Master Programmes MASTERS IN BUSINESS MANAGEMENT

THESIS

LIQUIDITY RISK MANAGEMET AT TIENPHONG

COMMERCIAL JOINT STOCK BANK (TIENPHONGBANK)

-It has been an extremely valuable experience to study and work under his supervision

Secondly, I also thank to MBM Program for their useful guidance on academic writing methods and resource links, as well as their deep understanding to approve this exceptional case of a co-thesis They all gave me the honor of attaining such a great program.

Finally, I also want to show my deep gratitude to my families and my classmates for their unconditional loves and their spiritual encouragement.

Hanoi, January 2010

TABLE OF CONTENT

ACKNOWLEDGEMENT

TABLE OF CONTENT

TABLE OF FIGURES

LIST OF TABLES AND LIST OF ANNEXES

ABBREVIATIONS

EXECUTIVE SUMMARY

INTRODUCTION 1

CHAPTER I: LITERATURE REVIEW 5

I.1 Banking Risks 5

I.1.1 Main types of risk in the banking service 5

I.1.2 Liquidity risk 7

I.2 Risk management 8

I.2.1 Role of risk management in banking activities 8

I.3 Liquidity risk management 11

I.3.1 International liquidity risk management structure 11

I.3.2 Framework for measuring and monitoring net funding requirement 12

I.3.3 Local laws and regulations relevant to risk management 19

CHAPTER II: LIQUIDITY RISK MANAGEMENT AT TIENPHONGBANK 23

II.1 Overview of Tienphongbank 23

II.1.1 Introduction 23

II.1.2 Strategy 24

II.1.3 Competition 25

II.1.4 Organizational structure 26

II.1.5 Business Segments 27

II.1.6 Performance from June 2008-September 2009 29

II.2 Liquidity risk management at Tienphongbank 31

II.2.1 Organization structure in liquidity risk management 31

II.2.2 Policy 32

II.3 Liquidity Measurement 35

II.3.2 Liquidity ratios 38

II.3.3 Concentration level or larger fund provide 39

II.3.4 Funding Structure 41

II.4 The problems of the liquidity risk management at Tienphongbank 43

II.4.1 Liquidity position 43

II.4.2 Problems in Liquidity risk management 44

CHAPTER III: RECOMMENDATIONS TO IMPROVE LIQUIDITY RISK MANAGEMENT 46

AT TIENPHONGBANK 46

III.1 Strengthening the liquidity risk structure 46

III.1.1 Improve the awareness 46

III.1.2 Strengthening the governance structure 46

III.2 Building Liquidity Standard 48

III.3 Building the procedures in liquidity risk management 49

III.3.1 Liquidity identifying 49

III.3.2 Liquidity risk measuring 50

III.3.3 Liquidity risk controlling 51

III.3.4 Liquidity monitoring 52

III.3.5 Reporting system 52

III.4 Others recommendations 53

III.4.1 Training program 53

III.4.2 Developing the Tienphongbank brand name 53

CONCLUSION 54

REFERENCES 55

ANNEX 56

LIST OF FIGURES

LIST OF TABLE

Table 7 List of 20 Larger Fund Providers as of 30 September 2009

TABLE OF ANNEXES

Annex 1 Gap Analysis Report Format

Annex 2 Break down VND liquidity ratio as of 30 September 2009

Annex 3 Break down VND liquidity ratio as of 30 September 2009

Annex 4 The current assets and liabilities used to calculate liquidity ratios

Tienphongbank Tien Phong Joint Stock Commercial Bank

EXECUTIVE SUMMARY

Risk management refers to the practices used by bank managers and riskmanager to limit and control uncertainty in the bank’s total portfolio Liquidityrisk management aims to strengthen the bank’s ability to meet its liabilities asthey come due and minimize the risk of loss from unexpected changes in thedaily business transaction

Liquidity risk management has become an integral part of international businessstrategy, and the bank use quantitative tools to measure and analyze risk The job

of the ALCO and Risk Management Division is to identify and address allpossible scenarios for liquidity risk, establish support and control mechanisms fordealing with it, and set the course for the risk management team in terms of itspolicies and objectives

To keep track of the myriad details of a risk management system, managers nowrely upon a wide range of new tools and technologies- computer-based tradingsystems, telecommunications technology, decision support systems that quantifyliquidity risk factors, and so on Intelligent liquidity risk management helps abank stabilize cash flows, reduce risk of insolvency, and focus on its primarybusiness

In this study, the liquidity risk management is examined from the perspective of

the most commonly used theories to identify liquidity risk and identify theinternational best practices in liquidity risk management The studies analyze theinterplay of currencies, exchange rates, interest rates, and accounting systems.Financial risk management is a specialized area of international accounting thatrequires specific training, tools and techniques, if one is to be successful inreduce risk for an international business

The research assesses the case study of liquidity risk management ofTienphongbank In this research, I approached the issue by evaluating andanalyzing all of the current liquidity risk management procedures and liquiditymeasurements which the bank has implemented, thereby, find out unreasonablefactors in these procedures Taking into account of such findings, somerecommendations were introduced for strengthen the banks’s liquidity riskmanagement

Having evaluating Tienphongbank’s liquidity risk management, I find out somekey issues such as: insufficient framework for identifying, measuring, managing

plan, not setting limit for the bank’s ratio, lack of skill supervisors in this field….Tienphongbank is now facing with high liquidity risk exposure.

