Literature Review
Bank capital, from an accounting perspective, is defined as the value of a bank's assets minus its liabilities, reflecting its equity value to investors and serving as the bank's net worth to absorb potential losses Under Basel II regulations, bank capital is categorized into different tiers.
- Tier 1 capital includes shareholder’s equity and retained earnings, and it is the main source that banks use to absorb losses without interrupting business operations
Tier 2 and Tier 3 capital serve as supplementary sources to Tier 1 capital, though they carry lower reliability This includes components like revaluation reserves, capital surplus, general loss provisions, and additional capital from instruments such as convertible bonds, preferred shares, and short-term debt.
Capital Adequacy Ratio (CAR) is a crucial indicator of commercial banks' ability to manage risks and reflects their financial strength In Vietnam, achieving a satisfactory CAR is essential for banks to maintain sound operations, enhance risk tolerance against market fluctuations, and boost profitability Numerous studies have explored the connection between capital levels and bank performance, revealing mixed results regarding the relationship between risk, profitability, and capital, as noted by Aggarwal and Jacques (2007).
The Basel Accord mandates that banks maintain a minimum capital level aligned with their financial health, which the Bank for International Settlements (BIS) views as beneficial for the economy This capital regulation strengthens banks' resilience against losses from various exposures, including credit, operational, and market risks Scholars such as Dowd (1999), Choi et al (2000), Mpuga (2002), and Angelini (2015) argue that the Accord enhances the safety and soundness of the banking industry by enabling banks to bolster their capital reserves, allowing them to navigate potential financial crises more effectively.
Numerous reports from commercial banks across various countries indicate a positive relationship between capital regulation requirements and profitability levels Notably, Berger (1995) established a strong positive correlation between capital adequacy ratio (CAR) and earnings, specifically return on equity (ROE) and return on assets (ROA), in the U.S banking sector using a two-variable empirical model Similarly, Caprau and Ihnatov (2014) found that higher CAR leads to increased profitability in Eastern European banks In contrast, Munene (2006) examined Indian financial institutions and identified a positive but weak relationship between capital and profitability, concluding that profitability is a minor determinant of capital structure.
The proponents of capital regulation who claimed that higher capital would result in higher profitability are including Abreu and Mendes (2001), Flamini et al (2009) , Hutchinson and Cox (2006), Lee and Hsieh (2013)
A study by Lee and Hsieh (2013) analyzed 42 banks in Asia from 1994 to 2008, revealing that neglecting influencing factors leads to a significantly positive effect of increased bank capital on profit and a negative effect on risk Similarly, Ahmed et al utilized a multivariate panel OLS regression model to assess the profitability of commercial banks in Bangladesh, considering key variables such as asset turnover, firm size, and capital adequacy ratios Their findings indicate that capital adequacy requirements may positively influence the profitability of these banks.
Research on the relationship between capital and profitability has yielded inconsistent findings Several studies indicate a negative correlation between capital requirements and profitability risk Notably, Benmanke and Gertler (1995) concluded that strict capital regulation negatively impacts bank performance Similarly, Jackson et al (1999) observed the same trend in their analysis of the banking sectors in Germany, Canada, Holland, Japan, and England.
In the United States and Switzerland, banks face capital regulations that require them to maintain equity levels above demand, which can hinder short-term profits and growth Blum (1999) noted that this requirement leads to reduced profitability, prompting banks to pursue higher-risk assets to enhance their profit margins.
In Vietnam, research by Le and Nguyen (2017) indicated a significant positive correlation between return on assets and the capital adequacy ratio (CAR) at a 10% significance level Conversely, Dao and Ankenbrand (2014) found a significant negative relationship between return on equity and return on total assets with CAR, based on data from eleven Vietnamese commercial banks from 2008 to 2013 Additionally, Nguyen, Ta, and Nguyen (2018) highlighted that new regulations requiring banks to increase CAR from 8% to 9% could have adverse effects Their study revealed that while Vietnamese banks leverage high capital adequacy to attract more stable, lower-yield deposits and improve their net interest margin (NIM), they struggle to enhance their return on equity (ROE) This challenge is partly attributed to the difficult economic period faced by Vietnamese banks, which saw declining growth rates and led corporations to hesitate in making business investments.
Objectives of the Study
This study examines the adoption and implementation of Basel II in Vietnam, aiming to establish the relationship between profitability and capital adequacy of Vietnam commercial banks
This paper analyzes Vietnam's domestic regulatory efforts for implementing international frameworks, highlighting the discrepancies between the intended objectives and the actual situation on the ground.
Specifically, the study shall address the following questions:
• What is the current situation of capital adequacy in Vietnam commercial banks?
• What is the relationship between Capital Adequacy and Profitability?
• What should commercial banks do to facilitate their capital?
Structure of the Study
New Basel Capital Acord (Basel II) overview
1.1.1 Brief history of Basel Acord
Established in 1974 by the Central Bank of the G10 countries, the Basel Committee on Banking Supervision (BCBS) serves as a platform for cooperation on banking supervision After six years of negotiations, the Committee introduced the Basel Capital Accord (Basel I) in 1988, which set capital standards aimed at mitigating risks in banking operations and enhancing global risk management practices Implemented in G10 countries since 1992, the accord has also been adopted voluntarily by other nations The capital adequacy ratio (CAR) guidelines indicate that a CAR above 10% is optimal, above 8% is appropriate, below 8% is insufficient, below 6% is clearly insufficient, and below 2% is seriously insufficient.
The Basel I regulations, initially introduced to both G10 and over 100 non-G10 countries, faced criticism from the industry and regulators for failing to adapt to the rapid evolution of the global financial system and banking sector In response, these regulations underwent a comprehensive review and modification, culminating in the release of Basel II in June 2004 Basel II was officially implemented in January 2007 and achieved full compliance by 2010.
