Credit Risk Management of Commercial Banks

The trend of globalization is taking place vigorously all over the world, so the fluctuations in the economic, political and social situation abroad also affect the economic, political and social life in the country, thereby affecting the activities of enterprises in general and commercial banks in particular. Enterprises as well as banks must grasp the development trends of the world and regional economy, its impacts on the business activities of the country as well as on each individual customer to have appropriate steps and plans for innovation and development.

 Causes from the borrower side

- Customer management and operation capacity

The management and operation capacity of the Board of Directors is decisive to the effectiveness of loan capital use, directly affecting the ability to fulfill commitments to the bank. Therefore, it affects the effectiveness of credit risk management. Many borrowers are willing to take risks with the expectation of high profits. To achieve their goals, they are willing to find any means to deal with the bank, such as providing false information, bribing, etc. Many borrowers do not calculate carefully, expand their investments excessively, or are unable to calculate possible uncertainties, and are unable to adapt and overcome difficulties in business. The remaining case is that borrowers borrow capital to do business with profit but still do not repay the debt on time. They procrastinate in the hope of being able to have their debt forgiven and use the loan as long as possible.

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- Weak and opaque corporate financial situation

Financial capacity is an important factor affecting the banking activities because if the customer has strong financial potential, stable business activities and reputation, when an incident occurs, the customer has the ability to withstand risks with equity capital and limit the impact on the process of performing obligations to commercial banks.

Small asset size, small capital, high debt to equity ratio are common characteristics of most Vietnamese enterprises. In addition, the habit of recording accounting books completely, accurately, and clearly is still not strictly followed by enterprises. Therefore, the accounting books that enterprises provide to banks are often more formal than substantial. When bank staff prepare financial analysis of enterprises based on data provided by enterprises, it often lacks practicality and authenticity. This is also the reason why banks always attach importance to mortgaged assets as the final support to prevent credit risks.

- Using capital for the wrong purpose, not having goodwill in repaying loans

Most businesses when borrowing capital from banks have specific and feasible business plans. The number of businesses using capital for the wrong purpose, intentionally defrauding banks to appropriate assets is not much. However, the cases that have been discovered

extremely serious, related to the reputation of the staff, negatively affecting other businesses.

Subjective causes include:

 Bank credit policy

Non-transparent credit policies distort credit activities, leading to the granting of credit to the wrong subjects, creating loopholes for capital users to violate contracts and State laws.

 Poor qualifications and violations of professional ethics of credit officers

Risks due to credit officers incorrectly calculating the investment efficiency of the loan project. Credit officers do not clearly understand the characteristics of the industry they are lending to, or credit officers themselves intentionally lend, even though they have calculated that the loan project is ineffective and has low feasibility, this will cause great risks for the bank. Risks due to banks incorrectly assessing the loan, the borrower, subjectively trusting loyal customers, neglecting the step of checking the financial situation, current and future payment capacity, and debt repayment sources.

Several major economic cases in recent times involving bank officials have involved the collusion of some bank officials along with customers in falsifying loan documents, or raising the value of mortgaged or pledged assets too high compared to reality in order to borrow money from banks at large values.

The ethics of the staff is one of the most important factors to solve the problem of limiting RRTD. A staff with poor capacity can be further trained, but a staff with moral degradation but good professional skills is extremely dangerous when assigned to credit work.

 Lack of monitoring and risk management after lending

Banks often have the habit of focusing a lot of effort on pre-lending appraisal and loosening the process of checking and controlling capital after lending. When banks lend, the loan needs to be actively managed to ensure that it will be repaid. Debt monitoring is one of the most important responsibilities of credit officers in particular and of banks in general. Monitoring the activities of borrowers to comply with the terms set out in the credit contract between the customer and the bank is to find new business opportunities and expand business opportunities. However, in the past, commercial banks have not done this job well.

