(Luận văn thạc sĩ) the effect of credit growth on credit quality evidences of commercial banks in dong nai province

Under the assumptions that banks reduce the lending rate as well as lower the credit standards of customers, the occurrence of supply shift which boost credit growth will tend to result

UNIVERSITY OF ECONOMICS ERAMUS UNIVERSITY ROTTERDAM

VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE EFFECT OF CREDIT GROWTH ON CREDIT QUALITY:

EVIDENCE FROM THE COMMERCIAL BANKS IN DONG NAI

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

DECLARATION

I hereby declare that the thesis “T HE E FFECT OF C REDIT G ROWTH ON

C REDIT Q UALITY : E VIDENCE FROM T HE C OMMERCIAL B ANKS IN D ONG N AI”, which is submitted to Vietnam – Netherlands Programme, is my original research work All of the contents which are not from my own work are cited carefully and clearly in this thesis

I certified that the contents of this thesis have not been and are not being submitted for any other degrees

This thesis was done under the supervision and guidance of Dr Vo Hong Duc, Economic Regulation Authority, Western Australia and the Edith Cowan University, Australia Any other contributions to this thesis are presented in the

A CKNOWLEDGEMENT section

Signature

Trinh Hoang Viet

Ho Chi Minh City, 1st November 2015

In my capacity as the supervisor of this thesis, I certified that the statements above are true to the best of my knowledge

Signature

Dr Vo Hong Duc

Date:

I wish to acknowledge the contributions of all VNP students in Class 20, especially Mr Vo Van Hung and Mr Nguyen Son Kien, for sharing learning experiences and valuable academic materials

I would also like to extend my thanks to all VNP Staffs for their enthusiasm of assisting my study over the last two years

Finally, I would not forget to send my deepest thank to my parents who always encourage me to keep up with my study objectives

ABSTRACT

This research is conducted to examine and quantify the effect of credit growth

on credit quality for the commercial banks in Dong Nai In relation to this possible effect, theoretical framework of the so–called “three shifts” in the credit market is likely to explain that credit growth might have positive or negative effect on credit

quality These three shifts are generally known as: (i) a supply shift (an expansion in

bank loan supply by lowering credit standards), (ii) a demand shift (an increase in loan demand to optimize business activities) and (iii) productivity shift (a positive change in macroeconomic conditions) In addition, empirical evidence confirms that rapid credit growth of commercial banks could lead to a deterioration or improvement of credit quality The macroeconomic context for banking industry indicates that the decline in credit quality after a period of growth might be a reflection of (1) negative changes in the macroeconomic determinants which have a bad influence on the business activities of borrowers; and (2) information externality which makes banks hardly gain efficiency in evaluating their customers

This study utilizes the data of 29 commercial banks operating in Dong Nai province for the period from 2009Q3 to 2014Q4 The econometric technique of Difference GMM for dynamic panel data model is adopted in order to examine the effect of credit growth on credit quality in the context of the commercial banks in Dong Nai This study finds empirical evidence to confirm that credit growth causes the decrease in credit quality after three quarters to one year In addition, this effect

of credit growth in the long run is found in this study

These findings obtained from this study reflects that: (i) commercial banks in Dong Nai might have lowered their credit standards to increase their lending to business customers and individuals; (ii) the conditions of local economy in Dong Nai might have not been really favorable for business activities during the research period; (iii) and the information externality in the loan market might have distorted the accuracy of customers evaluation in relation to their financial capacity