The new framework offered a greater degree of flexibility in risk measurement for banks and supervisors to blend in with diversified banking systems across the globe
It also attempts to broaden the scope of risk assessed by adding operational and market risk when calculating Captial adequacy ratio and upgrade the framework to a more
8 comprehensive level by placing more stress on banks’ internal risk-assessment in practice and market discipline
Basel II is the second revision of the Basel Accord, which outlines the recommendations on banking laws and regulations of the Basel Committee on Banking Supervision In addition to the initial purposes of 1974 Accord, two new goals have been added: one was to constitute a more comprehensive approach to address risks, the other was to maintain the consistency of regulations for banks from varying levels of complication and sophistication However, the complexity of the New Accord along with its interdependence with the International Financial Reporting Standards (IFRS) and the diverse banking regulations all around the world make the Basel II capital accord more idealistic, albeit challenging for international banks to comply
The Basel Accord aims to establish a benchmark for assessing the health of financial institutions, safeguard depositors, and enhance the stability of global banking systems while ensuring fair competition among banks in the international market Basel II represents a significant evolution in risk management and assessment, moving beyond simple solvency standards To achieve these objectives, the Basel Committee has developed a comprehensive measurement framework structured around three core pillars.
Under Basel I, the minimum required capital ratio is set at 8%, with risk assessment based on three primary factors: credit risk, operational risk, and market risk While advancements have been made in measuring credit risk, the methodology for calculating market risk has seen only minor adjustments, and operational risk has been introduced as a completely new component in the framework.
Credit risk can be assessed using three progressively complex methods: the Standardized approach, Foundation Internal Ratings-Based (FIRB), and Advanced Internal Ratings-Based (AIRB) Operational risk is evaluated through three approaches: the Basic Indicator Approach (BIA), the Standardized method, and the Advanced Measurement Approach (AMA) For market risk, the Value at Risk (VaR) method is the preferred approach.
Basel II enhances bank policy-making tools compared to Basel I, offering a comprehensive management framework for various risks associated with bank portfolios, including concentration and liquidity Consequently, banks must implement capital assessment procedures and strategies to uphold their capital levels, ideally operating above the minimum capital ratios Furthermore, it is essential for supervisors to regularly review the internal capital assessment processes and develop early intervention strategies to prevent capital from dropping below the required minimum.
Banks must enhance transparency by publicly disclosing essential information about their business operations, risks, and risk management strategies This includes both qualitative and quantitative data, such as capital structure, capital adequacy levels, and assessments of credit, operational, and market risks Such transparency is viewed as a fundamental requirement for the effective functioning of banking operations in accordance with market principles.
Theoretical background of risk management and Bank profits
1.2.1 Risk and risk management in commercial banks
According to the "Commercial Banking Management" textbook from the Banking Academy of Vietnam, risk is defined as unforeseen events that negatively impact entities In the banking sector, such risks can result in decreased revenue or financial instability Furthermore, Basel standards indicate that banks may face unexpected losses, underscoring the importance of maintaining revenue levels above these potential losses.
The banking sector faces unique and complex risks that can lead to significant losses Key factors contributing to these risks include credit risk, interest rate risk, foreign exchange risk, liquidity risk, and operational risk Additionally, less common risks such as legal and reputation risks also play a role Overall, banking risks are typically categorized into three main types: credit risk, market risk, and operational risk.
Market risk refers to the potential losses on a balance sheet caused by price fluctuations, encompassing four primary types of risk: interest rate risk from changes in interest rates, capital risk from stock price variations, exchange rate risk due to foreign currency price changes, and commodity risk linked to commodity price shifts The Basel Committee's "Amendment to the Capital Accord to incorporate market risks," adopted in October 2005, outlines the rules for calculating minimum capital requirements related to these risks.
Operational risk encompasses losses stemming from internal processes, human errors, systematic failures, and external incidents, including legal risks, while excluding strategic and brand risks As banking operations grow increasingly complex, it is essential to adopt more sophisticated methods; however, once a bank has been approved for advanced methods, it cannot revert to simpler approaches Conversely, if a bank is deemed ineligible to continue using advanced methods, it must revert to basic methods until it meets the necessary requirements.
Credit risk refers to the potential for financial losses when a borrower defaults on their obligation to repay either the principal or interest on a loan This risk is crucial for lenders to assess, as it directly impacts their financial stability and profitability.
Under Basel II, banks can utilize an advanced internal credit rating-based approach to assess outstanding loans, default probabilities, effective maturity periods, and credit loss proportions, enabling them to calculate their risk-weighted assets However, to implement this method, banks must obtain approval from regulatory bodies like state banks This internal ranking system establishes varying minimum capital requirements for loans extended to different customers.
Organizational structure of Risk management
The construction of risk management structures in banks varies significantly based on each country's unique banking system characteristics, human resources, and operational conditions Effective risk governance relies on a robust organizational framework that extends from the Board of Directors to the Board Risk Committee, Chief Executive Officer, Chief Risk Officer, Credit Committee, and Asset-Liability Committee, ensuring a comprehensive approach to risk management at all organizational levels.
This backbone is reinforced by other related departments such as the Compliance, Legal, Financial Control, Treasury, Internal Audit departments, etc
In Vietnam, the prevalent risk management approach is the "three lines of defense" model, which mandates participation from all bank departments in the risk management process This inclusive strategy ensures that all risks associated with a bank's operations are thoroughly identified, controlled, and mitigated.
Figure 1-2: The three lines of defense Model
The initial line of defense against risks begins within the sales and customer service departments at branch locations, as well as specialized teams at the head office These units are primarily responsible for identifying, assessing, preventing, and monitoring risks associated with business activities, particularly in lending and other operational processes.