Based on limited experience and practices in liquidity risk management, I havecome out to some recommendations to set up overall procedures for effectiveliquidity management as strengthen the Tienphongbank capability These include:Strenthen the liquidity risk structure; Building liquidity standard; Building theoverall procedures in liquidity risk management

1 Background of the study

The move of international banking supervision, typically the Basel II Accord hassteered much attention to risk, being inherent in any financial institutionregardless of size or geography Visibility and sensitivity to risks are so importantfor banks management since banks are “risk machines”, they take risks, theytransform them, and they embed them in banking products and services.Moreover, banks and financial institutions act as the intermediary in the economywith a special business field; risks if happened in any bank would not onlyinfluence the bank itself but also caused negative effects on the economic system.Unlike other risk, liquidity risk can lead to solvency risk and bankruptcy Inaddition, liquidity risk once happens, usually has systematic impact Financialmarket developments in the past decade have increased the complexity ofliquidity risk and its management

The global financial crisis that began in mid-2007 re-emphasized the importance

of liquidity to the functioning of financial markets and the banking sector Inadvance of the crisis, asset markets were buoyant and funding was readilyavailable at low cost The reversal in market conditions illustrated how quicklyliquidity can evaporate and that illiquidity can last for an extended period oftime The banking system came under severe stress, which necessitated centralbank action to support both the functioning of money markets and, in a fewcases, individual institutions

A key characteristic of the financial crisis was the inaccurate and ineffectivemanagement of liquidity risk Thus, identifying, controlling liquidity risk is anessential task of Vietnamese banks in general and in Tienphongbank inparticularly The bank needs to strengthen and implement effective liquidity riskmanagement in their daily operation

2 Problem statement

The current banking system and the global financial crisis have taughtTienphongbank that the danger of facing liquidity risk can reveal anytime due tofunding increases rapidly in assets and less capacity to meet obligations as theycome due, the capability of mobilizing capital is reduced, the concentration level

of assets and liabilities and from off balance sheet Although Tienphongbank hasjust established in June 2008, and the Board of Management understand clearly

some issues in liquidity risk management as: insufficient framework formeasuring, monitoring, controlling liquidity risk, not set up limits for the riskmanagement tools (gap, liquidity ratio…), undiversified the source of fund, nocontingency funding plan and lack of internal controls These may leadTienphongbank facing with high potential liquidity risk exposure at the moment.This situation requires Tienphongbank to review all of its liquidity riskmanagement procedure to strengthen the liquidity capacity of the system toobtain safeness in its operation beside the profit objective in doing business.

(iii) What should be improved for the bank’s liquidity risk management?

What are the recommendations for the bank in order to control theliquidity risk?

5 Research Methodology

The secondary data have been used for this study The data have been collectedfrom Tienphongbank’s annual reports, daily reports, some banking and financeliteratures and Basel Committee Reports These data are compared against thecommon practices in liquidity management with international standard, withBasel’s and SBV’s

The current practices of Tienphongbank liquidity risk management wereinvestigated through the regulations and some reports of Tienphongbank as thesecondary sources The analytical framework was designed as follow:

7 Structure of the Thesis

Apart from introduction and conclusion, the main body of the thesis includesthree chapters, which are:

Chapter 1: Literature review

We will study general knowledge found in the literature review Reviewing majorconcepts and definitions about liquidity risk and liquidity risk management Chapter 2: Liquidity risk management at Tienphongbank

As a most important part of the research evaluates the level of liquidity risk,calculates the indicators, discuss the current liquidity risk management atTienphongbank It provides an insight into Tienphongbank’s liquidity riskmanagement procedures

Chapter 3: Recommendations to improve liquidity risk management atTienphongbank

Some recommendations to improve liquidity risk management at Tienphongbankare presented here The recommendations should identify including:strengthening the liquidity management, building the regulatory complianceframework, upgrading the liquidity measuring and monitoring structure andbuilding the contingency plan framework

Chapter I LITERATURE REVIEW I.1 Banking Risks

In economics and finance literature, risk has been a subject of interest and study

in many fields including management science, decision science, andpsychology In general, risk is the uncertainty in the future, and has beentraditionally separated into two categories: pure risk or speculative risk A purerisk is a chance of loss or no loss, and a speculative risk is characterized as achance of loss or gain The general usage the convention is to focus only onpotential negative impact to some characteristic of value that may arise from afuture event

Any definition of risk is likely to carry an element of subjectivity, depending uponthe nature of the risk and to what it is applied As such there is no allencompassing definition of risk Smith (1999) defines risk as “Risk is the actualexposure of something of human value to a hazard and is often regarded as thecombination of probability and loss” When there are a range of possible outcomesbut no assumed probabilities, there is only uncertainty The problem with riskmanagement is that it concerns events that have yet to transpire, which are in turndependent upon events which may not be knowable at the time of prediction, thatare also dependent upon events, and so the cause effect chain continues

We also know many definitions of risk that vary by specific application andsituational context In statistical decision theory, risk is defined as the expectationvalue of the loss function understood as a function of probability of eventoccurring and the impact of event occurring In statistics, risk is often mapped tothe probability of some event which is seen as undesirable In information

security, a risk is written as an asset, the threats to the asset and the vulnerability

that can be exploited by the threats to impact the asset Financial risk is oftendefined as the unexpected variability or volatility of returns and thus includesboth potential worse-than-expected as well as better-than-expected returns Thenext part of this chapter would analyze type of risks in banking service – animportant component of the financial system

I.1.1 Main types of risk in the banking service

Commercial banks are in the risk business In the process of providing financialservices, they assume various kinds of financial risks Risks in banking system ifoccur would influent not only the banks themselves but all other fields of the

economy The risks associated with the provision of banking services differ by thetype of service rendered.

