LV Thạc sỹ_Evaluation of credit risk management in ACB Bank duyen hai branch

NATIONAL ECONOMICS UNIVERSITYADVANCED EDUCATIONAL PROGRAM ***************************** Bachelor thesis Evaluation of credit risk management in Asian Commercial Bank ACB Duyen Hai branch

NATIONAL ECONOMICS UNIVERSITY

ADVANCED EDUCATIONAL PROGRAM

*****************************

Bachelor thesis

Evaluation of credit risk management in Asian Commercial Bank

(ACB) Duyen Hai branch

Table of Contents

Chapter 1 INTRODUCTION ……… ………… 1

1.1 Objectives of the thesis 1

1.2 Overview of the subjected bank 2

1.2.1.Overview of Asian Commercial Bank (ACB) 2

1.2.2 Overview of ACB Duyen Hai branch 3

1.3 Data collection and methodology 5

1.3.1Data collection 5

1.3.2 Methodology 7

Chapter 2 LITERATURE REVIEW………

8 2.1 Bank and credit activities 8

2.2 Credit risk 10

2.2.1 Definition 10

2.2.2 Types of credit risk 11

2.2.3 Sources of credit risk 13

2.3 Credit risk management 16

2.3.1 Role of credit risk management 16

2.3.2 Principles of credit risk management 17

2.3.3 Credit risk measurement 20

2.3.4Risk mitigation and transfer techniques 24Chapter 3 EMPIRICAL

3.2.1 External management 383.2.2 Internal management at the Asia commercial bank 44Chapter 4 RECOMMENDATION FOR CREDIT RISK MANAGEMENT INACB DUYEN HAI BRANCH…….……… ……….59

4.1 Orientation of overall operation at Duyen Hai branch 594.2 Orientation for credit activity at Duyen Hai branch 604.3 Recommendation for credit risk management at Asian CommercialBank Duyen Hai branch 61

4.3.1 Promote professional employee training and utilize rationallyhuman resource 61

4.3.2 Disperse credit risk 624.3.3 Concentrating on borrower information collecting practice 63

Chapter 5 CONCLUSION, LIMITATION AND RECOMMENDATION FOR

FURTHER STUDY……….65

5.1 Conclusion 65

5.2 Limitation 66

5.3 Recommendation for further study 67

ABSTRACT

Banking industry is a crucial part in any economies It goes without sayingthat with the presence of banking firms, such developed countries as the UnitedState can achieve their success today However, inherent in banking industriesare a lot of uncertainty that can cause vast damage to their members The mostnoticeable and current example of this is the financial crisis 2008 stemmed fromfailure in banking system of the United State and the debt crisis in Europe from

2010 until now

In a small country like Vietnam, banking industry also have to face similarrisk and may encounter same problem as what banks in other developed countrydid Especially, when most of Vietnamese banks rely heavily on credit activities

to generate profits, credit risk is the issue that matter the most The mainconcerns of this thesis is to find out what a typical Vietnamese commercial bank

is doing with their credit risk management and recommend solution to improvedtheir weaknesses

How well a bank is doing with its credit risk management is firstdetermined by the performance of its credit activities That means in order toevaluate credit risk management, the first task is to evaluate the performance ofthe bank’s credit activities Then, through various data, the reason for theperformance of the bank will be revealed

1 ACB: Asian Commercial Bank

2 BIDV: Bank for investment and development of Vietnam

3 CIC: Credit information center

4 HNX: Hanoi Stock exchange

5 SBV: State bank of Vietnam

6 USD: United state dollars

7 VND: Vietnam dong

LIST OF FIGURES

Figure 1: Composition of branch's credit in 2009 38

Figure 2: Composition of branch's credit in 2010 39

Figure 3: Composition of branch's credit in 2011 39

Figure 4: Division of jurisdiction in ACB 52

List of tables

Table 1 Credit performance at Duyen Hai branch 35

Table 2credit risk at Duyen Hai branch 37

Table 3: Quality structure of branch's credit 40

Table 4: Internal regulation on interest rate 50

Table 5: Criteria weight in corporate borrower rating 56

Table 6: Individual borrower information 57

Table 7: Ranking scale of individual borrower 58

Table 8: Collateral rating scale 59

Table 9: Individual borrower rating 59

Table 10: Corporate borrower rating criteria 68

Table 11: Corporate borrower rating scale 70

Financial institutions always plays important role in every economy Nocountry can achieve its growth objectives without the support from commercialbanks and other institutions that also provide banking services to the public.With the main function of receiving money deposit from money supplier andlending it to money user, banks works as intermediaries in the money market.Without banks, the process of transferring money from people with excess ofmoney to people in need of money will be obstructed by many barriers such asthe lack of information, geographical distance, etc However this industry is alsovery risky As intermediaries in money market, banks make loans to a largenumber of borrowers in remarkable amount of money while their own capital isrelatively very small Certain incidents, hence, can cause trouble to the bankwhen the loss of their loan may exceed their capital and force them to gobankrupt.