The second line of defense encompasses risk management, compliance, operational risk management, and legislation, playing a crucial role in independently evaluating and controlling the effectiveness of the first line of defense This line of defense is responsible for managing risks by assessing risk appetite and developing as well as implementing internal risk management processes.
The internal audit department serves as the third line of defense, operating independently from the Executive Board and under the Supervisory Board of the bank This structure ensures that the evaluation of the first two lines of defense is conducted in an objective and impartial manner.
Numerous risk management processes have been established and implemented in both banking and non-banking sectors, encompassing essential steps such as targeting, identifying, assessing impacts, comparing risks, and effectively managing and monitoring them.
Banks can adopt various strategies to manage risks, including prevention, mitigation, risk transfer, and tolerance To identify the most effective approach, it is essential for banks to carefully assess their risk tolerance and the broader implications of each strategy Additionally, evaluating the costs and benefits associated with each method is crucial for informed decision-making.
Effective risk management in banking requires not only the selection of suitable methods but also ongoing governance to prevent potential threats to operations Banks should regularly reassess risks based on their unique characteristics The final step involves continuous monitoring and responding to the risk management process to ensure its effectiveness.
The CAMELS rating system and Basel Capital ratings are the most prevalent risk management models today Among these, the Basel Capital Agreement stands out as the most effective approach for monitoring banking activities, significantly enhancing the stability of the banking system.
Basel II implementation and its impacts on Global Banking system
The Basel Committee on Banking Supervision (BCBS) originally comprised members from developed countries, including Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom, and the United States Since 2009, the committee has expanded to include 17 additional countries such as Argentina, Australia, Brazil, China, Hong Kong, India, Indonesia, South Korea, Luxembourg, Mexico, Russia, Saudi Arabia, Singapore, South Africa, Spain, and Turkey The involvement of these countries in drafting Basel II demonstrates their commitment to implementing the established regulations.
In early 2006, FSA has finalized and formally introduced Regulation Capital Requirement and Comprehensive Supervision Guidelines
Since 2007, the Japanese banking system has been implementing Basel II standards to enhance its risk management techniques and align more closely with US and European banks A report from the Financial Services Agency (FSA) indicates that during the initial year of Basel II's adoption, there were 14 significant developments in this transition.
Fifteen banks in Japan, including the prominent groups Mizuho, Mitsubishi-UFJ, and Mitsui-Sumitomo, have implemented the FIRB method for evaluating credit risk Collectively, these banks represent 62% of the total assets managed by Japanese banks.
Under the market pressures and regulations of Basel II, Japanese commercial banks have successfully raised their capital by about 4.5 trillion Japanese yen in 2009-
In 2010, Japanese banks enhanced their total capital, Tier I capital, and Capital Adequacy Ratio (CAR) by consistently assessing and classifying assets based on risk characteristics This proactive approach allowed most banks to achieve a CAR exceeding 8% in line with Basel Committee standards and over 4% according to domestic regulations, ensuring financial safety and soundness.
Applying Pillar: 2 Reinforced control process
As a G10 country, Japan enjoys distinct advantages in the application of Basel II, bolstered by its robust risk management systems within commercial banks, as noted by the IMF The experience gained from Basel I has allowed Japan to develop a strong infrastructure for effective banking supervision Currently, Japanese supervisory agencies have successfully met 23 out of 25 Basel Committee standards, either partially or fully Furthermore, the close collaboration between the Financial Services Agency (FSA) and the Bank of Japan (BOJ) has established a solid foundation for comprehensive risk monitoring in line with Basel II requirements.
Japan has a well-established regulatory framework for disclosure and transparency, particularly in the banking sector Japanese banking law mandates that banks publish annual reports detailing their business and financial operations Since October 2004, the Financial Services Agency (FSA) has provided a comprehensive list of required disclosure items for banks.
16 accordance with pillar 3 of Basel II By March 2007, this list was released as a separate FSA Ordinance
Prior to the implementation of the New Basel regulations, the Japanese banking industry faces significant challenges, primarily due to a high volume of non-performing loans and low capital adequacy ratios Various rating agencies have published indices reflecting the financial health of Japanese banks, which are generally viewed as unfavorable For instance, Moody's ratings indicate that Japanese banks are ranked between D- and E+, in stark contrast to the G7 countries' banking systems, which average ratings between A- and C+ (IMF, 2003).
After three years of implementing Basel II capital safety regulations, the Bank of Japan (BOJ) reported improvements in the health and capital position of Japanese banks, both in quality and quantity Major banks have significantly reduced credit risk and enhanced the quality of their credit portfolios through reforms in managing bad debts While a high level of profitability has been maintained, enhancing profitability continues to be a crucial challenge for these banks.
In October 2008, the China Banking Regulatory Commission (CBRC) introduced the initial regulations for implementing Basel II in China, focusing on capital measurement, risk classification, and internal rating systems These regulations also addressed credit risk mitigation and operational risk management By the end of 2008, comprehensive guidelines for market risk measurement were established, enhancing the regulatory framework for the banking sector.
According to the CBRC's annual report, at the end of 2010, the CAR of most Chinese commercial banks has exceeded the minimum requirement of 8%, maintaining
In 2012, the average Capital Adequacy Ratio (CAR) of the Chinese banking industry reached approximately 13.3%, aligning with global standards This indicates that Chinese banks recognize the significance of Basel II regulations and have diligently adhered to the first pillar of capital requirements, whether through mandatory or voluntary compliance.
Since 2013, Chinese commercial banks have faced stricter regulations under the "Regulation on Bank Capital Management." As a result, the Capital Adequacy Ratio (CAR) has consistently remained high due to proactive capital raising, increased profit provisions, and a reduction in risky assets.