Keywords: credit growth, credit quality, commercial bank, difference GMM,

dynamic model, non–performing loan

TABLE OF CONTENTS

D ECLARATION i

A CKNOWLEDGEMENT ii

A BSTRACT iii

T ABLE OF C ONTENTS v

L IST OF T ABLES vii

L IST OF F IGURES viii

C HAPTER 1 I NTRODUCTION 1

1.1 PROBLEM STATEMENT 1

1.2 RESEARCH OBJECTIVE AND QUESTION 2

1.3 RESEARCH SCOPE AND METHODOLOGY 2

1.4 THESIS STRUCTURE 3

C HAPTER 2 L ITERATURE R EVIEW 4

2.1 THE MACROECONOMIC CONTEXT FOR BANKING 4

2.1.1 Main Characteristics of Banks 4

2.1.2 Shock and Vulnerability of Banking System 6

2.1.3 The Effect of Macroeconomic Determinants 6

2.1.4 Credit Growth and Vulnerability of Banking System 7

2.2 CREDIT GROWTH AND CREDIT QUALITY THROUGH DIFFERENT SHIFTS 9

2.3 CONTROL FACTORS FOR CREDIT QUALITY 17

2.4 PREVIOUS EMPIRICAL STUDIES 20

2.5 THE CONCEPTUAL FRAMEWORK 26

C HAPTER 3 M ETHODOLOGY AND D ATA 27

3.1 MEASURING CREDIT QUALITY 27

3.2 DATA COLLECTION METHOD 29

3.3 ECONOMETRIC METHODOLOGY 30

3.3.1 Dynamic Panel Data Estimator 31

3.3.2 Econometric Problems 31

3.3.3 Estimating The Long–run Coefficients 33

3.3.4 Econometric Specification 35

3.3.5 Hypothesis testing 35

C HAPTER 4 R ESULT AND D ISCUSSION 38

C HAPTER 5 C ONCLUSIONS 46

R EFERENCES 49

LIST OF TABLES

T ABLE 2.1 Change in credit standard, credit growth and credit quality 16

T ABLE 2.2 Summarization of the literature 25

T ABLE 3.1 Necessary items and their account type 29

T ABLE 3.2 The expected signs of variables used in the research 30

T ABLE 3.3 The calculation of variables 30

T ABLE 3.4 Hypotheses need testing 37

T ABLE 4.1 Descriptive statistics 39

T ABLE 4.2 Estimation result 41

LIST OF FIGURES

F IGURE 2.1 The macroeconomic context for banking 8

F IGURE 2.2 Supply shift 10

F IGURE 2.3 Demand shift 13

F IGURE 2.4 Productivity shift 15

F IGURE 2.5 Different shifts in the macroeconomic context for banking 16

F IGURE 2.6 The effect of credit growth on credit quality 26

F IGURE 4.1 Deposit growth rate and deposit interest rate 39

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C HAPTER 1

INTRODUCTION 1.1 P ROBLEM S TATEMENT

Commercial bank is one of the most important financial intermediaries in the economy Their main functions are mobilizing and lending money to allocate financial resources for households, firms and other economic entities The typical problem of banks is that when borrowers could not use well the money they had borrowed, a credit risk arose One of the main causes is that banks lower their credit standards to attract more borrowers Although it might be a good opportunity to boost credit growth in the present time, banks will face a higher probability to deal with non–performing loans (NPLs) in the future However, if loans expansion is due

to an increase in the demand, this growth will not essentially lead to bad loans Therefore, credit growth may be a reflection of credit quality under some circumstances

When the economy is in the stage of recession, it is certain to affect negatively

on the financial market especially the banking system The general picture is that commercial banks attempt to boost credit growth for profit objective whereas households and firms who borrow money from banks have to face with difficulties

in business activities This leads to a consequence that credit growth may reduce credit quality The problem is whether the profit target of commercial banks by boosting credit growth would be efficient or it just increases the NPLs which bring

no profits or even losses

The determination of the effect of credit growth on credit quality is getting more and more important for not only commercial banks but also central bank and policy makers For commercial banks, it may help them to consider the appropriate time of loosening or tightening credit standards and the decision to expand or limit lending activities For central bank, it will help to control the loans growth of

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commercial banks This is to prevent potential banking crisis when the credit quality

is too low In some cases, understanding the true influence of credit growth on credit quality could help to recognize the real state of the economy in order to apply macroeconomic policies more efficiently

In a report of The State Bank of Vietnam, Dong Nai branch (2015), the current debit balance of total loans is about 100 billion VND This source of capital is mainly concentrated on prior fields and industries of Dong Nai province The overdue loans are kept at a safe ratio of 2.32 percent However, the business activities of firms still meet many difficulties when commercial banks apply new standards of classifying debts Besides, commercial banks are detected of infringing credit regulations such as appraising credit documents carelessly; misevaluating customer financial capacity and collaterals; and not supervising capital usage closely Under these conditions above, commercial banks in Dong Nai might have

to face a high chance of potential credit risk while lending activities is more and more expanded

