Credit Risk Management of Commercial Banks

Bankruptcy of one bank risks leading to the bankruptcy of many banks like the phenomenon in the US in the 1930s, the 1980s,... or the collapse of many credit funds in our country in the late 1980s.

1.1.3. Credit risk of commercial banks

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1.1.3.1. Concept

Risk is the possibility of unforeseen events occurring, which when occurring will make the actual results different from the expected results according to the plan. Risks always appear unexpectedly and threaten the survival of the business, however, to make a profit, one must accept risks, so to survive and develop, stand firm in competition, businesses must face risks by anticipating and judging possible risks to find preventive and limiting measures to minimize the damage caused by risks.

According to Nguyen Van Tien (2010): "Credit risk arises in the event that the bank cannot fully collect the principal and interest of the loan, or the principal and interest are not paid on time. If all of the bank's investments are fully paid in terms of principal and interest on time, the bank does not bear any credit risk. In the event that the borrower goes bankrupt, the full recovery of the principal and interest is uncertain, so the bank may face credit risk."

According to Circular No. 02/2013/TT-NHNN dated January 21, 2013 of the State Bank of Vietnam, "Credit risk in banking activities is the potential loss to the debt of a credit institution or foreign bank branch due to the customer's failure to perform or inability to perform part or all of his/her obligations as committed."

Thus, credit risk is the risk when the borrower cannot repay the loan to the bank as committed. This is the biggest risk, occurs frequently and causes the most damage to commercial banks. Credit activities are one of the main activities of commercial banks, in Vietnam, income from credit activities often accounts for about 70-80% of the income of commercial banks. Although it brings a lot of income, if there is a risk in credit activities, the consequences are very large, directly affecting

to the business efficiency of commercial banks, potentially leading to bankruptcy. Therefore, managing and preventing credit risks is an important, difficult and complicated task for commercial banks. It requires banks to have synchronous and effective solutions to limit, prevent risks, and minimize possible losses.

1.1.3.2. Causes of credit risk

For banks, there are many causes of credit risk, which can be divided into the following groups:

Cause from the bank

Unreasonable credit policy of the bank: Credit policy is a system of policies and regulations governing credit activities to use capital most effectively. If the credit policy is not suitable, it will reduce the efficiency of the bank's operations and can create many risks. For example, many banks focus too much on lending based on collateral, only requiring full collateral, leading to laxity in appraisal and supervision of contract implementation; customers do not have the financial capacity to repay the bank's debt in full as committed. Concentrating credit on a few traditional customers may seem safe at first glance, but in fact, an undiversified credit portfolio contains many risks when "putting all eggs in one basket". Banks tend to want to quickly increase their debt balance, but expanding credit too quickly also threatens to cause overload, exceeding the bank's management capacity. Thus, an inflexible and inappropriate credit policy is also a cause of increased credit risk.

Qualifications and ethics of bank staff: The qualifications of bank staff are still weak, so they do not fully analyze the business management capacity of enterprises, analyze financial reports inaccurately, do not know how to evaluate whether the loan is really effective or will have many risks, limited knowledge of socio-economics and law of bank staff, do not grasp related regulations also lead to risks, inaccurate debt repayment period, after lending to banks

Lack of supervision and monitoring to allow borrowers to misuse capital and lack of timely handling measures also leads to credit risks.

Poor moral character of bank staff, lack of responsibility, deliberately not complying with credit policies, lending procedures, violating professional ethics,...

Ineffective internal inspection and control: Currently, most commercial banks organize internal inspection and control to promptly detect risks, thereby taking preventive and management measures. However, implementation at some banks has not been focused on, is formalistic, and the effectiveness of internal inspection and control is not high.

Post-loan supervision and management have not really been focused on: Although banks have focused a lot of effort on appraisal and assessment before lending, the supervision and inspection after disbursement of the bank are still loose and not focused on, so they cannot promptly detect signs of risk such as customers using loan capital for the wrong purpose, actual business performance not ensuring as planned, ... thereby not promptly having appropriate measures to ensure full recovery of both principal and interest on time.

Causes from the borrower side

The customer's business management capacity is weak. Banks lend based on business plans, strategies and solutions because this is the best source of debt repayment. However, if management is weak, actual production and business activities exceed the control of the enterprise, the business plan may go bankrupt or not achieve the desired results, not ensuring the ability to repay the loan in full and on time to the bank, leading to credit risks.

Customers do not comply with commitments, have no goodwill in repaying loans, intentionally defraud to appropriate bank capital: Customers intentionally provide dishonest, false financial reports, causing the bank to misjudge the financial capacity of the business, or there are customers with enough financial capacity to

perform the terms of the contract but still deliberately delay and refuse to fulfill the obligations. After borrowing, customers use the capital for the wrong purpose, the capital can be invested in other areas, many risks and when risks occur, the borrower has no source to repay the bank.

Objective reasons

This group of causes includes causes originating from the economic environment, legal environment, social environment, and natural environment. The operations of banks and customers are directly affected by this factor. When macroeconomic policies are unstable, customers will encounter difficulties in implementing business plans, and at the same time, it will be difficult for banks to analyze and predict production and business activities, the financial situation of customers in the future, and other risks that customers may encounter. In addition, factors such as the global economic crisis, earthquakes, natural disasters, storms, floods, and epidemics are beyond the control of both banks and borrowers, greatly affecting the ability of customers to repay debts.

The approach to the above risk factors and causes helps us to have a complete, comprehensive and objective view, thereby having more useful and practical recommendations for preventing and minimizing risks in commercial banks' business.

1.1.3.3. Consequences when credit risk occurs

Credit risk causes serious consequences not only for banking operations but also affects a country's economy.

