Improving Credit Risk Control through reforming Business Customer Assessment methodology – the case of VRB’s Hanoi office

Thus, this category of customer has high magnitude of impact to the financial health of VRB-Hanoi.To avoid the credit risk related to this category of customers, the[r]

Cohort 2015– 2017Master‟s Thesis

Improving Credit Risk Control through

reforming Business Customer Assessment methodology

– the case of VRB’s Hanoi office

Author: Le Hong Quan Supervisor: Nguyen Phu Hung

TABLE OF CONTENTS

TABLE OF CONTENTS i

LIST OF TABLE iv

LIST OF FIGURES v

LIST OF ABBREVIATIONS vi

ACKNOWLEDGEMENT vii

ABSTRACT viii CHAPTER 1 PROBLEM STATEMENT 1

1.1 Introduction of the VRB 1

1.2 Challenges facing VRB 3

1.3 Research objectives 4

1.4 Research questions 4

1.5 Scope of research 4

1.6 Methodology and Data 5

1.6.1 Methodology of the research 5

1.6.2 Variables and Indicators 5

1.6.3 Description of Data, Population, and Sample .5

1.6.4 Tools of survey and analysis 6

1.7 Conclusions and Roadmap of Dissertation 6

1.8 Plan of implementation 6

CHAPTER 2 LITERATURE REVIEWS 7

2.1 Operations of commercial bank 7

2.1.1 Function of commercial Banks 7

2.1.2 Credit activities of commercial banks 8

2.1.3 Risks of banks 8

2.2 Credit risks of commercial banks 9

2.2.1 The origins of risk 9

2.2.2 Credit risk 9

2.2.3 Key elements of credit risk 10

2.2.4 The causes and effects of credit risk .11

2.2.5 Factors driving credit exposure 12

2.3 Credit Risk Management 15

2.3.1 Risk management process 15

2.3.2 Collateralized 17

2.3.3 Tools 20

2.3.4 Measuring Credit Risk 20

2.3.5 Measures to Control risk 22

2.4 Conclusion 23

CHAPTER 3 SURVEY RESULTS OF THE CURRENT STATUS OF RISK SITUATION AND CONTROL OF VRB HANOI 24

3.1 Survey results of current VRB‟s risk situation and control 24

3.1.1 Bad debts status 24

3.1.2 Awareness of risk 25

3.1.3 Opinions in credit recovery and credit risk management 27

3.1.4 Opinions on the measures to reduce credit risk .31

3.2 Findings 36

3.2.1 Worsening credit risk 36

3.2.2 Credit risk management system need enhancing 36

3.2.3 The seriousness of credit staffs are inadequate .37

3.2.4 Quality of credit staffs is inadequate 37

3.2.5 Worsening economic situation is one of major causes of worsening customers credit 37

3.2.6 The internal system may be over rigid to react to business change .38

3.2.7 Problems of current credit risk management 38

3.2.8 Objective of credit risk management reform of VRB HANOI 38

3.2.9 Attributes of a viable credit risk management model in case of VRB HANOI 38 3.3 Financial pictures of competing banks 39

CHAPTER 4 CREDIT RISK MANAGEMENT REFORM PROPOSAL 41

4.1 Summary of credit risk management issues of VRB-Hanoi 41

4.2 Summary of credit risk management requirements 41

4.3 Principal bases guiding developing measures to enhance credit risk management at VRB Hanoi 41

4.4 Credit risk management policy reform recommendation 42

4.4.1 Tighten credit policy 42

4.4.1 Adjust lending policy appropriate to current economic situation 42

4.4.2 Enforce the compliance to credit assessment procedures and regulation 45

4.4.3 Require adequate collateral in all cases 46

4.4.4 Re-price loans for each customer group to reflect accurately new situations of risk 47

4.4.5 Diversify loan 47

4.4.6 Increase the degree of monitoring and inspection of active loans .47

4.4.1 Enhanced the role of inspection and internal control 47

4.5 Improving Credit Risk Control through reforming Business Customer Assessment methodology 48

4.5.1 Improve the quality of assessment 48

4.5.2 Improve internal audit operations 49

4.5.3 Improve credit risk forecasting 51

4.5.4 Improve transparency to promote accountability 52

4.5.5 Application of information technologies to improve management data system 52 4.6 Other recommendations 53

4.6.1 Innovation in organizational structure and improvement in human resource quality 53

4.6.2 Establishment department of research, analysis and macro-economic forecasting 55 CHAPTER 5 CONCLUSIONS 56

5.1 Conclusion 56

5.2 Limits of thesis 56

LIST OF REFERENCES 57

APPENDICES 58 1.1 Survey questionnaire 58

LIST OF TABLE

Table 1-1: Variables and Indicators 5

Table 2-1: The causes and effects of credit risk 11

Table 3-1: The magnitudes of credit risk 24

Table 3-2: What is the most critical risk category? 25

Table 3-3: Four most critical factors that exist in the creation, registration, and enforcement of security and collateral 26

