Credit risk management on loan portfolios in Vietnamese commercial banks

building organizational structure for risk management on loan portfolios in Vietnamese commercial banks. 1.1.2. Researches on information reporting principle between divisions in organizational structure of risk management on loan portfolios Firstly, Ghosh (2012) pointed out the principles of designing the reporting flow so that it separates the reports on business management from those on risk management. Moreover, according to this author, commercial banks should provide clear regulations on the tasks of each division involved in operational operations and risk management activities to avoid overlapping and conflicts of interests. The thesis uses the theory of above reporting principles to analyze and evaluate the current situation 11 of the organizational structure of risk management on loan portfolios in commercial banks. Secondly, Viet Dung (2007) through an empirical survey at Vietnamese commercial banks also recommends that commercial banks need to ensure a clear division of responsibilities and reporting channels in the implementation of daily credit risk management tasks. 1.2. Researches on risk identification on loan portfolios 1.2.1. Researches on credit risk early warning system Firstly, regarding study related to methodology in building credit risk early warning system in commercial banks. Some case studies are as follows:  Gramlich et al (2010); Zhou, Wang and Qiu (2008); Davis and Karim (2008)  Nguyen Van Huan and Do Nang Thang (2018)  Nguyen Thi Lan et al (2018) Secondly, on the practical efficiency when applying the credit risk early warning system in commercial banks. The role and effectiveness of this system for credit risk management in commercial banks has been clarified in many studies such as research by Azam (2016) in Iran; Qin and Luo (2014) in the group of developed countries G20; Koyuncugil and Ozgulbas (2012) in Turkey; Tiberiu (2006) in Romania; Sahajwala and Bergh (2000) in the G10 group of developed countries. These studies both come to the conclusion of the early warning as a method of confidence to identify credit risks on the bank's loan portfolios. 1.2.2. Researches on loan portfolios’ past quality evaluation models Firstly, for groups of foreign works, the method that is focused on research is Vintage analysis. This method proved to be quite effective as shown by Siarka (2011), Zhang (2009), Breeden (2004), Burns and Stanley (2001). Secondly, for domestic studies on loan portfolios’ past quality evaluation models, there is only the work of Pham Thi Nuong (2013) studies on migration analysis method. 12 1.3. Researches on risk measurement on loan portfolios Table 1.1: Summary of studies on loan portfolio risk measurement methods No. Author (Year of research ) Content 1 Bluhm, C., Overbeck, L. and Wegner, C. (2010)  Bernoulli model  Poisson model  Group of modern models: Credit model Metrics, Credit Risk + model, Credit Portfolio View model 2 Saunders, A. and Allen, L. (2010)  The model team considers a loan as an option contract: KMV and other models of Moody's  Compact model group: loan analysis system of KPMG and credit risk management model of Kamakura  Model group to approach VAR: Credit Metrics and other models  Model group according to macro simulation: Model Credit Portfolio View and other models  Model group to approach insurance: Bankruptcy Model and Credit Risk + Model. 3 Capuano, C. et al. (2009) Measure the probability of a group of borrowers defaulting on:  Loss distribution regression function by Andersen, L., Sidenius, J. and Basu, S. (2003)  Multifactor Gaussian Equations by Li, D.X (2000)  One-factor Gaussian Equations by Vacisek, O. (1987) 4 Engelmann, B. and Rauhmeier, R. (2006) Guide to determine three quantities PD, EAD, LGD Source: The author 1.4. Researches on using loan portfolio risk management tools 1.4.1. Researches on modern tools Regarding the group of modern tools used for loan portfolio risk management, 13 according to almost researches, credit derivative products are effective tool to almost researches, credit derivative products are effective tool to minimize and prevent the impact of credit risk on loan portfolios. The number of domestic and foreign studies on credit derivative products is quite massive, some of the typical studies of which are as follows:  Huynh Thi Huong Thao (2014)  Nguyen Thi Chau Long and Tran Thuy Ai Phuong (2014)  Nguyen Minh Sang and Nguyen Thi Lan Huong (2013)  Bluhm, Overbeck and Wegner (2010)  Le Ho An Chau (2006)  Minton, Stulz and Williamson (2005) 1.4.2. Researches on traditional tools Firstly, on loan portfolio diversification. In the group of traditional tools to manage loan portfolio risk, portfolio diversifying is used as a popular tool in commercial banks and there