Indicators Reflecting Financial Safety of Commercial Banks

The ability to recover principal and interest of loans and investments of commercial banks. When the asset quality is good, commercial banks can fully recover both principal and interest of loans and investments. This is the basis for commercial banks to repay depositors and make profits, ensuring the existence and development of commercial banks [57], [72], [73], [81].

- Ability to handle losses: Banking business is an activity of accepting and managing risks. Risks can occur due to objective and subjective factors. Commercial banks are considered to operate safely when risks occur, commercial banks can handle them without affecting the normal operations of the bank [57].

1.2.3.3. Liquidity safety

The liquidity of a commercial bank is the ability to be ready to pay, pay customers and compensate for losses when risks occur in the business activities of a commercial bank. Liquidity is a matter of survival for every commercial bank. The lack of liquidity can be a factor that triggers a bank collapse, while high liquidity can help a bank overcome difficult times. A commercial bank with liquidity problems is not only a risk to the safety of the bank's own operations but also threatens the safety of the banking system. Therefore, ensuring liquidity is an important issue in ensuring the financial safety of commercial banks.

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To ensure the safety of the operations of a commercial bank in particular and the entire commercial banking system in general, the central banks of each country prescribe liquidity safety ratios. Ensuring the liquidity of a commercial bank is demonstrated through the level of compliance with the liquidity safety ratios as prescribed by the central bank. In addition, ensuring liquidity is the act of a commercial bank creating enough mobilized capital to meet the needs of lending, investment and liquidity.

1.2.3.4. Ensuring profitability

Profitability and safety are trade-offs. Assets with high profitability have low safety and vice versa. If commercial banks only focus on maintaining high safety ratios and do not accept risks, banking operations may be safe but ineffective. Therefore, in the long term, to ensure the existence and development of commercial banks, financial safety is also about ensuring profitability based on the determined risk appetite [57], [72], [73], [81].

1.2.4. Indicators reflecting the financial safety of commercial banks

1.2.4.1. Capital safety indicators

- Equity capital of commercial banks

The larger the equity capital, the stronger the financial capacity of the bank and vice versa because equity capital is a buffer to prevent risks in the bank's business operations.

The equity capital of commercial banks includes tier 1 capital and tier 2 capital. In which:

+ Tier 1 capital (basic equity): includes common shares, long-term preferred shares, capital surplus, undistributed profits, general reserves, other capital reserves, convertible trust vehicles and credit loss reserves. This is the charter capital and published reserve funds.

+ Tier 2 capital (additional equity capital): This capital is considered to be lower quality capital including: undisclosed reserves, revaluation reserves, general provisions/general loan loss provisions. Hybrid capital instruments (debt/equity), subordinated debt. However, unsecured short-term debts are not included in this definition of capital.

Limits in calculating the total capital of the bank: Total Tier 2 capital must not exceed 100% of Tier 1 capital, secondary debt must be at most 50% of Tier 1 capital, general reserves must be at most 1.25% of risk-weighted assets, and revaluation reserve must be discounted.

55% discount, remaining maturity of subordinated debt is at least 5 years, bank capital does not include intangible assets. [10]

- Equity growth rate

Equity growth rate

= Equity in year N-Equity in year N-1 *100%

Equity in year N-1

The growth rate of equity capital shows how equity capital increases/decreases next year compared to the previous year. A high growth rate shows that the bank's ability to expand capital is good, the bank's financial capacity is improved and vice versa.

- Equity capital structure

Type i capital

Capital ratio of type i = Equity * 100%

Equity capital structure indicates the level of equity capital. Tier 1 equity capital is more reliable than Tier 2 capital and is the source of capital used to compensate for losses when risks occur. Therefore, if the ratio of Tier 1 capital is high, it proves the financial capacity and safety level of the commercial bank and vice versa.

- Capital Adequacy Ratio (CAR)

To determine the level of capital safety for each credit institution, people use the minimum capital adequacy ratio (CAR). This is an index given to suggest the minimum capital ratio for banks in the world. The goal of this ratio is to ensure that the bank can withstand a certain rate of capital loss before falling into a state of insolvency.