Supervision in the banking system
The China Banking Regulatory Commission (CBRC) has significantly enhanced its oversight of the banking sector, with an IMF report indicating that Chinese banking supervisors have largely adhered to 25 key principles The CBRC has established a comprehensive roadmap to assist Chinese commercial banks in implementing Basel II, enabling them to align with global banking trends effectively.
Disclosure information according to market principles
In recent years, Chinese banks have significantly improved their transparency by actively disclosing market-related information The growing number of listed banks demonstrates their commitment to compliance, as they consistently publish essential financial data on their websites.
The profitability of the banking industry, particularly large-scale commercial banks, has seen significant growth, especially after the global crisis of 2008-2009, during which these banks maintained effective operations Following the crisis, the net income of major banks surged by 230.6 thousand billion CNY, marking a 34.5% increase compared to 2009 In subsequent years, the Chinese banking sector continued to experience robust profit growth, which contributed to capital expansion and enhanced capital adequacy ratios (CAR).
Basel II implementation in Viet Nam Banking system
1.4.1 Basel II implementation process of SBV
❖ Regarding the policy of implementing Basel II
In Vietnam, the implementation of Basel II was officially introduced for the first time in the restructuring scheme for credit institutions during the 2011-2015 period, as outlined in Decision No 254/QD-TTg on March 1, 2012 The State Bank of Vietnam further detailed this initiative in the Action Plan for the banking sector through Decision No 734/QD-NHNN on April 18, 2012 Under these regulations, commercial banks are mandated to maintain adequate equity levels to address credit, market, and operational risks while developing a risk management system aligned with the Basel Committee's standards and practices.
The SBV issued Official correspondence No 1601 / NHNN-TTGSNH in March
On July 17, 2014, the implementation of safety regulations under Basel II was mandated for banks, requiring most to adopt the standard level; however, ten banks, including Vietcombank, Vietinbank, BIDV, VPBank, Techcombank, VIB, Maritime Bank, MB, Sacombank, and ACB, are permitted to use the advanced approach Recognizing the complexity of Basel II and the need for close collaboration with commercial banks, the State Bank of Vietnam (SBV) has adjusted the roadmap to align with local practices.
Phase 1: Basel II application would be piloted in ten commercial banks including
In February 2016, a program was initiated by Vietcombank, VietinBank, BIDV, MBB, Sacombank, Techcombank, ACB, VPBank, VIB, and Maritime Bank, aimed at ensuring these banks meet the fundamental requirements of Basel II by the end of 2018.
Phase 2: By 2020, all commercial banks in Vietnam are required to meet a level of equity in accordance with Basel II standards (standardized approach or higher), including at least 12-15 commercial banks to successfully apply Basel II (pursuant to the Resolution on the Economic restructuring plan 2016 - 2020 issued on November 8, 2016 of the National Assembly of the Socialist Republic of Vietnam)
From 2016 to 2020, the implementation of Basel II was a key focus for strengthening the credit institutions system, enhancing the banking sector's ability to provide quality financial services to the economy The State Bank of Vietnam (SBV) played a crucial role by guiding ten pilot banks in adhering to the Basel II roadmap outlined in Scheme 1058.
The State Bank of Vietnam (SBV) has released numerous documents aimed at enhancing the risk management capabilities of domestic banks in alignment with the Basel II framework Notably, Circular No 36/2014 establishes regulations concerning the limits and ratios necessary for maintaining the operational safety of credit institutions and foreign bank branches.
Circular No 02/2013 establishes the classification of assets, the deduction levels and methods for setting up risk provisions, and the utilization of these provisions by credit institutions and foreign bank branches Additionally, Circular No 41 outlines the capital adequacy ratio requirements for foreign banks and their branches Furthermore, under Pillar II, Circular No 44/2011, issued on December 29, 2011, governs the internal control and internal audit systems for credit institutions and foreign bank branches.
No 07/2013 regulating special control of credit institutions; iii) Towards Pillar III: Decision No 51/2007 dated December 31, 2007 issuing regulations on disclosure information; Circular No 16/2010 guiding the implementation of Decree No 10/2010
The Banking Supervision Agency, established by Decision No 83 on May 27, 2009, has made strides in aligning its monitoring reports with international standards, incorporating the CAMELS framework and the 29 monitoring principles of Basel II Despite these advancements, the agency faces significant challenges, including limited access to inspection information, inadequate quantitative models, outdated IT infrastructure, and a shortage of qualified personnel.
❖ Information disclosure under Basel II
The State Bank of Vietnam (SBV) has standardized the operations of the Credit Information Center (CIC) and diversified its products and services It has supported the implementation of Basel II at credit institutions by establishing a national credit information database that accurately reflects data from both internal and external sources Additionally, most commercial banks have adopted transparent information disclosure practices, leveraging modern information technology infrastructure.
1.4.2 The implementation of Basel II in Vietnamese commercial banks
Commercial banks are increasingly recognizing the significance of Basel II in enhancing their adherence to international standards for capital safety and risk management Ten pilot banks, along with other voluntary institutions, are committed to implementing Basel II through strategic organizational changes and improved risk management capabilities Key initiatives include the establishment of a Project Management Officer (PMO) to coordinate the implementation across departments, the development of a Loan Origination System (LOS) and an upgraded internal credit rating system, as well as projects focused on risk-weighted asset calculations and the ICAAP process Additionally, banks are engaging consultants to identify governance, data, and risk management gaps in relation to Basel II requirements, guided by the State Bank, to formulate a comprehensive plan for enhancing their databases and IT infrastructure.
Banks are familiarizing themselves with the standard methods outlined in Basel II for capital assessment, particularly in preparing quantitative assessment reports (QIS) as mandated by Circular No 41 This process aids in determining the optimal adjustments needed for maintaining an adequate capital adequacy ratio.
