Central Bank Management of Commercial Banks' Equity

Equity capital has important psychological value. If depositors and borrowers believe that a bank has enough capital to weather certain difficulties, they will not withdraw their deposits en masse and borrowers will be more likely to meet their obligations.

Fourth , equity helps regulate bank operations. With the view of limiting risks for depositors, many bank operations are regulated in close relation to equity. For example, the scale of deposit mobilization is calculated in proportion to equity, the maximum loan scale for one or a group of customers, the right to invest in company securities, the number of branches, the value of fixed assets, the portfolio of risky assets... are all calculated in proportion to equity. Therefore, the scale, structure and development of bank operations are regulated by equity in many countries. On the other hand, the equity structure has an important impact on the business performance of banks.

1.2.2. Central bank management of commercial banks' equity

1.2.2.1. Concept and management objectives of the central bank for the equity of commercial banks

Concept

Management is a popular and important concept. In the modern market economy, the state increasingly increases its role in managing economic activities to reduce the negative aspects of the market economy, and enhance the consistent operation of economic entities through various forms, tools, scopes, and levels. The management activities of the Central Bank for commercial banks are the process of implementing planning, organizing, leading, checking, inspecting, and supervising commercial banks to achieve the goals of monetary policy.

The central bank's management of commercial bank equity is essentially to determine and inspect and supervise the implementation of the scale and structure of bank equity to suit the requirements of capital safety and risk prevention for commercial banks, improving the business efficiency of commercial banks.

Management objectives

- To build a stable banking system, the Central Bank establishes capital requirements to ensure safety for banks, limit losses and protect depositors.

- The central bank's capital adequacy requirement is an important indicator to the public of a bank's reputation. The larger a bank's capital, the more confidence and security it creates for depositors.

- An important goal of equity management is to create a reasonable capital structure, limit the situation of virtual capital increase and bank acquisition. From the perspective of the management agency (the State Bank), a reasonable equity structure must ensure that the bank has enough equity to prevent risks in banking operations and ensure safety in banking operations. From the perspective of shareholders/bank owners, an equity structure is considered optimal when that capital ensures the implementation of the business model, brings maximum benefits on each capital, compensates for unexpected losses, and ensures capital safety ratios according to the provisions of law. The equity structure includes tier 1 capital and tier 2 capital, in which tier 1 capital management plays an important role because it has a great influence on the stable operation of the bank. Tier 1 capital management is the determination of the scale and structure of capital to meet the requirements of ensuring the safety of the banking system, protecting the interests of depositors, and enhancing the risk tolerance of credit institutions against market shocks. To protect depositors and build a stable banking system, the State Bank has established requirements for Tier 1 capital. This is an important indicator for the public to know about the reputation of the bank. Therefore, the requirement for commercial banks is to consider Tier 1 capital management as an important part of bank capital management. In addition, Tier 2 capital management requirements are extremely important to minimize virtual calculations of equity that commercial banks may make to meet the management requirements of the State Bank but do not reflect the true nature and scale of equity.

1.2.2.2. Legal basis for central bank management of equity capital of commercial banks

Practices and regulations of international financial institutions

In each country, the banking system always plays a particularly important role in promoting or restraining the development of the economy. Therefore, safety in operations is one of the top priorities of the banking system. To prevent risks in banking operations, a Committee on Banking Supervision was established by senior representatives of banking supervision agencies and the central banks of the G-10 developed countries - the Basel Committee (including the following countries: UK, France, Germany, USA, Netherlands, Canada, Belgium, Italy, Japan, Sweden). This Committee sets standards on operational safety as well as principles for supervising the implementation of those standards. In the global economy, countries have economic relationships and interests that affect each other, so the insecurity of any banking system has a certain impact on the financial stability of other countries. Therefore, the above standards are recommended to be applied to countries and become the common legal basis for central bank management of commercial banks' equity capital [13].