Table 3-4: Adequacy of current internal credit risk management system, procedures, and regulations 27

Table 3-5: The major factors affecting the quality of loan request assessment 28

Table 3-6: Compliance of credit officers with standardized procedures for handling credit assessment and credit recovery 29

Table 3-7: Four most important causes of credit risk 30

Table 3-8: Need of having a consolidated customer risk database 31

Table 3-9: The need of keeping documented records 33

Table 3-10: Ability for organization to adapt to changes in business environment 34

Table 3-11: Implementation of technology 35

LIST OF FIGURES

Figure 1-1: Organizational Structure of the VRB 3

Figure 2-1: Four levels of credit risk based on the risk level 11

Figure 2-2: Factors driving credit risk 15

Figure 2-3: Risk management process 16

Figure 2-4: 4 steps of Risk management process 17

LIST OF ABBREVIATIONS

VRB Vietnam Russian Bank

CRM Credit Risk Management

ACKNOWLEDGEMENT

First of all, I would like to express my sincere gratitude to my supervisor, Dr Hung Nguyen for his instruction and help for me to complete this dissertation Thanks for his support and his patience with my slow progress

Moreover, I would like to give special words to all lecturers of the program who always supported, inspired and guided me to carry on such a challenging project And moreover, I want to say thank you to my entire family member, classmates in FAB7 who give me the best time during I attended the course

ABSTRACT

During the past two years, Vietnam‟s economy has suffered a severe recession due to

a financial crisis The bankruptcy of various enterprises has had a negative impact on the performance of the banking sector Thus, during this time, the primary objective

of commercial banks become risk management, especially activities regarding credit risk management

The types of risks associated with banking activities are diverse, complex and usually hidden They can present from the cards, deposits and trade finance b usiness to investment and foreign exchange business and often at many different levels So far, the most serious and far-reaching impact that risks can have is on credit This is because credit is considered the basic operation and usually produces the bank‟s largest amount of profit as well the largest amount of potential loss Not only that this phenomenon has been predicted in theories, it has been considered true in the practices of the banking sector

This thesis focuses on measures to ensure the safety of banking activities in the midst

of increasing complexity and breadth of risks in credit, such as the traditional policy

of management focusing onincreasing revenue and decreasing cost, credit risk management.The new way to assess customers is critical to the successful business of VRB because it help to reduce potential losses

CHAP TER 1 PROBLEM STATEMENT

1.1 Introduction of the VRB

The Vietnam-Russia Joint Venture Bank (VRB) was established in 2006.The establishment of VRB is the result of the economic co-operation of the Vietnamese and Russian Governments and the two Central Banks

VRB is a joint venture between the two leading banks in Vietnam and Russia, Bank for Investment and Development of Vietnam (BIDV), accounts for 50% and Bank for Foreign Trade of Russia (VTB) with 50% of chartered capital

VRB opens new opportunities for co-operation of the two economies and the financial systems The opening ceremony was attended by the President of Vietnam Nguyen Minh Triet and of Russian President Vladimir V Putin

VRB‟svision is to be the leading bank to finance for bilateral trade and investment activities between Vietnam and Russia VRB will develop to become a multi- functional business bank with modern banking model under the principles of sustainable, effective, secure, and integrative development, meeting all safety indexes of normal operations of international banking practices

VRB has a commitment to customers, striving to bring conveniences to customers in approaching funds, products and services; the goal of VRB is to increase values and bring success to customers

Main business activities of VRB include

a Investment:

 VRB provides consultancy and information about investment possibilities

 VRB arranges investment capital, directly give loans or co-finance projects

 VRB provides guarantee services, such as guarantee for payment, bid, contract fulfilments

 VRB makes direct investments through provision of capital to by shares in the two countries‟ firms; indirect investments through activities on inter-bank markets or financial markets

b Trade promotion:

 VRB does financial and trading promotion activities;

 VRB provides support on sharing information of markets and customers;

 VRB cooperates with customers in assessing their partners as well as investment projects

to promote bilateral business activities between Vietnam and Russia

VRB‟s products and services include

(i) Consumer banking:Deposit; Individual account; Cards; Individual lending; Money

transfer in both domestic and oversea, direct transfer between Vietnam and Russia

in three currencies: VND, RUB, and EURO

(ii) Business banking:Deposit; Account; Loans; Guarantee; Money transfer: domestic

and oversea; Trade sponsor: import, export; Foreign currencies trading, and Others