Banking risks are defined as adverse impacts on profitability of several distinctsources of uncertainty; however the following types of risk are mentioned in

Commercial Bank Risk Management (Santomeo, 1997): market risk, credit risk,

interest rate risk, liquidity risk, operational risk, foreign exchange risk and legal risk We can have clear definition of these risks as follows:

Market risk is the risk of asset value change associated with systematic factors.

By its nature, this risk can be hedged, but cannot be diversified completely away

In fact, market risk can be thought of as undiversifiable risk All investors assumethis type of risk, whenever assets owned or claims issued can change in value as

a result of broad economic factors

Credit risk arises from non-performance by a borrower It may arise from either an

inability or an unwillingness to perform in the pre-committed contracted manner.This can affect the lender holding the loan contract, as well as other lenders to thecreditor Therefore, the financial condition of the borrower as well as the currentvalue of any underlying collateral is of considerable interest to its bank

Liquidity risk can best be described as the risk of a funding crisis While some

would include the need to plan for growth and unexpected expansion of credit, therisk here is seen more correctly as the potential for a funding crisis Such a situationwould inevitably be associated with an unexpected event, such as a large chargeoff, loss of confidence, or a crisis of national proportion such as a currency crisis

Operational risk is associated with the problems of accurately processing,

settling, and taking or making delivery on trades in exchange for cash It alsoarises in record keeping, processing system failures and compliance with variousregulations The Basel Committee defines operational risk as: “The risk of lossresulting from inadequate or failed internal processes, people and systems orexternal events It includes legal risk, but excludes strategic risk and reputation

risk” (International Convergence of Capital Measurement and Capital Standard,

2006).

Legal risks are endemic in financial contracting and are separate from the legal

ramifications of credit, counterparty, and operational risks New statutes, taxlegislation, court opinions and regulations can put formerly well-establishedtransactions into contention even when all parties have previously performedadequately and are fully able to perform in the future

Figure 2 The main banking risks

Although there are many types of banking risks, and all financial institutions faceall these risks to some extent, but the research only focuses on the liquidity risk –the risk that banks have to face in their everyday operation

I.1.2 Liquidity risk

When talking about liquidity we mean market liquidity which is the ability to buy

or sell an asset on a market In general the market liquidity is the ability totransform assets into cash or vice versa Or in a more relevant context in finance,

it is the ability to quickly liquidate big volumes to low costs when assets have to

be converted into cash

Liquidity which is represented by the quality and marketability of the assets andliabilities exposes the bank to liquidity risk Liquidity is necessary for a bank tocompensate for expected and unexpected balance sheet fluctuations and toprovide funds for growth Liquidity risk normally arises due to the nature of theassets and liabilities of the banks and most of the result from the potentialinability of a bank to generate cash in order to meet the commitments when theyare due Once the maturity of the assets exceed of those liabilities, there isinevitably liquidity risk The liquidity position of a bank is normally influenced

by the investment and financing decisions of the bank and liquidity positionshould be monitored both in the long run and also on a day to day basic

counterparty risk

I.2 Risk management

I.2.1 Role of risk management in banking activities

Risks are difficult to define and to avoid; people try to set up a mechanism toidentify and control risks Thus, risk management has become an integral part ofinternational business strategy, and accountants use quantitative tools to measureand analyze risk The job of the Chief Risk Officer is to identify and address alltypes of risk, establish support and control mechanisms for dealing with it, andset the course for the risk management team in terms of its policies andobjectives The process of risk management consists of several steps as shown in

Figure 3 (Bruno Brühwiler, Materials of Risk management workshop of

University of Applied Sciences Northwestern Switzerland, Hochiminh, Novemer 2008):

Figure 3 Process of managing risks

Source: Bruno Brühwiler, Materials of Risk management workshop of University of Applied Sciences Northwestern Switzerland, Hochiminh, Novemer 2008

In fact, the risk-management process is becoming an increasingly importantfinancial area for virtually all financial institutions With the dramaticallygrowing costs of losses from different risk sources, bank firms can gain acompetitive cost advantage through the development of a set of cost-effective andefficient risk-management strategies The advantages of a well-managed riskmanagement program include not only a lower total loss cost and an improved

business bottom line, but also an increased predictability of future losses and cost,which ensures greater budget control and reduced ambiguity for future netrevenue stream Bank is a portfolio of risks, the best practice in modern bankingrisk management is to manage, not eliminate them The watchwords are risk bychoice, not by chance, no risk, no reward We should manage in the manor thatrisk management for value creation.