Currently, the international Basel capital treaty has three versions: Basel 1, Basel 2 and Basel 3. The latter version is the inheritance, supplement and overcome the limitations of the previous version. Basel 1 stopped at providing the most common international definition of bank capital, providing a minimum capital adequacy ratio of 8% for banks and referring to credit risk. Basel 2 still maintains CAR 8% but has overcome the limitations of Basel 1, referring to both operational risk and market risk in bank capital management while building three main pillars of capital adequacy. Basel 2 is currently widely applied in many countries around the world. Basel 3 provides new regulations on concepts and higher minimum standards (CAR 11.5%), along with a method of macroprudential supervision, which is considered a historic change in banking regulations, however, Basel 3 has only been implemented in a few countries [21]. However, it is also necessary to clearly see that capital requirements for commercial banks are increasingly being raised, which

This has a great impact on the capital needs of commercial banks when implementing capital safety compliance according to Basel. To be close to the actual capital at Vietnamese commercial banks and the pilot implementation milestone of Basel 2 from 2015, within the framework of the thesis, the author refers to Basel 2 as the general legal basis for the topic.

Accordingly, the central bank manages the equity of commercial banks based on the regulations on capital safety and risk prevention in Basel 2 with 3 main pillars:

Pillar One – Minimum Capital Requirements [13], [21], [43]

According to Basel 2 regulations, a financial institution is considered adequately capitalized when the minimum capital adequacy ratio (CAR) reaches at least 4% for tier 1 capital and 8% for tier 2 capital. The CAR ratio [37] is calculated according to the formula:

Bank Capital – Deductions

Capital Adequacy Ratio

out of bank capital

Minimum = Risk-adjusted assets ≥ 8%

Bank capital [13]: Bank capital includes tier 1 capital and tier 2 capital.

According to Basel 2, Bank capital is limited by a number of regulations:

Total Tier 2 capital included in the CAR ratio calculation must not exceed 100% of Tier 1 capital;

Secondary debt is up to 50% of Tier 1 capital;

General provision is maximum 1.25% of risk-weighted assets; Revaluation reserve is discounted 55%;

The remaining maturity of subordinated debt is at least 5 years; Bank capital does not include intangible capital.

Deductions from bank capital

Depending on the operating situation of the banking system in each country, deductions from bank capital are specifically regulated. In general, these amounts may include: commercial advantages, business losses, capital contributions, purchase of shares at other credit institutions, capital contributions, purchase of shares of affiliated companies, etc.

Risk Weighted Assets (RWA)

In addition to credit risk and market risk as regulated in Basel 1,

Basel 2 adds operational risk. Therefore, the calculation of RWA in Basel 2 is more complex than in Basel 1 and is unlikely to accurately assess capital adequacy.

- Credit risk [43], Basel 2 provides measurement methods:

+ Standardization method:

Risk-Adjusted Assets (RWA): = Assets * Risk Weight

Each type of asset will be assigned a risk weight. In Basel 1, the risk weight of assets is divided into 4 levels: 0%, 20%, 50% and 100% according to the risk level of each type of asset, without mentioning the credit rating. Basel 2 has overcome this drawback, not imposing a risk coefficient for each item but also depending on the credit rating of the creditor. In addition, another difference in Basel 2 is that debt is divided into 5 groups with weights of 0%, 20%, 50%, 100% and 150% respectively.

+Basic and advanced internal rating system (IRB) methods:

RWA = 12.5 * EAD * K

In there:

EAD: Exposure at Defalt – Total outstanding debt of the customer at the time the customer defaults.

K – Capital Required: The capital ratio required to cover unforeseen but still occurring RRTD cases.

With this method, Basel 2 provides a way to determine default, effective maturity, credit loss ratio, and from there calculate converted risk-weighted assets. This determines more accurately the minimum capital requirement for credit risk and at the same time differentiates the minimum capital requirement between loans for each subject.

- Operational risk , Basel 2 provides three ways to calculate minimum capital for this risk [18]:

+ The Basic Indicator Approach (BIA):

In this way, to calculate the minimum capital required to cover operational risk, the bank takes the average annual gross income of the last three years with positive income and multiplies it by 0.15 (this factor is prescribed by Basel 2). The average gross income is the net interest income plus the net non-interest income.

Profit is income before provisions are made, excluding profits and losses from securities trading, insurance and other extraordinary income.

K BIA = [ ∑ (GI 1….n * α) ] / n In which:

K BIA : cost of capital for the fundamental index approach

GI: average annual positive income over three years; n: Number of years with positive income over three years

α: equal to 0.15

+ The Standardised Approach (STA) – The Standardised Approach:

In this way, banking activities are divided into 8 business areas. The bank will calculate the minimum capital required for each business area by multiplying the net income from that area by the corresponding coefficients below. The minimum capital for the entire bank's operating risk will be equal to the sum of the minimum capital for each business area.