Overall structure of VRB is shown in the picture below

Figure 1-1: Organizational Structure of the VRB

(Source: website of VRB)

1.2 Challenges facing VRB

In Vietnam, banking is a sector in fast development All commercial banks are conscious whether their existence and development depend on achieving customer, satisfying them, maintain their loyalty All commercial banks have regarded customers much like a top priority at all times in all their activities VRB is in a hard time of competition to retain customers from a number of newer banks VRB needs a strategictool to identify the bank's most profitable customers and prospects, and devotes time and attention to expanding account relationships with those customers through individualized marketing, repricing, discretionary decision making, and customized service-all delivered through the various sales channels that the bank uses

Today, many businesses such as banks, insurance companies, and other service providers realize the importance of credit risk management A close focus on risks involved customers will require astrong coordination between sales and marketing departments to provide a long-term retention of selected customers

This thesis is dedicated to the credit risk management which is a primarily lead to the fallen into a serious financial crisis in Vietnam economy recently The National Assembly blames that the financial crisis in banking sector arose largely because credit had been too lack to fund the national economic rapid expansion during 2007-2011, which resulted in growing uncontrollable bad debts, that in turn makes the Government to suddenly becoming too restrictive in financial and baking policies

Being a newer bank, VRB has many common risks, such as interest ratio exposure, credit exposure, exchange rate exposure, liquidity exposure, and operational exposure Among these exposures, credit exposure is the most important and impacting In order to control credit risk,

as well as other financial issues, VRB needs to have particular risk management tools, especially an appropriate credit risk control

This is the reason that this thesis will study the“Improving Credit Risk Control through reforming Business Customer Assessment methodology”

1.3 Research objectives

The objective of this thesis is to investigate and evaluate credit risk management (CRM) situation of VRB, understand the perception of VRB staffs on how to improve the situation, and to propose potential solutions or directions on building the capacity to meet with growing market requirements and to improve the internal performance

1.4 Research questions

1 What are the status-quo of VRB and how CRM is critical to the survival of VRB

2 How has the VRB managed CRM?

3 Does the current methodology and managerial policy perform well? What are the advantages and disadvantages of current CRM methodology?

4 How to enhance the performance of managing credit risk?

1.5 Scope of research

Indeed, risk management covers many types of risk but credit risk is the one this thesis focuses on The dissertation will limit its attention on the matters of CRM in the Hanoi office

of the VRB

1.6 Methodology and Data

1.6.1 Methodology of the research

In order to find the answers for the questions given above, the proposed approach is designed

as below

First, identifying problems of credit management facing VRB-Hanoi through a survey designed to credit staffs;The thesis will survey involved stakeholders to get to know the current situation of CRM challenging VRB

Second, review literature on problems identified above to learn lessons/experience of successes and failures from similar financial institutions in dealing with credit risks, based on that specify potential solutions.The literature review of credit risk management (CRM) is for building an critical analytical framework of CRM at VRB-Hanoi

Finally, analyze the applicability of specified potential solutions in case of VRB Hanoi, and select the most applicable one to propose to management board

All the values are in likert scale of 5

1.6.2 Variables and Indicators

The paper uses the following indicators:

Credit situation Bad debt status Multiple choice

Cause of credit risk Likert scale Credit risk management Human resource Likert scale

Credit policy Likert scale

Table 1-1: Variables and Indicators

1.6.3 Description of Data, Population, and Sample

The thesis also analyzes secondary data collected from academic journals, websites, and governmental offices to draw a comprehensive picture of the whole banking industry and

assess the comparative competence of the VRB‟s CRM in this context Lessons drawn from literature will serve as basis for recommending solutions to enhance the CRM performance for VRB

My targeted surveyee include:

 Survey in paper form

1.7 Conclusions and Roadmap of Dissertation

After the first chapter of introduction, we review literatures on the credit risk management in Chapter 2 The Chapter 3 describes analytical results from the survey and discuss the findings Finally, the Chapter 4proposes measure to enhance the situations

1.8 Plan of implementation

3/2017 Proposal submission

4/2017 Tutor comments proposal

5/2017 First Draft of thesis

6/2017 Second Draft of thesis

7/2017 Turn in final thesis

8/2017 Thesis defense

CHAP TER 2 LITERATURE REVIEWS

This chapter provides a brief review on literature of Credit Risk Management, which will be served as a basis to develop recommendations in the next Chapter

2.1 Operations of commercial bank

Commercial Banks are financial institutions providing a wide range of diversified financial

services - especially credit, savings, and payment service – for profit “A bank is an institution

whose current operations consist in granting loans and receiving deposits from the public”(Rochet, 2008; Gestel & Baesens, 2008)