are many practical studies given about the effectiveness of this tool in commercial banks at different markets as follows:  Nguyen Thi Que Thu (2016)  Nguyen Minh Hieu (2011)  Bui Dieu Anh (2010)  Rossi, Schwaiger and Winkler (2009)  Kamp, Pfingsten and Prath (2005) Secondly, on loan sale. Loan sale is a tool to manage risk across the loan portfolios that commercial banks have used for many years, as mentioned in Smithson (2003). With studies in Vietnam, domestic research towards loan sale quite diversified such as law on loan sale, current situation of the loan sale market in Vietnam and policy recommendations for market development, credit institution operations of debt trading companies, etc. However, there are not many domestic studies giving an overview of the current situation in using this tool for loan portfolio risk management in commercial banks. Some of the typical works can be mentioned as: 14  Huynh Thi Huong Thao (2019)  Hoang Thi Duyen (2016)  Dao Duy Huan (2013) 1.5. Research gaps Firstly, many studies have mentioned loan portfolio risk management but do not fully contain the above mentioned contents, or only conduct research on a selected group of loans, or on loan portfolio of a particular commercial bank. To date, in Vietnam, almost no official research has been published for a comprehensive study of organizational structure and process of risk management of loan portfolios in commercial banks. Secondly, with the existing researches on risk management on loan portfolios in Vietnamese commercial banks, there is currently no research conducted to measure the risk of the loan portfolios in commercial banks. This is the theoretical gap that the thesis will focus on exploiting, specifically, the author will simulate the risk measurement of loan portfolios in commercial banks according to two different methods given in the theoretical basis. Thirdly, there is currently no research in Vietnam comparing the situation of risk management on the scale of the loan portfolio for groups of commercial banks with different risk management qualifications in comprehensive contents, such as: risk management organizational structure, risk identification, risk measurement and using tools of risk management. Existing studies have just been exploited in terms of comparing the content of risk management of loan portfolio at commercial banks with the standards set out in recommendations, international standards and legal regulations. This research gap will be clarified by the thesis. 15 CHAPTER 2: THEORETICAL BACKGROUND FOR RISK MANAGEMENT ON LOAN PORTFOLIO IN COMMERCIAL BANKS 2.1. Theoretical background for credit risk management in commercial banks 2.1.1. Concept of credit risk management in commercial banks In the thesis, the author uses the concept of Basel (2000) on credit risk as follows: “Credit risk is the ability of the borrower or counterparty to not fulfill their obligations under the terms agreed in the credit contract”. Accordingly, the goal of credit risk management is to maximize the bank's risk-adjusted rate of return income according to the identified risk appetite. To implement this, commercial banks need to simultaneously manage credit risks across the entire credit portfolio and for each specific loan transaction. Next, regarding the concept of “Credit risk management”, many definitions have been made. On this basis, it can be summarized that credit risk management is an important activity contributing to the successful operation of a commercial bank in the long term with the aim of maximizing the rate of adjusted income by credit risk factors for banks. Credit risk management is implemented in accordance with the policy frameworks and organizational model established by commercial banks and includes the main contents as follows: risk identification; risk measurement; use of risk monitoring, minimizing and controlling tools5; and risk reporting. 2.1.2. Principles of credit risk management in commercial banks In the guidelines on credit risk management principles of the Basel Committee (1999), 17 principles on credit risk management are divided into five groups as follows: 5 Hereinafter referred to as “tools for risk management” 16 Diagram 2.1: Principles of credit risk management under Basel 2 Source: Adapted by the author 2.1.3. Contents of credit risk management in commercial banks The contents of credit risk management as above are summarized in the following diagram: Diagram 2.2: Contents of credit risk management in commercial banks Source: Ghosh (2012) 2.2. Theoretical background for loan portfolio risk management in commercial banks 2.2.1. Concept of risk management on loan portfolios in commercial banks Principle group about establishing rational credit risk environment Principle group about establishing an effective