Factor affecting risk exposure and profitability of the commercial banks operating in Vietnam

The factor analysis conducted indicated that liquidity and interest rate, market, business operation, credit are the factors affecting banks’ risk exposure.. This thesis is to examine fa

Ta Thi Xuan Hoa

FACTORS AFFECTING RISK EXPOSURE

AND PROFITABILITY OF THE

COMMERCIAL BANKS OPERATING IN

VIETNAM

MASTER’S THESIS

Ta Thi Xuan Hoa

FACTORS AFFECTING RISK EXPOSURE

AND PROFITABILITY OF THE

COMMERCIAL BANKS OPERATING IN

VIETNAM

MASTER’S THESIS

In Banking Code: 60.31.12

Supervisor

Assoc Prof Dr Bui Thi Kim Yen

Ho Chi Minh City 2010

DECLARATION

This is to certify that:

• the thesis contains no material which has been accepted for the award to the candidate of any other degree or diploma except where due reference is made

in the text of the thesis

• to the best of candidate’s knowledge contains no material previously published or written by another person except where due reference is made in the text of the thesis

Ta Thi Xuan Hoa

Signature:

Date:

ACKNOWLEDGEMENT

I would like to express my attitude to many individuals who helped me to complete this thesis First of all I would like to express my deepest acknowledgement to my supervisor, Assoc Prof Dr Bui Kim Yen for her valuable advice and recommendation

I would like to express my gratitude to my English teacher, Mr John William Hall who helped me in improving English speaking skills I would like to express my gratitude to Ms Ly Thi Minh Chau, who helped me a lot in providing reference materials, giving me valuable time, invaluable advice, assistance, support and recommendation

I would like to express my gratitude to Dr Vo Xuan Vinh, who helped me a lot in data analysis, giving me valuable time, support and recommendation

In the process of data collection for this research, many individuals contributed to the task and I am particularly grateful for their contributions I am greatly indebted to

Mr Nguyen Huu Nhan, Mr Nguyen Ngoc Tan for their support during the time of this thesis

I would also like to thank Mr Ngo Tran Kien Quoc and Mr Ho Phi Diep who helped

me to collect data, and to conduct personal interview

I would like to thank the people who have been working in The State bank of Vietnam, Ho Chi Minh City Branch for providing secondary data relating activities

of commercial banks in Vietnam in general and supporting my study leave to enable

me to complete the thesis It allowed me to concentrate on the completion of my thesis

Finally I wholeheartedly thank and acknowledge the most important people in my life, my parents and my husband, for their total support, encouragement and patience

in my completing the thesis

ABSTRACT

The basic principles of bank management have highlighted the need to balance between liquidity, asset, liability, capital adequacy, credit and interest rates risks in order to mitigate the loss in earnings Thus, the factors that may affect these risks are important indicators to formulate appropriate strategies for better bank management

It is therefore the purpose of this study to identify the factors that contribute to the risks that are faced by banks The factor analysis conducted indicated that liquidity and interest rate, market, business operation, credit are the factors affecting banks’ risk exposure Hence, banks have to seriously consider these factors in formulating

an effective risk management strategy to minimize any possibility of loss in income and to avoid bank failure This thesis is to examine factors affecting banks’ risk and the relationship between financial risks and profitability of the commercial banks in Vietnam

The objectives of the thesis are to investigate and analyze factors affecting banks’ risk exposure and relationship between financial risks on profitability of commercial banks in Vietnam to contribute some implications for management strategy of banks

in Vietnam From that, the recommendations are given to not only commercial banks but also SBV These recommendations are both “situated” recommendations and

“strategic” recommendations This creates the important and necessary perquisites for the business of commercial banks in Vietnam safer, more stabilized and more efficiency

Key words: bank risk, financial risk, profitability

2.5 Relationship between financial risk factors and profitability 28

Chapter 3

5.2 Links between data analysis and research objectives and research questions 54

5.4.1 Analysis of findings on factors affecting banks’ risk exposure 70

5.5 Conclusion 75

6.3.1 Implication 1 Implication for the State Bank of Vietnam 79

6.3.3 Implication 3 Developing and updating the risk management strategy in

6.3.4 Implication 4 Improving the efficiency of risk management in the bank 83

Appendix 93

LIST OF TABLES AND FIGURES Figures

Figure 1.1 Structure of chapter 1

Figure 1.2 Structure of the Research

Figure 2.1 Structure of chapter 2

Figure 2.2 Bank goal and risks

Figure 2.3 The link between liquidity and other typical risks

Figure 2.4 Two broad categories of operational risk

Figure 3.1 Structure of chapter 3

Figure 3.2 Market shares of Vietnamese banks

Figure 4.1 Structure of chapter 4

Figure 4.2 Hypothesis

Figure 5.1 Structure of chapter 5

Figure 5.2 Age group of respondents

Figure 5.3 Distribution of working experience

Figure 5.4 Distribution of Ownership

Figure 5.5 Distribution of educational level

Figure 5.6 Distribution of educational background

Figure 6.1 Structure of chapter 6

Tables

Table 3.1 Deposits of the commercial banks in Ho Chi Minh City

Table 3.2 Reserve requirement rate in 2004-2008

Table 3.3 Current Reserve Requirement Rate

Table 3.4 Changes of interest rate for reserve deposit in VND at State bank of VN Table 3.5 Changes of base rate from 2008

