Introduction
Introduction
This chapter serves as an introductory overview of the research study, laying the groundwork for subsequent chapters and the overall study It aims to present a comprehensive picture of the research, structured into seven sections as illustrated in Figure 1.1.
Section 1.1 provides a general introduction to the chapter and section 1.2 examines the research background where the research problem is identified Section 1.3 defines the statement of the problem and scope of the study
Section 1.4 which includes two subsections 1.4.1 and 1.4.2 defines the research questions and research objectives Subsection 1.4.1 addresses the research questions that will be respectively answered in chapters of the study Subsection 1.4.2 presents research objectives that the study covers in the process of solving the research problem defined
Section 1.5 discusses the aspects of research methodology such as selecting from alternative types of research, research design and research techniques Section 1.6 points out the significance and scope of the study, and finally section 1.7 describes overall structure of the thesis
Section 3: Statement of the problem and scope of the study
Section 2: Rationale of the study
Section 4: Research questions and objectives
Section 7: Structure of the study Section 6: Significance of the study
Rationale of the study
To meet the evolving demands of customers, banks must diversify their services beyond traditional lending and borrowing, incorporating activities like payments, leasing, and investments Despite this shift, lending remains crucial, as it generates a significant portion of banks' revenue—over half of their total operating income, with institutions like BIDV relying on lending for approximately 70% of their earnings.
Banks primarily generate profit by managing credit risk rather than simply taking deposits and issuing loans Their core business involves taking calculated risks to ensure a favorable return that covers funding costs and sustains profitability Effective credit risk management is essential for banks to successfully collect interest and principal from loans.
Credit risk is primarily linked to banks due to their role as intermediaries that connect surplus fund holders with those in need of funds for investments Historically, financial crises have often stemmed from banks' inability to effectively manage credit risk, resulting in poor-quality loans and a high likelihood of customer defaults.
BIDV, one of Vietnam's four State Banks established during the early development of the banking system, has faced significant challenges in credit risk management, particularly due to government control over loan allocation However, since 2008, BIDV has successfully managed to reduce its non-performing loan ratio to below 3%, aligning with international standards This remarkable improvement, from a high of 38.3%, highlights the effectiveness of BIDV's credit risk management strategies and serves as a key focus of this study.
1.3 Statement of the problem and scope of the study
This study conducts with particular emphasis on why non-performing-loan ratio in BIDV has been rapidly reduced from 38.3% in 2004 to 2.82% in 2009
This research focuses on two key areas: the background of credit risk management and a case study of BIDV's approach to managing credit risk The first section provides essential insights into credit risk, its measurement, management strategies, and influencing factors The second section examines BIDV's efforts to reduce its non-performing loan ratio, including an overview of the bank, an analysis of its credit activities, and the application of credit risk management theories in practice It also considers four critical factors—credit information, technology, credit staff, and loan policy—during the period from 2004 to 2009, leading to the formulation of hypotheses This analysis highlights the significant achievements of BIDV in credit risk management.
Since 2009, BIDV has effectively managed credit risk in accordance with international standards, maintaining a non-performing loan ratio of under 3% This success can be attributed to several key factors, including the utilization of credit information, advanced technology, skilled credit staff, and robust loan policies, all of which significantly influence BIDV's credit risk management practices.
This study explores four key factors impacting credit risk management, supported by a review of relevant literature It analyzes BIDV’s credit practices to demonstrate how these factors effectively reduce the non-performing loan ratio Additionally, survey findings validate the relationships identified in the research.
Figure 1.2: Fields of the research problem
1.4 Research Questions and Research Objectives:
Research questions involve the research translation of “problem” into the need for inquiry (Zikmund, 1997, p.88) The research problem defined above leads to the following research questions:
• What are factors that influence non-performing-loan ratio in BIDV?
This study is conducted with the purpose of:
• To know the main factors leading to BIDV success in reducing non-performing loan ratio,
• To consider whether BIDV applies theory to manage its credit risk or not
This study investigates the impact of four key factors—credit information, technology, credit staff, and loan policy—on lowering the non-performing loan ratio at BIDV The researcher formulates hypotheses to confirm these influences.