credit procedures Principle group about maintaining appropriate credit management systems, metrics Group of principles on ensuring adequate control systems for all credit risks Group of principles on role of supervisors Use of credit risk management tools Report on credit risk Credit risk management principle group Credit Risk identification Build a structure to organize and manage risk Strategy, policy, and procedure of risk management Determine your risky appetite Credit Risk measurement 17 There are the two aspects of credit risk management at commercial banks: loan portfolio risk management and individual loan risk management. Thus, we can understand the concept of loan portfolio risk management from the concept of credit risk management on the loan portfolio level. Besides, the concept of loan portfolio risk management is given as one of the most important goals of loan portfolio management (LPM). In general, commercial banks' loan portfolio risk management can be understood as a system of activities that enables banks to recognize and measure credit risks for the entire loan portfolio, from that allows the bank to correlate the amount of credit risk it can tolerate at a level commensurate with the profit that can be derived from lending; at the same time, it helps the bank to control and minimize those risks. 2.2.2. Contents of risk management on loan portfolios in commercial banks The contents of loan portfolio risk management is similar to that of a bank's general credit risk management, but with each content, there are specific features with the loan portfolio. Firstly, on building the organizational structure of risk management on loan portfolios: The organizational model of risk management of the loan portfolio must be consistent with the organizational model of credit risk management in commercial banks and in accordance with the general organizational model of commercial banks according to the powers and duties of Board of Directors/Members' Council, Executive Board and branches and business units. However, as mentioned above, to achieve the highest efficiency in risk management of loan portfolio, commercial banks should organize a risk management model in the direction of centralization. Secondly, on loan portfolio risk identification: Credit risk identification on loan portfolio needs to be done through both groups of information: (i) identify internal portfolio risks and (ii) analysis of the macroeconomic situation and the banking sector. There are two methods, namely: (i) credit reporting and credit risk early warning and (ii) loan portfolios’ past quality evaluation models. . 18 Thirdly, on loan portfolio risk measurement: Commonly used methods to measure credit risk on loan portfolio are as follows:  Key risk indicators  Standardized approach  Internal Rating Based approach by Basel 2 (FIRB and AIRB)  Loan portfolios’ quality forecasting models Fourthly, regarding the use of loan portfolio risk management tools: Based on a traditional or modern perspective on credit risk management, the following portfolio risk management tools are divided into two groups: (i) traditional tools and (ii) modern tools. 2.2.3. Factors affecting risk management on loan portfolios in commercial banks These affecting factors include: factors from commercial banks, factors from borrowers and factors from the macroeconomic environment. 2.3. International experiences of loan portfolio risk management in commercial banks 2.3.1. Experiences of Japanese commercial banks  Regarding organizational structure of risk management on loan portfolios All Japanese commercial banks apply a centralization model for organizational structure of credit risk management, then the credit risk management function is separated from the business and operational functions. Furthermore, the credit risk management for each loan is separated from credit risk management across the loan portfolio.  Regarding risk identification of loan portfolios Japanese banks’ operations and Japanese economy have a close relationship with each other. As a result, an early warning signs of credit risk on loan portfolios comes from indicators evaluating the “health” of the macro economy. 2.3.2. Experiences of Korea Development Bank (KDB)  Regarding organizational structure of risk management on loan portfolios The maintenance of the risk control system in the organizational structure of risk management is taken very seriously at KDB. Credit risk control system of KDB is 19 established independently, applying to individual credits, including off-balance sheet credits, and the bank's entire credit portfolio on a daily management principle and warning early once the system detects a risk. The results of the credit risk control will be reported directly to the Risk Management Committee (Nguyen Quang Hien, 2016).  