Table 3.6 Provision rates

Table 5.1 Respondents’ characteristics

Tables 5.2 Interest rate risk ratio

Table 5.3 Summary of interest rate risk ratios

Table 5.4 Liquidity risk ratios

Table 5.5 Summary of liquidity risk ratios

Table 5.6: Credit risk ratio

Table 5.7 Summary of credit risk ratios

Table 5.8: Capital risk ratio

Table 5.9 Summary of Capital risk ratios

Table 5.10 ROA

Table 5.11 Summary of ROA

Table 5.12 ROE

Table 5.13 Summary of ROE

Table 5.14 Summary Statistics of the Explanatory Variables Table 5.15 Liquidity and interest rate

Table 5.16 Domestic market

Table 5.17 International market

Table 5.18 Internal Operation

Table 5.19 External Operation

Table 5.20 Credit

Table 5.21 Factors affecting banks’ risk exposure

Table 5.22Correlation Matrix of the Explanatory Variables Table 6.1 Summary of all hypotheses

LIST OF ABBREVIATIONS

CHAPTER 1 INTRODUCTION

1.1 Introduction

This chapter provides a general introduction to the research study The purpose is to

establish foundations for following chapters and the study as a whole, by providing a

general picture of the study This chapter is structured into eight sections as presented

by figure 1.1

Figure 1.1: Structure of chapter 1

1.6 Justification for the study

1.7 Significance and scope of the study

1.8 Structure of the study 1.4 Research question

of information and communicative technology (ICT) is accountable for the evolution

of banking services, in particular, online banking The development in ICT has not only provided vast banking opportunities previously beyond reach, but also heightens the competition and risks faced by banks in the financial system The banks’ primary business in lending and investment are risky business Banks are exposed to uncertainty and instability of the financial market as interest rate fluctuations, exchange rate variation and economic volatility could all lead to insolvency, bankruptcy and financial crisis The present adverse effect of the sub-prime crisis in the US, for instance, has crumbled giant investment bankers like Bear Stearns and Lehman Brothers and shook the insurance company American International Group (AIG) Hence, proper understanding on the factors that constitute banks’ risks exposure will mitigate and minimize banks’ loss in earnings and capital due to risks and financial crisis Besides, the intensified global competition and the liberalization

of banking rules and regulations have also changed the current banking system by providing greater opportunities of banks’ risk diversification Therefore, it is the purpose of this study to determine the factors that will affect the banks’ risks taking

in the banking industry and impacts of financial risks on theirs profitability The identification of these factors would be beneficial in constructing effective risk management strategies in the banks and to minimize a loss in income In addition, an understanding on the association of risk involved in the banking industry will also help banks formulate appropriate strategy that will escalate positive and minimize negative impact of associated risks

1.3 Research problems

Right now, the Vietnam banking system is facing to serious difficulties in regard to uncertainty and instability of the financial market as interest rate fluctuations, exchange rate variation and economic volatility It made many commercial banks had been chaotic and potential bankruptcy; threat the safety of whole banking system and national economy This has put the country in difficult situation when it is on the way

to modernize and industrialize the nation and integrate with international

environment This research study is to investigate and identify factors affecting banks’ risk exposure and relationship between financial risks and profitability of the commercial banks in Vietnam

1.4 Research questions

The research study will answer for the following research questions:

1 What factors affect banks’ risk exposure in Vietnam?

2 What is relationship between financial risks (liquidity risk, interest rate risk, capital risk, credit risk) and profitability of the commercial banks in Vietnam?

1.5 Research objectives

In solving the research problem and answering the research questions mentioned above, the research study has the following objectives:

• To investigate and describe factors affecting banks’ risk exposure in Vietnam

• To develop models the impacts of financial risks on commercial banks’ profitability

• To contribute to knowledge of factors affecting banks’ risk exposure and the relationships of financial risks and commercial banks’ profitability

1.6 Research Methodology

In this research, casual and descriptive are used in combination research

1.6.1 Secondary Data and Limitations

The study uses secondary data from official publications of State Bank of Vietnam (SBV), World Bank (WB) Moreover, data from other publications such as journals, magazines, newspaper, banks’ annual reports and foreign banks’ researches are also used in this study

It should be noted that the quality of Vietnam’s data is poor and short in term of time series More especially, obtaining the data related to Vietnam‘s banking sector is a very difficult task because of non-transparency in this sector It is also widely known

that the validity of the published information by Vietnamese journals, newspapers, annual reports and Government documents varies greatly, thus, resulting in the difficulty of obtaining internal validity

1.6.2 Questionnaires

Questionnaires were constructed based on the objectives of the research and after exploring bank executive opinions about different aspects of the current risk management in Vietnam‘s banking system Based on the relationship with the author, respondents were selected as bank’s executives, officers in risk management department at different local banks as well as foreign banks doing business in Vietnam The number of respondents was 150 and most of them were willing to reply the questionnaires The questionnaire is in Appendix

