Managing non performing loans at the joint stock commercial bank for foreign trade of vietnam vcb factors and recommendations

Based on that fact, especially the importance of the management of bad debts in the process of financial restructuring of the Bank, the research topic “Managing non-performing loans at T

Lunghwa University of Science and Technology

Department Of Business Administration

Thesis for a Master’s Degree

Managing Non-Performing loans at The Joint Stock Commercial Bank for

Foreign Trade of Vietnam (VCB) – Factors and Recommendations

Researcher: Nguyen Nam Chinh

Supervisor 1: Dr Nguyen Phu Hung

Supervisor 2: Associate Professor Hsin-Fu Chen

November, 2018

Lunghwa University of Science and Technology

Approval Certificate of Master's Degree Examination Board

This is to certify that the Master’s Degree Examination Board has approved the thesis “Managing Non-Performing Loans at The Joint Stock Commercial Bank for Foreign Trade of Vietnam (VCB) – Factors and Recommendations”published by Mr Nguyen Nam Chinh in the Master Program of Graduate School of Department of Business Administration

Master’s Degree Examination Board

Board Members: Prof PhD Tsan Eric

Dr Dao Tung

Dr Nguyen Thi Hong Hanh

Assoc Prof PhD Hsin-Fu Chen

Date： 2018／11 ／24

iii

ABSTRACT

Thesis Title: Managing Non-Performing Loans at The Joint Stock Commercial

Bank for Foreign Trade of Vietnam (VCB) – Factors and Recommendations

Page:68 University: Lunghwa University of Science and Technology

Graduate School: Department of Business Administration

Date: November, 2018 Degree: Master

Researcher: Nguyen Nam Chinh Advisor: Dr Nguyen Phu Hung

Keywords: Bad debt, Non-PeformingLoans (NPLs), Vietcombank, the factors,

The Objective is the study of bad debt and the factors affecting the management of bad debts in the period 2005 – 2016 at The Joint Stock Commercial Bank for Foreign Trade of Vietnam (Vietcombank) After studying overview of bad debt, bad debt management, research topics focused on the relationships and the impact of macro factors and micro ones to bad loans at Vietcombank, which analyzed, evaluated the effectiveness of bad debts in the system during the past Vietcombank.Although the surface achieved, the difficulties and problems encountered still in the management of bad debts in Vietcombank

This thesis focuses on factors affecting credit growth in the period 2005 to 2016 to propose and propose solutions to limit bad debt at Vietcombank The survey of data on the financial statement for the period 2005-2016 and the results of the regression model test showed that NPLs at Vietcombank are influenced by factors such as size of bank, credit growth, efficiency Banking and Debt / Total Assets ratio

The results of the regression model of the factors affecting bad debt of Vietcombank

in the period from 2005 to 2016 show that the factors affecting bad debt in Vietcombank are: Bank size, Credit growth, Profitability Equity and Total Debt / Total

iv

Assets Ratio The results show that NPLs at Vietcombank are heavily influenced by factors related to credit (growth rate, credit quality)

By examining data on Vietcombank's 2005-2016 financial statements and the results

of the regression testing, the author has proposed some solutions and recommendations

to limit bad debt ratios at Vietcombank The author wishes solutions and recommendations can help Vietcombank have policies to direct and business activities suitable for sustainable development in the future

me during the past years, now and in the time coming

But most of all, I have been the grateful beneficiary of the help of Dr Nguyen Phu Hung, who patiently gave me her rare time and attention as well as her useful guidance and comments over the long gestation of this thesis

I am also grateful to Debt Handling Department of Vietcombank for kindly sharing their own data and their experience I especially appreciate the help of my friends for their unwavering supports

And finally, I am truly indebted in a more literal sense to all my family for their constant supporting and encouragement during the long journey of graduate school, especially to help me fulfill this thesis successfully

I am likewise responsible for the information, facts and figures in my thesis And I also commit that the thesis is completely the genuine result of my efforts in study and research, accepts in some cases other's works are used with proper acknowledgement

Thank you!