According to Basel 2, Basel 3 agreements

CAR

∑( Assets * risk coefficient) + (TT risk + RHHD) * 12.5 * 100%

Equity

bee

there :

According to Basel 2, Basel 3, CAR ≥ 8% [59] In which:

According to Basel 2:

+ Equity capital includes tier 1 capital, tier 2 capital minus deductions

+ For credit risk, depending on the collateral, the risk sensitivity of the collateral, the credit rating of each customer, the risk rating is regulated from 0% - 150%. To measure credit risk, Basel 2 stipulates that commercial banks choose the standard method or the internal credit rating method to determine the level of credit risk. The standard method is a method of measuring the level of credit risk based on the credit rating of an independent organization outside the bank approved by the banking supervisory agency. The internal credit rating method is a method of measuring the level of credit risk based on the bank's assessment by estimating the probability of default, default loss, outstanding debt at the time the customer defaults and the expected repayment term.

+ For market risk and operational risk: Commercial banks choose the basic method or the advanced method to determine capital for operational risk and market risk.

This ratio reflects the influence of asset structure on the financial safety level of the bank. If the bank determines the acceptable level of risk to be high, the expected profit is high, accordingly the capital adequacy ratio decreases and vice versa. This is the law of risk and profit trade-off, the higher the risk level of assets, the greater the profit that can be obtained.

According to Basel 3,

Regarding equity capital, Basel 3 focuses on improving the quality of bank capital and increasing the proportion of Tier 1 capital. Specifically:

+ For common stock capital: commercial banks must increase the common stock capital ratio from 2% as prescribed by Basel 2 to 4.5% as prescribed by Basel 3. At the same time, Basel 3 stipulates that commercial banks must add: "cushion" reserve

by common equity at a rate of 2.5% and a “cushion” against cyclical risk by common equity at a rate of 0% - 2.5%.

+ Basel 3 considers the impact of many risk factors on bank capital safety such as: credit risk, market risk, operational risk, liquidity risk and cyclical risk.

+ Supplementing risk-based capital requirements with a leverage ratio. The leverage ratio applicable to banks is at least 3% of Tier 1 capital, thereby limiting the formation of excessive leverage.

This ratio is the basic measure for the central bank to assess the financial health of a bank. If a bank fails to ensure its own capital, it is considered unable to operate normally and is placed under special control or forced to close.

- Ensure adequate capital for all types of risks according to Basel

Basel 2 sets out the following review and supervisory principles: (i) Banks should have a process for assessing the adequacy of internal capital in relation to their risk profile and an appropriate strategy for maintaining that capital level; (ii) Supervisors should review and assess the determination of internal capital levels and the bank's strategy, as well as the ability to monitor and ensure compliance with the minimum capital ratio. Supervisors should take appropriate supervisory action if they are not satisfied with the outcome of this process; (iii) Supervisors should recommend that banks maintain capital levels above the regulatory minimum; (iv) Supervisors should intervene at an early stage to ensure that the bank's capital levels are

The risk of a banking crisis falls below the regulatory minimum and may require immediate revision if capital levels are not maintained above the minimum. According to research by the Bank for International Settlements (BIS), when the minimum capital adequacy ratio increases from 7% to 8%, the probability of a banking crisis decreases by about 25%.

- 30%.

1.2.4.2. Indicators reflecting asset safety

* Indicator reflecting asset size

- Asset growth rate

Total assets growth rate

Total assets year N - Total assets year N- 1

= Total assets year N-1 *100%

Asset growth rate shows how much the total assets this year increased/decreased compared to last year. This high rate shows that the financial capacity of the commercial bank has improved and vice versa.

- Asset structure

Proportion of assets of type i =

Type i assets

Total assets *100%

Type i assets include: funds, credit, investments and other assets.

Asset structure is one of the important indicators to evaluate the safety of assets. Asset structure is considered safe when the proportion of funds meets the daily payment needs of the bank. At the same time, the bank does not focus too much on credit or investment items. Not focusing too much on credit or investment is a measure to spread risks for the bank.