 Laxity in internal inspection of banks

Internal audit has points for its timeliness because it is quick and timely as soon as a problem arises and the closeness of the auditor, because the audit is carried out regularly along with the business. But in the past, the internal audit work of banks almost only existed in form.

 Cooperation between commercial banks is too loose, the role of management agencies is not really effective.

Banking is a special profession that mobilizes capital for lending or in other words, borrowing to lend, so the risk in credit activities is inevitable, banks need to cooperate closely with each other to limit risks due to the need to manage risks for the same customer when this customer borrows money from many banks. In financial management, the ability to repay a customer is a specific number, with its maximum limit. If compared with the lack of information exchange, many banks have not been updated and handled promptly.

 Loosely designed credit model

Regarding the management model, credit risk management is still loose, creating gaps for credit risks to appear.

 Centralize credit portfolio

Concentrating a credit portfolio on a group of customers, industry groups or regions or sectors can lead to credit risk.

 Not conducting regular credit performance assessments.

One of the causes of credit risk is that commercial banks are still negligent in assessing irregular credit activities and do not have timely measures to handle arising situations.

1.1.2.4 Credit risk measurement criteria

To identify RRTD, we can base on direct indicators such as: overdue debt, bad debt, RRTD reserve. Besides, indirect indicators are also very important to indicate signs of risk recognition for banks such as: Credit scale, credit scale growth rate, credit structure, and indicators.

Direct criteria for assessing RRTD:

These are particularly important indicators, reflecting the bank's risk appetite.

specifically:

Overdue debt

Overdue debt is a basic indicator reflecting credit risk. Overdue debt will arise when

When the debt repayment deadline comes, the borrower is unable to repay part or all of the loan to the lender. Depending on the overdue period, this debt will be identified as qualified debt, debt requiring attention, substandard debt, doubtful debt, or debt with the possibility of losing capital... Overdue debt is reflected through the following two indicators:

Overdue debt ratio =

Overdue debt balance Total outstanding debt

x 100%

Rate of customers with overdue debt = Number of customers with overdue debt x 100%

Total number of customers with outstanding debt Total number of customers with outstanding debt

If a bank has a high overdue debt ratio and a large number of overdue customers, then that bank is at high risk and vice versa.

Bad debt Bad debt is the amount of money lent to customers that is difficult or impossible to recover due to the business's loss or bankruptcy, increased payables, the business's inability to pay... Bad debt will clearly reflect the credit quality of the bank through assessing both the overdue term of the loan and the criteria for assessing the risk of the loan. Bad debt is debt in groups 3, 4 and 5 [24]. The ratio of bad debt to total outstanding debt is the ratio to assess the credit quality of the credit institution.

Bad debt is most clearly reflected through the following indicators:

Bad debt ratio = Bad debt x 100% Total outstanding debt

Bad debt to equity ratio =

Bad debt Equity

x 100%

Bad debt to loss reserve ratio = Bad debt x 100%

Loss reserve fund

RRTD reserve

Risk reserves assess the bank's ability to pay when risks occur. The purpose of using risk reserves of a bank is to compensate for losses on bank debts that occur in the event of customers' inability to pay due to dissolution, bankruptcy, death, disappearance, or when the debt is classified into group 5. Credit reserves are calculated on the principal balance of customers including: (i) specific reserves - to insure specific risks for each loan, and (ii) general reserves - to insure general risks not identified in the credit portfolio and the entire reserve is included in the operating expenses of the enterprise. The use of reserves is used according to the principle of using specific reserves for each debt first, selling the collateral to recover the debt, and finally if the sale of the assets is not enough to recover the debt, then using the general reserves. Each bank needs to have a suitable reserve calculation method that is sufficient to cover risks while avoiding high costs that affect net income. Indicators showing RRTD reserve:

RRTD provision ratio = RRTD provision set aside x 100%

Total outstanding balance for the reporting period

Loan loss coverage ratio

RRTD provision is made

Debt cleared

RRTD provision is made

RRTD compensation factor =

Bad debt

Indirect criteria for assessing RRTD:

Although indirect criteria do not specifically reflect the bank's credit risk, if these criteria have large changes this period compared to the previous period or compared to the average of the banking system, these criteria are signs reflecting the bank's credit risk. On that basis, the bank can consider other criteria to comprehensively assess the bank's credit risk.