The basses of commercial banks‟ operation are (i) Activities to raise capital, (ii) Capital use activities, and (iii) Credit activities

2.1.1 Function of commercial Banks

Commercial banks perform various basic functions; some of them are as followed (Rochet, 2008; Gestel & Baesens, 2008):

 Raising capital: Commercial banks can increase their capital by some methods such as: raising capital from stakeholders by put more money in to the bank, through borrowing shareholders, lending from financial markets, from government, etc

 Using capital: Commercial banks use the capital to supply many products and services concerning to credit such as: overdraft services, discount by bill, loans etc

 Creating credit: Credit creation is the most significant function of commercial banks The loan provided to a customer is not available in cash, banks open a deposit account from which the borrower can withdraw

2.1.2 Credit activities of commercial banks

Bank credit is the process in which the lender must identify the specific legal borrower, independently define the borrower‟s credit needs to ensure that the credit offered by the bank matches the borrower‟s need

2.1.3 Risks of banks

The Basel II Capital Accord (Gestel & Baesens, 2008, p 23) identifies three majority reasons

of risk: operation risk, market risk and the most important is credit risk Like any other firm, banks are exposed to classical operational risks such as infrastructure breakdown, supply problems, environmental risks, etc However, the most typical and critical risks that a bank can face are financial risks (Heffernan, 2005) Financial risks can be split in three main categories: (i) credit risk, (ii) interest rate risk, and (iii) liquidity risk

 Credit risk occurs when a borrower can‟t able to payback fulfill his loan, including interest, original debt and other obligations This is also the focus of this paper

 Liquidity risk is the situation when a bank lack of funds or feasible short-term assets to response the demand deposit, withdraw, credit of customers, especially in deposit because this is a kind of account which allows customers can demand anytime When a large number of withdrawals occur during a short time, which maybe lead to a liquidity exposure for the bank

 Interest rate exposure: incurred when interest rate is fluctuate between lending interest rate and interest rate which the bank has to pay to the borrowers which leads to decrease the profit of bank This risk is the result of changes in interest rates In the economy, the interest rate is the very sensitive factor to economic fluctuations; moreover, it is a tool in the implementation of fiscal and monetary policies of the Government Therefore, interest rate risk is the risk that appears frequently in the banking business

 Systemic risk: systemic risk is the risk that a sole event can trigger the loss of economic value causing the increase in uncertainty to a substantial portion of the whole financial system and in turn leads to significant adverse effects on the real economy

Credit risks are the focus of this paper and explained in the next sections

2.2 Credit risks of commercial banks

2.2.1 The origins of risk

Nowadays, when the enterprises need more and more equity to develop, so the relationship between banking and enterprises become to coordinate closely Moreover, in the violent competitions among too much the banks in the finance market, it leads to many banks accept high risk or lack of stringent controlling and responsibility Banking faces to a serious risk and lead to bankruptcy Business in banking has the giant impacts to the stability of economic and society It is cause of crisis psychological, people have a panic about losing money and they want to withdraw money on the same time, cause of the mass collapse system

As any company or other organizations, a commercial bank earns money that they accept the risk in business In some cases, the bank could face with bankruptcy because risks, and uncontrolled risks So, we could see the business of banking contains many potential risks, more risk more profit, that‟s feature of Banking as well as other businesses

The risk that unexpected events leading to loss of the bank's assets, decline the actual profit than expected or have to add an expense to be able to complete a career financial services

2.2.2 Credit risk

In the banking operation, credit is profitable mainly activity but also is the big risk latent activity The statistics and research shows that credit risk accounts for 70% of total banking risks

Credit risk is the potential loss that can arise because the borrowers cannot afford or do not have enough capacity to implement their contractual obligations (repay money) in full or on time as committed to the lending institutions Corporate lending ofte n is highly exposed to credit risk due to the size of the loan involved, while retail lending risk often arises from constrained access to data (Heffernan, 2005) Credit risk has many impacts: reducing the profitability of banks; reducing the solvency of banks; reducing the bank's reputation; bankrupt banks

Although at present there has been a structural shift in the bank's profits Accordingly income from credit operations tend to decrease and income from other service tend to increase however credit revenue still accounts for 1/2 to 2/3 of total operation income in banks Thus

credit risk is one of the main reasons causing losses and affecting seriously the quality of the banking operations

Credit risk following the basic definition is the risk of loss due to failure of a borrower to meet its contractual obligation to repay a interest and a debt in accordance with the agreed terms

Credit risk probably has been prevalent and the most important risk type in banking sector Credit risk has wide and potentially detrimental financial impacts to economic transactions, thus must be under close control such that it will not result in social impacts (Gestel & Baesens, 2008, p xii)