1.2 R ESEARCH O BJECTIVE AND Q UESTION

This research is to investigate the influence of banks’ credit growth on their credit quality under the control of some characteristics of banks To achieve the research objective, this study attempts to answer the following question:

Does a positive change in the commercial banks’ credit growth lead to a negative change in banks’ credit quality in the case of Dong Nai banking system?

1.3 R ESEARCH S COPE AND M ETHODOLOGY

The research is carried out in the scope of credit growth and credit quality of

29 commercial banks in Dong Nai province, Vietnam The data is collected in the period from 2009Q3 to 2014Q1

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The main methodology of this study is quantitative analysis Due to the

availability of panel data, the limitations of common estimation methods and the

objective of capturing the changes of banks’ credit growth and credit quality, this

research applies the method of Difference GMM for the dynamic panel data model

Besides, the dynamic model could be used to generate long–run coefficients which

reflect the equilibrium of the effects of credit growth

1.4 T HESIS S TRUCTURE

This thesis includes five chapters Chapter 1 introduces the background and

motivation of the research on the effect of credit growth on credit quality Chapter 2

reviews related theories, previous empirical studies and builds a conceptual

framework for the research Chapter 3 presents the data collection method and

quantitative techniques for producing necessary results Chapter 4 shows the results

and discussions Chapter 5 summarizes main research findings, brings out policy

implications, raises some limitations and suggests further studies

2.1 T HE M ACROECONOMIC C ONTEXT FOR B ANKING

2.1.1 Main Characteristics of Banks

As the role of a financial intermediary, banks have a large contribution on the entire economy in the aspect of finance or anything relating to money Banking itself is an industry in the economy Therefore, banks have their own characteristics which are unique and different from other industries In order to analyze banking system under the impact of the macroeconomic context, this research is firstly to introduce the three main bank characteristics which have close relationship to credit growth and credit quality

Banks have extremely high leverage (1) Banks mostly use other people’s

money for their portfolio Similarly, banks primarily mobilize capital for lending activities According to Gavin and Hausmann (1996), bank leverage has two implications First, bank operations are very sensitive to the volatility of the macroeconomic determinants due to very thin capital They may become insolvent after small negative changes of the economy Second, high leverage may bring to a problem relating to the benefit of bank shareholders and debt–holders Bank

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managers often generate risky portfolio to bring the highest benefit for shareholders while debt–holders is limited in their capital recovery in case of insolvency

Banks are easy to become illiquid (2) First, the term of deposit liabilities tend

to be higher than the term of loan assets Borrowers – for example, firms and households need a long time to finance their business activities while the depositors have right to withdraw money at any time In case of time deposits, the depositors are still allowed to withdraw money as long as they accept low or no interest rate Second, if banks attempt to manage the term of their loans, the borrowers still have longer time in paying the debts There is a temporary solution in which borrowers could roll over their loans by borrowing the new to service the old ones in the same bank This action is not always allowed or even illegal, so it affects strongly and negatively on profitability of the borrowers, which causes a decrease in credit quality This characteristic raises a problem that banks have to plan for their additional reserves These reserves are used to reduce the illiquidity which may occur under the influence of adverse macroeconomic shocks

Banks cannot evaluate exactly their borrowers in the expansionary phase of the economy (3) Gavin and Hausmann (1996) indicated that “good times are bad

times for learning” about the truth of financial capacity of the borrowers The advantages of the economy may be one of the reasons of lending booms The borrowers could easily borrow money from a bank to service the debts in another bank Therefore, most of the borrowers appear in good state with banks although their financial capacity may be different In this case, banks have difficulty in determining which loans may potentially become NPLs

These characteristics above are to imply that the decision of boosting credit growth should be considered carefully especially in the disadvantageous conditions

of macroeconomic environment Banks have very high probability in the decline of credit quality, which is the source of illiquidity as well as banking crisis

