Financial Structure in Commercial Banks

CHAPTER 2

THEORETICAL BASIS OF THE IMPACT OF FINANCIAL STRUCTURE ON THE PERFORMANCE OF COMMERCIAL BANKS

Since the 1950s, there have been many studies on capital structure, especially on optimal capital structure. In theory, there are many theories studying capital structure and its relationship with operational efficiency such as M&M theory, pecking order theory, trade-off theory, agency cost theory, etc. There are many empirical studies on capital structure to re-examine the above theories, however, no theory can perfectly explain all research cases due to the characteristics of each economy, each country and each different industry. In the content of this chapter, the author clarifies the theoretical schools that have studied capital structure, thereby applying them to explain part of the impact of capital structure on operational efficiency at Vietnamese commercial banks.

2.1. Financial structure in commercial banks

2.1.1. Characteristics of commercial banks' business operations affect

to financial structure.

Concept of commercial banks : There are many different concepts of commercial banks, but in general, economists agree that "A commercial bank is a financial intermediary institution that provides financial services including accepting deposits and lending money, making payments and other financial services" (FS Mishkin, 1992). In developed countries, especially Europe and the United States, the term

"Bank" is understood as financial institutions including commercial banks, savings and loan institutions, funds or forms of cooperation providing credit services, etc. Meanwhile, in Vietnam, " Commercial bank " is a type of bank that iscarry out all banking and other business activities as prescribed.The provisions of this Law aim at profit”. “Banking activities are the business of regularly providing one or more of the following operations: a) Receiving deposits; b) Issuing deposit certificates; c) Providing credit; d) Providing payment services through accounts”. ( According to the Law on Credit Institutions No. 47/2010/QH12 issued by the National Assembly of the Socialist Republic of Vietnam on June 16, 2010).

Although there are differences in the terms used to define the concept or there may be certain limitations to the scope of operations of commercial banks between schools in different countries, the nature of commercial banks is basically recognized as unified. Commercial banks are understood as special enterprises, operating on a

special fields and with special goods as business objects.

Characteristics of commercial banks' business activities : Commercial banks have their own characteristics in their business activities, specifically:

- In business activities, mobilized capital accounts for a particularly large proportion compared to other types of capital and is a factor that influences the business performance of commercial banks. This capital also determines the scale of commercial banks. Mobilized capital comes from two groups of capital sources: deposits and non-deposits.

- The main business activities of commercial banks include currency trading, credit and services, in which lending activities account for a large proportion, so the bank's profit target depends largely on lending activities, or in other words, the operational efficiency of commercial banks depends largely on the efficiency of lending activities. However, lending activities of commercial banks always have the potential to face risks: Customers cannot repay their debts, customers intentionally do not repay their debts to the bank. Therefore, in the lending process, banks must comply with strict appraisal procedures to minimize and control risks.

- Banking operations are continuous: the nature of banking operations is continuous according to prescribed working hours and days. This ensures peace of mind for customers conducting transactions at the bank. Depositors can withdraw money during the bank's transaction hours, borrowers can contact and be considered for loans if they fully comply with the bank's regulations. This means that commercial banks must always ensure liquidity and balance reasonable cash resources to meet customer needs.

- The business activities of commercial banks are closely related to each other, contributing to the creation of cash flow in the bank. This interaction creates the operating machine of commercial banks, helping the bank's operations run smoothly, forming a complete unified block. When the bank's operations reach such a level, it will be an important factor to promote the bank's increasingly sustainable development. This relationship is created by the bank's customer system with the use of a variety of products, both on and off the balance sheet.

- The business activities of commercial banks are under the management of the State Bank through the implementation of monetary policy. The activities of commercial banks are monetary business: a special commodity, a highly socialized commodity. On the other hand, the business activities of commercial banks always face risks such as: credit risk, liquidity risk, interest rate risk, management risk... This requires banks to build a risk management framework and a system of indicators to evaluate the effectiveness of each activity. Banking activities are considered the lifeblood of the economy, so they are sensitive.

highly with economic decisions. The collapse of a commercial bank adversely affects the entire national financial system due to the multi-dimensional interaction between commercial banks and other entities in the economy. Therefore, any country builds a system of management policies for the activities of commercial banks. Establishing a complete legal framework for the activities of commercial banks will protect the interests of customers, investors and partners.