1.7 Significance and scope of the Research

Identifying the factors that may affect these risks are of importance and the impact of financial risks has had an effect on profitability of the commercial banks This study highlights that these indicators are implied for banks to formulate appropriate strategies for better bank management This study is to bring some applications in developing risk management strategy in commercial banks in Vietnam It will help banks in constructing effective risk management strategies in the banks and to minimize a loss in income

1.8 Structure of the Research

In term of research structure, the thesis has six chapters (Figure 1.2) The thesis begins by defining the research problem and questions, and providing a justification for the research study Chapter one also reviews the research background, significance and scope of the study Chapter two reviews banks’ risk in theory, ratios

to evaluate profitability of the commercial banks Objectives of this chapter are to review the theories related to banks’ risk and profitability of the commercial banks,

to review previous research related to the areas of banks’ risk and profitability of the

commercial banks and to build a model of the impact of financial risks (liquidity risk, interest rate risk, market risk and capital risk) on profitability

Chapter three examines the overview of banking industry The objective of this chapter is to review overview of banking industry and banking regulatory environment which affect management strategy of the commercial banks in Vietnam, Chapter four discusses aspects of the research methodology including research design, data collection and data analysis methods, and hypothesis testing to support the model Objectives of this chapter are: (1) to justify the research methodology of this study, (2) to explain research methodology used in the study, and (3) to demonstrate how research design, and data collection and analysis can be utilized in this study to answer the research questions outlined in the chapter 1

Data analysis and findings are presented in chapter five This chapter presents descriptive findings of factors and findings of the research study related to testing the model of profitability Objectives of this chapter are (1) to systematically present the descriptive findings of the research study, (2) to interpret significance of these findings based on data analysis, (3) to present the results of testing the model of commercial banks’ profitability, and (4) to explain how the model, developed from a literature review, was supported by data analysis Finally, the thesis ends with chapter six This chapter will give some conclusions and implications for banks in Vietnam to avoid bank failure

Figure 1.2: Structure of the Research

1.9 Conclusion

This research examines the factors affecting banks’ risk exposure and the relationship between financial risks and profitability of the commercial banks in Vietnam To date, there is no significant research related to factors affecting banks’ risk exposure and impacts of financial risks on profitability in Vietnam This research is designed

as a combination of descriptive and casual research in which a sample of 150 banks’ executives, officers in risk management department at different local banks as well as

Chapter 2: Literature Review Chapter 3: Overview of banking Industry

Chapter 6: Conclusions and Implications Chapter 5: Data Analysis and Findings Chapter 4: Research Methodology Chapter 1: Introduction to the Study

foreign banks doing business in Ho Chi Minh City for personal interview and a sample of 10 banks in Vietnam for analyzing impacts of financial risks on profitability

Gathered data will be processed by Excel, the Statistical Package for Social Science (SPSS) and EView 7.0 are the main computer software utilized in data analysis Findings of this study will be applied to increase efficiency of risk management of commercial banks in Vietnam To provide an in-depth picture of business environment in which commercial banks operate, chapter 3 will present information

on background of banking industry, the bank regulatory environment in Vietnam whereas chapter 2 reviews the literature of bank’ risks

CHAPTER 2 LITERATURE REVIEW

2.1 Introduction

This chapter is a review of the literature on banks risk in theory The objectives of

this chapter are to review previous research related to the area of banks’ risk

This chapter is structured into 5 sections (Figure 2.1)

Figure 2.1: Structure of chapter 2

2.1 Introduction

2.2 Bank’s Risks

2.4 Analyzing Bank Performance with

Financial Ratios

2.3 Characteristics of Bank’s Risks

2.5Relationship between financial risk

factors and profitability

2.6Previous studies

2.7 Conclusions

2.2 Bank’s risk

There are many different risk definitions by different economists Risk is uncertainty but it can be measured (Frank, 1981) Risk is uncertainty that an unexpected event was happened (Alan, 1989) Risk to a banker means the perceived uncertainty

connected with some events

Risk is defined as the effect of uncertainty on objectives (whether positive or

negative) Risks can come from uncertainty in financial markets, project failures, legal liabilities, credit risk, accidents, natural causes and disasters as well as deliberate attacks from an adversary

According to Spira (2003), the historical progression of the idea of risk and risk management can be traced back to the pre-modern era when risk was related to natural events, which were beyond human agency The development of rationalism during the seventeenth century suggests that both the natural and social worlds could

be subjected to scientific exploration People learnt that once techniques for the prediction and calculation of risk became available, it could also be avoided and compensated Risk became associated with unanticipated outcomes of human action, rather than simply the result of fate or acts of God Her Majesty's Treasury's website (2005) stated that, today, risks were an inherent part of both business and public life Every business and every person faces risks everyday but each person has different attitude to risks A person's aversion to risks is the main factor in deciding whether he/she will try to manage his/her risks The essence of risk is the uncertainty of outcome The term exposure refers to the combination of the probability of all potential events and the magnitude of their impact The Chinese symbol for risk is a combination of two symbols one for danger and one for opportunity (Damodaran 2003) In general terms, people often think of risks as the chance of something bad happening Being bad and chance are two key elements of risks Being bad is the first element which is also seen as a threat, and it refers to an event or outcome that is adverse, such as a crop failure due to a thunderstorm Chance is the second element, which also sometimes refers to opportunities (constructive events) which if exploited