 Credit risk can arise in typical cases below (Bessis, 2003; Gestel & Baesens, 2008):

 when the borrower is in a financially stressed situation and may be facing a bankruptcy procedure;

 When the borrower refuses to comply with its debt service obligation, e.g., in the case of a fraud or a legal dispute

 When the bank invests in debt of a historically high-quality borrower but his risk profile deteriorating over time When liquidating the debt of this borrower, the price at which the debt is sold on the market is lower than the cost at which the bank bought the debt, thus resulting in a net loss

The financial loss in the case of default depends on the percentage that one can recover from the defaulted counterpart and the total exposure to the counterpart The recovery depends on the presence of collateral and guarantees A good risk management tries to avoid large exposures on high-risk counterparts

2.2.3 Key elements of credit risk

Credit risk is not only limited to lending activities It can a lso present in many credit activities

of commercial banks such as underwriting, finance leasing, etc

According to the current method of credit risk management, the credit risk is divided into four levels based on the risk level

- Not collecting earned interest on time: This is the lowest level of risk, when a borrower cannot repay interest on time This type of risk is classified as low level because except for

the case of criminal activities, the reasons are mostly from the imbalance between debt collection and debt repayment

- Not collecting principal on time: the situation can become serious if a large of credit fund is lost The bank will move this debt to overdue debt resulting in delays the customers‟ scheduled business plan

- Not collecting enough interest: this situation occurs when the client‟s business is not efficient enough to be able to pay interest to the bank It can lead to adverse impact since the bank can lose its entire interest and principal

Figure 2-1: Four levels of credit risk based on the risk level

2.2.4 The causes and effects of credit risk

Some causes of credit risk are objective, while others are subjective

Table 2-1: The causes and effects of credit risk

Source Problems Consequences

Not collecting principal

Not collecting earned interest on

time

Not collecting principal on

time Not collecting enough interest

Source Problems Consequences

Borrowers  Capital used for the wrong

purposes; unwilling to pay the debt

 capacity management;

customer executive

 borrower‟s financial situation deteriorates resulting in a financial shortage to fulfill the obligation

The bank's credit policy Some banks loosen credit policy to

attract more customers

Many unqualified customers may still get credit, resulting in potential loss

The inadequacy of credit

Lack of supervision and

management after loan,

insufficient inspection of

local banks

Lack of continuous efforts on monitoring loans

Bank is caught by surprise due

to low awareness of the situation

Information of borrowers are not updated system-wide, thus

a bad customer from a bank may still qualify for other banks

2.2.5 Factors driving credit exposure

First reason arise from loopholes internal procedures of the bank for some reasons:

 Incomplete credit information (bank has no comprehensive vision of customers well

as the their financial situation);

 Limitation in professional qualifications and ethics of credits officers (lack of capacity

to handle the credit information, appraisal loan documents to protect and monitoring loans);

 The banks too focused on profits and income, they set the income expectation in higher priority than healthy loan So that, there was strong competition with other banks and non-banking institutions to approach more propotion of loans;

 Lack of knowledge of the market, lack of information or analysis incomplete information leading to the lending and investing unreasonable;

 Relaxing in the process of inspecting and monitoring after lending not lead to timely detect the phenomenon using loans for improper purposes ;

 Overconfidence in collateral, guarantees and insurance, as it is material to ensure the recovery of the loan principal and interest

 Focusing on the quantities (according to plan), neglect the quality of the loan, optimistic and confident in the success of the business plan

 Lack of the department is responsible for monitoring and managing risk credit on each customer, each branch, each product and services to diversify risk, set up forecasts in each period

 Competition between banks is becoming increasingly fierce; banks eased the conditions required for loans to attract more customers

The second group of reasons relate to customers

 Customers deliberately make the fake documents in order to cheat the bank ;

 Customers have some legal problems;

 In customers are enterprises, they suddenly have to change the managers, leader, or board of directors;

 Customers are working in high-risk occupations;

 In the fact of, many customers have good business plan in the beginning, however after that they are lacking of management ability, limit o f monitoring experience, not enough competence to face with market fluctuation, that make they can‟t follow and achieve their plan;

 Customers use the loan for wrong purposes because they accept the high risk, they hope that it will bring higher profit but the result is not good On other hand, some customers can‟t afford repay the loan in a difference bank and they find many ways to loan in another bank to swap the loan

Other external reasons:

 Volatile economic environment: The fluctuation and unpredicted of the market is the majority reasons impact to the activity of the loaner Vietnam‟s economic still belong

to the agriculture and many low value sectors It‟s very sensitive with the weather, price, policy and other barriers to entry It directly impact to The Vietnam enterprises

as well as the activity of banks

 During the finance free process, Vietnam takes part in the international market, which lead to the fierce competitions among the enterprises, that make almost enterprises face to loss of equity and bankrupt