In Vietnam, banking is a very flourishing industry but are facing manydifficulties Currently, 25 years after the economic reform, there are about 40Vietnamese commercial joint stock banks, 3 state-owned commercial banks andmany other foreign banks All of them are contributing to Vietnamese economicachievement in the recent years However, Vietnamese banking industry areconfronting many challenges, one of which is how to ensure the lowest risk incredit activity When the impact of 2007-2009 global crisis is still present allover the world, credit quality is a tricky problem High inflation, the climbing of

interest rate and input cost and fluctuation of USD and gold in global marketmake it very difficult for Vietnam companies and small business to gain access

to bank’s money For commercial banks, they have to be extremely cautious ingiving loan there is great odd that borrowers may encounter problem and failed

to fulfill their credit obligation in this scenario

So the question so far is that how commercial banks are doing onmanaging their credit risk portfolio With this question in mind, this thesisexamined the real situation at a branch of Vietnam Asian Commercial Banklocated in Haiphong city Specifically, the branch is Duyen Hai branch where thewriter was an intern

1.2 Overview of the subjected bank

1.2.1.Overview of Asian Commercial Bank (ACB)

In June 04, 1993, Asian Commercial Bank’s foundation was officialannounced and regulated in licenses number 0032/NH-GP issued by SBV inApril 24, 1993 and 533/GP-UB issued by People committee of Ho Chi Minhcity

ACB and its subsidiaries operate mainly in mobilizing money supplier’sdeposits in various forms of maturities and paying methods, making loan tomoney users, payment services, discounting securities, trading foreign currencyand gold, stock brokerage and trading and providing various corporate financialservices such as banker acceptance, financial leasing and financial consultant,etc ACB went public in 31/10/2006 and their stock was officially traded onHNX in 21/11/2006

1.2.2 Overview of ACB Duyen Hai branch

Foundation of Duyen Hai branch was regulated in license 3156/GCT.Duyen Hai branch locates at 15 Hoang Dieu street, Minh Khai, Hong Bang,Haiphong

Structure of Duyen Hai branch

Structure of Duyen Hai branch includes director and specializeddepartments:

 Transaction and inventory department

 Enterprise customer department

 Individual customer department

 Accounting department

 Administrating department

 Collateral legalizing and validating department

Main obligation of Duyen Hai branch:

Direct or

Direct or

Ente rprise customer department

Indi vidual customer department

Indi vidual customer department

Acc ounting department

Acc ounting department

Ad ministration department

Ad ministration department

Ass

et legalizing and validating department

Ass

et legalizing and validating department

The branch’s requirements of ACB system are:

 Reserving assets mandated to the branch by ACB head quarter.Those assets include land and equipments which are invested by the system’smoney

 Develop human resource, train employees to improve staff’sperformance, generate profits for the bank and better the bank’s image incustomers’ mind

 Implement communication and report as regulated by SBV andACB head quarter

 Implement business plan as specified in ACB’s business objectives

 Improve banking practice and recommend ACB head quarter aboutbetter practice in banking business, apply modern technology in daily activities

of the branch

Main businesses of Duyen Hai branch

Duyen Hai branch mobilizes funds as regulated by SBV and ACB Thismeans the branch receiving deposits from the public in short, medium and longmaturity Deposit can be in both domestic and foreign currency

Other business of Duyen Hai branch is making loan to individual andcorporate customers The branch’s loan can be long, medium and short termbased on the structure of mobilized funds

Duyen Hai branch also implements and manages banker acceptance andinternational payment service based on instructions from State Bank of VietNam and ACB head quarter

1.3 Data collection and methodology

1.3.1Data collection

a Secondary data

Secondary data are facts and figures collected by someone other than theresearcher himself These data can be used for purposes different from theresearcher’s (Ghauri & Gronhaug 2010, 90) For instance, a student doingresearch on economic growth factors can take a line graph showing GDP data inthe 2000-2010 period from the national statistics bureau Secondary data, infact, usually help the researcher a lot in the beginning phase of their study,especially when the research problem is not familiar The literature in thetheoretical background section is the very first example of secondary data.Secondary data can be obtained through numerous sources Some divide thesources into publication (books, journal articles, etc.) and electronic (websites,emails, anything from the internet) Others like Saunders, Lewis and Thornhill(2009) gives these categories: documentary (books, reports, newspapers,transcripts, voice recordings, video recordings, etc.), survey-based (any datacollected using survey strategy), and multiple source (documentary combinedwith survey-based combined) secondary data Another way of classification is:internal and external sources (Ghauri & Gronhaug 2010, 97)

Secondary data are particularly useful to this thesis A teacher’s materials

at school triggered an interest in the author to write something in riskmanagement Intense review of books, articles, academic journals (publications)

or electronic sources related to the topic during one month has helped tonarrowed down the research problem to credit risk management in a commercial

bank Accidentally, the writer went through an article about risk managementframework improvements in Vietnamese small commercial banks and wouldreally love to study more In Vietnam, disclosure of information in bankingbusiness is an extremely sensitive issue Primarily the researcher has to base heranalysis on information provided by the bank in published annual reports ornews and existing regulation documents Without secondary data, this thesiswould never become a reality.