Basic business activities of commercial banks

Capital activities : Capital activities are the basic activities, decisive for all other activities of commercial banks. Unlike other types of enterprises, the scale of equity of commercial banks is always at a "very small" level compared to the scale of business activities. Therefore, commercial banks mainly do business with capital from other entities in the economy through capital mobilization operations. A large commercial bank means a large scale of business activities and a large scale of capital. Only with a large and stable capital source can commercial banks expand lending, investment and provide services to meet the needs of the economy and society. The capital structure of modern commercial banks today includes the following:

Owner's capital of commercial banks : Like other enterprises, commercial banks must also have initial capital to register for business and conduct operations according to the law and is considered a very important source of capital. Depending on the type of organization of the bank, owner's capital can be formed from different sources, and is accumulated from the business results of commercial banks. Although, as mentioned above, the owner's capital of commercial banks only accounts for a small proportion of the total capital, its operation is very stable. Therefore, commercial banks can proactively use it without fear of liquidity risks. On the other hand, the size of owner's capital also reflects the financial capacity, capital mobilization capacity and reputation of a bank in the market. Moreover, owner's capital is the source to compensate whenever the asset portfolio of a commercial bank is reduced in value. Owner's capital is considered a "cushion" for risks in the business activities of commercial banks.

Because equity plays such an important role, the International Banking Association, the Basel Committee and governments around the world all have specific regulations on the scale of equity in relation to the scale of operations of commercial banks. Accordingly, equity can be divided into two parts, including basic capital (Tier 1 or core capital) and supplementary capital (Tier 2 or supplementary capital), but the total scale must not be less than 8% of the value of assets that can bring risks (CAR≥8%). In fact, commercial banks in most developed countries and many countries in Southeast Asia always have this ratio above 10%, while OECD countries are always above 15% (Source:

Basel Accord, Basel 2 (2005), Basel Committee)

Mobilized capital : on the basis of equity, commercial banks mobilize all temporarily "idle" money sources from all other entities in the economy in the form of deposits (from residents and businesses) or in the form of loans (borrowing from the Central Bank, from other commercial banks and through the issuance of debt instruments). Deposit capital always accounts for a large proportion and plays an important role in the business activities of commercial banks, including deposits from businesses, usually non-term, and deposits from residents, usually term deposits or savings.

With the function of "business treasurer", combined with the legal requirements of opening accounts and making payments through banks, the capital of businesses' deposits always has a very large proportion in the capital of commercial banks. This source of money is intended to serve the production and business activities of businesses, so it can be withdrawn or used at any time, also known as demand deposits or transaction deposits. Due to the purpose of depositing money and being used for free transactions, businesses do not pay interest, or only with very low interest rates for demand deposits, so this can be considered the "cheapest" source of capital for commercial banks. Commercial banks with great reputation with many business customers and demand deposits, the cost of capital will be lower and the efficiency will be higher.

Unlike businesses, most people often deposit money in the form of savings or term deposits for the purpose of earning income through interest. The source of capital is the non-term deposits of people on accounts using payment cards or issuing personal checks, traveler's checks, etc., which are very popular in developing countries and can be considered as transaction deposits. Although savings deposits have to pay high interest and have a smaller proportion, they are stable. This is extremely important in the capital activities of commercial banks.

Deposit capital is always the most important source of capital and is considered the main business object of commercial banks. However, in the process of business operations, commercial banks are still likely to fall into a state of capital shortage and not meet the sudden needs of customers, and may even encounter difficulties in payment capacity. To supplement deposit capital, commercial banks can borrow from other commercial banks and from the Central Bank in many different forms. The activities of mobilizing and using mutual capital of banks have formed and developed the interbank money market, which is very vibrant and is the most important component of the financial market system of countries.