Impact on Banks

Credit activities are the basic and important activities of commercial banks. Income from credit activities accounts for a large proportion of total income of banks, in Vietnam it is about 70% - 80%, but the risks involved are also very large.

Credit risk affects the reputation and competitiveness of banks in the financial market, affects the income and business efficiency of banks, reduces solvency, and risks causing loss of business capital and bank bankruptcy.

If a bank has consecutive, large credit risks, its reputation with customers will be seriously affected, thereby causing adverse effects on the bank's business operations.

Credit risk reduces the solvency of commercial banks. To have enough capital to provide credit to customers, banks must mobilize from organizations and individuals, or in other words, banks borrow from organizations and individuals to finance credit. If credit risk due to non-recovery of debt occurs, banks will limit the source to pay deposits to creditors, that is, individuals and other economic organizations.

When credit risks occur, not only will income from credit activities decrease, but it will also have a major impact on reducing income from other activities of the bank. When credit activities are expanded and credit quality is good, they will promote the development of other activities. On the contrary, if credit activities are of low quality, they will contribute to restraining other activities of the bank, resulting in a serious decrease in the bank's income. Credit risks occur, making it impossible for banks to recover capital and interest as per the signed credit contract, the bank's capital turnover rate, capital efficiency and solvency of the bank will all decrease.

Credit risk leads to the risk of bank bankruptcy. As mentioned above, credit risk affects the reputation, liquidity and profitability of the bank. If this risk continues for a long time and to a large extent, the losses will erode the bank's own capital, and the path to declaring bank bankruptcy is inevitable.

Impact on businesses and depositors

There are businesses whose bank loans account for 80% to 90% of their total business capital. Therefore, when credit risks occur, banks will also limit lending to businesses. And that means that the capital needs of businesses will not be fully met, negatively affecting the business's operations.

Credit risk will also greatly affect depositors. Because the bank's capital is partly mobilized from the population and economic organizations, people with temporarily idle money, when this mobilized capital is lent to the economy and credit risk occurs, the bank cannot recover the loan capital, thereby facing difficulties in meeting the deposit payment requirements of depositors.

Impact on the economy

Bank credit plays a very important role in regulating capital in the economy. Credit risk occurs, making banks slow or unable to recover capital to continue lending. Therefore, credit risk reduces the turnover of bank capital, reduces the ability to supply capital to the economy, and slows down the speed of capital circulation in the economy.

On the other hand, banks are often closely related to each other. When a bank encounters credit risk, it can lead to other banks being in crisis. This destabilizes the currency market, seriously affects the economy, and leads to a series of other complex social problems such as: reduced living standards, increased unemployment, other social evils, etc. All of these problems create instability in the economy and society.

1.2. Credit risk management of commercial banks

1.2.1. Concept of credit risk management

1.2.1.1. Concept of risk management

Risk management is a process that includes activities to limit, eliminate risks or overcome the consequences that risks cause to business operations, thereby creating conditions for optimal use of business resources, minimizing damage to people and property of the business.

Jobs in risk management:

 Anticipate with the smallest costs, the necessary and sufficient financial resources in case of risks.

 Control risks by eliminating them, mitigating them or transferring them to other economic agents.

 Anticipate the consequences of risks and plan organizational solutions to overcome those consequences.

 Identify and deal with the causes and consequences of risks in the business process of the enterprise.

Risk management is related to all risks that may occur during the production and business operations of an enterprise.

Risk is not merely a passive and preventive activity but also a proactive activity in anticipating losses and seeking to mitigate their consequences.

The essence of risk management is to prevent and overcome consequences, proactively approach and handle situations in business.

1.2.1.2. Concept of credit risk management

Credit risk management is the process in which the subject impacts the objects to achieve the goal of identifying, measuring and limiting possible risk events that may affect the customer's ability to pay debts to the bank in credit activities, while at the same time providing methods to minimize losses and compensate for losses when risks occur.

1.2.1.3. Objectives of credit risk management

Credit risk management should achieve the following objectives:

Create a reasonable credit portfolio with high profitability and low risk.

Create initiative and enhance the sense of responsibility of operational departments to seek loans with high profitability and low risk.

There are regulations to implement uniformity and transparency in the lending process; there are reasonable regulations on structure and ratio.

Ensure transparent and accurate reflection of credit portfolio quality, and adequate provisions to offset risks arising during the lending process.

Have appropriate inspection and control systems to detect, prevent and promptly handle risks arising from the credit portfolio.

1.2.2. Principles of credit risk management

In order to improve the safety of commercial banks in the financial services sector, since 1975, the Basel Committee on Banking Supervision has successively issued versions of Basel I, Basel II and Basel III with the best risk management principles and standards, contributing to strengthening the global banking system. Currently, more than 190 banks in the world have implemented compliance with Basel III, however, in Vietnam, after assessing the actual capacity of Vietnamese banks, the Government's target for joint stock banks by the end of 2020 is to basically have equity capital according to Basel II standards, of which at least 12 - 15 banks will successfully apply Basel II standard methods or higher. By the end of 2025, all commercial banks will apply Basel II standards, apply advanced Basel II at state-owned commercial banks and joint stock banks with good governance quality.

The Basel II Accord was designed to help banks manage risk more effectively. The Accord's principles for credit risk management include:

* Establish a suitable credit risk management environment

Principle 1: The board of directors is responsible for approving and periodically reviewing (at least annually) the bank's credit risk strategy and policies. This strategy reflects the bank's tolerance for risk and the level of return the bank expects to achieve when exposed to credit risk.

Principle 2: The Board of Management shall be responsible for implementing the credit risk strategy approved by the Board of Directors, and for developing policies and procedures.

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