b Qualitative and quantitative data

Qualitative data is information which does not provide a numericalmeasure of attributes, characteristics or properties of phenomenon In otherwords, qualitative data focus on the description of quality: it deals with theaspect of things that can not be expressed in a reasonable numerical way

In this research, qualitative data is very important It includes data on thecurrent credit risk managing practice at the branch like regulatory documents orinternal controlling practice that is currently implemented by the bank In thescope of this research, qualitative data helps in:

- Gathering details of the subject bank‟s credit policies: how the policieslook like and if they contain fundamental information

- Discovering how credit unit in the transaction office work and whetherits operation complies with the policies

- Understanding how well the transaction office is performing based oncomparing historical data and figures from year to year

- Detecting the credit employees‟ understanding of and attitudes towardsthe bank‟s formal policies

In addition to qualitative data, the research also utilizes quantitative data.The term quantitative data is used to describe a type of information that can becounted or expressed numerically This type of data is often collected inexperiments, manipulated and statistically analyzed Quantitative data can berepresented visually in graphs, histograms, tables and charts

In this research, quantitative data is mainly obtained from the subjectbank’s annual reports Specifically, from the numbers presented by the bank intheir balance sheet and income statements, the branch’s performance will berevealed both directly through analysis of trends and portion of numbers andindirectly through deriving certain ratios and examine them

1.3.2 Methodology

The main objectives of this study is to examining the current riskmanaging practices at one of ACB branches and derive a evaluation of thosepractices In order to achieve these objectives, the methodology is used in thisthesis is reviewing current literature on bank’s credit activities and credit riskmanagement, examining current performance of credit activities at the subjectbranches and recommending on how to the bank’s practice

Banking activities are one of the most complicated things on earth always

of a great concern of researchers all over the world They have been doing manyworks on issues problems associated with banking sector This thesis, inparticular, will give a review on such works, which revolve around the main aim

of the thesis - credit risk Various works on how to define a bank, what credit

activities are, what credit risk is as well as the tools to deal with credit risk will

be discussed

The critical point when evaluating performance of credit risk management

of a bank is that we must look at how well they are performing As a result, theempirical finding part of this thesis will focus on two main issues: making aanalysis of the current situation of the credit activities at Duyen Hai branch, andbased on the result of this analysis drawing a conclusion on the effectiveness ofthe bank’s practice

This thesis also includes a recommendation part where some solution toimprove ACB’s credit risk managing practice is suggested The weakness in thebranch’s practice will be revealed, and the recommendations must be based onthe bank’s current orientation

Chapter 2 LITERATURE REVIEW2.1 Bank and credit activities

Kent, as cited in a Ljubljana’s 2004 work, defined bank as “anorganization whose principle operations are concerned with the accumulation oftemporarily idle money of general public for the purpose of advancing to otherfor expenditure” This definition gives the basic idea of banking principle: abank works as an intermediary whose job is to facilitate the lending procedurebetween people with excess of money and people in need of money In Vietnam,commercial banks as well as other financial institutions are regulated in

“Financial institution law 2010” (47/2010/QH12) According to this document,commercial bank is defined as a financial institution that is able to performbanking procedures, including receiving deposits, making loans and providingpayment services Among these functions, the most important to a bank arereceiving deposits and making loans While receiving deposits provides banksraw material and represent the ultimate source of profitability (Peter and Sylvia,2009), granting loans is the process of making profit of banks

Banks’ granting loan activity is an example of credit services that financialinstitutions provide their customers Ciby (2005) defined credit as a transactionbetween creditor and debtor in which creditor transfers money and monetaryequivalent goods to debtor, in exchange for promised reimbursement of facevalue and interest This definition describes credit quite precisely It shows thatbanks and other financial institutions do not provide credit for free but charge acertain amount of interest This interest can be considered as operating revenue

in traditional banking firms The advantage of collecting interest creates an

incentive for financial institutions This incentive compensate for possible gainsfrom the fund lent if invested elsewhere.

Credit plays an important role in the economy To each borrower,borrowing is the most convenient way to obtain capital and the most importantmeasure to maximize wealth, adjust tax and reserve business control To thewhole economy, credit helps utilize most effectively the idle fund in the society.Also, because well-managed credit stimulates growth of each individual, itfinally stimulates the growth of the whole economy

2.2 Credit risk

2.2.1 Definition

According to David (1997),a risk of bank is defined as a reduction infirms’ value due to changes in business environment.In their daily businessbanks are very likely to encounter events that affect them negatively David(1997) identified 4 main risks that a typical bank may have: market risk; creditrisk, operational risk and performance risk Besides those, there are alsoregulatory risk and environmental risk that influence daily banks operation(Raghavan 2003) In an article written by Anh Tuan (2012) on [newspapername], the writer indicated 3 main risks present in Vietnamese banking sector.They are credit risk, liquidity risk and regulatory risk Regarding the importance

of management of risks, Kaminsky and Reignhart (1999) thought that credit riskwas the largest element of risk in the book of most banks