 Natural Disasters which are the factors can‟t be predicted when they have credit, the customers are difficult that lead to the expose credit in Bank

Figure 2-2: Factors driving credit risk

2.3 Credit Risk Management

2.3.1 Risk management process

Credit Risk Management is a well-designed process aiming to detect new potential risks and improve overall performance of existing systems The process involves (i) the identification

Credit Risk Sources

Procedures

Incomplete credit

information,

Limitation in professional qualifications and ethics

of credits officers

The banks too focused

on profits and income

Lack of knowledge of the market

Laxity in the process of

inspecting and monitoring

after lending

Too confident in collateral, guarantees and insurance

Focusing on the

quantities), neglect the

quality of the loan

Lack of the department responsible for monitoring and managing risk

Customers

Fake documents

Customers' legal problems

Sudden changes of managers, leader, or board

of directors

High-risk occupations

Lacking of management ability, limit of monitoring experience.

Customers use the loan for wrong purposes

External Sources

Volatile economic environment

Natural Disasters

of potential risks, (ii) the measurement of these risks, (iii) the appropriate treatment, and (iv) the actual implementation of risk models (Gestel & Baesens, 2008)

Figure 2-3: Risk management process

(Source: Gestel & Baesens, 2008, p 42)

This is a continuous task that evaluates relevant indicators to reveal potential threats so that the bank will not encounter any surprising loss

Figure 2-4: 4 steps of Risk management process

2.3.2 Collateralized

2.3.2.1 Collateralized versus uncollateralized netting sets

Collateralization (or margining) is the way to reduce credit exposure beyond the benefit achieved with netting and the other methods In the fact of, it is an essential condition between lender and borrower when break clauses in the contract Collateral can be used to pay for the lender in the case the borrower losses of solvency

The idea of collateral management is cash or other securities which belong to counterparty or third party to protect the loans, and the credit risk Although collateral can be used to reduce credit exposure, however it may be added new risks, such as market, legal, operational and liquidity Until now the collateral managements are still the best way to decrease the credit risk, including:

 It‟s not only to reduce credit exposure, but also able to broaden more customers The bank can open credit however still ensure secure credit ratio

 To allow to corporate with a special counterparty For instant, scoring credit system may not enable to make credit lines with some customers without collateral

 To depreciate capital requirements Basel regulatorycapital rules give capital relief for collateralized exposures

 To diversity competitive pricing of counterparty credit risk

(i) • identification of potential risks

(ii) • measurement of these risks

(iii) • Appropriate treatment

(iv) • actual implementation of risk models

2.3.2.2 Valuation

The valuation agent is normally the party calling for delivery or return of collateral and thus must handle all calculations The role of the valuation agent in a collateral calculation is as follows (Gregory, 2012 b, pp 64-65):

 To compute credit risk under the effect of netting;

 To compute the market value of the collateral before loan;

 To compute the uncollateralized exposure;

 To compute the delivery or return amount (the amount of collateral to be posted by either counterparty)

2.3.2.3 Types of collateral

In normally, the collaterals are the more liquidity the more preferred such as cash, or government securities (for example, Fannie Mae and Freddie Mac) and Triple-A MBS securities are also used for high-quality assets with minimal price volatility (Gregory, 2012 b,

pp 64-65)

However, in some cases, cash is in limited provided and securities have additional volatility from the price uncertainty of collateral posted If the market value of collateral decreases below the value in the mortgage contracts, it‟s necessary to make a new agreement about the value of collateral between counterparties immediately

When the local currency of two counterparties are different, one party will have to take FX exposureconcerned to the collateral posted, even when it is the cash Some collateral are various kind of currency securities may be allow in some banks FX exposure can be prevented and decreased by taking part in the derivatives market, using some tools such as swap, option, future and spot

Other collaterals also preferred are the real estates; it‟s very popular in Vietnam as well as in over the world Nonetheless, when the bank accepts real estates are collaterals to protect the loans, they also face to some potential risk from the legal regulations, the decrease price of real estate, the bubble of the market

In the fact of, some banks accept collaterals are the goods and the right to collect the debt from other counterparties; however the guarantee rate is very low About the essence, the

banks accept give unsecured loans to the customers because it‟s very difficult to liquidation these collaterals

2.3.2.5 Disputes and reconciliations

Collateral management relies on physical process and data standards, leading to significant disputes between counterparties due to a number of factors like trade population; trade valuation methodology; application of netting rules; and valuation of previously posted collateral

In case, the valuation or disputed a mounts of collaterals are difference with these in the collateral contract, parties may "divide the difference" In another way, it needs to clarify the reasons of the distinction