Following the State Bank of Vietnam's official introduction of the Basel application roadmap, ten pilot banks have initiated plans to implement Basel II Notably, three joint stock commercial banks are leading the way in their preparation efforts for this significant regulatory framework.
For Vietcombank, this bank has built a clear roadmap and started deploying Basel
Since June 2014, Vietcombank has been working on enhancing its risk management capacity in line with the Basel II capital accord In 2016, the bank successfully implemented a fraud risk management framework alongside other critical initiatives, including Basel II compliance, core banking upgrades, and market risk management enhancements These projects were carried out with the assistance of foreign experts, leading to effective control over credit risks and improved credit quality By December 31, 2017, Vietcombank achieved a non-performing loan (NPL) ratio of just 1.11%, significantly lower than the industry average.
In September 2014, BIDV established the Basel II Project Management Officer (PMO) and Project Steering Committee (PSC) to oversee the implementation of the Master Plan Basel II, a crucial initiative for the bank's compliance with Basel II standards PricewaterhouseCoopers Vietnam Co., Ltd (PwC) was appointed as the primary partner to support this project By 2016, BIDV successfully launched the "Improving Debt Management Capacity and FTP" program in collaboration with the consulting firm Ernst & Young.
& Young Vietnam Ltd (EY), contributing to the risk management capacity enhancement, especially the liquidity risk and interest rate risk management that strictly follow
22 international practices and Basel II standards Credit risk measurement models have also been successfully built by BIDV with PwC Vietnam in 2017
Vietinbank has effectively implemented the Three-circle model of control based on international standards, leading to a more rigorous internal inspection and control framework within the bank This enhanced model extends from local branches to higher management levels, significantly improving risk management processes at Vietinbank.
Qualitative Method
The author has compiled and evaluated information from published papers, journals, and industry reports to establish the theoretical framework of the Basel II accord By utilizing studies and reports from the Basel Committee, the State Bank, and commercial banks, the author analyzes capital adequacy within the Vietnamese banking system in accordance with Basel II standards Additionally, a comparative method is employed to examine the current state of capital sufficiency and the strategies banks have implemented to meet capital requirements.
Quantitative Method
The author employs ordinary least squares (OLS) regression to analyze a simple two-variable model, focusing on the dependent variables Return on Equity (ROE) and Return on Assets (ROA), alongside their one-year lagged values and lagged Cumulative Abnormal Returns (CAR) This approach aims to investigate the effects of changes in one variable on the other over a one-year period The correlation between these variables is assessed using annual data throughout the study duration.
Software package used in the data analysis is the Data analysis tool of Microsoft Office Excel 2016 to determine the nature of the relationship between these variables
Thus, the regression equation is:
While for ROA, the equation will be
The hypothesis of the thesis is as follow:
Independent variable Impact on ROE (t) Impact on ROA (t)
The study focuses on ten banks that participated in the pilot implementation of Basel II, including Vietcombank, VietinBank, BIDV, MB, Sacombank, Techcombank, ACB, VPBank, VIB, and Maritime Bank, during the period from 2010 onwards.
This study utilizes secondary data sourced from the published annual reports of commercial banks These financial reports offer insights into the banks' earnings, key factors influencing those earnings, and highlight important financial ratios.
Data regarding the banking sector is sourced from the State Bank of Vietnam's reports and the banking survey of enterprises, ensuring high credibility through reputable journals and papers.
The sampling window for this research covers the period 2010 to 2018 The study presumes that banks started to adjust their capital soon after the announcement of Basel
The study focuses on the period from January 2010 to December 2018, reflecting the implementation of minimum capital requirements that began in March 2012, ensuring compliance by December 2018.
CHAPTER THREE BANK CAPITAL ADEQUACY IN VIETNAM
Overview of Banks piloting Basel II
As of December 2018, Vietnam's banking sector comprises thirty-one commercial banks that significantly contribute to capital transfer and supply within the economy The State Bank of Vietnam (SBV) has identified ten domestic banks to pilot the implementation of Basel II, including three state-owned banks—Vietinbank, Vietcombank, and BIDV—and seven private banks: MBBank, Sacombank, Techcombank, ACB, VPBank, VIB, and Maritime Bank These banks are recognized among the top performers in the industry, playing a crucial role in enhancing the overall operational efficiency of the banking system.
The three largest banks in Vietnam's banking system are Vietcombank, Vietinbank, and BIDV Vietcombank, the first state commercial bank to undergo equitization, became a Joint Stock Commercial Bank in February 2008 after a successful Initial Public Offering Originally focused on foreign trade services, Vietcombank has evolved into a modern, multi-functional bank, offering a wide range of financial services, including international trade, capital trading, deposit mobilization, credit provision, project financing, forex trading, and electronic banking Recognized globally, Vietcombank has consistently been awarded the title of "Best Bank in Vietnam."
In 2018, Vietnam was recognized by The Asian Banker as having one of the Top 30 strongest banks in the Asia-Pacific region Vietinbank, established in 1988 and equitized in 2009, plays a crucial role in Vietnam's banking sector, offering a wide range of financial services through its extensive nationwide network BIDV, the oldest bank in Vietnam, also contributes significantly to the country's financial landscape.
With 60 years of development, BIDV has established itself as a leading provider of transaction banking and financial services for both personal and corporate clients in Vietnam Recognized as the largest bank brand in the country, BIDV consistently ranks among the top financial institutions, reflecting its commitment to excellence and growth in the banking sector.
30 larger banks of Southeast Asia by asset size, ranking among the top 1000 best banks in the world voted by The Banker Magazine
The total assets of the group have steadily grown over the years, representing a significant share of the banking system's overall assets Notably, these three banks alone comprise 38% of the total assets within the commercial banking sector.