Credit risk is defined formally as “the potential that a bank borrower orcounterparty will fail to meet its obligations in accordance with agreed term”(Basel 1999a) In Vietnamese regulation, credit risk is defined in Decree

493/2005/QĐ NHNN as the possibility of losses in banking activities, resultingfrom customers’ unwillingness or inability to meet their obligation Theexplanation for the importance of credit risk is that banks rely heavily on creditactivities to generate profitability If banks are ambitious and want to attain largeprofit, they have to make large amount of loan and endure high level of creditrisk The critical question for most bankers is that given certain level of risk,what the adequate level of return is (Ciby 2005)

2.2.2 Types of credit risk

Basing on the source of risk, Raghavan (2003) believed that credit riskcomprises of transaction risk and portfolio risk

Transaction risk also called firm credit risk (Ciby 2005) refers to thefailure in the banks’ process of assessing and approving loan to individualcustomers Raghavan divided transactional risk again into three components:

- Selection risk: selection risk is problems in the banks’ process

of selecting appropriate project to finance

- Collateral risk: collateral risk originates from the failure tocollateralize a loan or to put legal claim on collateral assets

- Operational risk: operational risk refers to the problems inmanaging loans and lending activity Specifically, difficulties in internal creditrating and treating bad debts are symptom of operational risk in banks

Portfolio risk is risk arises from the performance of banks’ portfolio ofloan This type of credit risk contains 2 components:

- Intrinsic risk: credit loss may develop from the sectorial andoperating characteristics of the borrowers

- Concentration risk: when bank’s loan portfolio is too concentrated

in a group of borrowers, an economic sector or a geographical region, it is said tohave concentration risk

The above risks do not take into account the loans involving counterpartyfrom different region of the world In fact, modern banks do not provide credit toonly domestic borrowers but also to foreign customers According to Ciby(2005), this practice exposes banks to settlement risk, sovereign risk and foreignexchange risk

- Settlement risk is explained by Ciby (2005) as sometimes banks’counterparties failed to deliver their payment at the settlement date Horcher(2005) points out that settlement risk is often related with foreign exchangetrading, where “payments in different money centers are not madesimultaneously and volumes are huge” One outstanding example of settlementrisk is the case of a German bank Bankhaus Herstatt In 1974, this bank wassuspended A lot of money was stuck in its account around the world and itfailed to transfer money to it counterparty

- Sovereign risk arises due to the impact of deteriorating foreigneconomic, social and political conditions on overseas transactions and sovereignrisk refers to the possibility that governments may enforce their authority todeclare debt to external lenders void or modify the movements of profits, interestand capital under some economic or political pressure (Casu, Girardone andMolyneux 2006)

- Foreign exchange risk exposes banks to the possibility that value ofbanks’ credit in different currency may deteriorate in value if exchange rateshifts negatively For example, an importing company wants to borrow USDfrom Asian Commercial Bank (ACB) to pay to its American exporter If at theexpiration of the loan, USD

2.2.3 Sources of credit risk

Generally, credit risk is related to the traditional bank lending activities,while it also comes from holding bonds and other securities Basel (1999a)reports that for most banks, loans are the largest and most obvious source ofcredit risk; however, throughout the activities of a bank, which include in thebanking book as well as in the trading book, and both on and off the balancesheet, there are also other sources of credit risk Various financial instrumentsincluding acceptances, interbank transactions, financial futures, guarantees, etcincrease banks’ credit risk Therefore, it is indispensable to identify all the creditexposures the possible sources of credit risk for most banks, which can alsoserve as a starting point for the following parts of this work

c On-Balance Sheet Exposures

According to Saunders and Cornett (2006), the major types of bank loansare commercial and industrial (C&I), real estate, consumer and others.Commercial and industrial loans can be made for periods from a few weeks toseveral years for financing firms’ working capital needs or credit needsrespectively Real estate loans are primarily mortgage loans whose size, price

and maturity differ widely from C&I loans Consumer loans refer to those such

as personal and auto loans while the so called other loans include a wide variety

of borrowers such as other banks, nonblank financial institutions and so on

Credit risk is the predominant risk in bank loans Over the decades thecredit quality of many banks’ lending has attracted a large amount of attention.The only change is on the focus of the problems from bank loans to lessdeveloped countries and commercial real estate loans to auto loans as well ascredit cards, which is an American example Since the default risk is usuallypresent to some degrees in all loans (Saunders and Cornett 2006), the individualloan and loan portfolio management is undoubtedly crucial in banks’ credit riskmanagement

 Nonperforming Loan Portfolio

According to Hennie (2003), nonperforming loans are those not generatingincome, and loans are often treated as nonperforming when principal or interest

is due and left unpaid for 90 days or more Thus the nonperforming loanportfolio is a very important indication of the bank’s credit risk exposure andlending decisions quality