Regarding credit risk measurement of loan portfolios Diagram 2.3: Steps to quantify credit risk at KDB Source: Synthesized by the author according to Nguyen Quang Hien (2016)  Regarding the use of loan portfolio risk management tools To manage credit risk on the whole loan portfolio, KDB implements credit limit including two main types: credit limit by industry and credit limit by customer. 2.3.3. Experiences of Bangkok Bank  Regarding organizational structure of risk management on loan portfolios In Bangkok Bank, the credit risk management model applied is a transformational model, which is a combination of centralization and decentralization model (Le Thi Huyen Dieu, 2010). This transformation model is considered suitable for developing economies such as Thailand, when commercial banks are making efforts to renovate credit risk management activities according to modern international standards. Besides, in these economies, they are also facing some limitations in terms of scale, technology, personnel level, cultural factors, etc., so it is impossible to fully apply the centralization credit risk management model. Calculate PD, LGD, EAD Calculate EL,UL Calculate ELp, ULp Calculate Economic capital and loan price Manage credit portfolio subjectively Manage risk on value based 20  Regrading risk identification of loan portfolios Bangkok Bank conducts credit information reports to the Credit Information Department6, who then collects and releases outputs reports on borrowers and their monthly repayment history to the bank when requested. This is an important basis of information to help banks identify risks from customers early. Besides, regular credit checks and supervision both before, during and after lending are an effective tools of Bangkok Bank in early detection of arising credit risks, with the customer monitoring model used mostly as CAMELS (Truong Quoc Doanh, 2007). 2.3.4. Experiences of Citibank  Regarding organizational structure of risk management on loan portfolios Diagram 2.4: Organizational structure of credit risk management in Citibank (USA) Source: www.citigroup.com  Regarding the use of loan portfolio risk management tools The facts of the US Citibank's credit activities show that in order to effectively control credit risk on the loan portfolio, it is necessary to implement the following tools: Firstly, the loan appraisal is considered more important than post-loan control in preventing credit risk. The credit officer at this commercial bank is more focused on assessing the borrower's health rather than being overly dependent on automated methods and formulas. 6 Credit Information Bureau is privatized Risk management committee Operation Dept. Risk Management Dept. Debt Management Dept. 21 Secondly, avoid using brokers in lending. Thirdly, banks use a centralization model in making lending decision to ensure consistency and control. Fourthly, require lenders to be responsible for the loan they take to their banks. Fifthly, apply a credit rating for new loans and reevaluate them periodically over the life of the loan. Sixthly, participate in new financial instruments as role of insurance for bad debts Seventhly, focus on setting safety limits to reduce the risk of concentration on the loan portfolio. 2.3.5. Lessons learned for Vietnamese commercial banks  Regarding organizational structure of risk management on loan portfolios Firstly, in terms of the organizational model, the experience of US Citibank or commercial banks in Japan shows that the centralization credit risk management model is chosen for risk management of loan portfolio. Secondly, regarding the role of internal control in credit risk management, the experience as shown at KDB is consistent with the theory that maintaining an independent internal control department increases enhance the transparency and efficiency of credit risk management. This division should be structured as a separate branch of the risk management organizational structure and is responsible for reporting directly to the Risk Management Committee or the Board of Directors.  Regarding risk identification of loan portfolios Regarding the information used in loan portfolio risk identification, the experiences of commercial banks in Japan show that the bank's credit risk early warning system needs to take into account the influence of factors in macroeconomic environment. Moreover, in order to improve the quality of information used in loan portfolio risk identification, information from a single credit information center used for the whole system of commercial banks are proven to be as effective as the experience at Bangkok Bank. 22  Regarding credit risk measurement of loan portfolios The modern six-stage roadmap of credit risk measurement that KDB is implementing is a useful suggestion for Vietnamese commercial banks.  