Figure 3-1: Total assets of State-owned commercial banks
BIDV stands as the largest bank in Vietnam, boasting total assets exceeding VND 1,313,038 billion, followed by Vietinbank and Vietcombank with assets of VND 1,164,435 billion and VND 1,074,027 billion, respectively Over the past four years, the total assets of BIDV, Vietcombank, and Vietinbank have surged by more than 1.5 times, highlighting significant growth within the banking sector.
Figure 3-2: Earning before tax of State-owned commercial banks
Between 2015 and 2018, the banking industry experienced significant growth, with many banks reporting billions in profits by 2018, largely driven by increased credit growth Notably, Vietcombank saw its profits triple over two years, while BIDV, despite falling to third in profit rankings, still achieved a 1.2 times increase in earnings Vietcombank and BIDV reported profitability growth of 61% and 11%, respectively, whereas VietinBank faced a challenging year with a 25% decline in profits This decline was attributed to difficulties in raising capital to meet adequacy regulations, which ultimately hindered credit growth in the fourth quarter of 2018 and led to decreased profitability compared to the previous year.
Vietcombank has achieved impressive profits that exceed the combined profits of VietinBank and BIDV, showcasing its competitive edge in the banking sector The bank's success can be attributed to its significant increase in charter capital, reaching nearly VND 37,000 billion, and its early adoption of Basel II standards Additionally, Vietcombank has been granted a higher credit growth limit by the State Bank of Vietnam (SBV), further solidifying its advantageous position in the market.
In respect of total assets, the seven banks in this group have accounted for approximately 22% of the total assets of the Vietnamese banking system
Figure 3-3: Total assets of Private commercial banks
Sacombank has ranked the first position in asset size for four successive years with above 425 trillion VND, followed closely by MBBank with over 383 trillion VND
In addition, it is obvious that ACB and Techcombank are the two banks with the highest asset growth rate of over 60%
Despite the dominance of state-owned commercial banks in total assets, private banks in Vietnam are showing significant improvement Notably, in 2018, three private banks—Techcombank, VPBank, and MB—ranked among the Top 5 banks in the country by revenue Remarkably, 2018 also marked the year when Techcombank became the first private bank to break into the Top 3 in terms of profits, highlighting its impressive growth over the past three years.
29 increased over 2.5 times, surpassing VPBank, Vietinbank and BIDV to rank just behind Vietcombank
Figure 3-5: Earnings before tax of Private commercial banks
Despite having the lowest earnings during the period, MSB is leading in profit growth rate with an impressive increase of approximately 566%, rising from 158 billion VND to 1,053 billion VND Techcombank, ACB, and VIB also reported remarkable profit growth rates of 423%, 386%, and 319%, respectively The banking sector has experienced continuous profit growth over the past two years, driven by a focus on retail banking, enhanced service activities, partnerships with insurance companies, and improved debt management strategies.
Capital safety in Vietnamese commercial banks
3.2.1 Regulations on Capital Adequacy in Vietnam
The size of equity is a critical factor in evaluating the financial health of banks, aligning with international standards In Vietnam, capital growth remains a key focus for bank management strategies Regulatory bodies, including the Banking Supervision Agency, the National Financial Supervisory Commission (NFSC), and the Deposit Insurance of Vietnam (DIV), have implemented various mechanisms to ensure strong financial stability.
30 capacity assessment, which emphasized the necessity of equity growth for the safety of financial system
Prior to the implementation of Basel II, Vietnam made strides towards aligning its capital adequacy standards with international norms The State Bank of Vietnam (SBV) introduced Decision No 297/1999/QD-NHNN on August 25, 1999, which established a minimum capital adequacy ratio of 8% However, the calculation method used was basic and failed to fully capture the essence of Basel II guidelines.
Following the introduction of Basel II, the State Bank of Vietnam (SBV) replaced Decision No 297 with Decision No 457/2005/QD-NHNN on April 19, 2005 This regulation mandates that credit institutions, excluding foreign bank branches, maintain a minimum capital adequacy ratio (CAR) of 8% relative to their total risk-weighted assets However, the CAR calculation method outlined in Decision 457 aligns only with the requirements set by Basel I.
In 2010, the State Bank of Vietnam (SBV) introduced Circular No 13 / TT-NHNN, which replaced Decision 457, providing guidelines for determining separate and consolidated Capital Adequacy Ratios (CAR) and increasing CAR to 9% This circular aligns the calculation methods more closely with Basel II standards.
In November 2014, the State Bank of Vietnam (SBV) issued Circular 36/2014/TT-NHNN, supplementing Circular 13 This regulation mandates that credit institutions maintain a minimum capital adequacy ratio (CAR) of 9%, which encompasses both separate and consolidated ratios The CAR is determined as a percentage of a bank's equity relative to its risk-weighted assets, categorized into five risk levels: 0%, 20%, 50%, 100%, and 150%.
The State Bank of Vietnam (SBV) has recently released Circular 41/2016/TT-NHNN, which updates the capital adequacy ratio (CAR) for banks, lowering it from 9% to 8% This adjustment introduces a revised calculation formula that incorporates capital requirements for both operational and market risks, establishing a legal framework for banks to comply with Pillar 1 and Pillar 3 of Basel II.
Circular 41 of the SBV, when referring to the capital adequacy ratio, has closely approached Basel II's risk management regulations, but the Circular 41 itself is not Basel
Basel II introduces broader and more complex regulations compared to its predecessor A key aspect of both Basel II and Circular 41 is the requirement that a bank's equity must adequately cover all risk-weighted assets These assets are meticulously assessed using specific risk factors assigned to each type of asset.
