Credit risk management of Vietnam Bank for Agriculture and Rural Development

will be treated together with other retail exposures and will be lower than the risk rating of unrated corporate exposures. In addition, some small and medium-sized enterprise (SME) exposures may be treated as retail exposures if certain criteria are met.

To help banks and supervisors in situations where there are limited options, the Basel Committee has developed a “Simplified Standardized Approach” that includes the simplest options for calculating risk-weighted assets. Banks that apply the simplified standardized approach are required to comply with the regulatory, supervisory and market discipline requirements of the new Basel Accord.

* Internal rating approach: (according to Sections 18, 19, 20 Basel II)

One of the most innovative aspects of the new Accord is the IRB approach to credit risk, which comes in two forms: the basic and the advanced versions. The IRB approach differs fundamentally from the standardized approach in that a bank’s internal assessments of key risk factors are the key inputs to the capital calculation. Since the approach relies on the bank’s internal assessments, it requires even more stringent requirements for risk-sensitive capital. However, the IRB approach does not allow banks to determine all the components necessary to calculate their capital requirements. Instead, the risk weights and therefore the capital required are determined by combining quantitative inputs provided by banks with formulas prescribed by the Basel Committee.

Risk ratio formulas or functions convert input data into a specific capital requirement. They are based on modern risk management techniques associated with quantitative statistical assessment of risk.

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IRB methods cover a wide range of investment structures with different capital calculation mechanisms for different types of risk.

(i) Risk classification:

Under the IRB approach, banks are required to classify risks across the banking book with different fundamental risk characteristics as defined below. The asset classes are: corporate; government; banking; retail, and equities. The corporate asset class is further divided into five sub-categories for specific and defined types of loans. The retail asset class is divided into three sub-categories. Within the corporate and retail asset classes, different treatments may be applied to receivables purchased subject to certain conditions being met (Basel II paragraph 183).

This classification of risks is consistent with current banking practice. However, some banks may use different definitions in their internal risk management and measurement systems. The Committee does not intend to require banks to change the way they manage their business and risks, but banks must apply appropriate treatments to each potential risk for the purpose of determining minimum capital requirements. Banks must demonstrate to supervisors that their methodology for classifying potential risk is appropriate and consistent (Basel II Paragraph 184).

(ii) Credit risk control (according to Sections 403 and 404 Basel II)

Banks must have independent credit control units responsible for the design and operation of their internal rating systems. These units must be functionally independent of management responsible for creating potential risks. Areas of control include:

- Check and monitor internal classification.

- Prepare and analyze summary reports from the bank's rating system, including historical data and defaults classified at the time of default and one year prior to the default, analyzing the

Risk mitigation measures, monitoring trends in key rating criteria.

- Implement processes to verify that classification definitions are used consistently across Departments, Divisions, and geographic areas.

- Evaluate and document any changes in the grading process and reasons for changes;

- Review the rating criteria to assess whether they continue to be predictive of risk. Changes to the rating process, criteria or rating parameters must be documented and maintained for review by supervisors.

The credit risk control unit must be actively involved in the development, selection, implementation and validation of rating models. It must be responsible for the control and monitoring of all models used in the rating process and has ultimate responsibility for the regular review and revision of rating models.

(iii) Internal audit and external audit:

Internal audit or an equivalent independent body must annually review the bank's internal rating system and its operations, including the operations of the credit function and its estimates of PD (probability of default), LGD (loss due to default), EAD (potential risk due to default). Areas of review also include compliance with applicable minimum requirements. Internal audit must document its findings. Some national supervisors may require external audits of the bank's rating and loss characteristics estimation process (Basel II Section 405).

(iv) Use of internal rating results (According to Sections 406, 407 Basel

II)

Internal ratings and estimates of default and loss

plays an important role in credit approval, risk management, allocation

internal capital and corporate governance functions of banks applying the IRB approach.

A bank must have a reliable record of using internal ratings information, and therefore must demonstrate that it has used a rating system that adheres to the minimum requirements set out in this document for at least three years prior to qualification. A bank applying the advanced IRB approach must demonstrate that it has estimated and used LGDs and EADs in a manner that is highly consistent with the minimum requirements for using its own estimates of LGDs and EADs for at least three years prior to qualification. Improvements to a bank’s rating system will not affect its compliance with the three-year period.

(v) Adjustment of debt maturity (According to Section 420 Basel II).

Banks should have clear policies and procedures for calculating the number of days past due, particularly for adjusting the maturity of loans and extending or deferring loans. At a minimum, the loan maturity policy should include: approval and reporting authority; minimum maturity of the loan before adjustment; default levels for loans that are subject to adjustment; maximum number of times a loan can be adjusted; and reassessment of the borrower’s ability to repay. These policies should be applied consistently and should support a “utilization test” (i.e. if a bank treats a potential exposure as having another default above the limit, the potential exposure should be treated as in default for the purposes of the IRB approach).