could offer an improved way of achieving objectives but which are surrounded by threats Tchankova (2002) stated that risk is an inherent part of business and public life Dynamic market relations continuously increase the uncertainty of the environment where business and public organizations work In order to maintain high competitiveness, it requires organizations to start considering other alternatives, which may lead to better return but at the same time, may create higher risks for the organization It is important for management to realize that risks cover all aspects of organizational activities and they should be considered at all management levels Risk to a banker means the perceived uncertainty associated with a particular event (Peter S.Rose, 2005) For example, whether the customer will renew his or her loan; deposits and other sources of funds will grow next month; or whether interest rates are going to rise or fall next week

Banking is the management of risk Bank accepts risk to earn profit They must balance alternative strategies in terms of their risk/return characteristics with the goal

of maximizing shareholder wealth

‘‘The fact is that bankers are in the business of managing risk Pure and simple, that is the business of banking.’’

(Walter Wriston, former CEO of Citibank; The Economist, 10 April 1993)

‘‘Banks have an ingrained habit of plunging headlong into mistakes together where blame minimizing managers appear to feel comfortable making blunders so long as their competitors are making the same ones VaR is the alibi that bankers will give shareholders (and the bailing out taxpayer) to show documented due diligence.’’

(Taleb, in Jorion and Taleb, 1997, p 3)

In doing so, banks recognize that there are different kinds of risk The Office of the Comptroller of the Currency (OCC) (OCC Formally Launches Supervision by Risk Program with distribution of Large Bank Supervision Handbook”, Office of the Comptroller of the Currency, News Release NR 96-2 (January 4, 1996) lists nine for

purposes of ban supervision: credit risk, interest rate risk; operational risk; liquidity risk; price risk; compliance risk; foreign exchange risk; strategic risk; and reputation risk The risks listed by the OCC may appear to differ from those listed by different bank supervisory agencies

Bank management must balance risk and return in seeking to maximize shareholder wealth However, such decisions are constrained by a number of factors These constraints may be classified into three separate though overlapping areas: market constraints; social constraints; and legal and regulatory constraints

Peter S Rose lists types of bank risk as follows: credit risk; liquidity risk; market risk; interest rate risk; earning risk; capital risk; inflation risk; currency or exchange rate risk; political risk; and crime risk

Shelagh Heffernan (2005) specifies risks to the business of banking are: credit, counterparty, liquidity or funding risk, settlements or payments risk, market or price risk, which includes currency risk and interest rate risk, capital or gearing risk, operational risk, sovereign and political risk

Bank goal and risks can be described as figure below:

Figure 2.2: Bank goal and risks

Goal

Source: Benton E.Gup, James W.Kolari (2005)

2.3 Characteristics of bank’s risks

In this study, the author concerns with six main types of risk as follows:

2.3.1 Credit risk

Credit risk is one of the oldest and most vital forms of risk faced by banks as financial intermediaries (Broll, et al., 2002) Commercial banks are most likely to make a loss due to credit risk (Bo, et al., 2005)

Banks are in business to take credit risk, it is the traditional way banks made money

To quote a former chairman of the US Federal Reserve System ‘‘If you don’t have

Maximize

Shareholder wealth

Amount of cash flow

Timing of cash flow Risk of cash flow

Credit risk Interest

rate risk

ity risk

Liquid- tional risk

Opera-

Capit-al risk

Fraud risk

Market

competition

Social Legal/regulatory

Constraints

some bad loans you are not in the business.’’(P.Volker, former chairman of the Board of Governors of the Federal Reserve System)

Generally, the greater the credit risk, the higher the credit premiums to be charged by banks, leading to an improvement in the net interest margin (Hanweck and Ryu, 2004)

Credit risks are a vital component of fixed-income investing, which is why ratings agencies such as S&P, Moody's and Fitch evaluate the credit risks of thousands of corporate issuers and municipalities on an ongoing basis

A form of risk that summarizes the risks a company or firm undertakes when it attempts to operate within a given field or industry

Peter S Rose (2005) indicates that the following are five of the most widely used indicators of credit risk:

• The ratio of non performing assets to total loans and lease

• The ratio of net charge-offs of loans to total loans and leases

• The ratio of the annual provision for loan losses to total loans and leases or to equity capital

• The ratio of allowance for loan losses to total loans and leases or to equity capital

• The ratio of non performing assets to equity capital

Non performing assets are income-generating assets including loans that are past due for 90 days or more

Charge-offs is loans that have been declared worthless and written of the lender’s book If some of these loan ultimately generate income for the lender, the amounts recovered are deducted from gross charge offs to yield net charge offs Both of the above ratios rise, exposure to credit risk grows, and failure of a bank or other lending institution may be just around the corner The final two credit risk indicator ratios

reveal the extent to which a bank or other lender is preparing for loan losses by building up its loan – loss reserves (the allowance for loan losses) through annual charges against current income (the provision for loan losses)

Another popular and long-standing credit risk measure, especially for banks is the ratio of total loans to total deposits

