Credit risk management in viet nam development bank vdb ha nam branch

Tien-Tsai Huang Keywords: Banking and Finance, Credit Risk Management, Vietnam Development Bank Ha Nam Branch.. In the item 1 Article 3, Circular 02/2013/TT-NHNN, in effect from 21st Jan

THE EXECUTIVE MASTER OF BUSINESS

ADMINISTRATION

Credit risk management in Viet Nam

Development Bank (VDB) – Ha Nam Branch

Graduate student: Chu Tat Thang

Supervisor 1: Assoc Prof., PhD Nguyen Van Dinh

Ha Noi, 2017

Lunghwa University of Science and Technology

Approval Certificate of Master's Degree Examination Board

This is to certify that the Master’s Degree Examinations Board has approved the thesis Credit risk management in Viet Nam Development Bank (VDB) – Ha Nam Branch

published by Mr Chu Tat Thang in the Master Program of Graduate School of Department

of Business Administration

Master’s Degree Examination Board

Board Members:

Advisor

Chair

Date 2016/11/…

ABSTRACT

Thesis Title：Credit risk management in Viet Nam Development Bank (VDB) – Ha Nam Branch

Pages: 77

University：Lunghwa University of Science and Technology

Graduate School：Department of Business and Management

Date：December, 2016 Degree：Master

Graduate Student：Chu Tat Thang

Advisor 1：Assoc Prof., PhD Nguyen Van Dinh

Advisor 2：Assoc Prof., PhD Tien-Tsai Huang

Keywords: Banking and Finance, Credit Risk Management, Vietnam Development Bank Ha Nam Branch

In a market economy, lending is one of most important activities of a bank However, the bank's credit activities are always exposed to many risks such as: Interest rate risk, foreign exchange risk, liquidity risk, customers' default risk, and so on Utilization is the largest and most complex type of risk When the bank falls into serious financial difficulties, the cause usually arises from the bank's credit activities From this fact, especially the importance of risk management in the process of financial restructuring of the bank is urgent and practical to solve the challenge that banks Vietnamese goods are facing

Based on the synthesis of theory on credit risk, credit risk management and credit risk management models in banking business This thesis focuses on in-depth investigation Assessment of credit risk management in Ha Nam Development Bank in recent years, achievements, difficulties and obstacles encountered in credit risk management at Ha Nam Development Bank Since then, the topic has provided practical solutions to further

improve the effectiveness of credit risk management in the context of the economy being restructured Credit risk is an urgent and priority concern

Thesis is conducted by scientific research methods: methods of data collection, synthesis, methods of data analysis and comparison In addition, statistical, comparative, comparative and empirical methods as well as financial and monetary researchers are used

in this study

ACKNOWLEDGEMENTS

It is hereby to acknowledge that this thesis is carried truthfully by myself All the figures and numbers in this thesis are from reliable sources and are cited according to the standards The conclusions are honestly resulted from the real activities of the examined subject

I would like to express my sincere gratitude to the lectures from the International School of Vietnam National University, Hanoi for their enthusiasm and guidance which has brought

to me valuable knowledge and experiences I also would like to say a special thanks to Associate Professor, Doctor Nguyen Van Dinh for your care and thoroughly guidance during my time working on this thesis Besides, I want to express the warmest thanks to all the managers and the staff of VDB – Ha Nam Branch who created favourable environment for me to collect data and information to complete this thesis

Despite my best effort to the accomplishment of this thesis, the limitation and mistakes are unavoidable Therefore, I am open to receive all the valuable suggestion and advice from the lectures to improve the results of my thesis and make it become more applicable in the

