Credit risk in the operations of commercial banks
The concept of risk and the credit risk
Risk in banking refers to unwanted events that can lead to asset loss, reduced profits, or increased expenses related to financial services Credit operations are crucial for bank profitability but also introduce significant risks, with credit risk comprising 70% of total banking risks Despite a shift towards increased service income, credit still represents two-thirds of banking revenue, as noted by Peter Rose in "Commercial Bank Management." Banking inherently involves managing risks to pursue profits, with former Fed Chairman P Volker stating, "If banks do not have bad loans, it is not operating business." Credit risk remains a primary factor in financial losses and impacts overall banking quality.
In "Financial Institutions Management - A Modern Perspective" by A Saunders and H Lange, credit risk is characterized as the potential financial loss a bank faces when extending credit to a customer, particularly when the anticipated income from bank loans may not be realized in terms of quality and timeliness.
Timothy W Koch emphasizes that when banks invest in higher-yielding assets, they face increased risks if customers default on their loans by failing to pay principal and interest as agreed This situation highlights credit risk, which refers to the potential fluctuations in net income and market value resulting from customers' failure to make timely payments or complete payment obligations.
According to paragraph 1 Article 2 in the Regulation on loan classification, provisioning and use of reserves to handle credit risk in banking operations of credit
Nguyen Van Truong 5 ATCB – K12 institutions, established under Decision 493/2005/QD-NHNN on April 22, 2005, by the Governor of the State Bank of Vietnam, define credit risk as the potential loss faced by credit institutions in banking activities due to customers' failure or inability to fulfill their committed obligations.
In summary, we can draw the basic content of credit risk as follows:
- Credit risk occurs when there is default in customers’ repayment obligations under the contract, including principal and / or interest Default may be delayed payment or nonpayment
Credit risk can result in significant financial losses, negatively impacting net income and reducing the market value of equity In severe instances, this risk may lead to substantial business losses or even bankruptcy.
In developing countries like Vietnam, the limited diversity in financial and banking services leads to credit being viewed as a highly profitable venture, particularly for smaller banks Consequently, the level of credit risk—whether high or low—plays a crucial role in determining the overall efficiency of banking operations.
The relationship between risk and expected return is a key concept in banking; generally, higher expected returns are associated with greater potential risks.
- Risk is an objective factor; therefore, it cannot be eliminated completely but we can manage its appearance as well as its harm.
Classification of credit risk
1.1.2.1 In terms of risk causes
Based on the causes of the risks incurred, the credit risk is divided into the following categories: a) Transaction risk
Transaction risk is a type of credit risk that emerges from constraints in the transaction process, loan approval, and customer assessment It encompasses selection risk, which pertains to the credit evaluation and analysis used to determine financing by the bank; guarantee risk, which involves standards for collateral, such as loan amounts and types; and operational risks linked to loan management and lending activities, including the implementation of risk ranking systems and strategies for managing non-performing loans Additionally, portfolio risk is also a critical consideration in this context.
Portfolio risk, a subset of credit risk, emerges from the constraints in banks' loan portfolio management It can be divided into two main types: internal risk, which stems from the characteristics of borrowers and their fund utilization within specific economic sectors, and concentration risk, which occurs when lending is overly concentrated on a limited number of clients, a particular economic sector, a specific geographical area, or high-risk loan types.
1.1.2.2 In terms of risk nature a) Objective risk
Objective risk arises from unforeseen events such as natural disasters, sabotage, or the death or disappearance of a borrower, occurring even when borrowers have met all their obligations In contrast, subjective risk is influenced by personal perceptions and interpretations of risk.
Subjective risk is the risk deriving from borrowers and lenders that, in accident or in purpose, cause the loss of loans or other subjective reasons
Besides, there are also other forms of classification based on risk structure, risk origin, fund user and so on.
Characteristics of credit risks
In the context of banking, credit risk arises when customers experience financial losses or defaults while utilizing funds This risk primarily stems from the inherent vulnerabilities in customers' businesses, which can lead to potential damage and failure in repayment.
1.1.3.2 Credit risk has the diverse and complex nature:
Credit risk is characterized by its diversity and complexity, stemming from various causes, forms, and consequences, as banks serve as financial intermediaries Effective prevention and management of credit risk require a thorough understanding of its underlying causes and implications, enabling the implementation of appropriate risk mitigation strategies.
Asymmetric information in the banking sector leads to insufficient risk assessment, making every loan a potential threat to financial stability Consequently, banking operates as a risk-oriented business, balancing appropriate levels of risk with corresponding profitability.