 Debt Securities

Besides lending, credit risk also exists in banks’ traditional area of debtsecurities investing Debt securities are debt instruments in the form of bonds,notes, certificates of deposits, etc, which are issued by governments, quasi-government bodies or large corporations to raise capital In general, the issuerpromises to pay coupon on regular basis through the life of the instrument andthe stated principal will be repaid at maturity time However, the likelihood that

the issuer will default always exists, resulting in the loss of interest or even theprincipal to banks, which can be a damaging impact

d Off-Balance Sheet Exposures

Since the 1980s, off-balance sheet commitments have grown rapidly inmajor banks, among which there are swaps, forward rate agreements, bankers’acceptances, revolving underwriting facilities, etc (Hull 1989) Thosecommitments give rise to new types of credit risk from the possibility of default

by the counterparty In this section, some of the off-balance sheet creditexposures will be introduced, among which the first one is related to derivativecontracts

 Derivatives Contracts

According to Saunders and Cornett (2006), banks can be dealers ofderivatives that act as counterparties in trades with customers for a fee.Contingent credit risk is quite likely to be present when banks expand theirpositions in derivative contracts Since the counterparty may default on paymentobligations to truncate current and future losses, risk will arise, which leaves thebanks unhedged and having to substitute the contract at today’s interest rates andprices This is also more likely to happen when the banks are in the money andthe counterparty is losing heavily on the contract Comparatively, the type ofcredit risk is more serious for forward contracts and swap contracts, which arenonstandard ones entered into bilaterally by negotiating parties While trading inoptions, futures or other similar contracts may expose banks to lower credit risksince contracts are held directly with the exchange and there are marginingrequirements However, the credit risk is also not negligible

 Guarantees and Acceptances

Bank Guarantee is an undertaking from the bank which ensure that theliabilities of a debtor will be met, while a banker’s acceptance is an obligation by

a bank to pay the face value of a bill of exchange on maturity(Basel 1986) It isstated by Basel (1986) that since guarantees and acceptances are obligations tostand behind a third party, they should be treated as direct credit substitutes,whose credit risk is equivalent to that of a loan to the final borrower or to thedrawer of the instrument In this sense,it is clear that there is a full risk exposure

in these off balance sheet activities

 Loan Commitments

A loan commitments are formal offers by a lending bank with the explicitterms under which it agrees to lend to a firm a certain maximum amount at giveninterest rate over a certain period of time In this activity,contingent credit riskexists in setting the interest or formula rate on a loan commitment According toSaunders and Cornett (2006),banks often include a risk premium based on itscurrent measurement of the creditworthiness of the borrower, and then in thecase that the borrowing firm gets into trouble during the commitment period, thebank will be exposed to dramatic declines in borrower creditworthiness, sincethe premium is preset before the downgrade

2.3 Credit risk management

2.3.1 Role of credit risk management

Series of bank scandal at the end of 20th century motivated delegators ofbanking sector in G-10 countries to create Basel Committee, hoping that thisorganization can protect the well-being of banking systems all over the world In

its consultative paper issued in 1999, Basel Committee points out that thoseserious banking problems are main attributable to the loose credit standards forborrowers and counterparties, poor portfolio risk management and so on Hennie(2003) also concludes that credit risk have always been a major cause of banks’failure, because “more than 80 percent of a bank’s balance sheet generally relates

to this aspect of risk management” All such evidence proves the extremely vitalrole credit risk management plays in the whole banking risk managementapproach as well as the sustainable success of the organization With a soundcredit risk management, banks would be able to curb credit value at risk andmaximum rate of return

2.3.2 Principles of credit risk management

Principles of credit risk management are clearly elucidated by Basel(1999) to have the following contents:

a Establishing an appropriate credit risk environment

Establish an appropriate credit risk environment, as indicated by Basel(1999), involves three issues First, board of directors is responsible fordeveloping credit risk strategy and significant credit risk policies Credit riskstrategy, as discussed by Basel, has to express bank’s tolerance for risk andexpected profitability for given levels of risk Second, senior manager are incharge of “implementing credit risk strategy and building credit risk policies andprocedures for identifying, measuring, monitoring and controlling credit risk.” It

is also noticed that banks’ policies and procedures should take into account all ofbank’s activities at both individual and portfolio level Third, sound credit riskmanagement must be based on a clear identification of credit risk inherent in all

of bank’s activities and products While such identification is easy for sometraditional banking products, it will be less obvious for credit risk analyst whenthey deal with contemporary activities like assets securitization or creditderivatives.

b Operating under a Sound Credit Granting Process

A strong credit granting process, according to Basel (1999), first has topossess a sound and well-defined set of credit granting criteria Those criteriashould involve an indication of bank’s target market, an understanding ofborrower and purpose and structure as well as source of repayment of the credit.The information of borrowers and their credit purpose gives banks a basis for theinternal credit rating process In addition to credit-granting criteria, banks shouldalso apply credit exposure limits on both individual counterparties and group ofrelated counterparties These limits are derived from credit rating process, which

is said previously to be developed from borrowers’ information A established approving and renewing process is also needed in credit grantingprocess That is, all individuals involved in credit granting process have to beable to coordinate harmonizingly Banks’ transaction evaluation and approvalhave to be instructed be written guidelines to avoid subjective problems Creditgranting process should also clearly stipulate the extension of credits, becausethis is a potential source of abuse

well-c Maintaining an Appropriate Credit Administration, Measurement and Monitoring Process