Unlike Circular 36, which solely addresses credit risk, Circular 41 requires banks to also consider market and operational risks Consequently, the formula for calculating a bank's capital adequacy ratio will be updated to reflect these additional risk factors.
In which: C is equity; RWA is total risk-weighted asset; KOR and KMR are required capital for operational risks and market risks
As the total risk-weighted assets increase while bank equity remains unchanged, the capital adequacy ratio (CAR) declines This is evident as the CAR specified in Circular 36 is set at 9%, which will decrease to 8% in Circular 41 Although the current CAR for the entire banking system exceeds 12%, a thorough recalculation in accordance with Circular 41 may reveal that many banks do not meet the new requirements According to a report by MB Securities Company, the CAR for these banks could potentially drop by 1-3%.
Circular 41 along with Circular 13/2018 /TT-NHNN (Circular 13) on internal control systems of commercial banks and foreign banks' branches and the Amendment of Credit Institutions Law would create a broad legal framework to ensure that banks have sufficient equity and healthy business, appropriate risk management In the contrary, if the bank failed to meet these safety rules, it can be merge into another bank or even force to be bankrupt
Nguyen T H highlighted that compliance with Circular 41 continues to pose challenges for domestic banks, particularly in raising owner’s equity and gathering historical credit data Despite these hurdles, the advantages of implementing Circular 41 are clear, as it mandates greater transparency in bank operations and ensures that banks maintain adequate equity levels for sustainable functioning.
The Vietnamese banking system is relatively young and faces several unregulated legal issues compared to global financial standards, resulting in low credit scores However, with the implementation of Circular 41, the system is set to align more closely with international financial safety standards, enhancing the reputation of Vietnamese banks and making it easier to attract foreign investment.
3.2.2 Capital adequacy in Vietnam commercial banks a Period of 2000-2010
The current landscape of Vietnam's banking sector is intricate, with the "big three" banks holding a significant 70-75% market share, indicating that their stability is crucial for the overall health of the banking system However, during the 2000s, the banking industry faced challenges, particularly with high non-performing loan (NPL) ratios concentrated in state-owned commercial banks, which struggled to meet capital adequacy standards.
Table 3-1: Capital adequacy in Vietnam in 2010
Source: SBV Website Table 3-2: Capital adequacy in State-owned banks
The table indicates that Vietnam's "big three" banks maintained a minimum capital ratio below the 8% threshold set by the State Bank of Vietnam (SBV), jeopardizing the overall safety of the banking system A significant factor contributing to this issue is cross-ownership among credit institutions, where banks hold shares in one another, leading to potential liquidity crises and increased risk of systemic collapse due to unchecked lending practices In contrast, following Decision 297, most private commercial banks successfully achieved the 8% capital adequacy ratio requirement The subsequent transition to regulation 457, combined with a stock market boom from 2006 to 2008, resulted in a substantial increase in the owners' equity of commercial banks, with some institutions raising their legal capital to meet the minimum capital adequacy standards.
Figure 3-6: Capital Adequacy ratio of the Banking system in 2010 - 2013
In 2010, the minimumCAR was raised to 9% in accordance with Circular 36 Although it is considered to be close to the Basel II principles, Circular 36 just included
Capital Tier 1 and Tier 2 in Owner’s equity and credit risk in risk-weighted assets In
In 2011, the State Bank of Vietnam (SBV) reported that the banking system maintained positive safety ratios, with financial institutions achieving sustainable equity growth that enhanced the minimum capital adequacy ratio compared to the end of 2010 Following the approval of the banking restructuring scheme for 2011-2015 by the Prime Minister, banks focused on improving executive management and financial capabilities to ensure safety and soundness, which are essential for economic stability The capital adequacy of Vietnam's commercial banks is detailed in the accompanying Circular.
Figure 3-7: Capital Adequacy ratio in State-owned commercial banks in 2010 - 2013
Relationship between Capital Adequacy and Profitability
❖ The regression model with ROE
42 df SS MS F Sign F F distribution
The data presented indicates a strong model fit, evidenced by an F-statistic of 14.37, which exceeds the F-distribution threshold at a 95% confidence level This suggests that the chosen variables, specifically the lagged capital ratio and return on equity (ROE), are significant factors influencing ROE.
It also shows that variables with a p-value of lower than 0.05 have a significant relationship with ROE
Table 3-4: Regression statistics for ROE
Adjusted R Square 0.285 Standard Error 5.617 Observations 68
The model summary indicates an R square value of 0.31, meaning the model accounts for 31% of the variations in banks' Return on Equity (ROE), while the remaining 69% is attributed to random factors and variables not included in the model Additionally, the beta coefficient table illustrates the individual effects of the independent variables.
The data indicates that a 1% increase in banks' capital levels leads to an average decrease of 0.19% in return on equity (ROE), demonstrating a significant negative relationship (β = -0.19, p = 0.005) Conversely, the lagged ROE positively influences current ROE, with an increase of up to 0.50% (β = 0.50, p = 0.000).
❖ The regression model with ROA
Table 3-6: ANOVA for ROA df SS MS F Sign F F distribution
The table's statistics reveal a strong model fit, evidenced by an F-statistic of 18.21, exceeding the F-distribution threshold at a 95% confidence level This confirms that the model is suitable and that the chosen independent variables significantly influence return on assets (ROA) Additionally, variables with a p-value greater than 0.05 do not exhibit a significant relationship with ROA, and the extent of their impact will be explored in the following paragraph.
Table 3-7: Regression statistics for ROA
The model summary indicates an R-squared value of 0.36, meaning that the model accounts for 36% of the variations in the banks' Return on Assets (ROA), while the remaining 64% is attributed to random factors and other variables not included in the model Additionally, the beta coefficient table presents the individual impacts of the independent variables.
Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
The regression analysis reveals that lagged capital does not significantly affect return on assets (ROA), with a p-value of 0.387, indicating no relationship at a 95% confidence level Conversely, lagged ROA demonstrates a significant positive impact on ROA, with a coefficient of 0.659 and a p-value of 0.000 This suggests that a 1% increase in lagged ROA correlates with an average rise of 0.659% in ROA, assuming other variables remain constant.
Minimum capital requirements may negatively impact banking industry performance by constraining operations and hindering short-term profits and long-term viability When banks are compelled to maintain excessive equity beyond their actual needs, it can limit their ability to grow Additionally, the pursuit of higher profits often leads banks to make insufficient provisions, deteriorating credit quality and increasing bad debts Furthermore, banks may opt for riskier, more profitable assets to enhance earnings, which raises the risk-weighted assets and ultimately reduces the capital adequacy ratio.
To comply with capital minimum requirements, many Vietnamese banks opt to raise new equity, primarily through share issuance However, this process is complex and time-consuming, requiring substantial human resources and incurring significant one-off costs for issuing agencies and service providers As a result, the increased expenses can lead to a decline in the banks' overall earnings.
CHAPTER FOUR: CONCLUSION, AND RECOMMENDATION
Conclusion
After 11 years since Basel I was issued, international standards for banking management were first studied and applied in Vietnam So far, CAR coefficient has been widely recognized in Vietnam as an economic indicator, an important measure to measure the soundness of banking operations The good news is that more commercial banks are increasingly aware of the importance of having enough capital as a solid shield to protect the bank against risks in their operations As a result, commercial banks have more sense of self-awareness and endeavor to abide by the government and SBV regulations, and constantly improve their own capabilities to be rival to international banks As a result, the CAR of both the banking system in general and of each commercial bank, although with differentiation by scale of assets and profits, has improved
Vietnam's regulations for calculating the Capital Adequacy Ratio (CAR) of commercial banks are moving closer to international standards, yet significant gaps remain As a result, the CAR may not accurately represent the actual risk levels faced by banks To address this issue, the State Bank should persist in amending and enhancing regulations to align safety standards with international benchmarks.
The relationship between bank capital and profitability highlights capital adequacy as a key determinant of earnings This study's ROE model reveals an inverse correlation between Capital Adequacy Ratio (CAR) and Return on Equity (ROE) Notably, different profitability metrics yield varying results regarding profit persistence; specifically, a significant negative relationship exists between capital and ROE, while the relationship between capital and Return on Assets (ROA) is found to be insignificant.
Recommendations for ensuring capital safety of commercial banks
Commercial banks must strategically develop a roadmap to effectively mobilize capital in both the short and medium to long term, aiming to enhance their equity scale A primary source of this capital mobilization should come from the banks themselves.
Banks with a low Capital Adequacy Ratio (CAR) of less than 9%, or between 9% and 11%, are required to retain all profits after tax and are prohibited from paying dividends or repurchasing shares This policy is justified as it places the onus on shareholders to ensure their banks maintain adequate capital levels; when a bank faces a capital shortfall, shareholders must forgo profit distribution.
To enhance capital, banks can seek additional funding from existing shareholders and both domestic and foreign investors They can also issue shares to boost Tier 1 capital and bonds to increase Tier 2 capital Furthermore, banks can improve their capital by focusing on upgrading the quality of their financial services, which involves gradually increasing service revenues while simultaneously reducing operating costs.
State-owned commercial banks have significant opportunities to attract foreign investment, similar to the strategies employed by Vietcombank and BIDV Selling shares to foreign strategic investors is advantageous, as these investors bring substantial financial resources and valuable management expertise.
The capitalization of banks poses a potential risk, as insufficient capital by 2020 may necessitate government intervention to inject funds into these institutions, potentially reducing GDP by 1-1.5% (IMF) To bolster capital, attracting foreign strategic investors is crucial for state-owned banks However, the selection of these investors hinges on the specific conditions of each bank, market dynamics, and government policies, emphasizing the need for banks to enhance the quality and transparency of their financial records.
Commercial banks in Vietnam should leverage international integration to enhance their capital base, particularly through the issuance of Tier 2 bonds in the global market This strategy is primarily viable for larger banks with strong reputations and solid financial stability, as the costs associated with bond issuance can be substantial Furthermore, pursuing mergers and acquisitions can also contribute to capital growth and financial strength.
In the past, the banking system's restructuring roadmap involved selecting certain banks for mergers to boost capital This strategy is effective primarily when a larger bank merges with a smaller one However, two banks with low Capital Adequacy Ratios (CAR) may not see an increase in their CAR, despite an increase in charter capital.
To ensure the sustainability of the banking system, it is essential for banks to maintain abundant capital, with the Capital Adequacy Ratio (CAR) serving as a crucial "risk buffer" during challenging times A robust banking management strategy focuses on minimizing the credit risk ratio of assets, thereby safeguarding a safe and stable CAR.
Experts recommend that banks implement effective asset structure strategies to comply with Basel II's quantitative requirements To address capital adequacy pressures in the long term, banks should prioritize restructuring their assets, concentrating on sectors with lower capital demands and greater growth potential while operating within limited capital constraints.
Limitations of the Study
The study's eight-year duration limits its ability to fully capture the impact of lagged variables; a longer period would provide more comprehensive insights Additionally, incorporating control variables such as the non-performing loan (NPL) ratio, bank size, and deposits, along with macroeconomic factors like inflation and GDP, is crucial, as these elements significantly influence bank earnings.
As Vietnam's commercial banks move closer to international standards for calculating Capital Adequacy Ratio (CAR), discrepancies remain, leading to a CAR value that does not accurately represent the banks' actual risk levels Additionally, some banks fail to publish their profitability indicators accurately, which undermines the reliability of regression analysis results.
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