Table 1.2: Coefficients in the standardized approach

Business Field

Coefficient β (%)
Corporate Finance	18
Buying and selling activities	18
Retail banking operations	12
Commercial banking activities	15
Pay	18
Agent Services	15
Asset Management	12
Retail Broker	12

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At the same time, focusing on developing non-credit services is consistent with one of the contents of restructuring the financial activities of credit institutions in the project "Restructuring the system of credit institutions in the period 2011-2015" approved by the Prime Minister in Decision No. 254/QD-TTg dated March 1, 2012 [14]: "Gradually shifting the business model of commercial banks towards reducing dependence on credit activities and increasing income from non-credit services". 2.2. Current status of non-credit service development at BIDV Tien Giang. 2.2.1. BIDV Tien Giang has deployed the development of non-credit services in recent times. Along with the development of the Head Office, BIDV Tien Giang's products and services are constantly improved and deployed in a diverse manner to ensure provision for many different customer groups in the area: individual customers, corporate customers, and financial institutions. Typical services are as follows: Payment services, treasury services, guarantee services, card services, trade finance, other services: Western Union, insurance commissions, consulting services, foreign exchange derivatives trading, e-banking services,... 2.2.1.1. Payment services: In accordance with the Prime Minister's Project to promote non-cash payments in Vietnam [15], banks in Tien Giang province have continuously developed payment services to reduce customers' cash usage habits through card services and electronic banking services such as: salary payment through accounts, focusing on developing card acceptance points, developing multi-purpose cards, paying social insurance by transfer, paying bills through banks, etc. Chart 2.3. Net income from payment services in the period 2011-2015 Unit: Million VND 6000 5000 4000 3000 2000 1000 0 3922 4065 4720 5084 5324 2011 2012 2013 2014 2015 Net income from payment services (Source: Report on the implementation of the annual business plan of the General Planning Department of BIDV Tien Giang [24]) Along with the technological development of the entire system, BIDV Tien Giang has a payment system with a fairly stable transaction processing speed, bringing many conveniences to customers. The results of observing chart 2.3 show that the income from payment services that the Branch has achieved has grown over the years but the speed is not high and the products are not outstanding compared to other banks. Domestic payment products such as: Online bill payment, electricity bills, water bills, insurance premiums, cable TV bills, telecommunications fees, airline tickets, etc. bring many conveniences to customers. Regarding international payment, this is an indispensable activity for foreign economic activities, BIDV Tien Giang is providing international payment methods for small enterprises producing agriculture, aquatic food and seafood that have credit relationships with banks in industrial parks in Tien Giang province such as: money transfer, collection, L/C payment. 2.2.1.2. Treasury services: BIDV Tien Giang always focuses on ensuring treasury safety and currency security, always complies with legal regulations, and minimizes risks in operations such as: counting and collecting money from customers, receiving and delivering internal transactions, collecting from the State Bank (SBV) or other credit institutions, receiving ATM funds, bundling money, etc. BIDV Tien Giang's treasury service management department is always fully equipped with modern machinery and equipment such as: money transport vehicles, fire prevention tools, money counters, money detectors, magnifying glasses, etc. to ensure absolute safety in treasury operations, immediately identifying real and fake money and other risks that may affect people and assets of the bank and customers. In addition, implementing regulation 2480/QC dated October 28, 2008 between the State Bank of Tien Giang province and the Provincial Police on coordination in the fight against counterfeit money, in the 3-year review of implementation, BIDV Tien Giang discovered, seized and submitted to the State Bank of Tien Giang province 475 banknotes of various denominations and was commended by the Provincial Police and the State Bank of Tien Giang province [17]. Chart 2.4. Net income from treasury services in the period 2011-2015 Unit: Million VND 350 300 250 200 150 100 50 0 105 122 309 289 279 2011 2012 2013 2014 2015 Net income from treasury services (Source: Report on the implementation of the annual business plan of the General Planning Department of BIDV Tien Giang [24]) However, as shown in Figure 2.4, income from treasury operations is not high and fluctuates. Specifically, in the period 2011-2013, net income increased and increased most sharply in 2013, then in the period 2013-2015, there was a downward trend. This fluctuation is due to the fact that fees collected from treasury services are often very low and can even be waived to attract customers to use other services. 