Regarding the use of loan portfolio risk management tools The experiences of many commercial banks, such as US Citibank or KDB have emphasized the role of credit limit tools in credit risk management across the loan portfolio. Furthermore, the experiences of US Citibank show that portfolio risk management should be done through a combination of several groups of measures: (i) credit risk management on each loan in the portfolio; (ii) strict compliance with regulations on prudential limits on the loan portfolio; (iii) using modern financial instruments, such as securitization to restructure and reduce risk in the loan portfolio. 23 CHAPTER 3: CURRENT SITUATIONS OF CREDIT RISK MANAGEMENT ON LOAN PORTFOLIO IN VIETNAM COMMERCIAL BANKS 3.1. Overview of Vietnamese commercial banks in research sample The thesis summarizes the operations of 16 commercial banks under the research sample on three aspects: (i) scale - expressed in Total Assets, (ii) profitability - as defined by Net Income on Average Total Assets (ROAA) and (iii) capital adequacy - It is reflected in the target of Capital Adequacy Ratio (CAR). 3.2. Current situations of loan portfolio risk in Vietnamese commercial banks 3.2.1. Regarding the ratio of NPLs on loan portfolios In general, the bad debt ratio in commercial banks in the sample for 2017 to 2019 period, most of them reached the threshold as prescribed in Circular 02/2013/TT- NHNN, but the NPLs ratio still exceeded 3% at some commercial banks in some points of time. 3.2.2. Regarding loss rate on loan portfolios Firstly, about the rate of provisioning for credit losses on the customer loan portfolio: The quality of loan portfolio of group 1 commercial banks in the research period is not good. For group 2 commercial banks, the rate of provisioning for this risk is much lower than that of commercial banks of group 1. However, it is not enough to draw a conclusion that the quality of the loan portfolio of group 2 commercial banks is better than group 1 because the size of the loan portfolio of commercial banks in group 2 is much smaller than that of commercial banks in group 1. Secondly, about the ratio of the cost of provision for credit losses on the loan portfolio: Group 1 commercial banks maintained both trends in the 2017-2019 period, while group 2 commercial banks also tended to improve during this period. 3.2.3. Regarding credit concentration on loan portfolio 3.2.3.1. Credit concentration by industry There are 04 commercial banks with a high level of credit concentration in lending by industry (at the level of more than 40% of outstanding loans), such as: VP Bank, VIB, AB Bank and PVcomBank. These are commercial banks that are potentially 24 risky due to focusing their loan portfolio in terms of industry. 3.2.3.2. Credit concentration by customer Commercial banks have high concentration of outstanding loans (at the level of more than 40% of the bank's loan balance) such as: (i) Group 1 includes Vietcombank, VP bank, MB, ACB, Techcombank, Maritimebank; (ii) Group 2 includes HDBank, PG Bank, Sacombank, and PvcomBank. Therefore, it can be said that the concentration level of loan portfolio by customers in both groups of commercial banks is quite high. 3.3. Current situations of risk management on loan portfolio in Vietnamese commercial banks 3.3.1. Regarding organizational structure of credit risk management on loan portfolios (i) Regarding the method of building the organizational structure of risk management on loan portfolios. The survey results show that 100% of commercial banks of both groups perform loan portfolio risk management under the centralization method of all contents, including risk identification, risk measurement, risk control and reporting. (ii) Regarding role of internal control department in the organizational structure of credit risk management on loan portfolio In fact, at all commercial banks in the research sample, there are clear internal regulations on the functions, tasks and powers of the internal control department in the credit risk management process. However, the actual effectiveness of internal control is assessed to be higher in commercial banks in group 1 compared to commercial banks in group 2. (iii) Regarding the reporting process among departments in the organizational structure of risk management on loan portfolios Firstly, with the report on credit risks to the SBV, commercial banks are all implementing the reporting regime prescribed by the SBV on each content and operation segment. Secondly, with internal reports on credit risk on the loan portfolios, these reports are 25 made at commercial banks on a quarterly basis or on an irregular basis. 3.3.2. Regarding risk identification of loan portfolios  Regarding information used to identify the ri