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2.1.2 Shock and Vulnerability of Banking System

The action of using mobilized money for lending requires a necessary condition in which the growth rate of deposit liabilities is higher than the deposit interest rate However, if this condition does not hold, in principle, banks still have

a solution for this problem by calling their borrowers for paying their mature debts Actually, banks have limitations to do so because it depends too much on the ability

of the borrowers Consequently, there would be a net resources transfer from banking system to depositors in the form of withdrawal and interest The large amount of this net resources transfer will create a shock in the banking system And

if this amount is large enough, the banking system would collapse, which create the vulnerability (Gavin and Hausmann, 1996)

2.1.3 The Effect of Macroeconomic Determinants

The shock from large change in the net resources transfer may originate from the changes of the economy When there is a negative economic surprise from one

or some macroeconomic determinants, there would be two cases: (i) the borrowers cannot service their debts due to the reduced efficiency in their business activities; (ii) banks are limited to investing activities especially lending and become illiquid due to the decline in deposit demand or increase in withdrawal Both cases lead to banking crisis in the form of insolvency In the first case, credit quality decreases and banks are not able to recover enough principal and interest to finance their deposit liabilities In the second case, banks hardly meet the demand of withdrawals These consequences may lead to potential financial vulnerability in the future However, if banks can boost their mobilizing activities, they would have a source of liquidity for withdrawal demand of depositors Besides, banks would have more time to deal with their NPLs

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2.1.4 Credit Growth and Vulnerability of Banking System

As discussed above, the macroeconomic determinants do not have direct and complete effect on the banking system Their affect is mainly on the business environment and the depositors’ behaviors The core question is the reason why banking system becomes too fragile to suffer from the negative changes of the economy It is easy to understand that borrowers’ business activities are strongly influenced by these changes If banks have very close relationship with their borrowers, absolutely, they are also influenced Rapid credit growth would be a typical proxy for this close relationship The more banks expand their loans, the more they rely on their borrowers

Boosting credit growth is closely related to the third characteristic of banks Once they recognized the good appearance in the ability of their borrowers, they are willing to lend more This creates a link between credit growth and the vulnerability

of the banking system However, credit growth should be considered as a signal of economic development than a cause of vulnerability The next question is in what circumstances credit growth performs its negative aspects The answer would be concerned about information problems

Gavin and Hausmann (1996) believed that “…it is very difficult for bankers to obtain information about the creditworthiness of borrowers” (p 14) First, due to the economic expansion, the borrowers can perform well on their capital and gain positive cash flow This would be an advantage opportunity to offer loans not only for the existing customers but also new borrowers Banks would have very limited information about their new borrowers Thus, the probability of misevaluating them may be quite high, which causes potential decline in credit quality in the future Second, the plenty of loans supply during the economic expansion helps the borrowers to approach more lenders As stated above, banks offer the loans and the borrowers use these loans as a source of paying debts in other banks These loans accidentally and adversely impact on other banks’ information, which create an

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information externality in the credit market This type of externality also leads to credit misevaluation and potentially low credit quality

Figure 2.1 summarizes the macroeconomic context for banking The scope of

this research concentrates on the “lending” and “paying debts” direction in this figure The negative relationship of credit growth and credit quality might reflect two situations Firstly, the adverse shocks from macroeconomic determinants would make business activities become inefficient, which obstructs the ability of paying debts Secondly, the good signals in the expansionary phase of the economy might create information externalities for banks to evaluate their customers

F IGURE 2.1 The macroeconomic context for banking

Source: Author’s summarization

Depositors

Banking system

Evaluating customers

determinants

Information externality Mobilizing

Macroeconomic effects Paying debts

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2.2 C REDIT G ROWTH AND C REDIT Q UALITY T HROUGH D IFFERENT S HIFTS

Theoretically, the nature of credit growth may not relate to its quality It means credit growth might not directly have any influence on the change in credit quality However, the amount of loans which banks decide to lend would depend greatly on the performance of themselves and their customers For instance, banks underestimate the risk of their borrowers and are willing to lend more Therefore, the relationship of credit growth and credit quality might exist