H 1 : Credit information variable influences non-performing-loan ratio in BIDV
H 2 : Technology variable influences non-performing-loan ratio in BIDV
H 3 : Credit staffs variable influences non-performing-loan ratio in BIDV
H 4 : Loan policy variable influences non-performing-loan ratio in BIDV
The research methodology includes research design, data collection and data analysis
1.5.1 Research design: provide a road map of the whole research,
The researcher employs a mixed-methods approach, integrating both qualitative and quantitative data to address the study's objectives This includes analyzing numerical data such as BIDV's performance and business lending indicators, alongside non-numerical data from respondents' backgrounds and suggestions aimed at reducing the non-performing loan ratio.
According to G Zikmund (1997), the four fundamental research design techniques are survey, experiment, secondary data, and observation This study employs both survey and secondary data methods to achieve its objectives The survey method is utilized to gather primary data that identifies the four factors affecting the non-performing loan ratio at BIDV, while secondary data is essential for gaining insights into the credit risk landscape and assessing BIDV’s strategies for managing credit risk and reducing the non-performing loan ratio.
This study employs a perception survey to gauge respondents' feelings regarding the research problem, which inherently introduces subjective judgment into the findings To enhance the validity of the results, the researcher also incorporates secondary techniques to gather evidence that supports the research problem.
This section outlines the data collection methods employed, encompassing both primary and secondary sources Secondary data was gathered from various available resources, including books, prior research, BIDV’s annual reports, and financial journals and magazines In contrast, primary data was obtained through surveys and interviews conducted by the author.
Utilizing secondary data in research offers several advantages, including cost-effectiveness, as it is typically less expensive than gathering primary data Additionally, it saves researchers significant time in data analysis and interpretation In some instances, secondary data may be the only available resource from previous periods Moreover, secondary data is generally permanent and easily accessible, allowing for straightforward verification and collection by others (Zikmund, 1997).
There are many types of secondary data such as documentary secondary data, multiple source secondary data and survey based secondary data (Saunders, Lewis
This study primarily utilizes documentary secondary data, drawing from BIDV's internal materials, including regulations and annual reports accessed via the internet and intranet Additionally, it incorporates various written resources such as previous research, books, journals, newspapers, and magazines These secondary data sources are crucial for the research's foundation.
This study utilized various written materials, including previous research, books, financial magazines, and journals, to develop a comprehensive literature review Additionally, BIDV's annual reports and regulations, sourced from the official BIDV internet and intranet websites, were analyzed to offer a clear understanding of the bank's credit risk management practices.
Figure 1.3: Method of secondary data collection
Based on the above advantages of secondary data, the researcher decided to use secondary data as one of the sources of information in order to conduct this study
Methodology
The research methodology includes research design, data collection and data analysis
1.5.1 Research design: provide a road map of the whole research,
The researcher employs a mixed-methods approach, integrating both qualitative and quantitative data to comprehensively address the research questions This includes analyzing numerical data such as BIDV’s performance and business lending indicators, alongside non-numerical data that encompasses respondents’ backgrounds, positions, and their recommendations for reducing the non-performing loan ratio at BIDV.
G Zikmund (1997) identifies four fundamental research design techniques: surveys, experiments, secondary data, and observation This study employs both survey and secondary data methods The survey method is essential for gathering primary data to identify the four factors affecting the non-performing loan ratio at BIDV, while secondary data is crucial for understanding the credit risk landscape and assessing BIDV’s strategies in managing credit risk and reducing the non-performing loan ratio.
This study employs a perception survey to gauge respondents' feelings regarding the research problem, which means the findings are shaped by their subjective judgments To enhance the validity of the results, the researcher also incorporates secondary techniques to gather evidence that supports the research problem.
This section outlines the data collection process, which involved both primary and secondary sources Secondary data was gathered from various resources, including books, prior research, BIDV's annual reports, and financial journals and magazines In contrast, primary data was acquired through surveys and interviews conducted by the author.
Utilizing secondary data in research offers several advantages, including cost-effectiveness, as it is typically less expensive than gathering primary data Additionally, secondary data allows researchers to save significant time on data analysis and interpretation In certain situations, it may be the only available resource from previous periods Furthermore, secondary data is usually permanent and easily accessible, making it convenient for verification and collection by others (Zikmund, 1997).
There are many types of secondary data such as documentary secondary data, multiple source secondary data and survey based secondary data (Saunders, Lewis
This study primarily utilizes documentary secondary data sources, including internal materials from BIDV such as regulations and annual reports obtained from its internet and intranet platforms Additionally, it incorporates other written resources like previous research, books, journals, newspapers, and magazines These secondary data sources serve as crucial foundational elements for the research.