Author

Nguyen Nam Chinh

vi

TABLES OF CONTENTS

ABSTRACT iii

ACKNOWLEDGEMENT v

TABLES OF CONTENTS vi

LIST OF TABLES x

LIST OF FIGURES xi

1 INTRODUCTION 1

1.1 The rationale of study 1

1.2 Objectives of the study 1

1.3 Scope of the study 2

1.4 Research methodology 2

1.5 Structure of the study 3

2 LITERATURE REVIEW ON RISK MANAGEMENT AND BAD DEBT IN BANK 4

2.1 Credit risks of commercial banks 4

2.1.1 Risk categories and risk levels at banks 4

2.1.2 Credit risk and non-performing debts 6

2.1.3 Causes and Impacts of credit risks to commercial banks, economy, and customers 9

2.1.4 Factors driving credit exposure from within the banks 11

2.1.5 Factors driving credit from customers of the banks 12

2.1.6 Other external reasons 12

2.2 Credit Risk Management in commercial banks 13

2.2.1 Risk management process 13

vii

2.2.2 Classification of bank credit to have proper controls over each

category 14

2.2.3 Tools 15

2.2.3.1 Questionnaires 15

2.2.3.2 Data-Input Tables 15

2.2.3.3 Credit scoring system 16

2.2.3.3.1 Moody's and Standard & Poor's rating models 16

2.2.3.3.2 Model scores Z 17

2.2.3.4 Capital cushion 17

2.2.3.5 Risk quantification 18

2.2.4 Measuring Credit Risk 18

2.2.4.1 The concept of bad debt 18

2.2.4.2 Sources driving bad debt 23

2.2.4.3 Measure of bad debt 25

2.2.4.4 Implementation Challenges 25

2.2.5 Measures to Control risk 26

2.2.5.1 Collateralized versus uncollateralized netting sets 26

2.2.5.2 Valuation 27

2.2.5.3 Types of collateral 27

2.2.5.4 Coverage of collateralization 28

2.2.5.5 Disputes and reconciliations 28

2.3 Bad debt management practices 29

2.4 Analytical Framework 31

2.5 Conclusion 32

3 OVERVIEW OF CREDIT AND BAD DEBT AT VIETCOMBANK33 3.1 General introduction on Vietcombank and business activities over the last time 33

3.1.1 History 33

3.1.2 Business performance 34

viii

3.2 Overview of Bad debts situation and Bad Debts handling at Vietcombank 36

3.2.1 Credit situation at Vietcombank 36

3.2.2 Bad debt situation at Vietcombank 38

3.2.3 Measures taken by Vietcombank to handle bad debts 40

3.2.3.1 Group management measures 40

3.2.3.2 Group of debt handling measures 40

3.2.4 Results of handling bad debt in Vietcombank over time 44

3.2.4.1 Results of bad debt handling 44

3.2.4.2 Classification of results of dealing with bad debts according to the implementation method 45

3.2.4.3 Classification of treatment results by region 47

4 RESEARCH MODEL, RESULTS AND FINDINGS 49

4.1 Research Process 49

4.2 Research models and research hypotheses 49

4.3 Source of data 51

4.3.1 Secondary research data 51

4.3.2 Processing of research data 51

4.4 Regression Model 51

4.5 Description of data 52

4.6 Statistics Results 52

4.6.1 Regression results 52

4.6.2 The correlation between variables 53

4.7 Findings and discussions 54

4.8 Conclusion 57

5 RECOMMENDATIONS AND SOLUTIONS 59

5.1 Summary of research results 59

5.2 Solutions to reduce NPL in Vietcombank 59

ix

5.2.1 Credit growth is associated with credit quality 60

5.2.2 Improve the quality of credit appraisal and analysis 60

5.2.3 Manage and monitor the disbursement and post-lending process 61

5.2.4 Develop a system to report bad debt transferability 63

5.3 Limit research models and future research directions 64

5.4 Conclusions 65

REFERENCES 66

x

LIST OF TABLES

Table 2-1: The causes and effects of credit risk 9

Table 3-1: Financial status of Vietcombank for the period 2011 - 2015 35

Table 3-2: Credit balance of Vietcombank in the period 2012 – 2015 36

Table 3-3: Bad debt situation and risk provision credit in the whole system of Vietcombank for the period 2012 – 2015 38

Table 3-4: Debt classification results under The Circulars No 02/2013/TT-NHNN at 2015.12.31 39

Table 3-5: Bad debt ratio and bad debt recovery period 2011-2015 45

Table 3-6: Recovery of NPLs by measures taken in the period 2011 - 2015 45

Table 4-1: Variables of the model 50

Table 4-2:Statistics table describing the observed variables 52

Table 4-3: The multivariate regression relationship of each variable with lnNPL 52