One of the earliest studies on the theoretical link between credit growth and credit quality is present by Clair (1992) This link comes from banks lowering their credit standards to attract more borrowers This action may lead to low credit quality in the future Besides, when banks boost credit growth but they do not have any appropriate strategies to administrate their borrowers’ loans usage Credit quality would decline

Clair (1992) also indicated that credit growth may positively correlate to credit quality during the recovery or expansion phases of the economy or the structural changes in the financial markets – for example, reducing barriers between banks and borrowers to expand credit growth and reduce credit risk through diversification

Keeton (1999) had developed a theory about different shifts to investigate the effect of credit growth on credit quality This study explained both negative and positive relationship between credit growth and credit quality

This relationship is firstly explained by a supply shift in the loan market In

this research, supply shift means banks have decision on the willingness to lend more and there are two ways for them to carry out The first is to reduce the lending rate of new loans and the second is to lower the credit standards of these loans To make lending become easier, banks would overestimate the value of collaterals of the loans, accept to lend customers with low financial capacity or go through

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projects of which cash–flow statement is not appraised carefully These actions lower the credit standards and put banks into a high chance of lending to the borrowers with low credit– worthiness The loans to these borrowers become low quality credit

Under the assumptions that banks reduce the lending rate as well as lower the

credit standards of customers, the occurrence of supply shift which boost credit

growth will tend to result in the low credit quality

F IGURE 2.2 Supply shift

re Expected rate of return from loans

z Measure of credit standards

L Total amount of loans

S Supply of loans from banks

D Demand of loans from the borrowers

Figure 2.2 presents how the supply shift has effect on total amount of lending

and the level of credit standards In the left–hand side, the expected rate of return of banks is a function of credit standards This figure assumes that the credit–standard could be measured in number z on the horizontal axis The high value of z shows that the borrowers are in good state of servicing debts, for example, they have high value on their collaterals or their investment project is safe Banks’ lending decision

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is made basing on the expected rate of return from loans which is measured on the vertical axis This expected rate of return depends on both lending rate and debt servicing capacity Good borrowers would bring high expected rate of return for banks and it might be the same as the lending rate If there are any signs of not good borrowers, the banks’ expected rate of return would be less than the lending rate

From the side of credit standard, with each value of z, banks could derive a maximum expected rate of return This is reflected by the curve reሺzሻ For a point

of any value of z, when the lending rate increases, the banks’ expected rate of return will increase However, the increase in the lending rate could not always raise the expected rate of return, there would be a limit For example, when the lending rate increases, good borrowers still have enough financial capacity in their project to repay for debts If the lending rate increases more and more, the borrowers tend to invest in riskier project with the expectation of higher return for repayment These borrowers might become inferior and banks’ expected rate of return could not increase any more Thus, the curve reሺzሻ in the left–hand diagram shows the maximum expected rate of return This curve is upward sloping because banks expect to earn more return from the borrowers with better credit standards by offering them high lending rate

The curve reሺzሻ could also be analyzed from the side of expected rate return For any given value of re, there would be a minimum credit standard level of the borrowers For example, at the equilibrium point in the loan market, banks will expect for r1e It is certain that banks could not give any credit to any borrowers with lower than z1 because the expected rate of return will be less than r1e no matter how high the lending rate is All borrowers from z1 and higher could receive loan and would be charged a lending rate which is high enough for bank to receive r1e The minimum level of credit standards would be a threshold for banks to decide whether they lend or not The higher the expected rate of return banks desire, the higher threshold of credit standards they set to their customers

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The right–hand side of Figure 2.2 describes the loan market which determines

the banks’ expected rate of return Banks are willing to lend more if their expected rate of return from loans increases Thus, the supply curve is upward sloping For the demand curve, it is downward sloping due to two reasons Firstly, banks could charge lending rate basing on their expected rate of returns Higher lending rate may bring higher return However, the borrowers have to suffer high cost of capital and they will borrow less Secondly, the negative slope of the demand curve could be explained through the left–hand diagram When the expected rate of return of banks increase, the threshold level of credit standard would be higher, then the number of borrower who meets the credit standards would reduce