The main basis for determining the level of credit risk
Non-performing loan is the loan that is not repaid on time, in which the customers are not permitted and are not eligible to be rescheduled
Overdue loans Non-performing loan coefficient = - x 100%
To ensure strict management, Non-performing loan is often divided into the following groups:
- Non-performing loan to 180 days, with the ability to recover
- Non-performing loan from 180-360 days, with the ability to recover
- Non-performing loan from 360 days or more (doubtful debts)
According to the State Bank of Vietnam's Decision 493/2005/QD-NHNN dated April 22, 2005, and Decision 18/2007/QD-NHNN dated April 25, 2007, loans are categorized into five groups, with Group 1 designated as prime loans.
- The term loans that are assessed to have a capability that the principal and interest could be fully recovered on time;
- The non-performing loan less than 10 days and are assessed to have capability that overdue principal and interest could be fully recovered in the remaining period;
- Other loans are classified into group 1, including:
A non-performing loan (NPL) is classified as such when it is overdue for 10 days or more, but if the borrower has fully repaid both the overdue principal and interest, including applicable penalties, it may no longer be considered non-performing For medium and long-term loans, this repayment must occur within six months, while for short-term loans, it is three months Branches are required to gather relevant documentation to demonstrate that the reasons for the NPL have been resolved and that the customer is capable of repaying the remaining principal and interest.
+ Restructured loans with full recovery of principal and interest in at least
(06) months for the medium and long-term loans Branch must have relevant documents, records to prove the causes of restructure loans have
Nguyen Van Truong 9 ATCB – K12 been addressed, and customers could afford to repay all the principal and interest in the remaining period
Restructured loans and non-performing loans that are overdue by 10 days or more, including short-term, medium-term, and long-term loans, will only be classified into Group 1 once all principal and interest payments have been fully repaid Furthermore, customers must demonstrate the ability to fully repay the principal and interest in subsequent terms and meet all obligations related to off-balance sheet items as per their commitments Group 2 is designated for notable loans.
- The non-performing loan from 10 to 90 days;
When rescheduling loans for the first time, branches must ensure they have sufficient documentation to demonstrate that customers can afford to repay both the principal and interest, with the exception of rescheduled loans categorized as group 1.
- Other loans classified into 2 groups according to the regulations c) Group 3 (subprime loan)
- The non-performing loan from 91 days to 180 days;
- The rescheduled loans due for the first time;
- The loans that enjoy the interest remission as the customers could not afford to repay all the interest under the credit agreement;
- The loans due for guarantee payments, overdue acceptance payments (the customer fails to comply with obligations) less than 30 days
- Other loans classified into 3 groups according to regulations d) Group 4 (Doubtful loans)
- The non-performing loan from 181 days to 360 days;
- The rescheduled loans overdue in less than 90 days;
- The loans that are rescheduled for the second time;
- The loans due for guarantee payments, overdue acceptance payments (the customer fails to comply with obligations) from 30 to 90 days
- Other loans are classified into 4 groups according to regulations e) Group 5 (loans with capital loss)
- The non-performing loan more than 360 days;
- The first-time rescheduled loans overdue in less than 90 days or more;
- The second-time rescheduled overdue;
- The loans that are rescheduled for the third time or more;
- The loans due for guarantee payments, overdue acceptance payments (the customer fails to comply with obligations) in 90 days or more
- The frozen loans, pending loans;
- Other loans are classified into five groups according to regulations
In addition, the provisions also stated that the probation period for loan promotion (for example from group 2 to group 1) is 6 months for long-term loans and
Short-term loans have a repayment period of three months, during which all principal and interest must be fully recovered If a customer has multiple loans with credit institutions and any one of those loans is categorized as high risk, all remaining loans must be classified into the same high-risk group.
Non-performing loans (or bad debts) are the loans classified into the group 3, 4 and 5 with the following characteristics:
- Customers did not fulfill the obligations to repay the bank when these commitments are due
- Customers’ financial situation suffers from difficulties, leading to the fact that the principal and interest could not be fully recovered
- Collateral’s auction value is insufficient to recover all the principal and interest
- Usually rescheduled loans, or Non-performing loan in 90 days or more
A credit institution is deemed to be within acceptable limits when its non-performing loan (NPL) ratio is below 5% However, if the NPL ratio surpasses 5%, it is crucial for the institution to conduct a thorough and careful review of its loan portfolio.
Consequences of credit risk
Loan defaults, including principal, interest, and additional fees, can lead to significant capital budget losses for banks, which continue to incur interest on working capital This situation results in diminished profits and, in severe instances, could push banks towards bankruptcy.
Banks within the national banking system maintain strong connections with socio-economic institutions and individuals, meaning that poor performance, insolvency, or bankruptcy of one bank can negatively impact other banks and various economic sectors Without prompt intervention from the central bank and government, widespread fear among depositors could lead to mass withdrawals, resulting in severe liquidity risks for banks.