Table 4-4: The correlation between variables 53

Table 4-5: The regression relationship of each variable with lnNPL 53

Table 4-6: Data 55

xi

LIST OF FIGURES

Figure 1-1: Steps of research 2

Figure 3-1: Steps of Risk management process 13

Figure 3-2: The Context of Bank Supervision 14

Figure 3-1: Structure of bad debt collection by measures taken 46

Figure 3-2: Regional bad debt recovery results as of December 31, 2015 47

Figure 4-1: Research Process 49

1

1 INTRODUCTION

1.1 The rationale of study

The commercial banking system of Vietnam has officially marked the birth and development of over 15 years (from 1990 to present) Through the above road, the system of commercial banks in Vietnam has constantly developed in terms of (increasing charter capital, branch network .), quality of operation and efficiency in business In addition to the positive aspects of the Vietnam Commercial Bank system, there are still too many weaknesses and shortcomings in which bad debts, weak liquidity and poor corporate governance are the issues that need attention in the Resettlement Plan Banking structure was approved by the Government in March 2012,

in which bad debt treatment is one of the priorities to be implemented

For any country, the problem of dealing with bank bad debt is always difficult and complicated Vietnam is no exception According to the State Bank of Vietnam, the bad debt ratio of the entire banking system at the end of the first quarter of 2015 is about 3.6%, while Fitch Ratings estimates bad debt of Vietnam about 12-13% and according

to some research Rescue in the water is about 10%

Based on a NPL ratio of 10% and a 60% loan-to-asset ratio of the whole banking sector, 10% of NPLs are seriously impacting about half of total equity The whole banking system of Vietnam

Based on that fact, especially the importance of the management of bad debts in the process of financial restructuring of the Bank, the research topic “Managing non-performing loans at The Joint Stock Commercial Bank for Foreign Trade of Vietnam (VCB) – factors and recommendations” is really urgent and practical to address the challenges that Vietnamese commercial banks are facing

1.2 Objectives of the study

The objectives of this study include studyingthe current situations of managing performing loans at VCB, factors affecting non-performing loans at Vietcombank, and

non-2

proposing practical solutions to improve the effectiveness and efficiency of bad debt

management in the context of the ongoing banking systemrestructure

1.3 Scope of the study

Due to time limit, this thesis focus only on the data of 2005 – 2016 The data used

for analysis and evaluation are actual data of Vietcombank, updated until 2016.12.31

1.4 Research methodology

The research uses a combination of different research methods to take advantage of

each method of scientific research such as methods of data collection, synthesis,

methods of data analysis and comparison; In addition, statistical methods, comparisons,

comparisons and experiences of themselves as well as monetary and financial

researchers are also used in this topic

In addition to qualitative methods, the author uses quantitative methods to assess the

relationship and impact of factors on bad debt in Vietcombank with data collected and

processed in the period from 2005 to 2016 to have an objective and overall view of the

causes, factors and causes of bad debts, and to take measures to effectively limit and

manage bad debts in the future

Figure 1-1: Steps of research

overview of bad debt, bad debt

management,

the relationship and impact of macro and micro factors to bad debt in VCB

analyzing and assessing the effectiveness

of bad debt treatments in VCB

the achievements, difficulties and problems

propose solutions

3

1.5 Structure of the study

Apart from the introduction and conclusion, the theme is composed of 5 main chapters:

- Chapter 1: Introduction

- Chapter 2: Literature review on Risk management and Bad debt in banks

- Chapter 3: Overview of Credit and Bad Debt at Vietcombank

- Chapter 4: Research Model, Results and Findings

- Chapter 5: Recommendations and Conclusions

4

2 LITERATURE REVIEW ON RISK

MANAGEMENT AND BAD DEBT IN BANK

2.1 Credit risks of commercial banks

Commercial Banks are financial institutions that provide financial services for profit,

including credit, savings, and payment service “A bank is an institution whose current

operations consist in granting loans and receiving deposits from the public” (Rochet,

2008; Gestel & Baesens, 2008; Phương, 2012; Tú, 2012) Commercial banks’ activities include (i) to raise capital, (ii) to use capital, and (iii) to create credit

 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

Credit activities of commercial banks include 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 Phuong contends that credit is a transaction between two entities, one of which transfers the money or property to another and at the same time the recipient of the money or property committed to repay within the agreed time and interest rates(Phương, 2012) Credit is the activity of commercial banks because most of bank's profit mainly comes from loans from customers(Tú, 2012)

2.1.1 Risk categories and risk levels at banks

According to the Basel II Capital Accord, there are three majority categories of risk First are classical operational risks such as infrastructure breakdown, supply problems, environmental risks, etc However, the most typical and critical risks that a bank can

5

face are financial risks which can be split in three main categories: (i) credit risk, (ii) interest rate risk, and (iii) liquidity risk (Heffernan, 2005; Gestel & Baesens, 2008, p 23)