my work and practice

Chu Tat Thang

TABLE OF CONTENTS

ABSTRACT i

ACKNOWLEDGEMENTS iii

TABLE OF CONTENTS iii

LIST OF TABLE vi

LIST OF DIAGRAM vii

INTRODUCTION 1

1.1 Literature review 4

1.2 Theoritical background 6

1.2.1 Credit risk 6

1.2.2 Credit risk management 9

CHAPTER 2 METHODOLOGY 30

2.1 Methodology 30

2.2 Secondary data collection method 30

2.3 Secondary data processing method (data analysis) 30

2.3.1 Aggregate analysis method 31

2.3.2 Comparative and statistical method 31

2.3.3 Methods of evaluating and analysing policy documents 32

2.3.4 Method of gathering information in official channels 32

CHAPTER 3 CREDIT RISK MANAGEMENT AT VDB – HA NAM BRANCH 34

3.1 Overview of Vietnam Development Bank - Ha Nam Branch 34

3.1.1 History and development process 34

3.1.2 Organizational Structure of Vietnam Development Bank - Ha Nam Branch 35

3.1.3 Some key performance indicators of Viet Nam Development Bank – Ha

Nam branch 38

3.2 Current situation of credit risk management at the Vietnam Development Bank - Ha Nam branch 40

3.2.1 Credit policy of VDB-Ha Nam Branch 40

3.2.2 Credit procedure 41

3.2.3 Credit risk management process 43

3.3.2 Achievements 58

3.3.3 Problems of risk management 59

3.3.4 Reasons for problems 60

CHAPTER 4 PROPOSED SOLUTIONS TO IMPROVE CREDIT RISK MANAGEMENT AT VIETNAM DEVELOPMENT BANK-HA NAM BRANCH 62

4.1 Credit development orientation at Ha Nam Development Bank 62

4.1.1 General direction 62

4.1.2 Specific direction 62

4.2 Proposed solutions to improve credit risk management at the Vietnam Development Bank Ha Nam branch 64

4.2.1 Improve the quality of credit appraisal and analysis 64

4.2.2 Improvement the management and monitoring of debt 64

4.2.3 Dealing with overdue debts and NPLs 65

4.2.4 Improving the monitoring of loan security assets 66

4.2.5 Enhance the role of internal inspection and control .67

4.2.6 Improvement of the quality of credit staff .67

4.2.7 Improvement of the efficiency of processing credit information systems .68

4.3 Some recommendations to the Vietnam Development Bank 68

4.3.1 Developing credit scoring and internal customer ratings 68

4.3.2 Measures to support debt recovery and debt recovery for affiliates 70

4.3.3 Strengthening the Debt Recovery Facility .71

CONCLUSION 72 REFERENCES 73 APPENDIX 74

LIST OF TABLE

Table 1.1 The maximum deduction rates of the collateral 23Table 2.1 Term loan structure 38Table 2.2 Business Performance from 2013-2016 39Table 2.3 Structure of outstanding loans by group of Enterprises customers under VDB Ha Nam on December 31st, 2015 – 2016 47Table 2.4 Credit risk allowance on December 31st, 2013-2016 at VDB Ha Nam 49Table 2.5 Detailed breakdown of specific debt groups as of December 31st, 2013-2016 at VDB Ha Nam 50Table 2.6 Details of general provision for debt groups as of December 31st, 2013-2016 at VDB Ha Nam 51Table 2.7 Sources of Bad Debts of VDB Ha Nam 52Table 2.8 Bad debt and bad debt ratio of VDB Ha Nam from 2013 – 2016 53Table 2.9 Branches with a high non-performing loan ratio as of 31/12/201 54Table 2.10 Credit classification at Ha Nam Development Bank 2013-2016 57

LIST OF DIAGRAM

Diagram 1 Credit risk management procedure 16Diagram 2 Organization chart of Ha Nam Development Bank 36Diagram 3 Loan providing procedure at VDB 42

INTRODUCTION

1 Rationale

Nowadays, the highly development of the economy and the actively economic markets has been expanded among the relationship between the domestic and international economy It is the beneficial environment for the development of the business activities in general and the banking industry specifically However, along with this development, there are highly risks associated with the opportunities that the integration of the international financial markets has brought about

In the banking industry, there is a close relationship between customers and the economy through the banking services, i.e borrowing and lending activities Therefore, the risks associated with these activities are complicated and could show up at variety of forms and at different levels Among the risks, in case of happening, credit risk could have enormous effects and directly influence the development of these financial institutions At the higher level, it is possible that the banking system in general could

be affected seriously because of the special features in the credit providing activities and other banking services

The Vietnam Development Bank – Ha Nam Branch is a financial institution without focusing on the profits The main objectives of the bank is to provide the loans for projects at industries and areas with difficulties, for the programs which have direct effects on the transformation of the economic structure and to foster the sustainable development of the economy Due to the aims of the loans which are to encourage investment and increase the efficiency of the society, the above projects and programs are granted a lot of benefits such as long-term loan, collaterals from the assets which are created from the loan itself… As a result, the loans are accompanied with many risk factors P Volcker, the former chairman of the Federal Reserve of the United States (FED) believed that: “A bank which do not have the bad debts is not doing business” Thus, credit risk is always in existence and is an obvious factor of any bank However, the difference between banks with good and bad credit risk management system lies in the control of the acceptable bad debt ratio due to the efficient and suitable management

to limit the credit risks which are derived from the personal views and other controllable credit risks

Because of all the problems discussed above, I choose to focus my research on the

“Credit Risk Management in Vietnam Development Bank (VDB) – Ha Nam Branch”

2.The objectives of the thesis

According to the summarization of the literature review and different models of the credit risk management, this thesis focuses on the analysis and evaluation of the credit risk management at VDB – Ha Nam Branch including the achievements and difficulties After that, this thesis will suggest some feasible solutions in order to increase the efficiency of the credit risk management procedure in the current economic environment when the implementation of the banking system restructuring at which credit risk management is highly emphasized and is the main priority

Owing to the above objectives, the thesis will bring together the following contents:

- Systematizing the literature reviews of the credit risk and the management of the credit risk in banking industry

- Defining the real situation including the achievements, the limitations and the issues in the credit risk management procedure in VDB – Ha Nam Branch

- Suggesting the solutions in order to strengthen the credit risk management system applied in the VDB – Ha Nam Branch

3 Scope of the thesis

4.Methodology

The thesis acquires different methods in order to take advantages of the strengths of each method including collecting the data, summarizing, analysing and comparing the

results Besides, statistics method is also applied along with the experiences of the author and other researchers

In addition, selective secondary database is acquired in order to provide the most unbiased assessment The secondary database is collected from the credit risk reports from VDB – Ha Nam Branch as well as the financial statements of VDB during the time of 2013-2016

5 Expected contribution of the thesis

The thesis is projected to evaluate the real business activities at VDB – Ha Nam Branch so that it could assist the managers of the branch in improving the efficiency of the credit risk management procedure and the business activities in general

6 Thesis structure

Apart from the content, lists of tables and abbreviations, introduction and conclusion, the thesis is divided into 4 main parts:

- Chapter 1: Theoritical background and literature review

- Chapter 2: Methodology of the research

- Chapter 3: Credit risk management at VDB – Ha Nam Branch

- Chapter 4: Proposed solutions to improve credit risk management at Viet Nam Development Bank – Ha Nam Banch

CHAPTER 1 LITERATURE REVIEW AND

THEORITICAL BACKGROUND

1.1 Literature review

Nowadays, despite the unfavourable condition of the financial market, the commercial banks in Vietnam is still expanding the scope of their business, the list of the investment portfolio and increasing the quantity of their products and services as well as loosen the requirements for the borrowers in order to keep their former customers and attract more potential customers Consequently, the risks associated with the banking business are increasing significantly, especially the credit risk Therefore, it

is undeniable that there has been a lot of research which are carried out on the topic of the credit risk management in banking sector For example:

The Doctoral dissertation “The credit risk management in Vietnam Bank for Agriculture and Rural Development” of the research student Nguyen Anh Tuan,

majoring in the Finance – Banking Economics, supervisor Professor, Doctor Cao Cu Boi, which is defended at the judgement council of national level thesis and dissertation

at the National Economics University The research made new contribution to the academic view of the credit risk and the management of the credit risk at the current international integration banking industry In details, the dissertation has brought about the fundamental factors to identify credit risk in Vietnam, including the early-recognition factors and the method to measure these factors It also proposed the model, which can be used in measuring the credit risk factors in the present and in the future, to establish the rating and ranking system depending on the customers’ database in comply with the international standard By combining the credit risk management principles of BASEL Committee and of Vietnamese standards, the dissertation has set up a relatively adequate rating system in order to evaluate the credit risk management procedure in Vietnam banking sector– which used to be the limitation of previous research in Vietnam It could be said that the results from this dissertation is an important principle

to bring and ensure the success of a completed credit risk management strategy in Vietnam commercial banks in general and at the Vietnam Bank for Agriculture and Rural Development specifically