As this ratio grows, bankers may become more concerned because loans are usually among the riskiest of all assets for banks and other depository institution, and, therefore deposits must be carefully protected A rise in bad loans or declining market values of otherwise good loans relative to the amount of deposits creates greater depositor risk

2.3.2 Liquidity Risk

Bankers are also very concerned about the danger of not having sufficient cash and borrowing capacity to meet deposit withdrawals, net loan demanded, and so on Faced with liquidity risk a bank may be forced to borrow emergency fund at excessive cost to cover its immediate cash needs, reducing its earnings Very few banks ever actually run out of cash because of the ease with which liquid funds can

be borrowed from other banks One useful measure of liquidity risk exposure is the ratio of purchased funds (including Eurodollars, federal funds, security repurchases, large CDs, and commercial paper) to total assets

Heavier use of purchased funds increases the chances of a liquidity crunch in the event deposit withdrawals rise or loan quality declines Other indicators of a bank’s exposure to liquidity risk include the ratios of net loans to total assets; cash and due from deposit balances held at other banks to total assets; cash assets and government securities to total assets

Cash assets include vault cash held on bank premises, deposit the bank holds at the Federal Reserve Bank in its district, deposit held with other banks to compensate them for clearing checks and other inter-bank services, cash item in the process of collection (mainly uncollected checks) Standard remedies for reducing a bank ‘s

exposure liquidity risk include increasing the proportion of bank funds committed to cash and readily marketable assets, such as government securities, or using long-term liabilities to fund the bank operations (S Rose, 1991)

Liquidity management involves acquiring sufficient liquid asset to meet the bank’s

obligation to depositors In the process of doing so, banks are exposed to liquidity risk where the more liquidity is generated, the greater are the possibility and severity

of losses associated with having to dispose of illiquid assets to meet the liquidity demands of depositor (Diamond 1999; Allen and Jagtiani, 1996) However, besides depositors, Gatev (2006) revealed that banks that make commitments to lend are exposed to the risk of unexpected liquidity demands from their borrowers The liquidity insurance role of banks, however, exposes them to the risk that they will have insufficient cash to meet random demands from their depositors and borrowers (Gatev, 2006)

Bankers are also concerned about the danger of not having sufficient cash and needs Faced with liquidity risk a bank may be forced to borrow emergency funds at excessive cost to cover intermediate cash needs, reducing its earning Very few financial firms ever actually run out of cash because of the ease with which liquid funds can be borrowed from other bank

Somewhat more common is a shortage of liquidity due to unexpectedly heavy deposit withdrawals, which forces a bank to borrow funds at elevated interest rates to attract negotiable money market CDs, which are sold in million-dollar units and therefore are largely unprotected by deposit insurance

Events in the second half of 2007 and early 2008 highlight the crucial importance of liquidity to the functioning of markets and the banking sector as well as links between funding and market liquidity risk, interrelationships of funding liquidity risk and credit risks, reputation effects on liquidity, and other links among liquidity and other typical banking features Liquidity risk is not an ‘isolated risk’ like credit or market risks (although credit risk often arise as a liquidity shortage when the

scheduled repayments fall due), but a ‘consequential risk’, with its own intrinsic characteristics, that can be triggered or exacerbated by other financial and operating risks within the banking business

Figure 2.3: The link between liquidity and other typical risks (McKinnon, 1973)

These interactions have gained in significance and involve that banks progressively more need to adapt their systems to control liquidity risks in a manner consistent with their business models Furthermore, the relationships with other risks tend to create uncertainty with regard to liquidity risk measurement and to the management of a bank’s liquidity gap profile (For example, as to market risks, adverse market conditions tend to create uncertainty with regard to the value of assets in the liquidity management framework Margin calls on derivatives transactions implied by negative market developments also have repercussions on liquidity risk As far as intraday liquidity risk is concerned, severe disruptions in significant payment systems could also affect money markets conditions In addition, the delay of other less essential payments might also force other institutions to delay their own settlements and cause many banks to manage increased uncertainty about their overnight funding needs)

Intraday Risk

Reputational Risk Liquidity Risk

Concentr Risk

Operational Risk

Market Risk

Credit Risk

One useful measure of liquidity risk exposure is the ratio of purchased funds (including Eurodollars, federal fund, security RPs, large CDs and commercial paper)

2.3.3 Market Risk

Volatile changes in the interest rates have created havoc for managers of bank assets portfolios, particularly for those responsible for bank investment in government bonds and other marketable securities When interest rates catapulted to record levels, the market value of bank-held bonds plummeted, forcing many banking firms

to accept substantial losses on any securities that had to be sold – a potent example of what financial analysts called market risk If interest rates increase, the market value

of fixed income securities (such as bonds) and fixed rate loans will fall A bank faced with the need to sell these assets in a rising rate market will take losses Falling interest rates, in contrast, will increase the value of fixed income securities and fixed rate loans, resulting in capital gains when they are sold (S.Rose, 1991)

The increased prominence of trading activities at banks has highlighted the banks’ exposure to market risk, the risk of loss from adverse movement in financial market

rates and prices A bank’s market risk exposure is determined by both the volatility

of underlying risk factors and the sensitivity of the bank’s portfolio to movements in

those risk factors (Hendricks and Hirtle, 1997)