Credit size

Credit scale is not a criterion that directly reflects RRTD, but if the credit scale increases too quickly, not corresponding to the control capacity of the bank, then the credit scale will reflect RRTD. Credit scale is clearly shown through the following criteria:

Debt to total assets = Total debt/Total assets

Average outstanding debt per number of credit officers = Total outstanding debt/Average total number of credit officers

Number of customers per number of credit officers = Total number of customers/Average number of credit officers

Credit growth rate compared to economic growth rate = Credit growth rate/Economic growth rate

If commercial banks expand credit scale in the direction of loosening credit for customers, it will lead to the risk that customers use capital for the wrong purpose, cannot control the purpose of using loan capital... this causes risks for commercial banks.

Credit structure

Credit structure reflects the level of credit concentration in an industry, sector, currency... therefore, although it does not directly reflect the level of risk, if the credit structure is too biased towards risky sectors, it will reflect potential RRTD. Credit structure is divided into the following groups:

- Credit structure by industry: If lending is focused on high-risk industries, the risk of not being able to repay bank loans is also high. Or if the credit structure is too focused on one industry or sector, the risk level may be high when that industry is in recession or affected by other factors.

- Credit structure by type: shows the concentration ratio according to the subjects: state-owned enterprises, private enterprises, and foreign-invested enterprises.

- Credit structure according to loan term: This factor must be based on the bank's capital structure. If the bank has a stable long-term capital structure, it can lend more medium and long term, and vice versa.

- Credit structure by currency: RRTD occurs when there is a strong or unfavorable fluctuation in exchange rates; the ability of mobilized capital in each currency to meet outstanding loans.

- Credit structure by collateral : If the ratio of secured loans is low, the bank faces risks when customers cannot repay their debts. Credit structure by collateral is reflected through the ratio of secured loans to total loans.

Profitability criteria

- Net income from lending and investment activities

Net income growth rate

+ Growth rate of net income from lending and investment

The growth rate of net income from lending and investment activities reflects how much the net income of the following year increases/decreases compared to the previous year. A high growth rate of net income from lending and investment activities shows that the bank's business activities are expanding or that the bank's business activities are more effective and vice versa.

+ Proportion of net income from lending and investment activities

Net income ratio

from loan and investment contracts =

This ratio shows how much lending and investment activities contribute to total net income. This ratio shows the strong activities that bring large income to the bank, from which the bank can more clearly define its operating strategy, promote its strong areas to improve business performance.

1.1.2.5 Impact of credit risk

Negative impact on banking operations

- Increase capital costs, reduce bank profits . RRTD occurs synonymously with the risk of not recovering enough principal and interest. This will directly reduce the bank's income and profits. In case the amount of loss is too large, it will cause the bank to suffer losses, even bankruptcy. In addition, when RRTD occurs, it will cause many additional expenses such as: debt management costs, provision costs... these costs will once again erode profits, leading to losses in banking operations.

- Reduce the payment capacity of the bank . With the characteristics of a currency trading enterprise, the main business capital is mobilized capital. These mobilized sources are all time-limited and the bank must pay interest to depositors. Therefore, the bank must find every way to expand lending, invest to create income to offset the cost of mobilized interest and make a profit. At the same time, loans and investments must be recovered on time.

term to have a source of repayment to depositors. RRTD makes the bank unable to collect the principal and interest on time, negatively affecting the capital plan. In case RRTD increases rapidly, without the ability to control, the bank will lack the source of payment to depositors, reducing the ability to pay.