Credit administration, as emphasized by Wesley (1993), can play a vitalrole in the success of a bank, since it is influential in building and maintaining a

safe credit environment and usually saves the institution from lending sins.Therefore, banks should never neglect the effectiveness of their creditadministration operations Then talking about credit risk measurement in banks,

it is required that banks should adopt effective methodologies for assessing thecredit risk inherent both in the exposures to individual borrowers and creditportfolios, and this will be explained in details later The last focus in this area ofprinciples is related to credit risk monitoring, which is definitely a must inbanks’ risk management procedure Banks should keep track on the borrowers’current financial conditions and ensure their compliance with the covenants.Both cash flows and collateral adequacy should be ensured and the potentialproblem credits should be considered In this way, banks are well in control oftheir credit qualities as well as all the related situations, and can react to anyfuture changes timely and readily

d Ensuring adequate controls over credit risk

On a regular basis, a separate system of banks should be responsible forreviewing their credit risk management process The result of this review, which

is then delivered to board of directors and senior management, should answer thequestion if the credit granting process works properly and the credit exposure is

at its appropriate level The aim of this action is to find if there is any odd inbank’s credit profile Once such odd found, banks’ managers have to takesuitable remedial as soon as possible to ensure the soundness of the wholeoperation

e The role of supervisors

In addition to the effort of banks themselves in managing credit risk,banks’ supervisors also need to play an active role in this job Their duty is toregularly evaluate banks’ credit risk management to identify its effectiveness.Supervisors base on such evaluation to rate the quality of banks’ credit riskmanagement and cooperate with management to address any problemdiscovered The other job of supervisor is to limit the concentration of banks’credit They must guarantee that banks’ fund is not partially distributed butscattered to a wide range of borrowers

2.3.3 Credit risk measurement

Measuring risk is always a crucial part in risk management process, and assuggested by Fabozzi (2006), quantifying credit risk can be complicated due tothe lack of sufficient historical data, the diversity of involved borrowers and thevariety in default causes With the dramatic development of technology, creditrisk measurement evolves greatly during the last 20 years In the following, thefundamentals of credit risk measuring and the three categories of methods forbank credit risk measurement -credit rating, credit scoring and credit modelingwill be explained

a Credit rating

A credit rating is for assessing the creditworthiness of an individual orcorporation to predict the probability of default, which is based on the financialhistory and current assets and liabilities of the subject As mentioned by theFederal Reserve (1998), credit risk ratings may reflect not only the possibility or

severity of loss but also the variability of loss over time For banks, both theinternal credit rating and the external one are concerned in their credit riskassessment

 Internal Credit Ratings

The internal credit ratings of banks, as suggested by Jacobson, Linde andRoszbach (2003), are the summary of the risk properties of the bank loanportfolio They can be treated as monotonic transforms of the probability ofdefault and shape the nature of credit decisions that banks make daily (Treacyand Carey 1998) A reliable and meaningful internal risk rating system can be auseful means for differentiating the scale of credit risk in loans and other sources

of exposure (Basel 1999a) The internal credit ratings of banks are becomingincreasingly important since the recommendations, as per the latest Basel IIaccord (Basel 2006), highlight the adoption of robust internal credit ratingsystem for risk assessment and buffer capital calculation, which will certainlyencourage and lead banks to further development in this method

 External Credit Ratings

The external credit ratings are provided by external credit rating agenciessuch as Moody, Standard & Poor and Fitch, and are a measure of the long-termfundamental strength of companies (Gonzalez et al 2004) One noticeable issue

is that credit rating agencies usually take a long-term perspective, which implies

a lower sensitivity of their ratings to short-term fluctuations in credit quality,and rating migrations are triggered only by significant credit quality change(Altman and Rijken 2004) Despite of this, those ratings still play a key role inpricing credit risk Since in the standardized approach to credit risk of Basel II

accord (Basel 2006), banks are allowed to slot assets into weighting bands (seeTable 2.1) according to ratings from eligible external agencies (Jackson 2001), it

is quite possible that the future role of external ratings will keep on expanding

b Credit scoring

Credit-scoring approaches, as mentioned by Reto (2003), can be found invirtually all kinds of credit analysis and share the same concept with creditratings A credit scoring system determines points for each preidentified factor,which are combined to predict the loss probability and the recovery rate.According to Altman and Saunders (1999), there are two types of accountingbased credit-scoring systems in banks -univariate and multivariate The first onecan be used to compare various key accounting ratios of potential borrowers withindustry or group norms while in the latter one, key accounting variables, arecombined and weighted for producing a credit risk score or a probability ofdefault measure, which if higher that a standard, indicates a rejection to the loanapplicant or a further scrutiny

c Credit risk measurement model

According to Basel (1999b), credit risk models try to aid banks inquantifying, aggregating and managing credit risk across geographical andproduct lines, and the outputs can be very important to banks’ risk management

as well as economic capital assignment Those models, in spite of the possibledifferences in assumptions,share the common purpose to forecast the probabilitydistribution function of losses that may come up from a bank’s credit portfolio(Lopez and Saidenberg 1999) And regarding the potential benefits from theapplication of credit risk models in banking sectors, Basel (1999b) has concluded

that they are responsive and informative tools offering banks “a framework forexamining credit risk in a timely manner, centralizing data on global exposuresand analyzing marginal and absolute contributions to risk” According toJackson, Nickell and Perraudin (1999), four types of models that are betterknown.