The Master dissertation in Finance and Banking “Credit risk management in investment-purpose loans in VDB – Gia Lai Branch” (2014), which is carried out by Vo

Hoang Thach In this research, the author has systematized the literature reviews of the credit risk management, analysed and evaluated the real situation in investment lending

at the Gia Lai Branch of VDB in 2011-2013 period Moreover, the author identified the achievement and limitation of the credit risk management procedure at the examined entity and proposed some solutions for improving the procedure as follows (1) Enhancing the quality of the loan especially at the stages of assessment, disbursement and debts recovery; establishing the bad debt classification system in conformity with the business practice of VDB, the procedure for setting up the Allowance for credit losses and the resolutions for recovering the bad debt in order to reduce the rate of general non-performing loans to under 7% in 2015, 4%-5% in 2020, 3% during the period of 2020-2030 (2) Credit institutions, except the branches of foreign banks, should maintain the minimum capital adequacy ratio 9% which is the rate of owner’s equity and the risk weighted assets

The article “Credit risk management models in Vietnam commercial banks” of

Master Nguyen Duc Tu – lecturer of the Human resource development and training school, on the official website of the Vietnam Banks Association on 25th November,

2011 The article focused on analysing the strengths and weaknesses of 2 credit risk management models including concentration model and dispersion model which are applied in Vietnam In addition, the article also suggested the direction for establishing the adequate model which could be applied in Vietnam commercial banks in the near future

The article “Reduce the credit risk in Vietnam commercial banks” of the author

Duong Thi Thanh Hai on Financial Market Reviews Issue 7 in April, 2013 The article emphasized that the banks should understand clearly the risks associated with banking business, especially the credit risk Moreover, the evaluation of credit risk in order to propose the suitable solutions is the main priority to ensure the safety and efficiency of banking business The article also suggested some solutions to reduce the credit risk of the current banking system

The above mentioned research and articles relates directly or indirectly to the thesis topic However, depending on each period of time, the management of credit risk

should be reviewed and then propose more adequate policy in accordance with the updated situation Therefore, the new research should be conducted to assist the banking sector with the more feasible solutions I choose this thesis topic with the aims of contribution to the improvement of the credit risk management procedure in VDB – Ha Nam Branch

1.2 Theoritical background

1.2.1 Credit risk

1.2.1.1 Definition of credit and credit risk

Lending is one of the most important business activities of a bank because the majority of the bank’s income derives from this activity According to the statistics, about 60% to 75% of the bank’s profits comes from the credit providing However, it also the source of enormous potential risks Some research shows that credit risks make

up about 70% of the total risks in banking business It cannot be denied that maximizing profit with acceptable rate of risk is the nature of banking business The former chairman of FED, P Volcker believes that “A bank which do not have the bad debts is not doing business” Although there is a lot of innovation in banking sector, credit risk

is still considered as the main source of the assets losses and could lead to the bankruptcy of a bank There are different definitions of credit risk

According to Thomas P Fitch: “Credit risks happen when the borrowers are incapable of paying the loan at the maturity of the credit contract” Along with the

interest risk, credit risk is one of the main source of risk in the lending activity of a bank

Sauders and H Lange also define “Credit risk is the potential losses when a bank provides loans for a customer, i.e expected profit from this activity is infeasible when it comes to the quantity and the deadline for payment as well”

In the item 1 Article 3, Circular 02/2013/TT-NHNN, in effect from 21st January, 2013,

defines: “Credit risk in banking business (known as risk in abbreviation) is the possible losses which could occur to the loan of a credit institution, a branch of the foreign bank due to the non-performance or incapability of customers to pay the partial or total amount of their obligations as commitment”

In this thesis, credit risk could be understood as the potential losses that might

happen in case the counterparty is unable to fulfill his/her obligation on time as being specified on the credit contract

1.2.1.2 Characteristics of credit risk

From the view of the nature of credit relationship, the definitions as well as the signs

of credit risk, it can be seen in the following features:

- Credit risk has the indirect nature

This feature comes from the consideration of credit relationship between the bank and its customer When the loans is provided to the customer for the pre-determined period, it is possible that losses can happen during this time However, because the use

of the loan is depended on the intention of the customer, it is difficult for the bank to recognize these losses in the most accurate and completed way when the business of their customers are in trouble

- Credit risk are complicated and multiform

This feature can be seen in the complicated and multiform nature of the sources, appearances and consequences of credit risk It could be considered as the unavoidability of lending activity because of the intermediary role of banking system in monetary market This feature is also seen as the result of the first feature because the indirect nature of credit risk, in turn, enables it to become more and more feasible to experience the complicated and multiform characteristic of credit risk

- Credit risk is unavoidable and always comes together with the lending activity

of a bank

Asymmetric information could be seen as the main reason that the experts and bankers as well consider banking business as managing the acceptable rate of risk in proportion to the profits Because it is impossible to achieve the state of symmetric information in lending activity, any loan is exposed to the risk of capital losses

1.2.1.3 Credit risk classification

There are variety of criteria to classify credit risk so that which factors could be used depends on the objectives and requirements of the researchers If the sources of credit risks are used to consider, it could be categorize as below

- Transaction Risk is the type of credit risk that derives from the limitation of the transaction and assessment of the customers and the loans It comprises of 3 main parts: Selection risk, Underwriting risk and Operation risk

+ Selection risk involves the assessment procedure and credit analysis in order

to select the efficient lending projects to provide loans

+ Underwriting risk comes from the insurance provisions in the credit contract such as the collateral, subject, method and the credit limit calculated on the value of the collateral

+ Operation risk is the risk that accompanies with the loan management and lending activity including the use of credit rating system and the mechanism to handle the doubtful debts

- Portfolio risk is a type of credit risk which comes from the limitation in managing the lending portfolio, including two parts: intrinsic risk and concentration risk