This study utilized a comprehensive literature review based on various written materials, including previous research, books, financial magazines, and journals Additionally, BIDV's annual reports and regulations, sourced from the official BIDV internet and intranet websites, were analyzed to present a detailed overview of BIDV's credit risk management practices.
Figure 1.3: Method of secondary data collection
Based on the above advantages of secondary data, the researcher decided to use secondary data as one of the sources of information in order to conduct this study
In addition to utilizing secondary data, the researcher collects primary data to understand respondents' perceptions regarding the study's problem This research aims to identify the factors contributing to BIDV's success in credit risk management Consequently, the target population for this study consists of all BIDV credit staff engaged in lending-related activities.
Due to constraints in time and financial resources, this study will not be able to gather data from the entire population of BIDV credit staff Instead, it will focus on a sample size of 100 individuals, comprising 20 managers and vice managers, along with 30 leaders from the credit department.
Previous researches, books, journals, newspapers
Annual reports, regulations (BIDV internal data)
Figure 1.4: Population, sample and sampling methods
The quota sampling technique is employed in this study due to its benefits in terms of time efficiency, cost-effectiveness, and convenience This method involves three key steps that facilitate the sampling process.
The population of BIDV credit staff is categorized into three key groups: managers and vice managers, leaders of the credit department, and credit officers This classification reflects the researcher's assessment that individuals in higher positions tend to have a more rational perspective.
In this study, the sample composition is strategically designed, with managers and vice managers representing 20%, credit leaders at 30%, and credit officers making up 50% of the total sample This distribution is guided by the researcher's judgment established in the initial phase As this is a perception survey, the results are shaped by the subjective opinions of the respondents, with a significant portion of the sample consisting of high-ranking credit staff The researcher benefits from their affiliation with BIDV, facilitating communication with managers, vice managers, and credit department leaders regarding the research objectives.
In this study, the proportion of credit officers in the sample is only 50%, compared to 90% in Chau's (2009) research This discrepancy is the primary reason for the researcher to retest the four hypotheses established by Chau (2009).
The study utilizes a fixed quota sample of 100 respondents, which includes 20 managers or vice managers, 30 credit department leaders, and 50 credit officers, ensuring a ratio of over five times the number of observed variables This sample size was determined based on insights from previous research, including the works of Tho & Trang (2008) and Trong & Ngoc (2008).
To obtain the desired sample size, a total of 150 self-administered questionnaires were distributed to the respondents by the researcher Of these, 100 questionnaires were returned making effective response rate 67%
This study employs two primary data collection techniques: interviews, including both telephone and face-to-face formats, and self-administered questionnaires The interview method is specifically utilized to gather responses from a group of managers, while the self-administered questionnaires are designed to capture additional data from participants.
30 staffs questionnaire is used to collect response of credit department leader group and credit officer groups
Before conducting survey, the researcher carries out depth-interview and pretest in order to increase quality of data collection
Significance of the study
This study helps readers realize the crucial importance of credit risk management and know the main factors that influence the reduction of non-performing-loan ratio in BIDV.
Structure of the study
Chapter 3: Case study of BIDV
Chapter 4: Data analysis and findings
The primary objective of this study is to analyze how credit information, technology, loan policies, and credit staff contribute to lowering the non-performing loan ratio at BIDV In addition to the first chapter, the study is structured into five additional chapters that further explore this topic.
Chapter 2: Literature Review: This chapter will provide general theories related to credit risk management Furthermore, the researcher’s insights on these theories will also be discussed
Chapter 3: Case study of BIDV: This chapter provides an overview of bank for investment and development of Vietnam (BIDV) and BIDV’s credit risk management is the main part of this chapter
Chapter 4: Data analysis and findings: analyzing the collected data in order to get results to test the hypotheses and answer the research questions in chapter one
Chapter 5: Recommendation and conclusion: based on these analysis and findings from chapter five, some suggestions or recommendations about the credit risk management strategies that BIDV can adopt to manage credit risk will be given.
Literature review
Introduction
This chapter introduces the literature on the primary operations of commercial banks, focusing on credit risk associated with lending activities It examines both external factors, such as financial deregulation, supervisory changes, competition, and recent financial crises, as well as internal factors like information systems, loan policies, credit staff, and technology that influence credit risk levels The significance of credit risk measurement is also highlighted, as excessive credit risk can undermine not only a bank's profitability but also the stability of the entire banking system and the global economy The recent financial crisis exemplifies this, showcasing how rising risks in banks contributed to a global recession and economic downturns across various countries Consequently, it is crucial for banks to prioritize credit risk management and implement effective strategies to mitigate potential credit losses.