- Increase capital to ensure adequate compensation for credit losses . According to the Basel Committee's recommendations, to limit credit risks and losses, banks must always have sufficient capital for credit risks. Increased credit risks will put pressure on banks to increase capital. Because minimum capital is measured on the basis of risky assets, when risks increase, banks must increase capital to ensure that the safety ratio always reaches the prescribed ratio.

- Limiting credit growth : In principle, a customer who does not fulfill his/her old debt repayment obligations will be restricted from new loans. In many cases, banks must handle RRTD through handling by selling collateral, filing lawsuits in court... these handling measures can to a certain extent damage the bank's reputation as well as the good relationship between the bank and the borrower. The above reasons show that RRTD is also the cause of reducing the bank's credit growth.

- Reduced bank reputation . Increased RRTD, reduced credit quality of the bank, reduced profits or losses will make the bank lose credibility in the market. Especially for businesses that rely on credibility, loss of credibility will be a threat of bankruptcy for any commercial bank. Reality has proven that many commercial banks have to close down or go bankrupt, the root cause of which is the inability to control RRTD. Negative impact on the economy

- Stagnation of economic activities: RRTD is the cause of congestion of capital circulation in the economy due to the reduction of capital "injected" into the economy by the banking system. In addition, enterprises with bad debts find it difficult to access new credit. As a result, enterprises increasingly lack capital, face financial difficulties, business losses, and even bankruptcy. These negative impacts once again have a double impact on income and employment of workers. Production, business, investment, and consumption activities are therefore increasingly stagnant. Prolonged situations can lead to recession and economic crisis.

- Causing instability to the financial-banking system: The commercial banking system is closely linked because the business activities of banks are often related to each other. Therefore, risks in the banking sector are often chain-like: A bank in difficulty or bankruptcy will drag a series of other banks in the system into a similar situation. When the credit risk at one or several commercial banks increases, causing those banks to lose money or go bankrupt, it will be a threat to instability, and more seriously, it can be the collapse of the entire financial-banking system.

- Negative impact on the state budget: RRTD makes businesses (including commercial banks) stagnate, suffer losses, and reduce workers' income. When businesses suffer losses, it will reduce budget revenue from corporate income tax. Commercial banks with large bad debts will increase RRTD provisions, increasing costs, reducing profits, thereby also reducing budget revenue from taxes. Reduced bank profits also reduce workers' income, resulting in a decrease in tax revenue. In many cases, commercial banks cannot handle bad debts themselves, and must use the state budget, which will increase state budget expenditures. Thus, bad debts both reduce revenue and increase state budget expenditures.

1.2 CREDIT RISK MANAGEMENT OF COMMERCIAL BANKS

1.2.1 Concept of credit risk management

In many current documents, the concepts of management and administration have not been clearly defined. However, according to the author, in the scope of activities of an economic organization, the term administration is used more appropriately with the implication of a series of actions/decisions/commands from the leader to the units and individuals in that organization to direct that organization to achieve the set goals and results. Management also has the same implications but is used in State management. Therefore, in the content of this thesis, the author uses the term "QTRRTD" instead of "RRTD management" as some documents have mentioned. Therefore, the author believes that:

Credit risk management is the process of developing and implementing credit management and business strategies and policies to maximize profits within acceptable risk levels.

Controlling credit risk at an acceptable level is the process by which commercial banks strengthen measures to prevent, limit and reduce overdue debt and bad debt in credit business, in order to increase credit revenue, reduce risk compensation costs, and achieve efficiency in credit business in both the short and long term. "Effective credit risk management is an important part of the overall risk approach and is considered to play a vital role in the long-term success of banks" (Basel Committee on Banking Supervision, 2000) .

In short, the concept of credit risk management can be mentioned from different perspectives, but the essence is the same and from the perspective of management, the concept can be interpreted as: Credit risk management is the process by which banks plan, organize, implement, and monitor and inspect all credit granting activities, in order to maximize the bank's profits with an acceptable level of risk.

1.2.2 The need for credit risk management

The level of risk in credit activities is increasing.