Modern banking risk management structure was described clearly in “Riskmanagement in banking” According to Bessis (2002), risk managementcombines top-down and bottom-up processes with ‘horizontal’ processes Topdown is starting with the management commitment, earnings targets and risklimits are defined These will lay down into strategic, operational, and processmanagement with signals translated to business units respectively Themonitoring and the reporting of risk are bottom-up oriented, starting withtransactions processing and ending with consolidated risks, earnings targets Theaggregation is required for supervision purposes and for comparison at all levelswhere decisions are made Illustrated as Figure 4 below, the process involves theentire banking hierarchy from top to bottom, in order to turn targets into businessunit signals, and from bottom to top, to aggregate risks and profitability andmonitor them

Figure 4 Liquidity Risk Management Framework

Source: Bruno Brühwiler, Materials of Risk management workshop of University of Applied Sciences Northwestern Switzerland, Hochiminh, Novemer 2008

The development of bank risk management organization is an ongoing process.The original traditional commercial bank organization tends to be dual, with thefinancial sphere versus the business sphere The business lines tend to developvolume, sometimes at the expense of risks and profitability, while the financialsphere tends to focus on profitability, with dedicated credit and market riskmonitoring units This dual view is fading away with the emergence of newdedicated functions implemented bank-wide Modern risk management alsogives prominence to the quantification of risks with the support of theinformation technology Here under is the comparison between the traditionaland modern risk management:

Mind set and Skill set

- Internal control

- Risk culture become an integral part of every businessdecision

- Perform Audits

- Set Limits

- Measure Exception

- Forward looking approach

- Risk based business decision

COMSTRAINT

- Risk management as ENABLER

Botttom up

Top Down

R

is anMag em en

Strategic Management

Liquidity Risk Management

Process Management Management Commitment

Although all risk management tend to fit in a common basic framework, and thechanges in risk management process would affect all types of risk, each of themstill require different techniques to control That is the reason now we turn ourdiscussion to the key subject of the thesis – the liquidity risk management.

I.3 Liquidity risk management

Liquidity is the bank’s ability to fund increases in assets and meets its financial

obligations as they come (Basel: Sound Practice for Managing Liquidity in

Banking Organizations, BCBS, February 2000) Within this definition is an

assumption that obligations will be able to be met “at reasonable cost” Liquidityrisk management seeks to ensure a bank’s ability to continue to do this Effectiveliquidity risk management helps ensure a bank's ability to meet cash flowobligations, which are uncertain as they are affected by external events and otheragents' behavior Liquidity risk management is of paramount importance because

a liquidity shortfall at a single institution can have system-wide repercussions.Liquidity risk management of a bank is defined as the frame work, set ofinstruments and rules the bank uses in order to control its price consistently withits ultimate goal (Ulrich Bindseil, Central Bank Liquidity Management, April

2000, Page 2)

The international practices for managing liquidity in banking systems wereintroduced by the Basel Committee on Banking Supervision through itsdocuments in “Sound Practices for managing liquidity in banking organizations”Basel, February 2000, in “Principles for sound liquidity risk management andSupervision” BIS, September 2008 According to Basel, the liquidity riskmanagement each bank not distinguishes any size of scope of operation, shouldinclude the following components:

- The structure for managing liquidity risk (policy, reporting structure,responsibilities…)

- The framework for measuring and monitoring net funding requirement

- Internal controls for liquidity risk management

I.3.1 International liquidity risk management structure

Each bank should determine key matters pertaining to liquidity risk managementpolicies Such a policy relate to basic asset and liability management policies,risk planning and market risk management and proposes responses toemergencies such as sudden market changes Such a policy should also enunciatespecific policies on particular aspects of liquidity management, such as the

relative reliance on the use of certain financial instruments and theencouragement of closer relationships with supervisors

The ALM & market risk management committee should be established The chiefrisk officer is responsible for matters relating to liquidity risk managementplanning and operations and is responsible for monitoring market risk, reportsand analyses, proposals, setting limits and guidelines, and formulating andimplementing plans relating to market risk management

The bank should set up liquidity limit Limits on liquidity risk are discussed andcoordinated by the ALM & market risk management committee, discussedfurther by the executive management committee and determined by the chiefexecutive officer

A bank must have adequate information systems for measuring, monitoring,controlling and reporting liquidity risk Reports should report to the chiefexecutive officer on a daily basis and to the board of directors and the executivemanagement committee on a regular basis The bank has constructed a systemunder which they will be able to respond smoothly in the event of emergencysituations that affect our funding by establishing action plans

I.3.2 Framework for measuring and monitoring net funding requirement

Under Basel Accord the typical framework is requiring each bank shouldestablish a process for the ongoing measurement and monitoring of net fundingrequirements This is essential for adequately managing liquidity risk Theliquidity measurement involves assessing all of a bank’s cash inflows against itsoutflows to identify the potential for any net shortfalls going forward This includesfunding requirements for off-balance sheet commitments An important aspect ofmanaging liquidity is making assumptions about future funding needs Whilecertain cash inflows and outflows can be easily calculated or predicted, banks mustalso make assumptions about future liquidity needs, both in the very short termand for longer time periods

Another requirement is that the bank should analyze liquidity utilizing a variety

of “what if” scenarios In order to evaluate whether a bank is sufficiently liquiddepends in large measure on the behavior of cash flows under differentconditions Analyzing liquidity thus entails laying out a variety of "what if"scenarios Under each scenario, a bank should try to account for any significantpositive or negative liquidity swings that could occur These scenarios should takeinto account factors that are both internal (bank-specific) and external (market-related) While liquidity will typically be managed under “normal” circumstances,the bank must be prepared to manage liquidity under abnormal conditions

Beside that the bank should also review frequently the assumptions utilized inmanaging liquidity to determine that they continue to be valid Since a bank’sfuture liquidity position will be affected by factors that cannot always be forecastwith precision, assumptions need to be reviewed frequently to determine theircontinuing validity, especially given the rapidity of change in banking markets.The total number of major assumptions to be made, however, is fairly limited.Ensuring adequate liquidity is a never-ending problem for bank management thatwill always have significant implications for the bank’s profitability To do this,liquidity managers should estimate exactly the liquidity needs of the banks.