+ Intrinsic risk itself derives from the internal characteristic of each borrower or the specific features of each industry and economic sector In particular, it depends on the business practice and the usage of the loan of the borrowers + Concentration risk occurs in the case of over-concentrated lending portfolio, i.e the bank providing loans to too many companies operated in one specific industry or area or the same high-risk loans

Credit risk

Transaction Risk

Portfolio Risk

Intrinsic Risk

Concentration Risk

Underwriting Risk

Operation Risk Selection

risk

Apart from the sources, credit risk is also categorized by other criteria such as objective/subjective features of the loan, structure of each type of risk or the classification of borrowers,…

1.2.2 Credit risk management

1.2.2.1 Credit risk management in commercial banks

 Overview of credit risk management in commercial banks

Definition of credit risk management

Credit risk is an inevitable factor in banking business If it is known clearly then the risk could be accepted in with full awareness and be controlled under suitable method In addition, it is possible to measure and predict the credit risk so that it can be tackled efficiently

Credit risk management is a procedure that involves the managing mechanism of

a bank to predict, to issue warning and to propose solutions in order to keep the potential losses at the minimum level

According to the Basel Committee, credit risk management is a course of action including setting up the mechanism to identify the risk, to quantify, to tackle and to control the current and potential losses in lending activity at the most completed way in order to maximize the profit in proportion to the risk-adjusted factors by maintaining the acceptable level of credit risk

As a result, credit risk management can be understood as the commercial banks take advantages of their professional skills and knowledge to control the lending activity and to minimize the potential losses that could in turn directly affect other risks

in banking business, leading to the bankruptcy

The necessity of credit risk management

It is undeniable that the credit providing activity is the most profitable part in banking business However, this also means that it can be seen as the highest risk activity which could lead to the devastating consequences in not only the banking system but also the economy and society

Meanwhile, credit risk is unavoidable that exists in unbiased form along with the lending activity Managing the credit risk plays an important role in the maintenance of

an acceptable level of credit losses to ensure the highest level of safety and efficiency of the banking business with sustainable growth rate

The objectives of credit risk management

The management of credit risk should be considered in relation with the lending business and the administration in general The main objective is to ensure the efficiency of lending activity and continuous improvement of the loan quality even in the case of market fluctuation with high potential rate of risks In more specific, credit risk management involves reducing the rate of risk while improving the safety level if banking business by acquiring the effective policies and supervising techniques

Basel credit risk management principles

Basel is also known as the Basel Committee of Banking Supervision, established by the central banks of G10 countries since 18th century under the sponsoring of the Bank for International Settlement (BIS) Basel II is a comprehensive set of reform measures replacing the Basel I reform which was in effect since 1988 in order to assist commercial banks in managing risks more effectively Particularly, there are 17 principles about bad debts management which can be seen as the set of regulation in managing credit risk to ensure the efficiency and safety in lending activity The key features of these principles are described as follows:

 Establishing adequate lending environment (3 principles)

- Principle 1: Approval and examination of credit policies periodically, review the acceptable level of risk and profitability ratio,…

- Principle 2: The process of implementing credit policy, establishing lending procedure for individual loans and the credit portfolio as a whole in order to identify, evaluate, manage and control the credit risk

- Principle 3: Identifying and managing credit risk in all products and services, assuring that they should go through all the stages of controlling procedure and are supervised carefully

 Performing healthy lending policy (4 principles)

- Principle 4: Lending activity should depend on healthy criteria with clear identification in borrowers, objectives, credit structure and sources of payment

- Principle 5: Setting up the credit lines for each types of customers and groups of borrowers to identify the different types of credit risk that could be tracked on the business accounts, on- and off-balance sheet accounts

- Principle 6: There should be a clear procedure for approval of credit lines as well as modification, extension of the loan term, restructuring and refunding policy of the current loans

- Principle 7: The credit business should be conducted in the fair basis among parties

 Maintaining the adequate procedure of managing, measuring and tracking the loans (6 principles)

- Principle 8: the management system of credit risk-bearing portfolio should be kept updated

- Principle 9: There should be tracking system to supervise the condition of individual loan, including the measure of the allowance for credit losses

- Principle 10: Encouraging the bank to develop and apply the internal credit rating system in managing credit risk procedure

- Principle 11: Commercial banks should acquire the information system with analysing techniques to measure the credit risk in all on- and off-balance sheet accounts

- Principle 12: There should be a special system to track down the structure and quality of the lending portfolio

- Principle 13: Commercial banks should consider the effects of economic changes on their lending activity

 Ensuring the completed controlling system (4 principles)

- Principle 14: Establishing the independent credit rating system which could be used continuously and reported regularly to the Board of Directors and Senior Managers

- Principle 15: Loan providing procedure should be monitored in the most completed method, in particular, it must comply with the cautious standards and acquire the internal control process with any violence of the credit policy being

- Improvement of credit risk management staff

- Establishing the managing system with updated information in order to identify, measuring and tracking the loans at the adequate level which can meet the requirement of credit risk management procedure

 Credit policy and the procedures

 Credit policy and procedures

The credit policy and procedures is considered not only as the guidance for the daily lending business but also the method to manage the credit risk which is currently applied at commercial banks Thanks to these documents, the development of the credit business is under control It assists to orientate the growth of the credit business, customer policy, loan providing procedure with step-by-step guidance,… so that the responsibilities of each department and staff are clearly assigned

Credit policy defines the general principles of the credit business in order to limit the lending activity of individuals and institutions within the acceptable level of risk Although each bank acquires different credit policies depending on the market conditions and macroeconomic factors, the following factors are applied:

- Credit policy is set up in the foundation of the laws, the regulations of the State Bank of Vietnam in lending business, the long-term business objectives, safety and efficiency maintenance principles for the sustainable growth

- Assigning the level of management, prioritizing the customers according to the

geographical areas and the bank’s policy Clearly defining the situations to promote or to restrict lending

- Establishing the safe, efficient and comprehensive credit policy for individual or group of customers In order to enter the credit contract with the particular kind

of borrowers, it is essential that the banks examine the creditworthiness of their customers in the most comprehensive way which depends on the credit portfolio

of the bank including types, terms, sizes of the contract and the quality of the provided loans