In case of a dispute, counterparties will try their best to solve the conte ntion within the shortest time The disputing party (i) is required to notify its counterparty reason for the dispute, it expects to litigate the risk or collateral computing no later than time of business day following the collateral call; then (ii) agrees to transfer the undisputed amount if the counterparties can't solve the conflict in the certain time, they can ask for help from one third party to make a reasonable agreement, or due to court for resolution

Instead of being reactive and focusing on dispute resolution, banks should be proactive and aim to prevent disputes in the first place Reconciliations are to minimize the chance of dispute, thus it is better to perform reconciliations weekly or monthly so as to minimize differences in estimation between parties, pre-empt later problems Reconciliations should also be detailed and highlight differences that otherwise may be within the dispute tolerance

or that by chance offset one another

Collateral management is developing, because a simplification a type of collateral (e.g the bank just accepts collateral is money) This is also concerning to assess the value of collateral

2.3.3 Tools

Efficient credit risk management tools are vital in fostering the growth in consumer credit In order to minimize credit risk, financial institutions establish a risk management system to monitor retail and corporate lending through reviewing a number of performance indicators (e.g., probability of default, exposure at default and loss given default) The system allows the financial institutions to detect borrowers‟ potential operational and financial risk and to give necessary appropriate responses The risk management system assesses credit risks before deciding whether to grant a loan using qualitative or quantitative me thods

Credit scoring system

The most well-known quantitative method and one of the earliest successful financial risk management tools are credit scoring The digitalization of data, computers, and application of advanced statistical modeling technique have supported with this credit risk measurement However, under many circumstances, due to the unavailability of information (such as the credit bureau cannot find a credit report for a particular applicant), the bank may switch to a qualitative approach This implies checking elements constituting the risk profile of the borrower such as how long the borrower has been with the bank, their employment history, or their financial asset

Market standards for credit risk management include:

Capital cushion: The Basel II establishes a level of capital adequacy for banks that plays as a

cushion to absorb credit and other losses The bank should match the capital cushion with the portfolio risk of individual transactions, their concentration, and correlation, and optimally allocated capital in relation to the selective investments made (Gestel & Baesens, 2008)

Risk quantification: Complementary to other tools of modern risk management

2.3.4 Measuring Credit Risk

2.3.4.1 Credit Valuation Adjustment

According to the “Basel committee on Banking Supervision”, Credit Valuation Adjustment (CVA) is “an adjustment to the fair value (or price) of derivative instruments to account for

further suggested that CVA depends on counterparty credit spreads as well as other the market risk factors influencing derivatives‟ values and exposure CVA is calculated as the difference between the risk-free and the true portfolio value, taking into account the possible risk of default It is also considered the market value of counterparty credit risk

2.3.4.2 Implementation Challenges

 Data challenges: Acquiring standard and exact data is a hard challenge for any banks Almost banking system just has the data from their current customers and reference from CIC

 Technological management system challenge: in order to building the modern and useful technology system requires the huge investment and the many time to experience and improve

 Human resource competency challenge: because banking system is too much complicate and highly potential risks, so the qualification and competency of staffs is noticed priority

2.3.4.3 A case study of Credit risk - Methodologies for credit risk quantification of

BBVA

The risk measurement and management models used by BBVA have made it a leader in best practices in the market and in compliance with Basel II guidelines The following summary is taken from its website1

The Bank quantifies its credit risk using two main metrics: expected loss (EL) and economic capital (EC) The expected loss reflects the average value of the estimated losses (i.e the cost

of the business) and is associated with the Group‟s policy on provisions, while economic capital is the amount of capital necessary to cover unexpected losses (i.e if actual losses are higher than expected losses)

These risk metrics are combined with information on profitability in value-based management, including the profitability-risk binomial into the decision- making process, from the definition of business strategy to the approval of individual loans, price setting, assessment of non-performing portfolios, incentives to the different areas in the Group, etc

1

http://shareholdersandinvestors.bbva.com/TLBB/ micros/FinancialReport2011/en/Riskmanage ment/Credit riskM

There are three risk parameters that are essential in the process of calculating the EL and EC measurements: the probability of default (PD), loss given default (LGD) and exposure at default (EAD) They are generally estimated using the available historical information and are assigned to operations and customers according to their particular characteristics In this context, the credit rating tools (ratings and scorings) assess the risk in each transaction/customer according to their credit quality by assigning them a score This score is then used in assigning risk metrics, together with additional information such as transaction seasoning, loan to value ratio, customer segment, etc The increase in the number of default events in the current economic situation contributes to reinforce the soundness of the risk parameters by adjusting their estimates and refining methodologies The incorporation of data from the years of economic slowdown is particularly important for refining the analysis of the cyclical behavior of credit risk The effect on PD estimates and the credit conversion factor (CCF) is immediate An analysis of the impact on LGD, however, requires waiting for the outcome of the recovery processes associated with those default events