 Credit risk occurs when a borrower cannot able to payback fulfill his loan, including interest, original debt and other obligations This is also the focus of this paper

 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

 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

 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

The risks originate from the relationship between banking and enterprises in case of lacks of close coordination Risks also is a consequence of more violent competitions among banks in the finance market making many banks to accept higher risk for more profits, therefore, market could see the business of banking contains many higher potential risks Risks also happen where banks lack of stringent controlling and responsibility Banking may face bankruptcy if fail to control risks Because the business in banking has serious and enormous impacts to the national economy and society, the failures of an individual banks may cause the mass collapse of the whole banking system

Credit risk is not only limited to lending activities It can also present in many credit activities of commercial banks such as underwriting, finance leasing, etc

 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

2.1.2 Credit risk and non-performing debts

According to Heffernan (Heffernan, 2005), the basic definition of Credit risk 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 According to Rochet (Rochet, 2008), Credit risk is defined as 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 often is highly exposed to credit risk for many reasons because of the size of the loan involved Retail lending risk often arises from constrained access to data (Greuning

& Iqbal, 2008)

According to The Circulars No 02/2013/TT-NHNN dated 2013.01.21 of the State

Bank of Vietnam, "Credit risk in banking activities (hereinafter referred to as risk) is

the probable loss of debt of a credit institution or branch of a foreign bank which is not performed by the customer or is not available the ability to perform part or all of its obligations under the undertaking"

The Basel Committee on Banking Supervision, credit risk is understood as the risk of property losses that may arise when a counterparty fails to meet its financial obligations

or contractual obligations For a bank, including non-performing debt repayments,

7

whether principal or interest arises when the debt is due (Basel Committee on Banking Supervision Working Paper, 2000)

Another misconception, according to Joel Bessis (2001), is that credit risk is defined

as loss due to default or loss of credit quality

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

In the banking operation, credit is the main source of profits but also is the main source of risk The statistics and research shows that credit risk accounts for 70% of total banking risks 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

Regarding the concept of Bad debts, common international standards consider performing loans (NPLs) as debts that the Bank cannot recover when it is due NPLs are

non-90 days overdue and cannot be repaid or restructured Bad Debt is a debt that is almost impossible to pay, debt outstanding is almost impossible to recover ECB and IMF Committee 18th(2005) classify NPLs of commercial banks into categories below:

- Irrecoverable debts: Debts that have lapsed or have no grounds for compensation; The debtor flees or disappears, no longer has the property to pay debts; Debts owed by the debtor in the past but remain indispensable, or debts repaid by the sale of the collateral but have not covered the entire debt; Debts owed by the debtor to business

or the business is terminated, or is in the process of liquidating the property and this indicates that the customer is unable to repay the full amount of the loan; Due debts and circumstances show that the Court's intervention must be made to the end or the Court intervenes to make repayment of the debt; Debts that the court claims the debtor is bankrupt and that the bank has demanded repayment and that the reimbursement will be less than the outstanding balance

The Vietnam banking system consider debts are bad if they have following characterizes:

 Customers have not repaid the loans when they are due;

 The financial status of customers become worsening, consequently the Bank cannot recover both capital and interest;

 Collateral is insufficient to cover principal and interest;

 Often, overdue debts are at least 90 days

According to The Circulars No 02/2013/TT-NHNN dated 2013.01.21 of the State Bank of Vietnam (abbreviated as Circulars No 02), overdue debts and bad debts are construed as follows:

 Overdue debt is a debt owed by a part or all of the principal and / or interest overdue

 Non-performing loans (NPLs) are debts of groups 3, 4 and 5, including:

+ Substandard debt (Group 3 debt): Debts that are overdue from 90 days to 180 days; Restructured repayment debts which are overdue for less than 90 days within the rescheduled term These debts are considered by the CI to be unable to recover principal and interest when due and possible loss of principal and interest;

9

+ Doubtful debt (group 4 debt): including debts overdue from 181 to 360 days; Restructured repayment debts from 90 days to 180 days in accordance with the rescheduled term These debts are considered by the CI to be high loss;

+ Debts which are likely to lose capital (group-5 debts): Debts which are overdue for more than 360 days; frozen debts awaiting the Government's handling; Debts which have been restructured for overdue debt repayment periods of more than 180 days within the rescheduled term These debts are estimated by the CI to be irrecoverable and lost

2.1.3 Causes and Impacts of credit risks to commercial banks, economy, and

customers

Regarding banks, credit risk has many impacts: reducing the profitability of banks; reducing the solvency of banks; reducing the bank's reputation; bankrupt banks (Greuning & Iqbal, 2008)