- Assigning the responsibilities to each credit staff, i.e not all the credit staff are possible to be in charge of and to manage the large-scale loans In addition, the managers should divide their staff into separated groups and allocate the credit lines to them Moreover, the allocation should be determined on the ability and the current working condition of each group

- Within each group, there should be clear internal procedure to assign responsibilities and to report

- Each admission, examination and determination stages of loan providing procedure should be reasonable and can minimize the potential losses

- The lists of acceptable and inacceptable collateral

 Credit risk management policy

In order to meet the objectives of credit risk management, commercial banks should establish the adequate policy which includes the lists of viewpoint, solution, instruments proposed by the Board of directors on the general director’s suggestion to manage outstanding loan and credit risk It is essential that the credit risk should be recognized and measured at early stage and reported promptly to the board of directors, supervisory board and the executive committee

Once being defined, credit risk should be analysed, measured and proposed the suitable solutions in order to manage and track down easily Meanwhile, the management system should be able to identify the potential risks then repeating the management procedure

Credit risk management policy includes the operation policy, lending activity policy, creditworthiness assessment policy, measurement policy and bad debts handling

policy

 Credit risk management models

Credit risk management model can be seen as the group of sub-model including the management model, measurement model and risk control model which are set up and operated in the comprehensive and continuous system It reflects the fundamental parts of credit risk management such as the policies and procedure in order to maintain credit risk within acceptable level or the measuring instruments and supervising activities in order to identify the risk and apply timely and suitable solutions

It is vital that the risk model should ensure the efficiency and continuity of the lending business while raising the level of credit quality even in the fluctuation of the market At current time, there are 2 popular models which are applied at the commercial banks in Vietnam: the concentration model and the dispersion model

 Concentration credit risk management model

The most distinctive feature of the concentration model is that the customer assessment stage and the risk management stage are the responsibility of the head office

or depend on the geographical areas Branches of the commercial banks are only responsible for the scan and skim of the customer’s profile then deliver it to the head office It allows the separation of each function, i.e the operation, conduction of business and risk management which all aims at the main priority to minimize the potential losses and to maximize the ability of each credit staff in a bank

 Strengths of the model:

The concentration model allows the overall risk management in banking system and assure the long-term competitiveness of the bank Meanwhile, it creates and maintains the comprehensive environment which is suitable for the activity of all the departments, enhancing the control of the credit risk, establishing the unified risk management policy which is completely separated between business function and operation function

 Weaknesses of the model:

The concentration model requires a lot of time and effort in order for setting up and

operating It also involves the investment of the information technology system which allows the summarization and categorization of the data from the branches to the bank

head office under specific set of criteria Moreover, the credit staff should acquire particular skills and knowledge and are capable to apply theories in the real practices

 The concentration credit risk management model is suitable for the large commercial banks

 Dispersion credit risk management model

The dispersion model requires the assessment of customer and risk management being conducted at branches instead of the head office as the concentration model Therefore, the head office is only responsible for the general orientation and are in charge of the special customers that the branches are unable to take care of As a result, the 3 main function of a bank, i.e risk management, conduction of business and operation are all taken by the credit department

 Strengths of the dispersion model

The dispersion model only requires simple and orderly operating system so that documents handled by the customers are processed quickly and the establishment and operation of the model do not take times and effort

 Weaknesses of the dispersion model

The model lacks of specialization because of the concentration of the 3 functions of lending business within 1 department of a branch The distant reports to the head office depends on the subjective of each branch and the head office only manages the loan indirectly which can be resulted in the difficulties in risk management

 The dispersion credit risk model can be applied in medium- and small-sized commercial banks

 The orientation of credit risk model application

According to the real practice in lending business, the recommendation of the Basel Committee and international standards as well as the regulations and technology system and human resources in Vietnam, the concentration credit risk management model should be applied

At the head office: the lending decisions and the risk management function should

be separated according to the assigned responsibility of each department including the assessment, approval, credit management and credit risk management

At the branches: to split up the sales function (marketing and customer services), the credit analyse function (analysing, assessing and forecasting) and the operation function (document processing, tracking and debt recovering)

Under the concentration model, the sales department should be responsible for finding, developing and taking care of the customers They should take time to understand the needs of the customers and to instruct the customers to complete the documents then delivering these documents to the credit analysis department

The credit analysis department, in turn, should be able to process the information, collecting additional information through the interbank sources, CIC questioning and on the media,… The department then conducts analysis and overall assessment of the customer’s creditworthiness from the general aspects to financial ability, loan projects and collaterals After that, they will report the results directly to the supervisor who can make the approval decision The results then will be returned to the credit analysis department for storing and be delivered to the customer services department to undertake the next stages

 Credit risk management procedure

The credit risk management procedure can be described as follows:

Diagram 1 Credit risk management procedure

As diagram 1.1, although there are 4 separated stages of credit risk management procedure, the relationship among these stage creates the closed cycle in order to maintain the pre-determined objectives

Identify credit risk

Measure credit risk

Control and prevent credit risk

Process credit risk

Source : Chrinko R.S Guill (2000 “A framework for assessing credit risk in

depository institution”.[60]

Each stage is described in detail as follows:

Identify the credit risk

Identifying the credit risk is an important aspect in credit risk management It is

undeniable that the potential losses should be identify at the early stage to propose the suitable solution and minimize the potential losses It is believed that credit risk only occurs when the loans are approved and provided However, if the assessment stage is not comprehensive enough, it could lead to the losses not only the income from interests but also the bank’s capital Therefore, the thesis defines : “Identify risk is the continuous process from the loan assessment stage until all the debts are recovered including interests and capital payments, the credit risk appears in the case customers are predicts to be unable to return the loan to the bank on time”

 Firstly, pre-lending identifying credit risk

Identifying credit risk before lending can be seen through the loan appraisal This is

an important step when making a loan decision The assessment of loans includes financial information and non-financial information of the customers

- Non-financial indicators: This is a set of non-quantifiable criteria reflecting the customers’ status including: legal capacity, repayment of customers in previous borrowings, Non-financial factors help the bank in assessing the partial of the potential risks in each loan Although the bank might consider many criteria for providing loans to their customers, they usually focus on 6 fundamental criteria which are called "6C" including: Character, Capacity, Cash flow, Collateral, Conditions and Control According to the 6 mentioned criteria, credit staff should be able to answer 3 questions before continuing with the disbursement stage: (i) Is the client eligible? (ii) Is the credit contract adequate and valid; (iii) Can the credit institution are able to recover the debts by collateral or income when the borrower defaults?