Basic functions of banks
A bank is an organization that facilitates banking activities by accepting deposits and providing loans It plays a crucial role in the payment system, acts as an intermediary between depositors and borrowers through various deposit and loan products, and offers a wide range of financial services, including fiduciary services, investment banking, and off-balance sheet risk management.
Banks primarily function as intermediaries, channeling funds from depositors who have surplus money to borrowers in need of financial resources This essential role of mobilizing and lending funds highlights the critical connection between those who save and those who seek to borrow, facilitating economic activity and growth.
Lending business
2.3.1 The board of directors written loan policy
According to Benton E.Gup & James W.Kolari (Commercial banking, 2005, p250-
The board of directors of a bank holds ultimate responsibility for all loans issued by the institution To effectively manage this responsibility, the board must implement a written loan policy that outlines the guidelines and principles governing the bank's credit risk strategies This credit risk strategy should align with the bank's objectives of maintaining credit quality, achieving earnings, and fostering growth, thereby addressing the essential risk/reward tradeoff.
Loan policies differ significantly between banks, with small local banks having distinct guidelines compared to large banks focused on business lending Regardless of size, all banks emphasize the importance of making sound and profitable loans A crucial aspect of any loan policy is the requirement for a clear repayment plan to be established at the time the loan is issued Additionally, loan policies encompass various other elements that govern the lending process.
• Loan authority: Who has the authority to make loans; the lending limits relative to capital, deposits, or assets; the lending approval process
A bank's loan portfolio encompasses various types of loans, including consumer loans, startup business loans, large business loans, farm loans, and international loans It is essential for the lending policy to establish limits on the concentration of specific loan types to ensure a balanced and diversified portfolio.
The geographical boundaries of a bank's lending area significantly influence its operations, as research shows that 97 percent of small and medium-sized businesses typically seek financial services from institutions located within 30 miles of their main office.
• Policies for determining interest rates, fees, and contractual terms of the loans
• Limits and guidelines for off-balance sheet exposures from loan commitments, letters of credit, securitized loans, and derivative products (swaps, options, and futures, etc.)
• A loan review process to evaluate lending procedures and the quality of the loan portfolio
The lending procedure is the method by which banks assess borrowers' financial conditions and creditworthiness before granting loans (Rose & Hudgins, 2008) While various banks may utilize distinct approaches for their final lending decisions, they typically adhere to a standardized process that involves several key steps (Hempel & Simonson, 1999).
Step 1: Receiving application: Customers including individuals and corporations apply for a loan from banks by filling out a loan application
Step 2: Evaluating application: Bank credit officers evaluate the loan application
To effectively evaluate loan requests, banks assess customers' character and borrowing intentions through interviews Additionally, they can access existing customer information and credit histories from their own databases Other banks and credit information agencies also serve as valuable resources for gathering comprehensive credit data on potential borrowers.
Step 3: Lending decision: Refusing application or Granting credit
If credit officers determine that a customer does not meet the eligibility criteria for a bank loan, they will reject the loan application Following this decision, credit officers are required to formally communicate the status of the loan application to the customer within a specified timeframe.
When a loan application meets the bank's criteria, a loan agreement is created and signed by the customer and an authorized bank officer It is essential to consider additional activities upon signing the agreement, including verifying and securing the collateral, which may consist of property or other assets.
Step 4: Monitor loan: After granting credit, credit officers must monitor customers in order to ensure that customers use the loan accordingly with the purpose stated on the loan agreement In addition, as credit officers can quickly assess customers’ financial condition or their ability to pay the loan back by a proper monitoring process, banks managers and credit officers who are aware of the importance of this process can effectively help preventing their banks from credit losses
Step 5: Collecting loan: The duty of credit officers has not finished upon granting the loan to customers Their last and important mission is to collect debt and liquidate credit agreement However, one of four things can happen to an outstanding loan: (1) It can be repaid on schedule; (2) It can be renew and extend;
The bank has several options regarding the loan, including selling it to another investor or facing potential default, which could lead to financial losses While selling the loan and avoiding default are favorable outcomes, the possibility of default represents the most significant risk for the bank.