2.2.1.3. Guarantee and trade finance services: BIDV Tien Giang, thanks to the advantages of the province and the favorable location of the Branch, has continuously focused on developing income from guarantee services and trade finance. Chart 2.5. Net income from guarantee and trade finance services in the period 2011-2015 Unit: Million VND 14000 12000 10000 8000 6000 4000 2000 0 5193 5695 2742 3420 8889 3992 11604 12206 5143 5312 2011 2012 2013 2014 2015 Net income from guarantee services Net income from Trade Finance (Source: Report on the implementation of the annual business plan of the General Planning Department of BIDV Tien Giang [24]) Through chart 2.5, we can see that BIDV Tien Giang's income from guarantee services and trade finance has grown over the years. The reason is: Among BIDV Tien Giang's corporate customers, the construction industry is the industry with the highest proportion of customers after the trading industry, this is a group of customers with potential to develop guarantee services. The second group of customers is corporate customers in the fields of agricultural production, livestock and seafood processing with high import and export turnover in the area. are the target of trade finance development. In addition, BIDV Tien Giang also focuses on continuously developing these customer groups to increase revenue for many other products and services in the future. 2.2.1.4. Card and POS services: As a service that BIDV Tien Giang has recently developed strongly, it can be said that this is a very potential market and has the ability to develop even more strongly in the future. Card services with outstanding advantages such as fast payment time, wide payment range, quite safe, effective and suitable for the integration trend and the Project to promote non-cash payments in Vietnam. Cards have become a modern and popular payment tool. BIDV Tien Giang early identified that developing card services is to expand the market to people in society, create capital mobilized from card-opened accounts, contribute to diversifying banking activities, enhance the image of the bank, bring the BIDV Tien Giang brand to people as quickly and easily as possible. BIDV Tien Giang is currently providing card types such as: credit cards (BIDV MasterCard Platinum, BIDV Visa Gold Precious, BIDV Visa Manchester United, BIDV Visa Classic), international debit cards (BIDV Ready Card, BIDV Manu Debit Card), domestic debit cards (BIDV Harmony Card, BIDV eTrans Card, BIDV Moving Card, BIDV-Lingo Co-branded Card, BIDV-Co.opmart Co-branded Card). These cards can be paid via POS/EDC or on the ATM system. In addition, with debit cards, customers can not only withdraw money via ATMs but also perform utilities such as mobile top-up, online payment, money transfer,... through electronic banking services. In order to attract customers with card services, BIDV Tien Giang has continuously increased the installation of ATMs. As of December 31, 2015, BIDV Tien Giang has 23 ATMs combined with 7 ATMs in the same system of BIDV My Tho, so the number of ATMs is quite large, especially in the center of My Tho City, but is not yet fully present in the districts. Basic services on ATMs such as withdrawing money, checking balances, printing short statements,... BIDV ATMs accept cards from banks in the system. Banknetvn and Smartlink, cards branded by international card organizations Union Pay (CUP), VISA, MasterCard and cards of banks in the Asian Payment Network. From here, cardholders can make bill payments for themselves or others at ATMs, by simply entering the subscriber number or customer code, booking code that service providers notify and make bill payments. Chart 2.6. Net income from card services in the period 2011-2015 Unit: Million VND 3500 3000 2500 2000 1500 1000 500 0 687 1023 1547 2267 3104 2011 2012 2013 2014 2015 Net income from card services (Source: Report on the implementation of the annual business plan of the General Planning Department of BIDV Tien Giang [24]) Through chart 2.6, it can be seen that BIDV Tien Giang's card service income is constantly growing because the Branch focuses on developing businesses operating in industrial parks, which are the source of customers for salary payment products, ATMs, BSMS. Specifically, there are companies such as Freeview, Quang Viet, Dai Thanh, which are businesses with a large number of card openings at the Branch, contributing to the increase in card service fees [25]. Table 2.6. Number of ATMs and POS machines in 2015 of some banks in Tien Giang area. Unit: Machine STT Bank name Number of ATMs Cumulative number of ATM cards POS machine 1 BIDV Tien Giang 23 97,095 22 2 BIDV My Tho 7 21,325 0 3 Agribank Tien Giang 29 115,743 77 4 Vietinbank Tien Giang 16 100,052 54 5 Dong A Tien Giang 26 97,536 11 6 Sacombank Tien Giang 24 88,513 27 7 Vietcombank Tien Giang 15 61,607 96 8 Vietinbank - Tay Tien Giang Branch 6 46,042 38 (Source: 2015 Banking Activity Data Report of the General and Internal Control Department of the Provincial State Bank [21]) Through table 2.6, the author finds that the number of ATMs of BIDV Tien Giang is not much, ranking fourth after Agribank Tien Giang, Dong A Tien Giang, Sacombank Tien Giang. The number of POS machines of BIDV Tien Giang is very small, only higher than Dong A Tien Giang and BIDV My Tho in the initial stages of merging the BIDV system. Besides, BIDV Tien Giang has a high number of cards increasing over the years (table 2.7) but the cumulative number of cards issued up to December 31, 2015 is still relatively low compared to Agribank, Vietcombank, Dong A (table 2.6). div.maincontent .content_head3 { color: black; font-family:"Times New Roman", serif; font-style: normal; font-weight: bold; text-decoration: none; font-size: 14pt; } div.maincontent .p { color: black; font-family:"Times New Roman", serif; font-style: normal; font-weight: normal; text-decoration: none; font-size: 14pt; margin:0pt; } div.maincontent p { color: black; font-family:"Times New Roman", serif; font-style: normal; font-weight: normal; text-decoration: none; font-size: 14pt; margin:0pt; } div.maincontent .s1 { color: black; font-family:"Courier New", monospace; font-style: normal; font-weight: normal; text-decoration: none; font-size: 14pt; } div.maincontent .s2 { color: black; font-family:"Times New Roman", serif; font-style: italic; font-weight: normal; 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Source: Basel 2, commercial banking textbook 2013 (National Economics University)