I.3.2.1 Measuring liquidity requirements

In recent year, several liquidity measurements methods have been developed forestimating the bank’s liquidity requirement such as the sources and use of fundapproach, the structure of fund approach, and liquidity indicators approach Eachmethod is built under some assumptions and estimated only an approximation ofactual liquidity requirement at any given time That is why a liquidity managermust always be ready to adjust the anticipated liquidity requirement as newinformation becomes available In fact, most banks make sure their liquidityreserves include both a planned component, consisting of the reserves called for

by the latest liquidity forecast, and a protective component, consisting of an extramargin of liquid reserves over those dictated by the most recent forecast Theprotective liquidity component may be large or small, depending onmanagement’s philosophy and attitude toward risk

The Sources and uses of fund approach

According to Rose, Peter S (1999), the sources and uses of fund method beginwith two simple facts: (i) The bank liquidity rise when deposits increase andloans decrease; (ii) The bank liquidity declines when deposit decrease and loanincrease

Whenever the bank sources and uses of liquidity are mismatched, the bank faceswith liquidity gap Liquidity gap is the difference between cash inflows and cashoutflows in each period, the excess or deficit of funds, becomes a starting-pointfor a measure of a bank's future liquidity excess or shortfall at a series of points

in time Typically, a bank may find substantial funding gaps in distant periodsand will endeavor to fill these gaps by influencing the maturity of transactions so

as to offset the gap Banks will typically collect data on relatively distant periods

so as to maximize the opportunities to close the gap before it gets too close Mostbanks would regard it as important that any remaining borrowing requirement

the bank's capacity to fund in the market.

The key steps in the sources and uses funds approach are as follows: (i) Loansand deposits must be forecasted for a given liquidity planning period; (ii) Theestimated change in loans and deposits also is calculated for that same planningperiod; (iii) Nets funding requirement must be estimated for that planning period

by comparing the estimated change in loans to estimated change in deposits.This method uses wide variety of input information, so, expected loans anddeposits are accurate/reliable data in comparison to the fact But, it is rathercomplicated and requires that bank has a good knowledge on statistics and hasgot enough information

The Structure of fund approach

Another approach to estimate a bank’s liquidity requirement is the Structure offunds method In the first step, the bank’s deposits and non-deposit liabilitiessources are divided into 03 categories based on their estimated probability ofbeing withdrawn:

- “Hot” funds: deposits and other borrowed funds that are very sensitive tointerest or surely will be withdrawn during the current period

- “Vulnerable” fund: customer deposits of which a substantial portion,perhaps 25 or 30 percent, will probably be withdrawn from banksometime during the current time period

- “Stable” funds (also called Core deposits or core liabilities): fund thatmanagement considers most unlikely to be withdrawn from bank) exceptfor a minor percentage of total)

Second step, the liquidity manager must set up liquid funds according to desiredoperating rule for each of three kinds of funding sources For example, the bankrule decided to set up 95 percent of liquid reserve for hot funds (after excludingany required reserve at the Central bank) The same approach applies so as toresult in 30 percent of liquid reserve for vulnerable funds and 15 percent forstable funds

The bank total liquidity requirement is subjective estimates that rely heavily onmanagement’s judgment, experience, and bank attitude toward risk

The Liquidity ratio method

Banks can use various ratios to measure the liquidity requirements These ratiosuse in comparing with industrial averages to make the bank decision

Cash position ratio, cash and deposit at other financial institutions divided by

total assets A higher ratio in comparison to industrial average shows a strongability to handle immediate cash needs Common bank cash liquidity ratios –simply variations on corporate working capital ratios – include cash divided bytotal assets and quick assets divided by total assets; the higher the ratios, themore liquid the asset portfolio

Hot money ratio, the money market assets (cash, short term treasury bills)

divided by money market liabilities (inter-bank deposit and borrowing) The ratioreflects whether the banks have balanced its position in money market or not

Borrowing ratio, such as total deposits divided by borrowed funds, volatile funds

divided by liquid assets, and volatile funds minus current assets divided by totalassets minus current assets, measure a bank’s need to use volatile borrowings tosupport business High ratios indicate a larger amount of deposit turnover orvolatile funding in a bank’s total plan, which can create liquidity pressure

The loan to deposit ratio, or total loans divided by total deposits, indicates the

degree to which a bank can support its core lending business through deposits; arefinement of this ratio excludes from total deposits the more stable retailcomponent, to demonstrate the degree to which credit business is truly supported

by hot money

Core deposit ratio: core deposit dived by total assets, where core deposits are

defined as stable fund

Banks typically compute an overall ratio to provide a picture of the total liquidityposition It is important to note that in some jurisdictions, banks are required toproduce specific liquidity measures as evidence of their financial strength Thesemight be duplicates of those already produced and used internally, or they might

be supplemental Other regulators impose their own liquidity metrics todetermine whether an institution is being managed prudently