Before granting loans, banks assess the creditworthiness of potential borrowers by evaluating their character, financial status, and repayment capability Upon approval, the terms of the loan—including the credit facility, borrowed amount, loan duration, repayment method and schedule, interest rate, fees, collateral requirements, and borrower covenants—are formalized in a loan agreement Post-approval, banks are responsible for monitoring the loan to ensure repayment, with the ideal scenario being full repayment and the worst-case scenario resulting in a charge-off as a loss.
Credit risk in banks
Banking involves the strategic management of risk, as banks take on risks to generate profits By balancing various strategies based on their risk and return profiles, banks aim to maximize shareholder wealth effectively.
Jane E Hughes and Scott B MacDonald (2002) emphasize that a banker’s role is centered around managing, rather than avoiding, risk Banks encounter various risks in their operations, including credit risk, market risk, liquidity risk, interest rate risk, and operational risk Among these, credit risk is particularly significant, as it is closely linked to the primary functions of modern banks, which involve lending and borrowing.
Credit risk, as defined by Benton E Gup et al (2005), refers to the potential that a borrower will not fulfill their repayment obligations This risk encompasses various financial activities, including loans, derivatives, foreign exchange transactions, and investment portfolios Understanding credit risk is essential for banks to manage their financial exposure effectively.
This study focuses on credit risk specifically related to bank lending activities Credit risk arises when borrowers default on their loans, leading to potential losses for lenders If borrowers repay the full principal and interest on time, banks incur no credit risk However, if borrowers only make partial payments, regardless of their willingness or ability to repay, banks are exposed to credit risk, increasing the likelihood of financial loss.
Effective credit risk management is essential for safeguarding banks' lending activities and overall operations from potential failures Given their significant impact on the economy and society, banks are deemed too important to fail The collapse of a single bank can lead to severe repercussions for households, corporate sectors, and the economy at large.
The interconnectedness of banks means that the failure of one institution can have a ripple effect, impacting others both nationally and globally, as evidenced by the recent subprime mortgage crisis in the U.S When funds cease to flow into a troubled bank, it can lead to a shortage of liquidity for other banks that have financial ties, such as placements or credit positions, with the failing entity This systemic risk highlights the vulnerability of the banking sector to crises.
The challenges faced by other banks mentioned earlier could trigger a domino effect, ultimately threatening the stability of the entire banking system, reminiscent of the recent financial crisis (Yehning, Hasan & Iftekhar 2008).
In market-oriented economies, banks play a crucial role by facilitating the flow of funds from savers to individuals and businesses with investment opportunities This function enhances the efficiency of capital allocation within the economy, ensuring that financial resources are directed toward productive uses.
Effective bank operations enhance the flow of funds and increase funding opportunities for profitable projects However, challenges faced by one or a few banks can escalate into systemic issues affecting the entire banking sector, global economy, and society This could lead to savers losing their savings and interest-earning potential, while entrepreneurs miss out on investment opportunities, ultimately hindering economic development and job creation Therefore, credit risk management is crucial not just for individual banks, but for the stability of the entire banking system and the broader economy.
In 2005, the governor of the State Bank of Vietnam (SBV) issued a decision regarding loan classifications and the provisioning for bad debts within credit institutions This regulation categorizes loan portfolios into five groups based on the overdue indicators of debts, as outlined in Article Six.
Group 1, known as standard debts, comprises overdue debts that credit institutions assess as fully recoverable in terms of both principal and interest upon maturity Debts in this category do not require provisioning, maintaining a 0% provisioning rate.
Group 2 consists of debts that require attention, specifically those that are overdue for less than 90 days and rescheduled debts that are currently not due under the new terms These debts should be provisioned at a rate of 5%.
Group 3, categorized as sub-standard, encompasses debts that are overdue for a period ranging from 90 to 180 days, as well as rescheduled debts that are overdue for less than 90 days in accordance with their new terms It is essential to provision this group at a rate of 20%.
- Group 4 (doubtful debts): includes debts overdue for between 181 and 360 days and rescheduled debts that are overdue for between 90 and 180 days
1Decision 493/2005/QD-NHNN dated 22 April 2005 according to the rescheduled terms This group is subject to a provisioning rate of 50%;
Group 5 consists of debts classified as potentially irrecoverable principal, which includes overdue debts exceeding 360 days, debts frozen due to government intervention, and rescheduled debts that have now been overdue for more than 180 days as per their revised terms All debts in this category must be fully provisioned at 100% For debts frozen by the government, specific provisions will be established based on the financial capacity of the credit institution.