General or systematic market risk is caused by a movement in the prices of all

market instruments because of, for example, a change in economic policy Unsystematic or specific market risk arises in situations where the price of one instrument moves out of line with other similar instruments, because of an event (or events) related to the issuer of the instrument For example, the announcement of an unexpectedly large government fiscal deficit might cause a drop in the share price index (systematic risk), while an environmental law suit against a firm will reduce its share price, but is unlikely to cause a general decline in the index (specific or unsystematic market risk)

A bank can be exposed to market risk (general and specific) in relation to equity; commodities (e.g cocoa, wheat, oil); currencies (e.g the price of sterling appreciates against the euro); debt securities (fixed and floating rate debt instruments, such as bonds); debt derivatives (forward rate agreements, futures and options on debt instruments, interest rate and cross-currency swaps, and forward foreign exchange positions); equity derivatives (equity swaps, futures and options on equity indices, options on futures, warrants)

Thus, market risk includes a very large subset of other risks Two major types of market risks are currency and interest rate risk If exchange rates are flexible, any net short or long open position in a given currency will expose the bank to foreign exchange or currency risk, a form of market risk In this case, it is the market for foreign exchange, and the ‘‘price’’, the relative price of currencies given by the exchange rate A bank with global operations will have multiple currency exposures The currency risk arises from adverse exchange rate fluctuations, which affect the bank’s foreign exchange positions taken on its own account, or on behalf of its customers For example, if a bank is long on dollars and the dollar declines in value

against other currencies, this bank is going to lose out Banks engage in spot, forward and swap dealing, with large positions that can undergo big changes within minutes Mismatch by currency and by maturity is an essential feature of the business – good mismatch judgments can be profitable and signal successful risk management

Indicators of market risk in banking and financial institutions management are

• The ratio of book-value assets to the estimated market value of those same assets

• The ratio of book-value equity capital to the market value of equity capital

• The market value of common and preferred stock per share, reflecting investor perceptions of a bank’s books

• The market value of common and preferred stock per share, reflecting investor perceptions of a bank’s risk exposure and earning potential

2.3.4 Interest Rate Risk

Movement in the market interest rates can also have potent effects on bank’s margin

of revenues over operating costs For example, rising interest rates can lower a bank’s margin of profit if the structure of the institution’s assets and liabilities is such that interest expenses on borrowed money increase more rapidly than interest revenues on loans and security investments

The impact of changing interest rates on the bank’s margin of profit is usually called interest rate risk Among the most widely used measures of bank interest risk exposures are:

• The ratio of deposit to loan

• The ratio of interest sensitive assets to interest sensitive liabilities: when interest sensitive assets exceed interest sensible liabilities in a particular maturity range, a bank is vulnerable to losses from falling interest rates

• The ratio of uninsured deposits to total deposits, where uninsured deposits are usually government corporate deposits that exceed the amount covered by insurance and are usually so highly sensitive to changing interest rates that they will be withdrawn if yields offered by competitors rises even slightly higher (S.Rose, 1991)

2.3.5 Operational risk

Operational risk is not a new but a long-standing risk faced by all businesses The Bank for International Settlements (2004) stated that operational risk was inherent in every business and support activities, in other words, operational risk can occur anywhere and anytime in any business environment A newly established organization is confronted with operational risk before it even decides on its first transaction (Muermann and Oktem 2002) Of all the different types of risk faced by

an organization, operational risk is among the most devastating and the most difficult

to anticipate and it can result in sudden and dramatic reductions in the value of a firm (Mainelli 2002) Muermann and Oktem (2002) stated that operational risk could manifest itself in various ways, including errors, business interruptions, inappropriate behaviour of employees and natural disasters These events can potentially result in financial losses and other damages to the firm, including causing harm to the firm's reputation Even some of the almost invisible individual pinpricks of recurring operational risk events over a period of time can drain the resources of an organization

Operational risk events can be divided into high frequency / low severity (HFLS) Operational events that occur regularly but each of this type of event individually exposes an organization to low level of losses On the contrary, low frequency / high severity (LFHS) operational risk events are quite rare but the losses to an organization can cause enormous loss (Geiger 1999, Allen and Saunders 2000)

Operational risk does not mean only failures in the banks operations, but also the

causes of the failures, such as terrorist attacks, management failures, competitive actions and natural disasters (King, 1998) These caused are largely uncontrollable

and unpredictable Moreover, human or technological errors, lack of control to prevent unauthorized or inappropriate transactions being made, fraud and faulty reporting may lead to further losses caused by internal process, people and operating system (Medova, 2001)

All banks are subject to financial and operational risks While most banks are highly aware of the potential impact of financial risks such as interest rate and exchange rate movements, the area of operational risk is often less well understood Historically, the area of operational risk within banks has been that associated with criminal activities In 1993, the accounting firm KPMG conducted a fraud survey of six countries-the United States, Canada, Australia, the Netherlands, Ireland, and Bermuda This study indicated that, on average, approximately 80% of all frauds were committed by employees In all of the countries surveyed, misappropriation of cash was the most common form of employee fraud However, with the change of the business environment, the scope of operational risk is also broader (Pyle 1997)