* Indicators reflecting asset quality

- For credit activities

+ Credit balance growth rate

Credit growth rate

= Outstanding balance year N- Outstanding balance year N-1 *100%

Outstanding balance year N-1

Credit growth rate shows how much this year's outstanding debt has increased/decreased compared to last year. This high rate shows that the credit expansion ability of commercial banks is good and vice versa. However, to assess the financial safety of commercial banks, this indicator must be evaluated simultaneously with the overdue rate and bad debt rate of commercial banks.

+ Overdue debt rate

Overdue debt is a debt for which the customer does not pay the principal or interest on the due date committed in the credit contract.

Overdue debt

Overdue debt ratio = Total outstanding debt * 100%

The overdue debt ratio shows how many out of 100 units of bank loans are not paid on time to the bank. A high overdue debt ratio indicates low credit quality and vice versa.

+ Bad debt ratio

Bad debt is a loss to a commercial bank due to the borrower's financial difficulties and inability to repay. According to IMF regulations, bad debt is debt that satisfies one of the following conditions: (i) Principal or interest debts are overdue for 90 days or more; (ii) Debts with extended debt; (iii) Debts that are not overdue for more than 90 days but the bank assesses the ability to repay as low.

Bad debt

Bad debt ratio = Total outstanding debt * 100%

The bad debt ratio reflects the credit risks that banks face. If this ratio is high, the bank will be assessed as having low credit quality and vice versa. According to the World Bank, this ratio is acceptable at below 5%, good at 1-3%.

* For investment activities

- Investment activity structure

Value of type i investment

Investment value of type i =

Total assets * 100%

Investment activities of commercial banks include: investment in government securities, bonds of other credit institutions, bonds of economic organizations, stocks on the stock market and capital contribution in joint ventures and associations in enterprises. The structure of investment activities shows the proportion of investment items of commercial banks. If the proportion of investment is in assets with high risk level, the safety level of investments is low but the ability to generate income is high and vice versa.

- Credit quality of debt securities of economic organizations that the bank holds.

These are investments of commercial banks to earn interest, however, the ability to pay principal and interest of each customer is different. In essence, this amount is like a credit that commercial banks provide to customers. Therefore, to assess the safety of this investment, it is necessary to classify debt and consider the debt ratio of each debt group of these securities.

Group i debt securities ratio

Value of group i debt securities

= Total value of debt securities of groups

* 100%

Securities are classified by quality from group 1 to group 5, according to decreasing credit quality. Debt securities in group 3, group 4, group 5 are considered to be securities of poor quality. The higher the proportion of securities of poor quality, the higher the level of risk in the investment activities of the bank and vice versa.

* Risk compensation ability

Loan Loss Reserve Ratio (LLR)

Reserve fund

LLR =

Total bad debt * 100%

This ratio indicates the bank's ability to offset the risk of bad debts at the bank. According to international practice, banking operations are safe if this ratio is greater than 100%.

1.2.4.3. Indicators reflecting liquidity safety

- Level of compliance with liquidity assurance ratios as prescribed by the State Bank

To ensure liquidity safety for each commercial bank in particular and the whole system in general, the Central Bank of each country stipulates liquidity assurance ratios. The fact that commercial banks comply well with liquidity assurance ratios shows the level of compliance and liquidity capacity of the bank.

- Liquidity reserve ratio

Liquidity reserve ratio =

Highly liquid assets

Total liabilities * 100%

If this ratio is too high, it shows that the amount of non-profitable assets and the bank's profitability are low, leading to ensuring liquidity but reducing profitability and vice versa.

- Loan balance ratio/Total deposits

Loan to Deposit Ratio (LDR) =

Outstanding Loans

Total deposit * 100%

This ratio indicates the bank's ability to mobilize capital for its lending and investment activities. If this ratio is too low, it shows that the bank's mobilized capital exists largely in the form of non-profitable assets or low-profitability assets. That helps the bank's liquidity to be high but its profitability to be low and vice versa.

- Ratio of short-term capital for medium and long-term loans : In business activities, commercial banks can use short-term capital for medium and long-term loans. If this ratio is high, it shows the liquidity risk that the bank may have to face.