According to Article Seven of the decision, credit institutions may classify loans according to their credit rating system, provided that their risk provision policy has been approved by the State Bank of Vietnam (SBV) In this context, the loan portfolio is categorized into five distinct groups.
Credit risk measurement
According to Anthony Saunders (2002, p.9), distinguishing between traditional and modern approaches can be challenging, as many effective concepts from traditional models are incorporated into contemporary frameworks.
The traditional approach is comprised of four classes of models
In an expert system, the branch lending officer plays a crucial role in making credit decisions, relying on their expertise and judgment to evaluate various factors Key to this process are the five "Cs" of credit assessment: character, capital, capacity, collateral, and economic cycle These elements are essential for determining the eligibility and risk associated with loan applications.
1 Character: A measure of the reputation of the firm, its willingness to repay, and its repayment history In particular, it has been established empirically that the age of a firm is a good proxy for its repayment reputation
2 Capital: The equity contribution of owners and its ratio to debt (leverage)
These are viewed as good predictors of bankruptcy probability High leverage suggests a greater probability of bankruptcy
3 Capacity: The ability to repay, which reflects the volatility of the borrower’s earnings If repayments on debt contracts follow a constant stream over time, but earnings are volatile (or have a high standard deviation), there may be periods when the firm’s capacity to repay debt claims is constrained
4 Collateral: In the event of default, a banker has claims on the collateral pledged by the borrower The greater the priority of this claim and the greater the market value of the underlying collateral, the lower the exposure risk of the loan
5 Cycle (or Economic) Conditions: The state of the business cycle; an important element in determining credit risk exposure, especially for cycle- dependent industries For example, durable goods sectors tend to be more cycle-dependent than nondurable goods sectors Similarly, industries that have exposure to international competitive conditions tend to be cycle- sensitive Taylor (1998), in an analysis of Dun and Bradstreet bankruptcy data by industry (both mean and standard deviation), finds some quite dramatic differences in U.S industry failure rates during the business cycle
In addition to the 5 Cs, an expert may also take into consideration the level of interest rate
Many computerized expert systems are time-consuming and prone to errors, prompting the use of induction to replicate human decision-making processes Artificial neural networks have emerged as a viable solution, effectively simulating human learning These networks learn the relationships between inputs and outputs by continuously sampling and analyzing input/output data.
An internal rating system is essential for financial institutions to effectively manage and mitigate credit risks associated with lending activities By categorizing the creditworthiness of borrowers and assessing the quality of credit transactions, these institutions can enhance their loan origination and monitoring processes This systematic approach not only supports better decision-making but also promotes overall financial stability.
Banks have refined the classification of pass/performing loans, recognizing that there is always a risk of default, which necessitates the maintenance of reserves To manage this risk effectively, banks have implemented internal rating systems that evaluate loans on a scale of 1 to 9 or 1 to 10.
Bond Rating Score Risk Level
Table 2.2: Example of a loan rating system and bond rating mapping
Source: Adapted from Saunders A & Allen L, 2002
Credit scoring, as defined by Benton and James (2005), utilizes statistical analysis, operational research, and data mining techniques to assess the credit risk associated with potential borrowers This process generates a credit score, a numerical representation of an individual's creditworthiness, typically calculated by credit bureaus or companies like Fair Isaac Corporation, which provides the widely recognized FICO score These scores play a crucial role in informing credit decisions and various financial assessments.
The advantages of using credit scoring model are that they reduce the cost of evaluating credit and increase the speed, consistency, and accuracy of credit decisions
Credit scores reflect the historical financial behavior of similar borrower groups, with higher scores indicating lower credit risk Each lender establishes its own thresholds based on acceptable risk levels, often utilizing a specific rating system to assess potential borrowers.
• FICO scores of 720 and above: Excellent credit
• 584 and below: Very-high-risk-credit
Adapted from Anthony Saunders (2002), VAR is a technique used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatilities
Value at Risk (VaR) helps financial institutions assess their potential exposure to significant loan losses by addressing critical questions such as, "What is my worst-case scenario?" and "How much could I lose in an exceptionally bad month?"
A Value at Risk (VAR) statistic consists of three key components: a specified time period, a confidence level, and a defined loss amount or percentage Understanding these elements is crucial as we explore various examples of the questions that VAR can address.
• What is the most I can - with a 95% or 99% level of confidence - expect to lose in default on loan repayment over the next month?
• What is the maximum percentage I can - with 95% or 99% confidence - expect to lose over the next year?