 Merton-based Models

Merton-based models are also referred to as structural models The basicprinciple of this category of models, as suggested by Merton (1974) first, is that

a firm is considered to be in default when the value of its assets falls below that

of its liabilities Merton has modeled a firm’s asset value as lognormal process,with the equity modeled as a call option on the underlying assets, and the default

is allowed at only a future time t (Arora, Bohn and Zhu 2005) The current valueand the volatility of the firm’s assets, the outstanding debt and its maturity arerequired as inputs, from which the borrower’s default probability can bedetermined (Hull, Nelken and White 2004) Based on the Merton model,Moody’s KMV model has been developed for providing a term structure ofdefault risk probabilities The term “Distance-to-default” is proposed in theKMV model, which is calculated from the market assets value of the firm, thevolatility as well as the default point term structure, and the model derives theactual probability of default -the Expected Default Frequency for each obligorinstead of relying on the average historical transition frequencies produced bythe rating agencies (Crouhy, Galai and Mark 2000)

of calculations.

2.3.4Risk mitigation and transfer techniques

The last step for any kind of risk management is to mitigate and transferthe risk in order to avoid or reduce losses In this area, a variety of approachesare available and new methods keep on emerging Generally speaking, thetraditional methods for reducing credit risk focus on loan underwriting processand diversification, while the new means refer to asset securitization and hedgingwith credit derivatives (Neal 1996) In this section, all those essential ways forminimizing credit risk will be covered

a Accurate Loan Pricing

One of the most obvious ways for minimizing credit risk, as mentioned byHeffernan (1996), is that banks should ensure the price of a loan exceed a riskadjusted rate, and include any loan administration costs Basically, the riskpremium is higher for riskier borrowers and the loan rate should keep changingwith the alteration of the loan risk profile

 Credit Rationing

The tenet of credit rationing, as concluded by Horcher (2005), is thatcredit granting favors the most attractive risk-to-return tradeoff According toMishkin (2004), credit rationing takes two forms in a bank The bank may eitherrefuse to make a loan to a borrower regardless of his/her willingness to pay ahigher interest rate, or restrict the quantity of the credit, which can be much lessthan what the borrower want

 Credit Limits

The use of credit limits on both single and group obligors assists a carefulcounterparty selection in the risk management process, and the limits should beprepared for different products, activities as well as industries respectively Forexample, they can be applied to the asset management in the form of exposuresize limits while to trading activities in the form of exposure position limits

 Collateral

The use of collateral to support various lending agreements for reducingcredit risk has been adopted by banks for a long time already It is applied notonly to loans but also in other transactions such as derivative trading, where itworks as an initial margin However, the usefulness and importance of collateraluse has actually been doubted Wesley (1993) used to comment that collateralseldom provides a way out for a loan because when it matters most it has theleast value Since the value of collateral diminishes very quickly, it may not beable to generate enough cash flow for the debt as planned Therefore, what reallymatters is actually whether the borrower has continuing access to sufficient cashflow when needed, not merely an existence of the collateral

 Diversification

Diversification is a very common concept in the area of risk management.For minimizing credit risk, diversification can be used to offset the additionalvolatility created from an increase in the number of risky loans Seeking outassets whose yield returns are negatively correlated, banks can combine differenttypes of loans into a portfolio and diversify away the non-systematic risk Sincethe loss from defaulted loans will be offset by the earnings from other loans, thetotal probability for the bank to suffer a loss can be well reduced

 Netting Agreements

A netting agreement nets the amounts to be exchanged betweencounterparties, which reduce the credit exposure For banks, netting agreementsare mostly applied to interbank transactions, including bilateral paymentsnetting, multilateral payment systems with net settlement and master derivative

agreements (Emmons 1995) In a bilateral netting agreement, for instance, allpayments for the given day are totaled and what the participants need to make isonly the net payments Emmons (1995) has commented that interbank nettingagreements reduce interbank credit exposures and shift the default risk to bankcreditors whose claims are not included in such netting agreements Therefore,they are also useful tools for bank credit risk control.

b Newer method for credit risk transfer

 Asset Securitization

Asset securitization is about turning traditional, non-marketed balancesheet assets into marketable ones and moving them off balance sheet (Twinn1994) For a bank, securitization requires it to set aside a bunch of incoming-earning assets and to sell securities against those assets in the open market,which means transforming loans into public traded securities in effect (Rose andHudgins 2008) Many kinds of assets can be securitized including residentialmortgages, commercial mortgages, credit card loans, trade receivables Assetsecuritizations can improve credit risk management because they help todiversify a bank’s credit risk exposure and reduce the need for monitoring eachindividual loan’s condition For instance, if a bank finds its lending tooconcentrated in a given sector, it can securitize some of lending to reduceexposures