Credit revenue still accounts for 1/2 to 2/3 of total operation income in banks, consequently credit risk is one of the main reasons causing losses Credit risk affect seriously the quality of the banking operations This is the reason that banks are shifting

to higher proportion of service to decrease the income from credit operations and replace by incomes from other service 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

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

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

Borrowers  Capital used for the

wrong purposes; unwilling

to pay the debt

 capacity management;

 borrower’s financial situation deteriorates resulting

in a financial shortage to fulfill the obligation

10

customer executive Institutions  Legal environment and

economic environment facilitating or discouraging

 Performance of borrowers may get better or worsen

The development of

banking technology

The bank’s credit policy Some banks loosen credit

policy to attract more customers

Many unqualified customers may still get credit, resulting

Inadequate price leads to low recovery if credit loss actually happens

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

Regarding the link between the banking system and the national economy, the banking system mobilize non-used money from peoples and organizations to provide to business organizations and individuals who need capital As a result, credit status has direct impacts on the health of the national economy At low levels, credit risk makes access to capital available to expand business or consumer spending , which can adversely affect the economy's ability to grow At a higher level, when a bank falls into

a difficult situation leading to bankruptcy, the chain effect is very likely to occur

2.1.4 Factors driving credit exposure from within the banks

There are a number of factors driving credit exposure, which mainly arise from failure

to comply with internal procedures or loopholes in controls Some reasons include:

 Banks have no comprehensive vision of customers because of incomplete credit information, as well as the their financial situation;

 Banks lack knowledge and/or information of the markets

 Banks analyze incomplete information leading to the lending and investing unreasonable

 The banks spent over efforts to profits and income, setting the income expectation in higher priority than healthy loan That is the results of hard competitions with other banks and non-banking institutions for higher shares of loans;

 Credits officers do not have required professional qualifications and ethics They lack of capacity to handle the credit information, appraisal loan documents to protect and monitoring loans

 Bank credit officers fail to comply with strict process of inspecting and monitoring after lending This would lead to the failure of timely detect of 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

12

 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

2.1.5 Factors driving credit from customers of the banks

 Corporate customers often tend to deliberately make the fake documents in order

to cheat the bank

 Certain customers have certain legal problems

 Certain business customers have sudden changes in managers or board of directors, leading to sudden strategic changes in business orientations

 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 of 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 couldn’t afford repay the loan in a difference bank and they find many ways to loan in another bank to swap the loan

2.1.6 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

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 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

2.2 Credit Risk Management in commercial banks

2.2.1 Risk management process

Risk management is a continuous task that evaluates relevant indicators to reveal potential threats so that the bank will not encounter any surprising loss(Source: Gestel

& Baesens, 2008, p 42) 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 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 2-1: Steps of Risk management process

(1) Identifying potential risks

(2) Quantifying risks

• indicators

• measurement of these risks

(3) Planning appropriate treatments

(4) Controlling risks

• Monitoring risks

• Implementing risk models

14

Figure 2-2: The Context of Bank Supervision

2.2.2 Classification of bank credit to have proper controls over each category

In Vietnam, commercial banks often categorize by credit term perspective (which is closely related to the safety, profitability of credit and the ability to repay customers) In this perspective, credits are classified into short-term (less than 12 months), medium-term (from 12 months to 60 months)1, and Long-term (over 60 months)2 The banks also may classify credit risk by the levels of customer certainty perspective into (i)

guaranteed credits3 and (ii) Unsecured credits4 (for example, given to reputable, profitable, well-financed and strong financial customers)

of production and business, construction of new projects

infrastructure works, improvements and expansion

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2.2.3 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 methods

2.2.3.1 Questionnaires

Questionnaires and data tables should be designed to capture management’s perspective on and understanding of the bank’s risk management process The information requested in the questionnaire will provide an overview of the bank for the managers to assess the quality, the bank policies, the management and control processes, and the financial and management information

According to Greuning (Greuning & Iqbal, 2008), questions may include categories below:

 Institutional development needs;

 Overview of the financial sector and regulation;

 Overview of the bank (history and group and organizational structure);

 Accounting systems, management information, and internal controls;

 Information technology;

 Corporate governance, covering key players and accountabilities;

 Financial risk management, including asset-liability management, profitability, credit risk, and the other major types of financial risk

2.2.3.2 Data-Input Tables

Data input tables are for collecting financial datato facilitate the gathering and provisioning of data to create dashboards of ratios or graphs For example, data tables may gather the balance sheet and income statements serving as anchor schedules