In addition, like other businesses, commercial banks can also borrow more proactively by issuing promissory notes and bonds to mobilize capital in the market.

finance whenever needed. This capital activity not only brings benefits to commercial banks but also provides a source of goods to enrich trading activities on the stock market.

Capital use activities of commercial banks: The above capital activities will form liabilities and commercial banks are responsible for paying all these capital sources according to customers' requests. Although capital is the decisive factor for all business activities of commercial banks, it is only truly meaningful when commercial banks are able to use it for lending purposes, investing in economic development and improving the living standards of the community in general and the interests of the bank itself in particular.

Financial intermediary activities of commercial banks: Along with the above-mentioned capital mobilization and use activities, financial intermediary activities, which are also very basic and important activities of commercial banks, provide financial services to satisfy the needs of customers. In addition to intermediary payment, along with the development of science and technology, intermediary services are becoming increasingly diverse and rich. On the one hand, this development increases the efficiency and ability to manage assets as well as commercial banking activities, on the other hand, it allows commercial banks to connect with each other in each country and around the world to carry out very complex business operations as well as best meet the needs of customers everywhere in the world. By providing electronic payment methods, automatic cash withdrawal systems, home banking services and other convenient financial services, commercial banks have truly become indispensable "companions" not only for the production and business processes of enterprises but also for the daily lives of all classes of people.

2.1.2. Commercial Bank Financial Structure

Overview of financial structure: There are many different views on the scope of research on financial structure:

Firstly , researchers believe that financial structure is capital structure, which is the ratio between equity and debt in the total capital of the enterprise. Or "Financial structure of an enterprise is the combination of using debt and equity capital in a certain ratio to finance the production and business activities of the enterprise" (According to SARoss W.Westerfield and Bradford D. Jordan, 2003; Dare and Sola, 2010; Doan Ngoc Phi Anh, 2010; Foyeke et al., 2016).

Second: researchers believe that “The financial structure of a business includes short-term debt plus medium- and long-term debt, preferred stock and equity capital often used to finance investment decisions in a business” (Macguigan et al., 2006; Cameron and Trivedi, 2010; Tran Ngoc Tho, 2010)

Third : researchers believe that when studying and examining financial structure, it is necessary to study from both perspectives: the first perspective is the capital structure of the enterprise and the second perspective is the capital structure considered in relation to the asset structure of the enterprise (Nguyen Van Cong, 2010; Nguyen Nang Phuc, 2011; Pham Thi Thuy and Nguyen Thi Lan Anh, 2012).

Thus, according to the first point of view, financial structure is only considered within the scope of capital structure, while the second point of view considers financial structure in a broader scope in both the short and long term. In the third point of view, in addition to considering financial structure including capital structure as the two points of view above, it also studies asset structure and the relationship between capital structure and asset structure.

According to the author, financial structure is the capital structure in businesses and commercial banks, and this structure includes short-term debt, long-term debt, preferred equity and common equity used to finance investment decisions in a business or a bank.

2.1.2.1.Capital structure

Capital structure (also known as capital structure) refers to the relationship between different sources of funding in a business and often emphasizes the combination of debt and equity (Vu Duy Hao and authors, 1997; Nguyen Minh Kieu, 2006; Brealey and authors, 2008; Brigham and Houston, 2009).

In other words: capital structure is the index measuring the proportion of each capital component in the total capital of enterprises and commercial banks. The capital of enterprises as mentioned above includes many different sources of funding but mainly belongs to two main sources: equity and liabilities.

Liabilities are the amount of money that a business is responsible for and obligated to pay to its creditors, based on the payment period, it is divided into: short-term debt and long-term debt. Short-term debt is a debt or a debt obligation that a business is responsible for paying within one year. Long-term debt records the obligation to pay principal and interest that the borrower must pay to the lender over a long period of time.

Owner's equity is the capital owned by business owners, banks, shareholders in companies and joint-stock commercial banks, members in companies, joint-venture banks. Components of owner's equity include: common equity, undistributed retained earnings, asset revaluation differences, capital surplus, funds, funding sources...