However, there are also two important problems with asset securitization.The first one involves the Special Purpose Entities (SPE), which are set up bybanks for separating and securitizing loans As pointed out by Tavakoli (2003),the SPEs are off-balance sheet and bankruptcy remote, which facilitate the risk

management of banking community, but can also be used for illegitimate uses,such as embezzlement and mischaracterizing revenues and losses Just as hementioned, the SPEs are ideal for both securitizing assets and hiding assets, since

“any legitimate means can be exploited for illegitimate gain” Good news is thatever after the Enron case, much more attention is already given to this issue and

it should always be treated as a focus of the regulators The second problemabout asset securitization is that banks which are securitizing their assets fortransferring credit risk may also purchase the assets-backed securities issued byother banks Due to the fact that those purchased securities may be riskier thanthe issued ones, the extent to which credit exposures can be reduced by assetsecuritization can actually be quite ambiguous for banks to tell

 Loan Sales

Rather than being collateral in the securitization, bank loans themselvescan be sold in entirety to a new owner, and such a bank loan sale occurs when abank originates a loan and sells it either with or without recourse to an outsidebuyer (Saunders and Cornett 2006) According to Haubrich and Thomson(1993), there are two types of loan sales, the participation and the assignment Inthe participation, the original contract between the borrower and the bankremains in place, and the bank still keeps on collecting payments, overseeing thecollateral as well as examining the books While in the assignment, which is aless common type, the debtor-creditor relationship is transferred to the buyer byallowing the buyer to take direct action against the borrower

Loan sales have existed for many years already and their use has beenincreasingly recognized as a valuable tool in a bank manager’s portfolio of credit

risk management techniques Neal (1996) thinks the strategy of loan sales isattractive to banks since a fee from the loan origination is earned but the creditrisk is assumed by the new investor And in the occasion where the banks lendlarge amounts in a single takeover, loan sales are especially important forcontrolling credit risk.

 Credit Derivatives

The continuous development of credit risk transfer techniques broughtcredit derivatives several years ago, which recently have gained importancerapidly in situations where the diversity of loans and credit risk makes it difficult

to carry out securitizations or sell loans individually (Broll, Pausch and Welzel2002) They are contractual agreements based on credit performance that mainlyrefers to predetermined events such as default, nonpayment of loan obligations,downgrading and insolvency According to Neal (1996), credit derivatives canhelp banks to manage the credit risk by insuring against adverse movements inthe credit quality of the borrowers, and the major types of credit derivatives arecredit default swaps, credit options and credit-linked notes

Credit Default Swaps

Credit default swaps (CDS) are the most widespread and liquid creditderivatives, which together with the related products, account for approximatelyhalf of the credit derivative market today (Duffee and Zhou 2001) A CDS is abilateral contract that offers safety against the risk from a particular credit event,under which the buyer makes periodic payments to the seller until the occurrence

of a credit occurrence or the maturity while the seller makes a contingentpayment to reimburse the buyer if the defined event occurs Blanco, Brennan and

Marsh (2003) point out that the economic importance of a CDS is like that of aninsurance contract, but the difference is that it is not necessary to clasp aninsured asset for claiming compensation under a CDS.

Credit Options

Credit options are credit-spread derivatives based on the interest rate gapsbetween the debts of different types of issuers (Horcher 2005) For instance, in acredit spread call option, the buyer pays premium to the seller in exchange for acontingent payment when the credit spread expands past a certain level, thus abank that worries about the increasing risk on a loan can obtain such an optionfor hedging purposes

Credit-linked Notes

A credit-linked note is a kind of debt instrument with an embedded creditderivative, which can therefore be treated as a combination of a bond and a creditoption It is the credit derivative suitable for debt issuers to hedge against creditrisk, which reduced payments for the issuer when a specified credit eventhappens The reason for the wide acceptance of credit derivatives in controllingcredit risk is that these instruments provide a mechanism permitting the transfer

of unwanted risk from organizations with too much or wrong types of credit risk

to the willing counterparty, as concluded by Horcher (2005) Besides, creditderivatives facilitate a portfolio approach to credit risk management anddiversification since banks can enter into a derivative contract to transfer somecredit risk in order to reduce the risk in their portfolios

Chapter 3 EMPIRICAL FINDINGS3.1 Performance of credit activities at Asian Commercial Bank (ACB) Duyen Hai branch in the last 3 years

3.1.1 Overview of credit activities at the branch

Table 1 Credit performance at Duyen Hai branch Credit balance

Source: branch’s annual summary

The above table gives us an overview of credit situation at Duyen Haibranch in the last three years In general, aggregate granted loan has beenincreasing every year In 2009, credit balance was recorded to be 714 billionVND Three years later, this number grew to 2056 billion VND Although totalcredit has been increasing, its growth rate shows a reverse trend Especially in

2011, value of granted loan was only 17.91% higher than that of the previous