These ratios could be vary depend on the government regulations and internalbank’s policy However, each of them should be compared with the average value

of that ratio for banks of comparable size in a similar location and marketenvironment Moreover, bank managers usually focus on changes in theirinstitution’s liquidity indicators rather than on the level of each ratio They want

to know whether liquidity is rising or falling and why

I.3.2.2 Liquidity risk management policy

Preparing suitable strategies for liquidity risk management is drawn the attention

broad strategies for dealing with bank liquidity problems: (1) Asset liquiditymanagement strategy, (2) Liability liquidity management strategy, and (3) Asset

and liability liquidity management strategy (Source: Rose, Peter S, Commercial

Bank Management, McGraw-Hill, 4th edition, 1999, p352-355).

Asset Liquidity Management Strategies

The oldest approach to meeting bank liquidity needs is known as asset liquidity

management This strategy calls for storing liquidity in the form of holdings of

liquid assets – predominantly in cash and marketable securities When liquidity isneeded, the bank transfers liquid assets into cash This liquidity managementstrategy is often called asset conversion because liquidity funds are raised byconverting non-cash asset into cash

A liquid asset must have three characteristics: (i) A liquid asset must have a readymarket so that it can be converted into cash without delay, (ii) Convert cost must

be reasonable and not depend on the volume of sold assets and transaction time,(iii) It must be reversible so that the seller can recover his or her originalinvestment (principal) with little risk of loss

The most popular liquid assets for bank are treasury bills, central bank bonds,Deposit in financial institutions and banker’s acceptances Although a bank canstrengthen its liquidity position by holding more liquid assets, it will notnecessarily be a liquid institution if it does so, because a bank’s liquidity position

is also influenced by the demands for liquidity made against it

Asset liquidity management strategy is used mainly by smaller banks that find it

a less risky approach to liquidity management than relying on borrowing Butasset conversion is not a cost-less approach to liquidity management First,selling assets means the bank loses the future earnings those assets would havegenerated had they not been sold off Moreover, the assets in question may need

to be sold in a market experiencing declining prices, subjecting the bank to therisk of substantial capital losses Management must take care that those assetswith the least profit potential are sold first in order to minimize the opportunitycost of future earnings forgone Selling assets to raise liquidity also tends toweaken the appearance of the bank’s balance sheet because the assets sold areoften low-risk government securities that give the impression the bank isfinancially strong Finally, liquid assets generally carry the lowest rates of return

of all financial assets

Liability Liquidity Management Strategies

In the 1960s, many banks began to raise their liquid funds through borrowings in

the money market This borrowed liquidity strategy – often called purchased

liquidity or liability management Borrowing liquid funds has a number of

advantages A bank can choose to borrow only when it actually needs funds,unlike storing liquidity in assets, banks do not lose the opportunity in investment

in higher expected return assets Then, using borrowed funds permits a bank toleave the volume and composition of its asset portfolio unchanged if it is satisfiedwith the assets it currently holds Finally, liability management comes with itsown control lever-the interest rate offered to borrow funds If the borrowing bankneeds more funds, it merely raises its offer rate until the requisite amount offunds flow in If fewer funds are required, the bank’s offer rate may be lowered.Beside, purchasing liquidity also has a number of disadvantages: Firstly,borrowing liquidity if the most risky approach to solve problems because of thevolatility of money market interest rate The bank may face higher borrowingcost and its net earning can be affected if interest rate moves in adverse direction;Secondly, in case of liquidity difficulty in general, the bank’s purpose may not besatisfied if at the same time other financial institutions becomes less willing tolend due to risk involved

Asset and Liability Liquidity Management Strategies

Due to the advantages and disadvantages of the above strategies, most banks use

both asset management and liability management Under a balanced liquidity

management strategy some of the expected demands for liquidity are stored in

liquid assets, while other anticipated liquidity needs are backstopped by advancearrangements for lines of credit from correspondent banks or other suppliers offunds Unexpected cash needs are met from near-term borrowings The majorcontribution of Asset and Liability management strategy has given the bankerflexibility in managing their balances sheets, and to force them to think aboutboth sides of the balance sheets as potential instruments of liquidity management

I.3.2.3 Managing market access

It is essential for a bank to review periodically its efforts to maintain thediversification of liabilities, to establish relationships with liability-holders and todevelop asset-sales markets A bank needs to examine the level of reliance onindividual funding sources, by instrument type, nature of the provider of funds,and geographic market In addition, a bank should strive to understand andevaluate the use of inter-company financing for its individual business offices

Building strong relationships with some providers of funding can provide a line

of defense in a liquidity problem and form an integral part of a bank's liquiditymanagement The frequency of contact and the frequency of use of a fundingsource are two possible ratios of the strength of a funding relationship

I.3.2.4 Contingency planning

A bank should have contingency plans in place that address the strategy for handlingliquidity crises and include procedures for making up cash flow shortfalls in emergency situations