16

According to Greuning (Greuning & Iqbal, 2008), the output of an analytical model are tables and graphs can assist managers to evaluate a bank’s financial risk management process and its financial condition

2.2.3.3 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:

2.2.3.3.1 Moody's and Standard & Poor's rating models

Credit risk in loans and investments is usually expressed by the rating of bonds and loans This ranking is made by a number of private rating services, including Moody’s and Standard & Poor’s, which are the best

For Moody’s the highest rating from Aaa but with Standard & Poor’s the highest was AAA Gradual ratings from Aa (Moody) and AA (Standard & Poor’s) are then lowered

to reflect the high non-return risk In particular, securities (loans) in the first four categories are considered the type of securities (loans) the bank should invest in, while the securities (loans) below are ranked lower Aviation investment (no loan) But in fact, considering the positive relationship between risk and return, the securities (loans) are classified as low (high return risk) but have high returns The bank still accepts these types of securities (loans)

17

Z = 1,2*X1 + 1,4*X2 + 3.3*X3 + 0.6*X4 + 1.0*X5

Inside:

X1: ratio of “net working capital / total assets”

X2: “cumulative profit / total assets” ratio

X3: ratio of “profit before tax and interest / total assets”

X4: ratio of “share price / book value of long-term debt”

X5: “Revenue / Total Assets” ratio

The higher the Z-score, the lower the probability of a default Thus, a low Z or a negative number will be the basis for placing the customer into a high-risk group

Z < 1,8: High risk customers

1,8 < Z < 3: Unspecified

Z > 3: Customers are not likely to default

Any company with a score of < 1,81 should be classified as a high risk group (Tran Huy Hoang, 2007)

2.2.3.4 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

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optimally allocated capital in relation to the selective investments made (Gestel & Baesens, 2008)

2.2.3.5 Risk quantification

Complementary to other tools of modern risk management

2.2.4 Measuring Credit Risk

2.2.4.1 The concept of bad debt

* According to international standards:

In countries around the world, the concept of non-performing loans is debt that the Bank cannot recover when it is due Bad Debt is a debt that is almost impossible to pay, debt outstanding melon wire is difficult to recover

According to international standards, NPLs are 90 days overdue and cannot be repaid

or restructured

The major banks in the world now classify bad debt associated with the cause to determine the corresponding level of risk According to some criteria of ECB and IMF Committee 18th(2005), it is possible to identify bad debts of commercial banks as follows:

- Irrecoverable debts:

 Debts that have lapsed or have no grounds for compensation;

 The debtor flees or disappears, no longer has the property to pay debts;

 Debts owed by the debtor in the past but remain indispensable, or debts repaid by the sale of the collateral but have not covered the entire debt;

 Debts owed by the debtor to business activity or liquidation of property or business suffered a loss and the remaining assets were not sufficient to repay the debt

- Debts may not be fully paid to the bank:

 Debts that the bank cannot contact the debtor or cannot find the debtor;

 Debts that are difficult for debtors to repay and require repayment schedules but do not pay off the debt within the agreed time;

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 Debts that the collateral is not sufficient to pay off and repay when due, or the mortgaged property of the bank is unlawful and the business of the debtor has suffered a loss for a few years, or the business is terminated, or is in the process of liquidating the property and this indicates that the customer is unable to repay the full amount of the loan;

 Due debts and circumstances show that the Court's intervention must be made to the end or the Court intervenes to make repayment of the debt;

 Debts that the court claims the debtor is bankrupt and that the bank has demanded repayment and that the reimbursement will be less than the outstanding balance

* According to the IMF bad loans are defined as follows: “A loan is considered

unprofitable (bad debt) when interest payments and / or principal are overdue from 90 days or more, or interest payments of up to 90 days or more have been restructured or rescheduled, or payments below 90 days, but there are suspected causes of repayment will be fully implemented.”