The banking system is intricately linked to the economy, serving as a crucial channel for funding Consequently, a bank's bankruptcy due to credit risk can disrupt economic stability, resulting in imbalanced supply and demand, inflation, rising unemployment, increased social issues, and unstable security and political conditions.
1.1.5.4 For the external economic relations
Credit risk affects the status and image of the national financial and banking system as well as the entire economy
Credit risk significantly impacts banks at various levels, potentially leading to profitability losses due to risk provisions and uncollectible interest In extreme cases, banks may fail to recover both interest and principal, resulting in substantial financial losses and capital depletion If unaddressed, this could culminate in bank bankruptcies, which would have dire consequences for the overall economy and the banking system Consequently, it is crucial for bank managers to implement effective strategies to mitigate and manage credit risk.
Causes of the credit risk
Banking is inherently a risk-oriented business, necessitating that commercial banks identify risk factors to implement effective prevention and mitigation strategies Credit risk, in particular, can be categorized into three primary groups, highlighting the importance of understanding these causes to safeguard financial stability.
1.1.6.1 The objective causes from the external environment a) Natural disasters, epidemics, fires, etc b) Unstable security situation c) Crisis or recession, inflation, international payment imbalances, exchange rate fluctuations
Nguyen Van Truong 13 ATCB – K12 d) The unfavorable legal environment, loose macroeconomic management
1.1.6.2 The causes from customers a) Lack of legal capacity b) Improper and inefficient loan utilization c) Continuous trading losses, unsold goods d) Irrational capital management leading to lack of liquidity e) Business owner’s management incompetence, corruption and fraud
1.1.6.3 Causes from banks a) Inappropriate credit policy b) Lack of market information or inadequate information analysis leading to unreasonable investments c) The banking competitiveness desiring the higher market share d) Lack of professional qualifications e) Lack of accuracy in evaluating collateral accurately, fulfilling the necessary legal procedures, or ensuring the principles of collateral, namely: ease of pricing, ease of ownership transfer, ease of consumption
Credit risk arises from a variety of factors, encompassing both objective and subjective causes related to participants in credit relationships The influence of these participants significantly impacts the quality of bank credit, and implementing appropriate measures can help mitigate these risks effectively.
Credit risk management
The necessity of the credit risk management
1.2.1.1 Forecasting and detecting potential risks
Credit risk management will help to detect unexpected events, prevent unfavorable situations that are able to spread to a wide range
Banks must resolve risk consequences to limit the damage to the banks’ property and income Credit risk management is necessary to ensure the synchronization
Credit risk management will set out specific targets to help banks develop on the right track.
Mission of the credit risk management
1.2.2.1 Drawing risk prevention directions and plans
To effectively manage risks, it is essential to develop clear guidelines that assess and predict potential conditions, causes, and consequences Implementing risk prevention plans will ensure that specific objectives are met while maintaining an acceptable level of errors.
Credit risk management will help to build professional programs, structure risk prevention and control, assign rights and responsibilities to each member
Banks must rigorously inspect and monitor the implementation of risk prevention plans to identify potential trading risks and errors This proactive approach enables them to propose effective measures and necessary adjustments, ultimately enhancing their risk management systems.
Credit risk measurement
One of the fundamental characteristics of modern finance is potential risk; in other words, all models of modern finance are placed in the risky environment
To effectively manage credit risk, it is essential to establish a quantitative understanding of risk and develop measurement tools Numerous models are currently available to assist credit officers in evaluating credit risk accurately.
1.2.3.1 Qualitative Model for Credit Risk - Model 6Cs
Before extending credit, banks must assess whether customers can and will repay their loans on time, focusing on the 6Cs of credit evaluation: Character, ensuring borrowers have the intent and purpose to repay; Capacity, confirming borrowers possess the legal authority to represent their enterprises; Cash flow, identifying reliable payment sources; Collateral, which serves as a secondary repayment source; Conditions, adhering to bank credit regulations; and Control, evaluating the effects of legal changes and operational rules on the borrower's ability to meet bank standards.
The model's implementation is straightforward; however, its effectiveness relies heavily on the accuracy of the gathered data, the predictive capabilities, and the analytical skills of the Credit Officers involved.
1.2.3.2 The quantitative model of credit risk a) Model Z
The model relies on two key components: (i) the financial indicators of borrowers, denoted as X, and (ii) the significance of these indicators in assessing the likelihood of borrower default based on historical data.
X1: ratio of "net working capital / total assets"
X2: ratio of "accumulated profits / total assets"
X3: ratio of "earnings before interest and taxes / total assets"
X4: ratio of "the market price / book value of long-term debt"
X5: percentage of "revenue / total assets"
A higher Z value indicates a lower likelihood of borrower default, while a low or negative Z value serves as a key indicator for categorizing customers into a high default risk group.
+ Z