(vi) Handling of overdrafts

Overdrafts are permitted subject to a credit limit determined by the bank and communicated to the customer. Any violation of this limit is subject to

are monitored. If the account is not brought back under the limit after a period of 90 to 180 days (depending on the delinquency incurred), the account is considered to be in default. Unauthorised overdrafts involve zero credit downgrades for the purposes of the IRB approach. Therefore, the number of days past due is calculated from the date of the extension of credit to an unauthorised customer (overdraft); if the credit is not repaid within 90 to 180 days, the potential exposure is considered to be in default. Banks must have strict internal policies for assessing the creditworthiness of customers who are permitted to have overdraft accounts (Basel II Section 414) .

(vii) Effectiveness of collateral, credit and cash control systems (According to Basel II Section 460).

Banks must have effective policies and procedures to control collateral, credit and cash. In particular:

Internal policy documents should clearly state the key elements of the receivables purchase program, including lending rates, eligible collateral, required documentation, concentration limits, and treatment of cash receivables. These elements should take into account all relevant key factors including financial condition, risk concentration, trends in the quality of the seller/servicer's receivables, and the seller's customer base.

Internal systems must ensure that loans are only granted when there is supporting collateral and documentation (e.g., debtor's affidavit, invoices, shipping documents, etc.).

(viii) Confirmation of the value of internal estimates

Banks must have a robust system to validate the accuracy and consistency of their systems, processes for rating and estimating relevant risk components. Banks must demonstrate to supervisors

its members that the internal validation process helps to evaluate the performance of internal rating and risk estimation systems in a consistent and meaningful manner (Basel II Paragraph 463).

Banks must regularly compare actual default rates with estimated PDs for each class and be able to demonstrate that actual default rates are within the expected range for that class. Banks using the advanced IRB approach must complete such an analysis for LGD and EAD estimates. Such comparisons must utilize historical data over the longest possible period. The bank’s approaches and data used in such comparisons must be clearly documented. This analysis and documentation must be updated at least annually (Basel II paragraph 464) .

Banks should also use quantitative valuation tools and other comparisons with appropriate external data sources. This analysis should be based on data that is relevant to the portfolio, regularly updated, and covers a suitable observation period. Banks’ internal assessments of the performance of their rating systems should be based on long-term historical data, covering a wide range of economic conditions and preferably one or more business cycles (Basel II Section 465).

Banks must demonstrate that their quantitative testing approaches and other valuation approaches do not vary systematically over the business cycle. Changes in approaches and data (both data sources and time periods covered) must be clearly and thoroughly documented (Basel II paragraph 466).

Banks should clearly define internal standards for situations where deviations from expectations of actual PDs, LGDs and EADs are significant.

The standards should take into account business cycles and systematic changes in experience of defaults. Where actual values continue to exceed expected values, banks should make upward adjustments to reflect their experience of defaults and losses ( Basel II paragraph 467).

Where banks rely on supervisory estimates rather than internal estimates of risk parameters, they should compare actual LGDs and EADs with supervisory estimates. Information on actual LGDs and EADs should form part of a bank's assessment of economic capital (Basel II Paragraph 468).

(ix) Legal certainty

The legal mechanism by which collateral is accepted must be certain and ensure that the lender has clear rights to the proceeds from that collateral (Basel II Paragraph 475).

The bank must take the necessary measures to implement the requirements for the enforceability of the security interest, for example, by registering the security interest with the registry. There will be a framework provision allowing the borrower to have a first priority claim on the collateral (Based on Section 476 of Basel II).

Banks must obtain a legal opinion affirming the enforceability of collateral in all relevant jurisdictions (Basel II Section 477).

The settlement of mortgaged assets must be fully documented, with a clear and certain process for the timely collection of proceeds from mortgaged assets. The bank's procedures must ensure that all necessary legal conditions for declaring a customer in default are met and that timely collection of mortgaged assets is emphasized. In the event of financial difficulties or default by the lender, the bank has the statutory right to sell or transfer such proceeds to other parties with the consent of the lender.

consent of the obligor to such payments (Based on Section 478 Basel II).

(x) Credit risk management

Banks must have a robust process for determining credit risk in receivables. Such a process must include an analysis of the borrower's business and industry (e.g., the impact of business cycles) and the types of customers with whom the borrower does business. Where banks rely on borrowers to determine the credit risk of their customers, banks must evaluate borrowers to determine the soundness and creditworthiness of the borrower (Basel II Section 479).

The difference between the potential exposure and the value of the receivables should reflect appropriate factors, including the cost of collection, the concentration of receivables in a pool collateralized by each borrower, and the potential risk from the concentration of the bank's total potential exposures (Basel II paragraph 480).

Banks must maintain an ongoing review process appropriate to each potential exposure (either direct or ad hoc) to the collateral used as a hedge. This process may include reporting on maturity, control of trade documents, loan certificates, regular audits of collateral, account confirmations, control of receivables from paid accounts, analysis of dilution (credit extended by borrower to issuer), and regular financial analysis of both the borrower and the issuer of such receivables, particularly where a small number of large receivables are used as collateral. The bank’s compliance with concentration limits must be reviewed. Furthermore, compliance with loan agreements, environmental restrictions, and other regulatory requirements must be regularly assessed (Basel II Paragraph 481).

Credit risk management of Vietnam Bank for Agriculture and Rural Development - 10

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