- Financial indicators: In order to calculate and evaluate the financial indicators credit staff should be able to perform the following steps:

Step 1: Collecting information and analysing the financial status of the customer

Solvency ratios such as current ratio, quick ratio, cash ratio If the solvency ratios are too low, it can be seen as a sign that the repayment capacity of the business is

a problem and are possible to result in the credit risk

Debt ratio shows as one unit of assets is in proportion to how many unit of debts The use of debt will boost the income of the business but also cause financial risks On the bank’s perspective, the debt ratio of the business should be as low as possible because it is safer when one unit of assets is in proportion to as many as possible unit of debts

Performance ratios such as inventory turnover, receivables turnover which reflects the length of an inventory or receivables cycle depending on the characteristics

of each industry However, if the cycles of inventory and receivables are too long compared to the average figure of the industry, it can be understood that the capital cannot be used efficiently in investment leading to difficulties in production and other business activities of enterprises and affecting the ability to repay the principal

Profitability ratios suggest that if the profitability of the business is high compared to the overall calculation of the industry, this partly ensures the ability to pay interest as well as the principal for the company

Step 2: Processing information

After collecting information, credit staff are in charge of screening these information to analyse and evaluate the financial ability of customers Based on that, the credit staff will identify the risk to provide loan or to refuse loan and other conditions to limit risks

Step 3: Identify the risks of the customer to recognise the credit risk

 Secondly, identify after-lending risk

For after-lending monitoring, banks need to regularly review their loans so that timely detection of potential risks can helps to prevent and to reduce the credit risk Here are some signs of a problem bank loan:

- Customers avoid or credit staff cannot contact with customers

- Frequently violating financial terms under the agreed credit contract

- Revenue increases abnormally

- Customers have large purchases without legitimate causes or unsuitable financial resources

- The companies do not provide timely, completed, truthful related information

- Having difficulties in borrowing money at other banks/ Less favourable terms on the credit contract

- Changing key positions in the company board of managers

- Being impacted by the risks from policy and natural conditions on business activities

- Spouse or children of the customers are unable to recover their debts or suffer from serious diseases

- Customers have signs of divorce, separation, …

- The prestige of the board of directors is reduced or there are complaints with the board’s members

- Revenue from sales decreases or increases abnormally

- Unreasonable sales price and sales price policy

- The increase in debt/investment for subsidiaries, joint ventures/ associates or individuals involved in the business

- Increase in the payables account

Credit risk assessment

Risk measurement is an important stage after identifying and detecting credit risk The measurement of credit risk helps the bank to eliminate the loan to high risk customers and to recognise the potential risks

At present day, the world is beginning to pay close attention to quantify credit risk and to apply of modern methods and models of risk management Here are some of the credit risk measurement models which are currently in use:

 Credit risk measurement under Basel II framework

Commercial banks will use the models which are based on their internal data systems to determine the possibility of credit losses The commercial banks will define the following variables:

PD (Probability of Default): probability of customers cannot pay the debt;

LGD (Loss Given Default): estimated loss ratio;

EAD (Exposure at Default): total outstanding debt of customers at the time the customer are insolvency

Depending on the above variables, commercial banks will determine EL (Expected Loss) For each specified term, estimated losses can be calculated based on the following formula:

LGD = (EAD - Amount recoverable) / EAD

EAD: total outstanding loans of cusotmer at the time the customer cannot repay the debt The Basel Committee required the EAD to be calculated as follows:

EAD = average outstanding debt + LEQ x Average unused credit line

In particular, LEQ (Loan Equivalent Exposure) is the proportion of unused capital is likely to be withdrawn more at the time of default

 Measurement of credit risk by internal credit rating system

The internal credit rating system is a combination of procedures for classifying customers by industry, size, ownership, financial indicators and non-financial indicators for scoring purposes The internal credit rating system is an important tool in managing and monitoring the quality of loan to each customer as well as the entire loan portfolio The good internal credit rating system are able to tell the difference between the levels

of risk in lending activities of commercial banks It also allows a more precise definition

of the characteristics of the loan portfolio, the level of problem loans and the adequacy allowance of loan losses

The internal credit rating system must be developed specifically for the three targeted groups: corporate customer, individual customer and business household of the

credit institution The total score of the program is determined on a maximum scale of

100 divided by financial indicators and non-financial indicators at a certain proportion Highly rated customer can be understood that the bank's good judgment on the customer and its ability to recover the lending, the provision for loan interest rates and other conditions will be more favourable than those with lower scores Currently, this method

is used by many commercial banks in Vietnam and has obtained certain results in the process of screening and selecting good customer for providing loans

 Measurement of credit risk by Z-Score model

Z-Score model (Z-Credit scoring model) is set by E.I.Altman to obtain the credit scores for US manufacturing companies Z-Score is measured to classify credit risk for borrowers which is depends on:

+ The numeric value of the borrower's financial factors (Xj)

+ The importance of these indicators in determining the probability of a borrower's default in the past The model is described as follows:

Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5

That is:

X1: "Net Working Capital / Total Assets"

X2: "Cumulative Profits / Total Assets"

X3: "Earnings before tax and Interest / Total assets"

X4: "Stock price / book value of long-term debt"

X5: "Revenue / Total Assets"

The higher the Z-score, the lower the probability of a default So when the Z value

is too low or a negative number, it will be the time for classifying customer in the risk group

high-Z <1.8: The cusotmer is likely to be at high risk

1.8 <Z <3: Unspecified

Z> 3: The customer is unlikely to default

Any company with a Z-score of <1.8 must be classified as high credit risk

Control and prevention of credit risk

Checking and controlling credit risk helps to detect errors in the credit providing procedure It can also help to prevent risk According to Basel II framework, commercial banks must establish credit control department which is independent in design, implementation and operation of its internal rating systems This department should also be separated to the manager who must take the responsibility for creating potential risks This is to ensure the unbiased and accuracy during the regular credit control and credit risk management control procedure In order to perform well the credit risk management procedure, the bank should enhance the following duties:

- Credit monitoring: The bank supervises the customer through account activity, periodic financial analysis, loan guarantee and information from external sources

- Loan insurance: The implementation of any form of loan insurance depends on the particular status of the client and the internal policy of the bank In order to minimize the credit risk, loan insurance should:

+ Loans insured by assets: Accurately assess the ownership of assets, whether they are in dispute or not? Assess the market value of current and future assets, determining the level of the devaluation of the asset within the guaranteed term The procedure must be in accordance with the regulations of the authority and of the specific industry

+ Loans insured by a guarantee: Evaluate the legal ability, financial capacity and willingness of the guarantee Ensure the guarantee procedures

The table below shows the maximum discount rates which are used to determine the deductible value of collateral assets in accordance with the latest regulation of the State Bank of Vietnam - Circular 02/2013-NHNN on the basis of comparison with the deduction rates of the same type of collateral under former regulations, Decision 493/2005-NHNN and Decision 18/2007-NHNN

Table 1.1 The maximum deduction rates of the collateral

Type of Collateral

Maximum Deduction rate (%)

Maximum deduction rate (%) as the former regulation

Gold ingot, except the gold that is invalid in listing,

other type of gold; deposits in foreign currency 95% 95% Government bond, transferable instruments,

certificated securities issued by the credit institutions

themselves; savings book, deposit certificate, treasury

notes, bill of exchange issued by the credit

institutions and foreign banks

Applied to the government bond only

Securities issued by the different credit institutions

Securities issued by the different companies which

Unlisted securities, certificated securities issued by

the listed company, except the certificated securities

issued by the same credit institutions; savings book,

CDs, treasury notes, bill of exchange issued by the

credit institutions and foreign banks

Unlisted securities, certificated securities issued by

the unlisted company, except the certificated

securities issued by the same credit institutions;

savings book, CDs, treasury notes, bill of exchange

issued by the credit institutions and foreign banks

Unlisted securities, certificated securities issued by

the company which already applied for listing in the

Unlisted securities, certificated securities issued by

the company which have not applied for listing in the

Exchange

Real estate 50% 50%

Gold ingot which is invalid for listing, other types of

(Source: Circular 02/2013- NHNN effected on 21/01/2013)

Table 1 indicates the maximum deduction rate under the new regulation much tighter and the discount rate has been significantly reduced for some types of collateral against the former regulations This also means that the value of the collateral assets under the new regulations will be reduced accordingly and the specific provisioning for the loans using these collateral assets of the bank should be increase

Handling the losses in case credit risk occurs

Solutions for dealing with this situation are implemented when the loan cannot be recovered, so that the bank must take sturdy measures to recover the maximum amount

of debt The solutions include:

 Debt recovery

Bank decides to recover the debt by terminating the loan agreement to reduce further costs incurred due to loan losses The bank recovers the debt by asking the customer to pay the debt to them If customer has fully repaid the amount owed to the bank, the contractual relationship between the bank and the customer is terminated If customer fails to return the full amount or not repay the bank's total debts, the bank will continue to apply the following measures to recover the maximum amount of capital such as asset sales or debt repayment, litigation, selling the debt,

Compulsory sales of the collateral: The bank will try to persuade the customer to voluntarily sell their assets If the customer refuses to do so, the bank will proceed to sell mortgages under the supervision and judgment of the law enforcement

Debt repayment by guarantee: The bank will require the guarantee to repay the loan on behalf of the customer because the loan is guaranteed by a third party The guarantee is obliged to repay the debt on behalf of the customer for the outstanding amount

Court actions: In case the collateral and the guarantee do not meet the payment

obligations with the bank, the bank can use the lawsuit to recover all the money Bank must prepare the necessary legal procedures for the lawsuit

Sales of debt: When the bank cannot recover its debt, the bank can use the debt sales method, i.e selling the debt and the value of debt to another organization Collected debts are often much smaller than the former value of the debt, but this is also

a way of recovering a portion of the debt Debt sales is often applied to large valuable businesses that sell the entire business or part of an enterprise for the purpose of replacing the board of managers with the new leaders, which might be able to recover the business activity of the company

Incentives for debt recovery: Partial interest rate exemption, interest reimbursement,

no interest penalty,… which can be applied to the customer intending to pay back the loan

 Handling by the reserved fund

Using a reserved fund to make up for credit losses only exacerbates the financial situation of the bank It does not mean completely eliminating debt for the plan For debts covered by the reserved fund, it will be transferred to the off-balance sheet for full collection, banks still have to take measures to recover the debts

 Measures for bank officers and related departments in the bank

In addition to the above solutions, based on the level of risk and the responsibility of the staff, the bank will choose the level of penalty (this should be based on the internal regulations of each bank) as: To take responsibility, to pay compensation, to handle the review, to dismissal or be fined according to the regulations of the bank

 Credit risk management assessement

To assess credit risk management, there are many indicators However, within the framework of this thesis, the following indicators may be given:

Firstly, the growth rate of the outstanding loans

Growth rate of the

outstanding debts =

Outstanding debts at year t – Outstanding debts at year (t-1)

x 100% Outstanding debts at year (t-1)

Normally, the growth rate of the outstanding debts is stable and in corresponding with the economy's conditions, which implies that credit risk management of commercial banks is effective

Secondly, the structure of outstanding debts

A commercial bank with effective credit risk management will have a reasonable credit balance structure to minimize the risks and to maximize the profit to the bank

Thirdly, non-performing loans (NPL) ratio

NPL

Total debts NPL ratio is one of the indicators that reflects the quality of the loans If the rate

of bad debt over the years tends to decrease, it implies that the management of credit risk of commercial banks also tends to improve In contrast, if bad debt ratio tends to increase significantly over those years, the bank's credit risk management activities need

to be reviewed However, if only based on the bad debt ratio over years, the assessment

of credit risk management is not accurate because of many other objective factors such

as the sharp decline in the economy condition which could rise the bad debt rates Therefore, it is necessary to combine multiple indicators to evaluate, not only a single indicator