Below we consider the differences between the capital structure of commercial banks and that of businesses:

Table 2.1: Capital structure of commercial banks and enterprises.

BANK'S STATEMENT OF FINANCE

Form No. B02-TCTD

BUSINESS ACCOUNTING STATEMENT

Form No. B01 – DN

LIABILITIES PAYABLE

I-Government and State Bank debts

II- Deposits and loans from other credit institutions III- Customer deposits

IV-Derivative financial instruments and other financial liabilities

V-Funding, investment trust, lending to credit institutions at risk

VI-Issuance of valuable papers

VII- Other debts

LIABILITIES PAYABLE

I-Short-term debt II-Long-term debt

VIII-OWNERS' EQUITY

EQUITY

I-Equity

II- Other funding sources and funds

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(According to Form No. B01/DN, issued under Circular No. 200/2014/TT-BTC dated December 22, 2014 of the Ministry of Finance and B02/TCTD, issued under Circular No. 22/2017/TT-NHNN dated December 29, 2017 of the State Bank)

Similar to the capital source section in the balance sheet of an enterprise, the capital source section in the balance sheet of a bank also reflects the source of existing assets at the time of the report of the commercial bank, divided into liabilities and equity, thereby assessing the bank's ability to mobilize capital. The liabilities section in the balance sheet of a bank will not be divided into short-term liabilities and long-term liabilities like in the balance sheet of an enterprise. The reason is that most of the bank's liabilities can be realized or paid in the near future. The theories on corporate capital structure provide useful foundations when analyzing the capital structure of a bank. However, the capital structure between banks and non-financial enterprises also has differences as shown in the table above. Thus, looking at the capital structure of banks as in Table 2.1 above, we can see that instead of presenting the liabilities of banks in order of payment terms of debt obligations as in the case of enterprises, the liabilities of banks are classified "according to their nature and arranged according to their liquidity corresponding to their maturity and short-term and long-term liabilities of banks are not presented separately because most of the assets and liabilities of banks can be realized or paid in the near future".

Another characteristic of the capital structure of commercial banks is that the bank's capital includes deposits. Not only that, in the total liabilities of banks, deposits always account for a very large proportion. Customer deposits can be divided into types with specific terms or no terms, but customers have the right to withdraw money before maturity. For that reason, the debt of commercial banks is very volatile. Even so, because the number of customers depositing money in the bank is very large, when there is a withdrawal, there is immediately another deposit that can compensate, so the total amount of deposits in the bank will not fluctuate much. The bank will only encounter difficulties when depositors withdraw money en masse (called the domino effect), at which time the bank's liquidity will decrease, leading to many risks that the bank may encounter, including bankruptcy.

Therefore, within the scope of this thesis, the author studies and examines the financial structure of commercial banks from the perspective of capital structure including liabilities (Government and state bank debts; Deposits and loans from other credit institutions; Customer deposits; Derivative financial instruments and other financial debts; Funding capital, investment trusts, loans to credit institutions at risk; Issuance of valuable papers; Other debts) and equity.

2.1.2.2. Capital structure indicators

To represent the capital structure of commercial banks, researchers such as Demirguc and Huizinga (2000); Swicegood and Clark (2001); Kolari et al. (2002); Gaganis et al. (2006); Bach (2006); Osborne, Fuertes and Milne (2010); Kundid (2012); Pastor, Marobhe and Kaaya (2013) often use a number of indicators:

Equity to Total Asset (Equity to Total Asset - EQA): This is an indicator that reflects the level of asset financing by equity. The higher the value of this indicator, the more financially autonomous the bank is and the lower the risk level of the bank. This indicator is calculated as follows:

EQA = Total Equity/Total Assets

For commercial banks, this indicator is especially important because, as the author has presented above, due to the nature of business in the banking sector, it is to mobilize capital from many sources to re-lend with the main goal of making a profit, which is the reason why loans always account for a very large proportion of the total capital of commercial banks. The advantage of using loans is the low cost of capital and commercial banks as well as businesses benefit from the tax shield, which is also the weakness of

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