The loan market is in the equilibrium when the bank loan supply equals to the loan demand Before the supply shift, the supply curve is S1S1 At the equilibrium, banks’ expected rate of return is r1e and the total amount of loans is L1

Let assume that banks desire to expand the total amount of loans which causes the supply shift To do this, banks have to firstly reduce their credit standards for attracting more borrowers On the right–hand diagram, the supple curve will shift to the right from S1S1 to S2S2 The total lending would increase from L1 to L2. Then the expected rate of return would decrease from r1e to r2e It means banks do not require such high rate of return Therefore, they not only charge lower lending rate for good borrowers but also reduce the credit standards threshold to approach more borrowers This decline in the credit standards is presented by the movement down along the curve reሺzሻ Once the credit standard declines, banks have to suffer more borrowers with low capacity of servicing debts, which causes NPLs or low credit quality The whole progress could be describes in brief as follow:

𝐂𝐫𝐞𝐝𝐢𝐭 𝐬𝐭𝐚𝐧𝐝𝐚𝐫𝐝𝐬 ↓ → 𝐂𝐫𝐞𝐝𝐢𝐭 𝐠𝐫𝐨𝐰𝐭𝐡 ↑ → 𝐂𝐫𝐞𝐝𝐢𝐭 𝐪𝐮𝐚𝐥𝐢𝐭𝐲 ↓

H YPOTHESIS A: Credit growth might negatively associate with credit quality

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Keeton (1999) also supposed that the expansion in lending which occurs not

by a supply shift may have positive effect on credit quality There would be two reasons First, the source of loan expansion is caused by positive shift of the

borrowers’ demand This positive demand shift may come from – for example, the

decision to change the capital structure of firms or projects in order to improve the cash–flow In this case, the borrowers’ repayment capacity might become better, which improved the credit quality Second, the source of loan expansion is still from the positive demand shift but this shift come from the productivity of borrowers It

could be called productivity shift The case of productivity shift reflects favorable

conditions in the borrowers’ business activities, which boost credit growth first and credit quality afterward

For demand shift, under the consumption that increase in the borrowers’ loans

demand does not related to their goodness in financial capacity – for example, requiring loans from banks to avoid high interest rate in the capital market or

restructuring capital to reach optimal leverage ratio, the demand shift which boost

credit growth will lead to high credit quality

F IGURE 2.3 Demand shift

When banks face with the increase in loans demand, they will charge higher lending rate and give more strict credit standards However, this is still a good

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choice for the borrowers to achieve their objectives of – for example, restructuring capital Therefore, the demand shift also raises the credit standards

As can be seen in the right–hand diagram of Figure 2.3, the increase in the

loans demand shifts the curve D1D1 to the right, D2D2 The total amount of loans increases from L1 to L2 and the expected rate of return raises from r1e to r2e However, this change does not have any influence on the curve reሺzሻ in the left–hand diagram Thus, the increase in expected rate of return also tightens the minimum credit standards from z1 to z2 In other words, when the loans demands increases, bank will expect more return by raising both lending rate and the minimum credit standards This action helps banks to avoid some bad borrowers and the credit quality would be improved

In a demand shift, banks do not often realize demand shift, they still keep the lending rate and the threshold level of credit standards unchanged There would be more and more borrowers who meet the credit standards desire to borrow money Then, they realize the growth in demand and start to raise lending rate and tighten credit standards Lastly, the credit quality increases Therefore, the process would

be as follow:

𝐂𝐫𝐞𝐝𝐢𝐭 𝐠𝐫𝐨𝐰𝐭𝐡 ↑ → 𝐂𝐫𝐞𝐝𝐢𝐭 𝐬𝐭𝐚𝐧𝐝𝐚𝐫𝐝𝐬 ↑ → 𝐂𝐫𝐞𝐝𝐢𝐭 𝐪𝐮𝐚𝐥𝐢𝐭𝐲 ↑

For productivity shift under the consumption that the increase in loans demand

comes from the favorable conditions in business activities of the borrowers Although the credit standards may decline in this case, boosting credit growth could result in high credit quality