A bank’s ability to withstand both temporary and longer-term disruptions inits ability to fund some or all of its activities in a timely manner and at areasonable cost can depend on the adequacy of its formal contingency plans Acontingency plan needs to spell out procedures to ensure that information flowsremain timely and uninterrupted, and that they provide senior management withthe precise information it needs in order to make quick decisions Another majorelement in the plan should be a strategy for taking certain actions to alter assetand liability behaviors Other components of the contingency planinvolve maintaining customer relationships with liability-holders,borrowers, and trading and off-balance-sheet counterparties

I.3.2.5 Internal control

According to Basel, a fundamental component of the internal control systeminvolves regular independent reviews and evaluations of the effectiveness of thesystem and, where necessary, ensuring that appropriate revisions orenhancements to internal controls are made The results of such reviews should

be available to supervisory authorities

Banks should have adequate internal controls to ensure the integrity of theirliquidity risk management process The internal controls should be an integralpart of the bank’s overall system of risk control They should promote effectiveand efficient operations, reliable financial and regulatory reporting, andcompliance with relevant laws, regulations and institutional policies An effectivesystem of internal control for liquidity risk includes:

• A strong control environment;

• An adequate process for identifying and evaluating liquidity risk;

• The establishment of control activities such as policies and procedures;

• Adequate information systems; and,

• Continual review of adherence to established policies and procedures

With regard to control policies and procedures, attention should be given toappropriate approval processes, limits, reviews and other mechanisms designed

to provide a reasonable assurance that the institution's liquidity risk managementobjectives are achieved Many attributes of a sound risk management process,including risk measurement, monitoring and control functions, are key aspects of

an effective system of internal control Banks should ensure that all aspects of theinternal control system are effective, including those aspects that are not directlypart of the risk management process

Although procedure for establishing limits and for operating within them mayvary among banks, periodic reviews should be conducted to determine whetherthe organization complies with its liquidity risk policies and procedures.Positions that exceed established limits should receive the prompt attention ofappropriate management and should be resolved according to the processdescribed in approved policies Periodic reviews of the liquidity managementprocess should also address any significant changes in the nature of instrumentsacquired, limits, and internal controls that have occurred since the last review The internal audit function should also periodically review the liquiditymanagement process in order to identify any weaknesses or problems In turn,these should be addressed by management in a timely and effective manner

I.3.3 Local laws and regulations relevant to risk management

In the following table, there are time-ordered laws and regulations relating toliquidity risk management which is currently practiced in Vietnamese bankingsystem These regulations step by steps are amended to conform to internationalpractice like CAR ratio It is required the minimum of 8 percent for Vietnamesebanks

Table 1 Vietnamese laws and regulations Compliance Risk

Category

Laws / Regulations

Bank of Vietnam on the intensification of

restraining and preventive measures for risks in business activity of credit institutions

on the prudence and confidentiality of the informatics technology system in Banking area

Bank of Vietnam on the issuance of the Regulation

on internal inspection, control of credit institutions

Bank of Vietnam on the issuance of the Regulation

on internal audit of credit institutions

Ratios

Decision No 1141/2007 of the Governor of the

State Bank on the adjustment of required reserve

ratios applicable to credit institutions

7 Joint stock

commercial bank’s

establishment and

operation

Decision No.24/2007/QD-NHNN of the Governor

of the State Bank on promulgating the Regulation

on the grant of licenses for the establishment and operation of joint-stock commercial banks

capital requirement for

Joint Stock

Commercial Bank

Document No 7910/NHNN-CNH of the Governor

of the State Bank of Vietnam about joint stock

commercial banks must have a minimum compulsory chartered capital of one trillion dong

by December 31, 2008 and three trillion dong by December 31, 2010

9 Prudential ratio in

commercial bank

Decision 457/2005/QD-NHNN, “The Regulation

on prudential ratios in the activities of credit institutions”, 2005 and its amendment.

Source: State bank of Vietnam’s Website

Basically, upon happening events and actual situations does the government ofVietnam promulgate decisions and guidelines for directing the whole bankingsystems It could be seen that before June of 2007, there was no risk managementframework, specific guideline or risk management process formally instructed bythe SBV to be applicable for the banking system as the whole and for joint stockcommercial banks as individual cases

Until 27th June 2007, eight months after becoming the 150th member of WorldTrade Organization, to standardize Vietnamese banking system for adapting withinternational financial standards and practices, the SBV concretized the role of

risk management by issuing the decision No.24/2007/QD-NHNN According toarticle no.5 and no.6 of this decision, in order to establish and operate a new jointstock commercial bank, besides the required financial capacity of shareholders, abank must have:

a) The professional and qualified personnel in the organizational structure inwhich, each member of control, administration and management teams is totallycapable of the administration, control and executive role For example, for thegeneral director position and control position, the persons in charge must haveprofessional ethics, university or postgraduate diploma in economics, businessadministration or law qualifications and at least 3 years experience in the bankingand financial domains

b) The risk control capability by being able to manage risks expected to arise inthe course of operation including credit, operation risks and market risks andowning the measures to prevent and control three kinds of risks arising

c) The internal supervision, control and audit system in the bank’s operation Theinternal regulations must include (i) the regulations on organization and operation

of the Managing Board, the Control Commission, the Executives, the internalsupervision, control and audit function; (ii) the regulation on management of thebank's risks, debit and credit assets, debt classification and deduction for setting

in the near future; (ii) be more stabilized in the changing financial market; and(iii) keep pace with international financial market and attract more strategicpartners

In summary, the first chapter has pointed out the fundamental theory about risk,type of risk, liquidity risk and risk management in economic life in general and inbanking service in particularly It also shows out the role of liquidity riskmanagement Liquidity risk management becomes one of the most importanttasks that any bank has to take care thoroughly Under the above mentioned

management policy, evaluate the liquidity risk that Tienphongbank hasencountered, the reason leading to the liquidity risk at Tienphongbank.