The need for QTRRTD not only comes from the complexity and great risk of RRTD but also from the increasingly demanding business trends of banks today.

become more risky. According to research by experts, in the period from 1970 to 1995, the world had an average of one banking crisis per year; in the period from 1980 to 1995, this ratio was 1.44. Some of the main reasons for the increasing level of risk in banking activities include:

Firstly, due to the process of liberalization and loosening of regulations in banking activities worldwide. In recent decades, the trend of globalization, economic liberalization, and promotion of competition has become popular. When competition increases, it also means increased risks and bankruptcy. In the banking sector, competition makes the interest rate margin increasingly decrease. This impact makes banks increasingly tend to expand their business scale to compensate for the decline in profits, in which expanding the credit scale means that RRTD also has an increased risk. In addition, the competitive elimination rule will increase the bankruptcy rate of bank customers, leading to losses for banks.

Second, banking activities are increasingly multi-functional, with increasingly developed technology, along with the trend of fierce integration and competition, increasing the level of risk and new risks. In the credit sector, credit products have developed strongly, far surpassing traditional credit products. Credit products based on technological development such as credit cards, individual loans, etc. always contain new risks. However, under the pressure of competition, the expansion and diversification of products as well as the scope of credit activities are vital to banks. With the complexity of credit products as well as RRTD, it is increasingly required that QTRRTD must be focused on upgrading accordingly.

Third, for developing countries, especially countries in transition like Vietnam, the economic environment is not stable, the legal system is under construction, the level of information transparency is low, banking activities become more risky, so starting to do well in credit risk management from the beginning is a very important task.

Good risk management is a competitive advantage and a value creation tool for commercial banks.

"Tell me how you manage risk, and I'll tell you how your bank is doing?" - Dr. SL Srinivasulu, Chairman of KESDEE Inc. - a provider of e-learning solutions on finance based in California, USA, spoke about the importance of risk management in banking. Risk management has long been considered a function to satisfy the requirements of legal compliance and internal control. From this perspective, risk is considered as "unwanted but acceptable" in business, and risk management activities

considered a cost center. Mr. Srinivasulu argues that banks should take the opposite approach: Good risk management is a source of competitive advantage and a value creation tool, which also contributes to more effective business strategies.

RRTD is the main cause of bank failures.

The collapse of a series of credit funds in Vietnam in 1989 - 1990 was due to poor quality of loans that could not be recovered. In 1999 - 2000, for this reason, the State Bank of Vietnam placed a number of banks under special supervision. Major cases and the handling of thousands of billions of VND of outstanding debts of banks from 2000 and before all originated from bad loans. The 1997 financial crisis originating in Southeast Asia caused many banks in Asia to lose billions of US dollars, go bankrupt, or be forced to merge, in which the most important reason was the high rate of overdue debt of banks. Before the crisis, the rate of overdue debt of Thai banks was 13%, Indonesia 13%, Philippines 14%, Malaysia 10%. The 2008 US financial crisis, which originated from a wave of high-risk mortgage lending, clearly demonstrated the fundamental cause of the banking problem: credit risk. Therefore, credit risk management is always a matter of survival for commercial banks.

1.2.3 Credit risk management content

1.2.3.1 Building a credit risk management strategy

- Building a risk management strategy: The bank needs to determine the vision, goals, and mission of the bank in order to develop a "risk appetite" - the acceptable level of risk - in order to plan a suitable risk management strategy. The risk management strategy must answer and resolve important issues: The bank's attitude towards credit risk; The bank's level of acceptance of credit risk; The bank's capacity to manage credit risk.

- Develop QTRRTD policy: To implement the Risk Management Strategy, in each period, the Board of Directors issues QTRRTD policies as the basis for forming a credit process with detailed operational instructions and specific steps in the credit granting process. The risk management policy also stipulates lending limits for customers, debt classification, and provisioning. The policy must outline for credit officers the direction of operations and a clear reference framework to serve as a basis for considering loan needs.

+ The authorized judgment level is the maximum credit limit that the head office gives to the branch to decide.