When the productivity shift occurs – for example, firms have some improvements in their technology, the input costs reduce or the economy is in good condition, the borrowers will need more credit to operate their business or invest in new projects In this case, banks might believe that most borrowers would have good opportunities in business and obtain more cash inflows to service debts Thus,

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their attitude to credit standards may change negatively and riskily It means banks would expect higher rate of return than at the same level of credit standards or they are willing to loosen the credit standards in order to earn the same expected rate of return Therefore, the curve reሺzሻ shifts to the left, which can be seen on the left–

hand diagram of Figure 2.4 On the one hand, this shift of the curve reሺzሻ could attract more borrowers due to the decline in credit standards and on the other hand, the productivity shift also increase the loans demand to meet the requirements of business activities This would bring a significant positive shift in loans demand In

the right–hand side of Figure 2.4, total amount of loans will grow dramatically from

L1 from L2 and banks’ expected rate of return increase from r1e to r2e Although banks loosen their credit standards to accept more bad borrowers, these borrowers are not certain to be really bad because they still experience benefits from productivity shift As a result, the credit quality is still improved However, there would be a possibility that banks still safely keep the curve reሺzሻ unchanged like

the demand shift case

F IGURE 2.4 Productivity shift

As discussed above, productivity shift make banks loosen credit standards and make borrowers demand large amount of loans The question of whether the change

of credit standards or credit growth happens first would depend on who could

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realize the productivity shift first Anyway, credit quality is improved lastly The process would be as follow:

𝐂𝐫𝐞𝐝𝐢𝐭 𝐠𝐫𝐨𝐰𝐭𝐡 ↑ ሺ𝐂𝐫𝐞𝐝𝐢𝐭 𝐬𝐭𝐚𝐧𝐝𝐚𝐫𝐝𝐬 ↓ 𝐨𝐫 ↑ሻ → 𝐂𝐫𝐞𝐝𝐢𝐭 𝐪𝐮𝐚𝐥𝐢𝐭𝐲 ↑

H YPOTHESIS B: Credit growth might positively associate with credit quality

T ABLE 2.1 Change in credit standard, credit growth and credit quality

Type of shift Order of change

H.A: Credit growth might negatively associate with credit quality

Supply shift Credit standards ↓ Credit growth ↑ Credit quality ↓

H.B: Credit growth might positively associate with credit quality

Demand shift Credit growth ↑ Standards ↑ Credit quality ↑

Productivity shift Credit growth ↑ ሺCredit standards ↓ or ↑ሻ Credit quality ↑

Table 2.1 summarizes the relationship between credit growth and credit

quality with the appearance of level of credit standards Besides, the order of change

of different shifts is to confirm that a change in credit growth in the past may lead to

a change in credit quality in the future This effect is not contemporaneous

Figure 2.5 shows the position of different shifts in the macroeconomic context

for banking and they do not exist simultaneously First, banks lower their credit

standard in evaluating customers to make a supply shift Second, the demand of

capital from borrowers for improving their business activities would create a

demand shift Finally, the advantages from macroeconomic determinants would

generate a productivity shift for business activities

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F IGURE 2.5 Different shifts in the macroeconomic context for banking

Source: Author’s summarization

2.3 C ONTROL F ACTORS FOR C REDIT Q UALITY

“Bad management I” hypothesis

This hypothesis was developed by Berger and DeYoung (1997) to indicate that measured cost efficiency could affect credit quality Low measured cost efficiency may be a signal of bad management which could be considered as, first, banks’ credit appraisal process is weak and they may offer loans for the bad borrowers or invest in projects of which cash flow is inflated Second, banks’ valuation skill is not accurate, which may cause the underestimation for collateral values and banks could not recover their low quality loans This problem may be related to the phenomenon that the compromise between the banks’ asset pricing department and the borrowers may exist Third, the banks’ customer supervision is

Depositors

Banking system

Evaluating customers

Productivity shift Demand shift

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loose that borrowers may use the loans with improper purposes – for example, borrowers use loans to invest in high risk and high return projects instead of projects which are appraised by banks Due to these three reasons, the credit quality would decrease