2.3.5 Measures to Control risk

Typically, financial institutions manage risk s through five ways (Heffernan, 2005):

1 Computing loan pricing according to the level of risk: calculating all factors that can lead to financial loss and risks involved with the loan This means charging a higher interest rate and loan fee for borrows who are more likely to default

2 Customer rating: the credit score system is based on many elements such as the financial status of the customer, purpose of the loan, credit rating principles, loan to-value ratio, the customer‟s business plan and estimated effect on yield or credit spread

3 Using collateral: collateral is offered to secure repayment of the loan in case of financial loss

4 Diversification portfolio: decreasing unsystematic risks, limiting potential risks within major sources and thereby reducing the possibility of default

5 Asset securitization and the use of credit derivatives

Other ways to mitigate credit risk include transferring from the lender to the insurer via credit insurance, hedging credit risk and tightening credit while broadening o ther services to reduce the proportion of income from credit Credit risk can be assessed based on criteria such as credit score, credit structure, overdue or provision for credit losses (Gestel & Baesens, 2008)

Furthermore, some banks also mitigate cred it risks by imposing limits on the transacted notional amounts, central clearing and netting

2.4 Conclusion

In this Chapter, the thesis has reviewed relevant literature relating to credit risk management

In the next Chapter, the thesis will present the results of a survey which is used to assessment current situation of the VRB Ha noi

CHAP TER 3 SURVEY RESULTS OF THE CURRENT STATUS OF RISK SITUATION AND CONTROL OF VRB HANOI

This section provides results of the survey and discuss the implications of the survey results to the Credit Risk Management of the VRB

3.1 Survey results of current VRB’s risk situation and control

The surveys were responded by 15 key staffs and executive relating to credit services The answers are anonymous to promote honest answers and sharing The answers appear to support the paper‟s reasoning

3.1.1 Bad debts status

For 15 surveyees, 13 stated that he/she has customers' bad debt, account for 87% Almost 50% of surveyees have over 5% of his/her customers‟ borrowings fall into bad debt category,

of which the proportion of “over 10%” is terribly high, about 1/3 (Table 3-1) Compared with the statutory limit of bad debt of under 5%, this indicator show VRB HANOI OFFICE is in high risk of credit

Table 3-1: The magnitudes of credit risk

Category Count Percentage

3.1.2 Awareness of risk

3.1.2.1 Most critical risk category

Half of staffs contended that credit risk is the most critical to bank financial health, while 1/3 think it is the liquidity risk (Table 3-2)

Table 3-2: What is the most critical risk category?

Category Count Percentage

3.1.2.2 Four most critical factors that exist in the creation, registration, and

enforcement of security and collateral

When asked to select four most critical factors out of total 8 factors that exist in the creation,

registration, and enforcement of security and collateral, the Customer's capacity and the

Collateral to the loan contract are the most selected (ticked by 60% of surveyees), then the capital resource and the size of the loan are the next critical (Table 3-3)

Table 3-3: Four most critical factors that exist in the creation, registration, and enforcement

of security and collateral

Category Count /15 Percentage

Customer's character 5 33%

Customer's ability 6 40%

Customer's capacity 9 60%

Customer's capital 7 47%

Collateral to the loan contract 9 60%

The purpose of the loan 6 40%

Amount of the Loan 8 53%

Obligation Repayment of customer 4 27%

Market risk 7%

Liquidity risk 33%

Operation risk 7%

Interest risk 0%

Credit risk 53%

Foreign exchange risk

0%

The most critical risk category

Market risk Liquidity risk Operation risk Interest risk Credit risk Foreign exchange risk

3.1.3 Opinions in credit recovery and credit risk management

3.1.3.1 Adequacy of current internal credit risk management system

Almost 30% (4 out of 15) of surveyees stated that a proportion of their corporate lending is not secured by adequate collateral

Around 70% of surveyees think that the current internal credit risk management system, procedures, and regulations of VRB HANOI OFFICE are adequate to control the risks it is facing (Table 3-4)

Table 3-4: Adequacy of current internal credit risk management system, procedures, and regulations

Answer Count Percentage

Customer's character 9%

Customer's ability 11%

Customer's capacity 17%

Customer's capital 13%

Collateral to the loan contract 17%

The purpose of

the loan 11%

Amount of the Loan 15%

Obligation Repayment of customer 7%

Percentage

Customer's character Customer's ability Customer's capacity Customer's capital Collateral to the loan contract The purpose of the loan Amount of the Loan Obligation Repayment of customer