The risk is high because when banks use many short-term capital sources to lend medium and long-term, when the payment deadline for depositors comes, the bank may not have the source to pay, leading to a lack of liquidity.

- Liquidity coverage ratio and stable net funding ratio according to Basel 3

Basel 3 sets standards to achieve two separate but complementary objectives. The first objective is to promote short-term liquidity resilience in a bank’s liquidity risk portfolio by ensuring that the bank holds liquid assets of sufficiently high quality to survive a month-long enhanced stress. The second objective is to promote resilience over a longer period of time by creating additional resources to fund the bank’s operations with more stable and continuous funding. These two objectives are expressed through the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR).

+ LCR ratio

Reserve high quality liquid assets

LCR = Total net cash outflow in next 30 days * 100%

In which, highly liquid assets are divided into 2 groups: level 1 reserve assets and level 2 reserve assets. Level 1 reserve assets are primary reserves including: cash, deposits at the Central Bank and cash equivalents such as the highest-rated government debts. Level 2 reserve assets include lower-rated public debts and financial corporate bonds. This type of asset is at a minimum of 15% and a maximum of 40% of total liquid assets.

Total net cash outflow within 30 days is the size of the cash outflow based on the withdrawal rates for wholesale and retail financing obligations and the withdrawal rates for contingent liabilities reflecting the amount of debt that is likely to mature or be called within 30 days under a scenario that combines systemic liquidity and shock characteristics.

According to Basel 3, LCR ≥ 100% [61]

+ NSFR rate

Stable source of capital available

NSFR = Stable Funding Requirements * 100%

Current stable capital sources include equity capital, debts with a term of 1 year or more (weighting 100%); stable demand deposits or deposits with a remaining term of less than 1 year (weighting 90%); less stable demand deposits or deposits with a remaining term of less than 1 year (weighting 80%) and large-scale loans from non-financial organizations, the Government, the Central Bank, and multilateral development banks with a remaining term of less than 1 year (weighting 50%). Stable capital sources on demand include: debts issued or guaranteed by the Government, the Central Bank, the BIS, the IMF, non-governmental organizations, and multilateral development banks (weighting 5%); corporate bonds with priority for payment, not secured by physical assets and freely transferable, rated AA or higher, with a term of 1 year or more (weighting 20%); Listed freely transferable equity securities or unsecured corporate bonds (or secured bonds) rated from A+ to A-, with a maturity of 1 year or more, gold, loans to non-financial organizations, governments, central banks, multilateral development banks with a maturity of less than 1 year (weighting 50%); loans to individual customers with a maturity of less than 1 year (weighting 85%) and other assets (weighting 100%).

According to Basel 3, NSFR ≥ 100% [61]

1.2.4.4. Indicators reflecting profitability

Commercial banks are enterprises operating for profit, so for commercial banks to survive and develop in the future, profitability is always considered at the same time as ensuring safety.

- Proportion of net income from business activities

Net income type i

Proportion of net income type i = Total net income *100%

The proportion of net income of a commercial bank is divided into the proportion of net income from interest and the proportion of net income from non-interest. The proportion of net income indicates the role of that business in the business activities of a commercial bank. If net income from interest accounts for the majority, the financial safety of a commercial bank is not high because this is an activity with many potential risks. On the contrary, if net income from non-interest accounts for the majority, the safety of a commercial bank is higher because non-credit activities are fee-based activities, with no or little potential risks.

- Return on Equity

Profit after tax

Return on Equity (ROE) =

Equity *100%

This is an indicator that reflects the profitability of equity, indicating how much profit 1 dong of equity generates, reflecting the business performance achieved in relation to the capital structure of the bank. ROE is the indicator that shareholders are most interested in because it reflects their income each year. Therefore, this is considered an indicator that attracts investors and is of primary interest to investors.

- Return on assets (ROA)

Return on assets (ROA) =

Profit after tax

Total assets * 100%

This ratio shows how much profit after tax is generated for every dollar of assets. It measures the efficiency and ability of the management in using assets to generate net income.

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