* From the perspective of Vietnam:

Debts incurred in the Bank’s business include: (i) loans, advances, overdrafts and financial leases; (ii) discount, rediscount of commercial paper and other valuable papers; (iii) factoring and (iv) other forms of credit In particular, bad debt is characterized by:

 Customers have not fulfilled their obligation to repay the loan with the Bank when these commitments are due;

 The financial situation of customers is bad, leading to the Bank cannot recover both capital and interest;

 Collateral (mortgaged, pledged, guaranteed ) is considered to be insufficient to cover principal and interest;

 Often, overdue debts are at least 90 days

According to The Circulars No 02/2013/TT-NHNN dated 21/01/2013 of the State Bank of Vietnam (abbreviated as The Circulars 02), overdue debts and bad debts are construed as follows:

 Classified by quantitative methods:

- Group 3 (Substandard debt) includes:

(i) The debt is overdue from 91 days to 180 days;

(ii) First-time debt reschedule;

(iii) Debt exemption or reduction due to the inability of the customer to fully repay interest under the credit agreement;

(iv) Debt falls into one of the following categories:

+ Debts of customers or securing parties being organizations and / or individuals, which are not entitled to credit as prescribed by law by credit institutions or branches of foreign banks;

+ Debts secured by shares of the credit institution itself or a subsidiary of the credit institution or loan used to contribute capital to another credit institution on the basis of the lending credit institution Securities guaranteed by shares of credit institutions themselves receive contributed capital;

+ Debts unsecured or granted with preferential terms or value in excess of 5% of the own capital of credit institutions or foreign bank branches when granted to clients subject to credit limit restrictions according to regulations of the Law;

+ Debts granted to subsidiaries, associated companies of credit institutions

or enterprises controlled by credit institutions are valued in excess of the limit rates prescribed by law;

+ Debts are in excess of the credit limit, except where they are allowed to exceed the limit, in accordance with the law;

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+ Debts breaching the provisions of law on credit extension, foreign exchange management and prudential ratios applicable to credit institutions and foreign bank branches;

+ The debt is in breach of internal regulations on credit extension, loan management, risk reserve policy of credit institutions and foreign bank branches

(v) Debt that is recovering according to inspection conclusions;

(vi) Debts are classified into Group 3 in accordance with Clauses 2 and 3 of this Article 10 of The Circulars No 02/2013/TT-NHNN dated 2013.01.21 of the State Bank

of Vietnam

- Group 4 (Doubtful debt)includes:

(i) Overdue debt from 181 days to 360 days;

(ii) First-time rescheduling debts which are overdue for less than 90 days under the restructured repayment term;

(iii) Debt restructuring for the second time;

(iv) Debts specified at Point c (iv), Clause 1 of this Article 10 of The Circulars No

02/2013/TT-NHNN dated 2013.01.21 of the State Bank of Vietnam (Group 3 –

substandar debt), which are overdue for between 30 days and 60 days as from the date

the recovery decision is issued;

(v) Debts which are subject to revocation according to the inspection conclusions but have not been recovered for a maximum of 60 days;

(vi) Debts are classified in Group 4 in accordance with Clauses 2 and 3 of this Article 10 of The Circulars No 02/2013/TT-NHNN dated 2013.01.21 of the State Bank

of Vietnam

- Group 5 (Potentially irrecoverable debts) includes:

(i) Overdue debts over 360 days;

(ii) First-time rescheduling debts which are overdue for 90 days or more under the restructured repayment term;

(iii) The second repayment loan is overdue within the rescheduled payment term;

(vi) The debt must be recovered in accordance with the inspection conclusions but

it has been overdue for more than 60 days but has not yet been recovered;

(vii) Debts of customers being credit institutions announced by the State Bank to

be put under special control, foreign banks' branches are free of capital and assets; (viii) Debts are classified in Group 5 in accordance with Clause 3 of this Article 10

of The Circulars No 02/2013/TT-NHNN dated 2013.01.21 of the State Bank of Vietnam

 Classified by qualitative methods:

- Group 3 (Substandard debt) includes: Debts which are considered by the credit

institution or foreign bank branch to be unable to recover principal and interest when due These debts are assessed by the credit institutions and foreign banks' branches are likely to suffer losses

Off-balance-sheet commitments are considered by the foreign bank branch as a failure of the customer to fulfill its obligations

- Group 4 (Doubtful debt) includes: Debts which are considered by the credit

institutions and foreign bank branches to be highly probable

Off-balance-commitments that customer commitment is not high

- Group 5 (Potentially irrecoverable debts) includes: Debts which are considered

by the credit institution or foreign bank branch to be irrecoverable or loss of capital Off-balance-sheet commitments in which customers are no longer able to perform their obligations

In addition, in the case of a customer having more than one debt to the credit institution where any debt is transferred to a higher risk group, the credit institution is required to classify the remaining debts of the customer into the group higher risk exposure corresponding to the level of risk; In cases where the debts (including the debts in the restructured repayment period) have been fully credited by credit