As suggested by Allen and Sanders (2002), the banking industry, in particular, is vulnerable to losses resulting from operational failure Even a fundamentally strong organization may often recover from market risk and credit risk but may not recover from certain operational risk events Crouhy et al (2001), Lopez (2002) and Thirlwell (2002) all pointed out that during early and mid 1990s, much attention had been focused on measuring and managing market risk and credit risk in the banking industry It was not until the late 1990's that banks and regulators increasingly shifted their attention to risks other than market and credit risk These came to be collectively known as operational risk In other words, operational risk is anything but well defined

As part of this evolving risk-aware environment, banks want to know and understand their operational risk in order to manage their loss events and to leverage certain opportunity risk to their competitive advantage They also want to align their investment and development strategies with the organizations risk appetite In order

to monitor and control operational risk, banks should maintain a system of comprehensive policies and a control framework designed to provide a sound and well controlled operational environment The goal of the managing operational risk is

to keep it at appropriate levels in light of a bank's financial strength, the characteristics of its businesses, the markets in which it operates and the competitive and regulatory environment to which it is subjected (Mainelli 2002; Schroeck 2002; 'Thirlwell 2002) Croupy, Galai and Mark (2001) claimed that banks were establishing a risk management function and developing dedicated compliance practices These steps will provide a solid foundation to protect the bank's reputation and ensure that regulatory requirements are met

In brief, banks are challenged to:

- Meet their compliance commitments for process transparency and communications, for example USA Patriot Act;

- Employ best practice, for example Basel II Accord;

- Capture, measure, analysis and report risk loss events;

- Design strategies to align and manage the operational risk across the business;

- Have timely and accurate risk reporting, tracking and controls;

- Perform and manage risk self-assessment exercise that evaluates inconsistencies across different lines of business within organization hierarchies; and

- Maximize the potential benefit of freeing up capital under the Basel IT capital charge calculation methods

However, even with better guidelines which have been set by the Basel Committee recently, the industry may still find that operational risk management is not as easy as just applying an equation Anderson (2000) and Mainelli (2002) believed that there was still much work that needs to be done to guide the industry In summary, the issues faced by banks include the lack of a comprehensive definition, problems with

identification, measurement and control; lack of an integrated system or model; and a lack of senior management support in operational risk management (Croupy, Galai and Mark, 2001)

Figure 2.4 Two broad categories of operational risk

Source: Croupy, Galai and Mark 2001, p 40

2.3.6 Capital risk

Banker must be directly concerned about risks to their institutions’ long-run survival, often called capital risk For example, if a bank takes on an excessive number of bad loans or if a large portion of its security portfolio decline in market value, generating serious capital losses when sold, then its equity capital account, which is designed to absorb such losses, may be over-whelmed If investors and depositors become aware

of the problem and begin to withdraw their funds, regulators may have no choice but

Operational risk

Operational failure risk

(Internal Operational risks)

The risk encountered in the

Operational strategic risk

(External Operational risks) The risk of choosing an inappropriate strategy in response to environmental factors, such as

to declare the institution in solvent and close its door The failure of a bank may leave its stockholders with none of the capital funds they committed to the institution Banks are more highly geared (leveraged) than other businesses – individuals feel safe placing their deposits at a bank with a reputation for soundness There are normally no sudden or random changes in the amount people wish to save or borrow, hence the banking system as a whole tends to be stable, unless depositors are given reason to believe the system is becoming unsound Thus, for banks, the gearing (or leverage) limit is more critical because their relatively high gearing means the threshold of tolerable risk is lower in relation to the balance sheet This is where capital comes in: its principal function is to act as a buffer by supporting or absorbing losses Banks which take on more risk should set aside more capital, and this is the principle behind the Basel risk assets ratio Banks need to increase their gearing to improve their return to shareholders To see the link, consider the equation below:

ROE = ROA × (gearing multiplier)

where: ROE: return on equity or net income/equity ROA: return on assets or net income/assets Gearing/leverage multiplier: assets/equity

Basel requires a bank’s risk assets ratio to be 8% (i.e [capital/(weighted risk assets)]

= 0.08) If a bank satisfies this requirement, it means its equity is about 8%, its debt

must be 92%, giving a gearing/leverage ratio of 92/8, or 11.5 Since the bank’s ROA

is typically very small, the ROE can be increased by higher leverage or raising the ratio of assets to equity But with higher leverage comes greater risk, because there

are more assets on the bank’s balance sheet Generally, a bank is said to be highly

geared/leveraged when a large exposure is associated with a small capital outlay This can occur in the more traditional activities such as fractional reserve lending (they only keep a small fraction of their deposits as reserves), or because of newer

types of business, such as the use of derivatives Capital risk is the outcome of other risks incurred by the bank, such as credit, market or liquidity risk Poor earnings, caused by high loan losses, or inappropriate risk taking in other areas put the bank’s capital at risk Banks perceived to have an insufficient amount of capital will find it difficult to raise funding Two ratios will be monitored by agents funding or considering funding the bank:

• The bank’s capital ratio or its Basel risk assets ratio – capital/weighted risk assets;