“Skimping” hypothesis

Berger and DeYoung (1997) also showed the adverse relationship between measured cost efficiency and credit quality Banks may have more short–term operating costs to monitor their current loans to avoid NPLs in the future In other words, skimping on some short–term costs for monitoring loans may lead to low credit quality Banks would be less cost efficient if they are willing to spend some costs which prevent them from suffering higher losses from NPLs in the future However, this trade–off reflects a decrease in measured cost efficiency and an increase in credit quality afterward

Both “Bad management I” and “Skimping” hypotheses relate to the measured

cost efficiency There may be a variable which could capture it However, it is necessary to distinguish these two hypotheses The difference is in the cost, one is waste because of consequences of bad management and one is useful to prevent losses in the future

“Bad management II” hypothesis

Similarly to “Bad management I” hypothesis, banks’ bad management

including limitations of credit appraisal process, valuation skill and customer supervision may be reflected by low performance which could be recognized by low profitability on equity or assets In contrast, banks with better performance would have high quality skills of administrating lending activities, which could reduce problem loans or increase credit quality in the future (Louzis, Vouldis and Metaxas, 2011)

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“Pro–cyclical credit policy” hypothesis

Banks credit policy depends on the goal of not only maximizing profitability but also keeping their reputation at good state According to Rajan (1994), banks cannot show the market their efficient loan portfolios as well as how high performance their customers are The only thing that market could observe is banks’ earnings As a result, banks are willing to inflate their earnings to maintain the good perception of the market Inflating earnings would be easy to do if banks use a liberal credit policy This kind of credit policy is also called “pro–cyclical” because

it is correlated with the demand conditions – for example, banks keep offering new loans to the bad borrowers to continue their business although they had problem loans before This action not only conceals the existence of NPLs but also convince the market that banks still gain profits from lending However, it is not safe for banks in the future Therefore, pro–cyclical credit policy might lead the increase in performance but then, the credit quality would decline

“Diversification” hypothesis

Louzis et al (2011) believed that banks could enhance their credit quality if they have diversification opportunities For example, banks have good ability in seeking good business projects or investing in stocks of companies with high potential development The proportion of capital for lending would decline, which limit the probability of lending the bad borrowers However, diversifying investment fields other than lending may bring high return but they need a very long time to recover both principals and interests Liquidity risk will happen if banks’ customers want to withdraw money because the capital structure of banks is mainly liabilities from mobilizing Therefore, large banks will have more diversification opportunities which hardly affect their liquidity In contrast, bank with small size have less chance to diversify due to liquidity risk

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“Too–big–to–fail” hypothesis

According to Stern and Feldman (2004), large banks believe in government’s intervention when they are in failure because they have enormous influence on financial market Therefore, larger banks are willing to increase more leverage and attempt to lend more This act of credit expansion increases the chance of approaching low quality borrowers (Louzis et al., 2011)

Under this hypothesis, the effect of leverage on credit quality would be negative and adjusted by banks size When banks increase an amount of leverage, credit quality of larger banks would decline more than smaller banks It is similar to lending aspect which banks boost credit growth

Nguyen (2015) believed that this hypothesis could be appropriate only for some largest banks It means only some largest banks could be able to receive support from government while they are in distress Due to this reason, “some largest banks” is a characteristic which could be used as an alternative for bank size–adjustment under “too–big–to–fail” hypothesis

H YPOTHESIS C: The effect of credit growth on credit quality from large

commercial banks might be larger than the smaller banks

2.4 P REVIOUS E MPIRICAL S TUDIES

Clair (1992) is one of the earliest authors who investigated the relationship between credit growth and credit quality of banks in Texas using annual data from

1980 to 1990 The author used the loan loss ratio and NPL ratio to measure credit quality The independent variables were divided in to three groups including: (i) credit growth, (ii) financial characteristics (bank assets, bank equity, business loans and real estate loans) and (iii) business conditions (non–agricultural employment growth) There were three types of credit growth used simultaneously in the model: internal growth, growth through bank merger and growth through bank acquisition