At the stage of assessing bad debts, commercial banks should compare their conclusion with the branches in the same banking system This is a measure of credit risk management of this branch compared to other branches in the same banking system In order to have an accurate assessment of a bank credit risk management If the bad debt ratio of commercial banks compared to other commercial banks is lower than that, it shows that credit risk management of these commercial banks is better and vice versa In addition, the ratio of bad debts of commercial banks compared to the whole system should be considered also It is likely that the rate of bad debt over the years of a bank increase due to objective or subjective reasons Therefore, to be better in evaluating the management of credit risk, commercial banks should compare with the rate of the whole system If the bad debt ratio of commercial banks is lower than that of

the whole banking system, it shows that credit risk management of commercial banks is more effective than the system If the bad debt ratio of commercial banks is higher than that of the whole system, then commercial banks should consider and propose solutions

to improve their credit risk management

Fourthly, debt collection after handling the risk

Debt recovery proceeds after handling the risk indicate the ability to control the loan after it has been dealt with The higher the debt collection for the loans, the greater control it made over commercial bank loans

Fifthly, irrecoverable debts ratio

When the bad debt is likely to be irrecoverable (debts at group 5 are higher), it indicates that the credit risk management procedure is still inadequate

1.2.2.2 Factors affecting credit risk management

 Subjective factors

The credit policy of the bank

Credit policy reflects the fundamental orientation of credit activity, which is critical to the success or failure of the bank In order to ensure and improve the quality

of credit, the bank needs to have a credit policy in line with economic development, while combining the interests of depositors, banks and borrowers

The credit procedure

The credit procedure can be seen as the sequence of implementing basic technical business steps, indicating the way from the beginning to the end of a transaction within the functions and duties of the credit staff and managers Establishing

a sound credit procedure will improve the efficiency of the risk management

Credit risk management content

Credit risk management is a systematic reflection of regulatory, policy, and operational issues to establish safe operating limits and risk control points in a process including measuring, risk detection instruments, monitoring activities for compliance and timely identification of new types of risks arising as well as the options and measures to actively prevent and to cope with the risks arise

Internal control system

Internal control should be considered as the bank's "immune" system The larger the bank is, the more effective it is to protect the bank against the risk A good internal control system with a team of professional supervisors acquired great training will quickly detect and adjust the lending procedure as soon as problems arise to help to limit credit risk of a bank

Qualification of credit officers

People are always the decisive factor to success in all business activities in general and of course it does not exclude from the operation of a bank In order to improve efficiency in business, or the quality in credit activities in general, the bank needs to have a good team of credit staff who are trained systematically, and have broad knowledge about the market

Information technology applications in banking

Information technology is an important factor in improving the bank's operational capacity The technology will clearly help the bank in the field of management, in the expansion of products and services, and to meet the strict needs of the banking system In addition, the technology also allows banks to be better at risk management, thus providing supportive instruments to help banks make the right decisions

 Objective factors

Customer factor

- The use of the loan and the sense of repayment of customers: Most customers when borrowing bank loans have business plans, specific consumption plans which are feasible In fact, due to the number of products and services are limited compared to actual needs of individuals and businesses, customers are prone to be forced to use the funds for the incorrect purposes to meet their needs This affects significantly the ability to repay the loans of the customer

- Business ability to generate income, value of collaterals: Borrowers with strong financial capacity having feasible and effective business projects are less likely

to be at risk Therefore, when risk occurs, losses to banks are minimized However, if the customer uses the loan for the right purpose, but the repayment

capacity is not well enough, or other unpredicted events could deteriorate the repayment capacity, so that the customer cannot guarantee the repayment schedule

Factors in the operating environment of the bank

 Economic environment

The stability or economic instability and economic policies of each country always have a direct impact on the performance of enterprises in the market The stable economy will be more favourable environment for enterprises to operate their business and earn higher profits, subsequently contributing to the success of banking business and vice versa

 Political environment

The political environment plays an important role in business, especially for banking business Political stability in the country will be one of the most favourable factors for businesses to operate effectively If unpredicted events such as war, riots, demonstrations, strikes, etc occur, it is possible to lead to damages in businesses and the economy as a whole And so, the loans will be difficult to be recovered fully on time

 Regulatory environment

An incomplete legal environment, lack of uniformity and consistency between laws, sub-law documents will cause businesses to encounter difficulties In addition, the lack the necessary flexibility might put the business at risk Therefore, building a sound legal environment will facilitate the improvement of business efficiency of enterprises including banking system

 Natural environment

Risk factors caused by nature such as floods, fires, earthquakes, epidemics, etc can

cause unforeseeable damage for both borrowers and banks Although these risks are difficult to predict but it only make up a small proportion On the other hand, banks are often sharing risk with insurance companies by entering insurance contracts or can be supported by the government

CHAPTER 2 METHODOLOGY

2.1 Methodology

The dissertation approaches the research subject basically depending on using dialectical materialism method as general methodology The approaching method of the dissertation is that comment, evaluation, and analysis are given based on the theoretical and practical basis of the research subject, finally solution is proposed to improve banking risk managing mission Besides, from reality survey and summary, comparing with credit risk management theory of national and international credit agencies, the dissertation proposes as the way to create credit risk management model of The Vietnam Development Bank (VDB) – Ha Nam Branch

2.2 Secondary data collection method

Experiment data collection (from initial science research documents as well as experiment observation and performance) is a vital step in science research for the purpose of being basic science reasoning, finding out the ground of hypothesis demonstration, and addressing the research issue

In scope of research topic, the method of collecting data from reference is mainly used It depends on both primary and secondary information sources which are gathered from previous research documents in order to build ground basis for hypothesis demonstration In banking sector, the process of collecting and processing information encounters obstacle because of strict security as well as close risk managing operation, leading public information to verify carefully

In this topic, secondary data which needs collecting and analysing is about business operation, credit operation, credit risk management of VDB – Ha Nam Branch

in the period of 2013-2016 through the audited annual and financial reports, brief reports, announcements, and internal documents of the branch

Moreover, secondary data source of the branch is also published: on the Internet, newspapers, magazines, and annual reports of the State Bank;

2.3 Secondary data processing method (data analysis)

Secondary database is also used selectively and processed carefully to create the most objective analysis and evaluation in the dissertation After analysing and