• The bank’s leverage ratio – debt/equity

According to Peter S Rose (2005), default or failure risk can be measured

approximately by such factors as:

• The interest rate spread between market yields on debt issues (such as capital notes and CDs issued by banks and thrifts) and the market yields on government securities of the same maturity An increase in that spread indicates that investors in the market expect increased risk of loss from purchasing and holding the financial institution’s debt

• The ratio of stock price per share to annual earnings per share This ratio often falls if investors come to believe that a bank in undercapitalized relative to the risks it has taken on

• The ratio of equity capital (net worth) to total assets, where a decline in equity funding relative to assets may indicate increased risk exposure for shareholders and debt holders

2.4 Analyzing bank performance with financial ratios

To evaluate the profitability of a commercial bank, there are many kinds of ratios Like all financial ratios, each of profitability measures varies substantially over time and from market to market We can use the financial ratios as follows: ROA, ROE, NIM, Net non-interest margin, Net operating margin and EPS

ROA and ROE have been used in most structure-performance studies ROA shows the profit earned per dollar of assets and most importantly, reflects the management ability to utilize the bank’s financial and real investment resources to generate profits For any bank, ROA depends on the bank’s policy decisions as well as uncontrollable factors relating to the economy and government regulations Many regulators believe return on assets is the best measure of bank efficiency ROE, on the other hand, reflects how effectively a bank management is using shareholders funds A bank’s ROE is affected by its ROA as well as by the bank’s degree of financial leverage (equity/ asset) Since returns on assets tend to be lower for financial intermediaries, most banks utilize financial leverage heavily to increase return on equity to a competitive level So in this study the author only evaluate the profitability of a commercial bank through 2 main ratios, they are ROA and ROE

2.4.1 Rate of return on equity (ROE)

ROE (%) = Net income/Total equity capital x 100

The rate of return on equity is a good starting point in the analysis of a bank financial condition for the following reasons:

If the ROE is relatively low compared with other banks, it will tend to decrease the bank’s access to new capital that may be necessary to expand and maintain a competitive position in the market

• A low ROE may limit a bank’s growth because regulations require that assets

be (at a maximum) a certain number of times equity capital

• ROE can be broken down into components parts that help to identify trends in the bank’s performance

Because the ultimate of bank management should be to maximize shareholder wealth, this ratio is particularly important

2.4.2 Rate of return on asset (ROA)

The rate of return on assets (ROA) measures the ability of management to utilize the real and financial resources of the bank to generate returns ROA is commonly used

to evaluate bank management

ROA (%) = Net income/Total assets x 100

2.5 Relationship between financial risk factors and profitability

The basic need for liquidity, asset, liability, capital adequacy, credit and interest rates risks management are now more challenging than before (Mishkin, 2007) These principles of bank management are crucial to maintain a healthy and profitable banking system

The four financial risk factors were identified using the study by Cheng and Ariff (2007) That study uses twenty one financial accounting/financial ratios calculated from the balance sheets information The twenty one ratios were re-grouped as factors using factor analysis The factor analysis in the above study identified four financial risks This study uses the direct ratios that proxy for the four financial risks The four financial risks identified are Interest risk factor, Liquidity risk factor, Credit risk factor, and capital risk factor In this study the author uses the following ratios as the measures for the four financial risks

Deposits/ Loans: Interest rate risk factor,

Loans/Deposits: Liquidity risk factor,

Provision for bad and doubtful debts/Loans: Credit risk factor, and

Shareholder equity/Total assets: Solvency risk factor,

The relation between ROA, ROE as dependent variable and interest rate risk, liquidity risk, credit risk and capital risk (solvency risk) as independent variables is tested in the regression:

PRO= a1 + a2 Ir + a3 Lr + a4 Cr + a5 Sr + ε

where,

PRO: ROA, ROE

Ir: Interest rate risk factor,

Lr: Liquidity risk factor, and

Cr: Credit risk factor,

Sr: Solvency risk factor or Capital risk factor,

2.6 Previous study

2.6.1 Factors affect to bank’s risks exposure

Although Demasi (2007) and Fatemi and Fooladi (2006) discovered that credit and market risk are the main factors contributing to risk exposure in the banking industry Voon-Choong, Yap; Hway-Boon, Ong; Kok-Thim, Chan and Yueh-Sin, Ang in Malaysia (2010) discovered that commercial banks in Malaysia are subjected to several other factors The five factors identified as the main factors that contribute to banks’ risk exposure in the Malaysian banking scenario are liquidity and interest rate factor, domestic market factor, international market factor, business operation and credit factor The banks’ ability to manage its level of liquidity and capital adequacy, appropriation of excess reserves due to interest rates fluctuations, and the impact of governments capital controls are vital aspects to commercial banking business in Malaysia Besides, in support to Gatev and Strahan’s (2005) results, the availability

of liquidity within banks is also found to be directly affected by the domestic and international market Then again, setback in the banking system due to technological glitches, political turmoil, and natural disasters are also found to be significantly contributing to banks’ risk taking business Hence, banks have to take due consideration of all of these elements of risk to design an effective bank management strategy and to minimize any loss in earnings