Chapter II LIQUIDITY RISK MANAGEMENT AT TIENPHONGBANK

II.1 Overview of Tienphongbank

II.1.1 Introduction

Tien Phong Joint Stock Commercial Bank (Tienphongbank) was establishedunder Decision No.123/NHNN dated 05th May 2008 by the Governor of Statebank of Vietnam with registered charter capital of VND 1,000 billion in May

2008 and was officially opened in June 06, 2008

Tienphongbank is one of the first two banks which State bank of Vietnam (SBV)licensed after 10 years of standstill on licensing new bank, providing a range oflending, deposit-taking and banking service to various sectors in Vietnam

Three founding members of the bank are FPT Joint Stock Investment &Technology Corporation (FPT); Vietnam Mobile Telecom Services Company(Mobifone) and Vietnam National Reinsurance Corporation (Vinare) Thestrategic investment and cooperation brought about by these organizations hasgiven Tienphongbank undisputable legacy in information technology, mobiletelecommunication technology, and finance

Tienphongbank has expanded its network to 05 branches and 10 kiosk banking(as at 30 November 2009) across Vietnam as part of its strategy to expand itsretail banking business by increasing funds mobilization, promotingtechnologically advanced banking products and targeting new customers

The following timeline shows the major events in the development of theTienphongbank since its establishment:

May 2008: Received license

June 2008: TienPhongBank inauguration ceremony

Signed a comprehensive cooperation agreement with the Bank forInvestment and Development of Vietnam (BIDV), and acooperation framework agreement with CitiBank Hanoi

August 2008: Opened Hanoi Branch

Joined Smartlink, the largest payment system of Vietnam

Launched MiniBank 24/7 – TienPhongBank’s automatic banking system

Oct 2008: Opened Ho Chi Minh City Branch

Launched Internet Banking service for individuals and businesses Dec 2008: Receive ISO 9001:2000 Certificate

June 2009: Opened CanTho Branch

August 2009: Opened Da Nang Branch

October 2009: Opened Hai Phong Branch

Tienphongbank has invested in training programs for staff as part of its strategy

to develop human resources, and has drawn up a credit manual, an internal auditmanual and guidelines laying down operational procedures to improve riskmanagement and corporate governance standards

II.1.2 Strategy

Tienphongbank’s strategy is to become the leading commercial bank in Vietnamwith solid banking foundation, always creates and brings the best opportunitiesfor customers, shareholders, and employees to fulfill their dreams of a simple andeffective financial life strong financial position, a diverse business platform and

a well-regarded bank To become one of the twelve leading banks, or one of theeight largest market capitalization listed banks in Vietnam

Tienphongbank’s specific objectives for each major business segment are asfollows:

Lending

 Improve lending quality and overall loan portfolio quality by identifying,classifying and pricing loans based on improved measures of commercialrisk

 Reduce the proportion of bad debts to levels in line with internationalstandards

 Diversify loan portfolio by industry sector as well as increase theproportion of short-term lending

 Increase the proportion of secured loans to total loans outstanding

 Further develop consumer lending and lending to small and mediumenterprises

Funding

 Increase income and profitability and minimize expenses, in order toincrease the amounts available for funding

 Increase proprietary trading in domestic equity, debt and other securities

 Develop real estate, primarily for the Tienphongbank’s own commercialuse and rental purposes

Services

 Increase fee based income as a proportion of total revenue

 Develop investment banking advisory services

 Improve service quality through the widening of the Tienphongbank’sbranch network, and the use of technology to better deliver existing andfuture banking services such as e-banking channels (internet/phone/SMSbanking) and premium services for VIP customers

II.1.3 Competition

Tienphongbank faces competition from three types of commercial banks:

State-owned commercial banks (SOCBs):

SOCBs dominate two third of the deposit and lending market in banking system.Each of the SOCBs has its own strengths and comparative advantages: Bank forInvestment and Development of Vietnam has the second largest branch network

in Vietnam and is known for its development of innovative products; the Bankfor Foreign Trade of Vietnam is the leading commercial bank in internationalpayment services, credit services and foreign exchange funds; the Industrial andCommercial Bank of Vietnam has strong relationships with manufacturing andtrading companies, small and medium enterprises and urban customers; andVietnam Bank for Agriculture and Rural Development is a major player in therural finance market

Joint stock banks (JSBs):

JSBs dominate 13.2% and 11.6% of the deposit and lending market in bankingsystem Almost all JSBs in Vietnam have rather strong financial capacity relative

to their scope of business Some JSBs has capital adequacy ratios in line withinternational standards Some banks such as Asia Commercial Bank, SaigonThuong Tin Commercial Joint Stock Bank and v.v attract investment fromforeign banks, enabling them to improve their management systems and diversifytheir range of products and services