The total capital required is calculated using the formula: K STA = { ∑ years 1-3 max [ ∑(GI 1-8 x β 1-8 ), 0] } / 3

In there:

K STA : total capital according to STA approach;

GI 1-8 : total annual income of a business sector;

β 1-8 : fixed ratio according to the table above;

+ Advanced Mesurement Aproach (AMA):

Under this approach, the minimum capital a bank needs to maintain is equivalent to the risk level that the bank has calculated using its internal operational risk measurement system. However, to apply this approach, a bank must ensure that it meets the qualitative and quantitative standards set by the Commission and must be accepted by the supervisory agency, so this approach is less popular than the STA approach.

- Market risk [43], Required capital is calculated by adding Tier 3 capital including short-term dependent debts for reserve purposes. Minimum required capital is calculated by the following methods:

+ Standardization method:

This approach considers each risk element including: interest rate risk, exchange rate risk, commodity risk and capital position risk. Specific regulations on how to calculate minimum capital for each type of risk are mentioned in Part A of the document “Adjustment of the Capital Standards Accord Regarding Market Risk” issued by the Commission in November 2005.

+ Internal model method:

When applying this method, the bank must be permitted by the supervisory authority and must meet the following requirements: a compatible, modern risk management system with full necessary data; qualified specialists equipped with skills to use complex models; the bank's model is assessed by the supervisory authority to be of good quality, has been tested for accuracy and reasonableness in measuring risk. This is a demanding method, so it is not

Many banks apply this method.

Pillar Two - Strengthening Monitoring Mechanisms [13]

Under this pillar, Basel 2 focuses on building a risk management system. The control testing process ensures that banks have enough capital to address all risks while also encouraging banks to control and manage risks through the development and use of better risk management techniques. There are four main principles covered under pillar two:

 Principle 1 : Banks should have a process for assessing overall capital adequacy, managing the bank's risk profile and a strategy for maintaining capital levels. Key attributes of a robust process include [1]:

- Supervision of the board of directors and executive board;

- Estimate reasonable capital level;

- Comprehensive assessment of risks;

- Monitoring and reporting;

- Review and evaluate internal control inspection activities.

 Principle 2 : Supervisors should review and evaluate banks’ internal capital adequacy assessment strategies and practices, as well as their ability to monitor and ensure compliance with capital ratios. Supervisors should take appropriate action if they disagree with the outcome of the supervisory process.

 Principle 3 : Supervisors require banks to maintain capital adequacy ratios above the minimum adjusted capital ratio and must have the ability to require member units to maintain capital levels above the minimum.

 Principle 4 : Supervisors should intervene at an early stage to prevent capital from falling below the minimum level, address the risk attributes of a particular bank, and take immediate action if capital cannot be maintained or restored.

Pillar Three – Market Discipline [1]