Since the 1980s, banks have effectively utilized modern portfolio theory (MPT) to address market risk, employing earnings at risk (EAR) and value at risk (VAR) models for managing interest rate and market risk exposures However, despite credit risk being the predominant challenge for most banks, the application of MPT to credit risk has not kept pace Acknowledging the detrimental effects of credit concentrations on financial performance is crucial for banks in their risk management strategies.
Sophisticated institutions are increasingly adopting quantitative methods for credit risk measurement, despite ongoing data challenges Significant advancements are being made in developing tools for assessing credit risk within a portfolio framework Additionally, the use of credit derivatives allows for efficient risk transfer while maintaining customer relationships Together, these developments have led to rapid progress in managing credit risk in a portfolio context in recent years.
External factors that affect the level of credit risk
Financial deregulation is defined by Casu, Girardone and Molyneuz (2006, p.37) as:
The removal of regulations that once safeguarded financial institutions, particularly banks, marks a significant shift in the banking landscape Historically, governments imposed strict regulations to maintain stability within the domestic banking system and shield local banks from foreign competition through complex barriers However, with the advent of globalization, banks are increasingly operating beyond their national borders, rendering traditional government controls potentially detrimental in today's highly competitive banking environment Consequently, financial deregulation has become an unavoidable trend in the contemporary banking sector.
Financial deregulation offers numerous advantages but also presents significant challenges The reduction of government oversight grants banks greater autonomy in their operations, yet this newfound freedom comes with the responsibility of managing risks independently Consequently, many modern banks face heightened risks as they may misuse their autonomy by extending credit to high-risk businesses.
Re-regulation is defined as: The process of implementing new rules, restrictions and controls in response to market participants efforts circumvent existing regulations (Casu, Girardone and Molyneuz, 2006, p.38)
The deregulation process has led to a heightened level of credit risk within the banking system In response, governments worldwide, as noted by Hubbard (2008), are actively seeking to regulate financial markets and institutions to mitigate these risks.
• Ensuring that all participants in the financial system have the opportunities to access to timely and accurate information in order to make their financial decisions
• Maintaining the stability and safety of the overall banking sector by preventing the failures of banks
In July 2008, the Group of Thirty (G30), comprising financial experts from public, private, and academic sectors, launched a project titled “Financial Reform: A Framework for Financial Stability.” This initiative aimed to analyze the global financial crisis and highlighted the crucial role of supervisory systems and central banks in managing credit risk to maintain the stability of the global banking system (Williams 2009).
Prior to deregulation, governments in many countries exerted significant control over the banking sector, shielding domestic banks from competition, particularly from foreign institutions This regulation aimed to maintain the stability of the banking system and mitigate the risk of banking crises (Lange et al 2007).
The role of competition in enhancing the stability of the banking system is a topic of debate among experts Researchers such as Smith (1984), Keeley (1990), and Repullo (2004) argue that increased competition encourages banks to engage in riskier business practices Conversely, theoretical studies by Caminal and Matutes (2002) and Mishkin (1999) suggest a different perspective, indicating that competition may have varying effects on banking stability.
The concentrated banking system is more likely to encourage risk-taking behavior among bank managers, who may rely on government bailouts in case of failures While this perspective is valid, evidence from the recent financial crisis supports the argument that increased competition leads to higher levels of credit risk in the banking sector As banks lose their lending power to the commercial paper market and securitization, they face threats to their profitability and market position Consequently, banks are compelled to engage in riskier ventures, such as subprime mortgage loans and credit cards, complicating their lending operations and making it more challenging to monitor and control risks effectively.
Internal factors that affect the level of credit risk
The recent financial crisis that originated in the U.S has significantly impacted the global financial system and the world economy Key effects include the collapse of the housing market, a slowdown in global economic growth, challenges within the financial system, and increasing unemployment rates These issues stem from elevated credit risk levels in banks, prompting financial experts and stakeholders worldwide to prioritize risk management, particularly in credit risk management within the banking industry (Brown & Davis 2008).
2.7 Internal factors that influence NPL ratio
Chau (2009) proposed a credit risk management strategy model for Vietnamese banks, emphasizing four crucial factors: the necessity of accurate and timely credit information, the importance of skilled and ethical banking staff, the need for significant investment in technology and innovation, and the establishment of a clear and effectively communicated loan policy.