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institutions, the CIs shall take initiative in deciding on the debt repayment capability of the credit institutions Classification of those debts into higher risk groups corresponds

to the level of risk

Bad debt in the thesis is understood as the debt of the groups 3,4,5 in the debt classification report under The Circulars No 02/2013/TT-NHNN dated 2013.01.21 of the State Bank of Vietnam

2.2.4.2 Sources driving bad debt

Basically, bad debts are loans that are overdue for at least 90 days, not recoverable or reassigned Although bad loans and losses are the result of many factors, they are generally the result of a borrower's unwillingness to repay the loan, or the inability to make a profit to reduce it reduce the outstanding debt or repay the entire debt, as agreed According to Phan Thi Thu Ha (2009), there are several reasons leading to bad debts arising in business operations of the Bank as follows:

- The reasons for the bank's management capacity:

+ Due to the weakness in management: Human factors play a decisive role in business as the business environment is more and more internationalized and competitive as in our country today Many executives do not have enough conditions to operate the bank, have not been trained basically, do not catch up quickly change information, lack of management, not knowledgeable law, layout personnel inconsistent with the responsibility, …

+ Credit policies are unreasonable, too focused on profit targets that lead to reckless lending, focusing too much loan capital on a business or an economic sector + Due to lack of market knowledge, lack of information or inadequate information analysis leading to unreasonable lending and investment

+ Due to the competition of banks, they want to have a higher proportion and market share than other banks

+ By bank staff moralizing morality, metamorphosis, self-interest: In some cases credit officers or bank leaders colluded with customers, occurring negative in the loan, the risk of occurrence The risk for that loan is very high It is not due to the weak capacity level, it is not enough to assess the credibility of the project or loan application,

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but because of the self-interest and ethical qualities of some bankers who tend to be metamorphosed Although the law, business rules and other constraints are so strict that they still try to break the law and risk

+ Asset valuation is not accurate; failing to fully comply with the necessary legal procedures; or does not guarantee the principle of collateral is: to price; easy to transfer ownership; easy to consume

- The reasons belong to the customer:

The cause of the borrower is one of the major causes of problem debt Normally, customers are exposed to risk in the business of the borrower: Business risk of the business is reflected in the level of fluctuations more or less in the negative direction of business results Risks in the business of the business will occur if the development and implementation of projects, investment projects business production of non-scientific enterprises, the cost estimation and determination of output levels do not match well suited The losses suffered by the business due to the fluctuation of the market supply, consumer market

In general, for these reasons banks can be identified through a process of understanding and understanding the "health of customers" before, during and after lending, to understand the purpose of using the loan and the effectiveness of the business plan

There are also other reasons for the borrower's misbehavior, such as fraudulent use of bank accounts, fraudulent bank robberies, Customers are not unified unity, exist conflicts in the management work also caused stagnation, production was stagnant, no money to repay the bank

- Objective causes related to the external environment:

+ Due to natural disasters, epidemics, fire

+ Security situation, in the country, in the unstable area

+ Due to crisis or economic recession, inflation, balance loss

+ International settlement, exchange rate fluctuations

- The legal environment is not favorable, loose in macro management

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In summary, the causes of bad debts are diverse, there are objective reasons and the causes of the subjects involved in credit relations Subjective causes, because the subjects have a great influence Credit quality and banking can be controlled if appropriate measures are taken

2.2.4.3 Measure of bad debt

Daniel Foos & GCG (2010) develop the following formula to measure credit risk:

- NPL ratio / owner's equity

- NPL ratio / risk reserve fund

- NPL ratio / value of security assets

This metric criterion considers the provisioning for possible losses for each specific debt, thus more accurately reflecting credit risk If a general comparison between the value of bad debts of different debt groups (groups 3, 4 and 5) and total outstanding loans from groups 1 to 5 will not reflect the exact nature of credit risk

2.2.4.4 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

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2.2.5 Measures to Control risk

Typically, financial institutions manage risks 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 other 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 credit risks by imposing limits on the transacted notional amounts, central clearing and netting

2.2.5.1 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 could 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 could 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:

 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)

2.2.5.3 Types of collateral

As normal, 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 exposure concerned 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

2.2.5.4 Coverage of collateralization

Collateral contracts will be made based on the reference value from the netted value

of some or all sector or with some particular customers To decrease the risk, the conditions value should be based on the estimation of maximum number of the sectors; however, it also should be balanced against the demand of customers and some specific sectors

Some kind of product and services frequently are affected by region that is the important factor has to notice in the collateral contract Collateral contact don’t require

to transfer of the undisputed amount immediately, which means that the main of products should still be collateralized even when there are disputes regarding a minority

2.2.5.5 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 amounts 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 contention 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