+ Risk limit is the maximum level of risk that the bank can tolerate to ensure achieving the corresponding level of profit.

+ Loan portfolio management

Banks must regularly analyze and monitor their credit portfolio, especially bad debts and problem debts, to take timely measures when risks arise. Based on the loan portfolio, banks classify debts into groups of overdue debts, debts requiring special attention, substandard debts, doubtful debts and debts with the possibility of losing capital. In addition, banks also need to pay close attention to debts with special attention because when there are adverse changes in the bank's lending activities, these debts can easily turn into bad debts. Banks take measures to manage these debts to ensure credit quality for the bank.

Banks should establish a centralized credit information system that includes periodic and special reports. Periodic reports may include reports on the following: Group of customers with the largest credit balances, largest outstanding balances; credit portfolio analysis, exceptions (e.g. over-limits); bad and doubtful debts; early warning signs, provisions for individual outstanding balances, profits for each customer and product, loan tracking logs.

+ Review risk management policies periodically

The policy of QTRRTD aims to expand credit while limiting RRTD to increase income for the bank. The policy of QTRRTD aims to limit risks such as: collateral policy, guarantee policy, co-financing policy... The policy of QTRRTD is the basis for forming a credit process with detailed professional instructions, specific steps in the credit granting process. The policy must help credit officers with the direction of operation and a clear reference framework to serve as a basis for considering loan needs. This creates a general unity in credit activities to limit risks and increase profitability.

1.2.3.2 Building a credit risk management model

The QTRRTD model is a system of models including a risk management organization model, a risk measurement model and a risk control model that are built and operated fully, comprehensively and continuously in the credit management activities of the bank. The QTRRTD model systematically reflects the following issues:

(i) Mechanisms, policies, and business processes to establish safe operating limits and risk control points in a business process.

(ii) Risk measurement and detection tools

(iii) Activities to monitor compliance and promptly identify new types of risks.

(iv) Proactive plans and measures to prevent and respond when risks occur.

The QTRRTD model must aim at ensuring the effectiveness of credit activities and continuously improving the quality of credit activities of commercial banks even in volatile market conditions with increasing risks. Thus, the QTRRTD model is understood as follows:

The QTRRTD model is a way to organize, manage, measure and control RRTD to control RRTD within an allowable limit according to the principle of maximizing the credit institution's profit.

A. QTRRTD model from a single research perspective

a. According to RRTD measurement criteria:

Model 1: Qualitative RRTD measurement model

This model delves into the study of the following 5 criteria (also known as the 5C method):

Capacity - Cash flow . This factor is considered the most important among the five factors. Capacity refers to the ability of the customer to operate the business and repay the loan successfully. The bank wants to know exactly how the customer will repay the loan. Capacity assessment is based on the evaluation of factors: operating experience, past financial statements, products, market performance and competitiveness. From there, the bank can estimate the cash flow that will be used to repay the loan, the repayment period and the probability of the customer successfully repaying the loan. Evaluating the history of loans and loan payments, whether personal or commercial loans, is also considered an indicator of future repayment ability.

Capital (Capital structure) Is the amount of capital that customers invest in the business. Banks will feel more secure if customers have enough equity. Equity can be mobilized during operations, helping to ensure the bank's loan status. Banks also see equity as an indicator of the level of commitment and risk of customers to their business and will feel more comfortable knowing that customers will lose a lot if their business fails. It is better if this capital is taken from the shareholders' own assets.

Collateral (Collateral) The bank can take over the customer's collateral when the customer becomes bankrupt or is unable to pay the debt. The bank is guaranteed the right to take over the customer's collateral before other creditors. The bank can also require the customer to use other personal assets outside the company as collateral . For the bank, this is a guarantee and an alternative source of repayment in addition to the expected repayment cash flow. Some banks may require a guarantee along with the collateral. A guarantee is a form of third party signing a guarantee to commit to payment if the borrower cannot repay the debt.

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