Credit information that banks collect for making lending decisions is in terms of borrower’s characteristics, loan purposes, the primary and secondary sources of loan repayment (Sinkey 1998)
Access to timely and accurate credit information is essential for banks in their lending practices, as it enables them to assess a loan applicant's willingness and ability to repay This information plays a critical role in reducing credit risk by ensuring that loans are granted to suitable customers Without reliable credit data, banks face challenges in making informed lending decisions, which can lead to outdated and inaccurate assessments Consequently, poor lending choices can negatively impact a bank's assets and profitability, highlighting the importance of maintaining up-to-date credit information.
In their 2005 work "Commercial Banking," Benton E Gup and James W Kolari discuss the significant impact of asymmetric information on credit risk management Asymmetric information refers to the imbalance of information between banks and borrowers, where borrowers possess more knowledge about their financial situations than banks do This disparity often leads banks to inadvertently attract higher-risk borrowers, a phenomenon known as adverse selection Furthermore, once a loan is issued, asymmetric information can create a moral hazard, where borrowers may engage in riskier activities with the loan funds, hoping for greater returns Such higher-risk behaviors can subsequently elevate the likelihood of loan defaults.
Chau (2009) identified four key aspects of credit information that significantly enhance the capacity of Vietnamese banks to manage credit risk: the impact of credit information, the sources from which it is obtained, the sharing of credit information, and the processes for checking this information.
Hempel and Simonson (1999) emphasize the importance of banks having dependable credit information sources to enhance credit quality and risk management Banks can gather credit information from three primary sources: customers, internal bank records, and external institutions However, challenges may arise in the process of collecting data from these sources.
Lending practices often reveal a conflict of interest between banks and borrowers, as borrowers typically possess a deeper understanding of their financial circumstances This knowledge disparity can lead some borrowers to hide critical financial information to secure loans, putting banks at risk of making poor judgments based on incomplete data.
Banks can gather credit information from their internal databases when borrowers have an existing relationship with them However, significant investment in technology upgrades is required for banks to effectively store and analyze this internal data Additionally, since this information is supplied by borrowers, banks must diligently verify its accuracy and timeliness.
Banks can enhance their lending decisions by gathering information from external sources like suppliers, credit rating agencies, and other financial institutions While this approach offers valuable insights, it also poses the risk of relying on potentially inaccurate third-party data, which could complicate the decision-making process.
The evolution of technology is revolutionizing the banking sector, particularly in lending practices Banks increasingly utilize advanced technology to store, transmit, and analyze credit information, enhancing their lending decisions Today, statistical techniques play a crucial role in accurately predicting the likelihood of customer defaults, making consumer loan decisions more reliable Consequently, the credit analysis process has become faster and more efficient, thanks to technological advancements (Ritter, Silber & Udell 2000).
The banking industry heavily relies on information technology due to its specialized products and services that manage substantial amounts of customer funds and sensitive data As a result, financial institutions globally invest billions of dollars each year in enhancing their technological infrastructure and computer systems to gain a competitive edge.
Technology streamlines manual processes and enhances the efficient management of information, enabling banks to reduce operating costs while boosting staff productivity and accuracy This leads to increased profitability for financial institutions Additionally, technology serves as a vital risk management tool, effectively collecting, storing, processing, and transmitting customer data—such as age, occupation, family size, and income By leveraging these capabilities, banks can significantly mitigate credit risk through well-managed customer information.
Chau (2009) identified four key aspects highlighting the significance of technology in the banking sector: the impact of technology, the frequency of maintenance, the level of investment in technology, and the alignment of banks' growth with modern technological advancements These factors collectively enhance the capacity of Vietnamese banks to effectively manage credit risk.
In today's economy, competitive advantage hinges on human knowledge rather than machines or manual labor Skilled employees contribute significantly to a bank's intellectual capital, influencing its success or failure (Lengnick & Cynthia, 2003) In lending activities, even the latest technologies, well-defined loan policies, and extensive credit information are ineffective without the ability to recruit and retain ethical and skilled employees.
Ethics, as defined by Blumberg, Cooper, and Schindler (2005, p.92), refers to the moral principles, norms, and standards that guide our decisions and interactions with others Essentially, ethics serves as a framework that shapes and influences individual behavior.
Summary
This chapter integrates the theoretical aspects of credit risk management, offering readers a comprehensive overview of its key functions within banks, the lending process, and the factors influencing credit risk levels It also highlights four essential internal factors in credit risk management: credit information, technology and innovation, loan policy, and the ethics and skills of credit staff Overall, this literature review serves as a foundational step, equipping readers with the necessary knowledge for the subsequent chapters.