This study provides a closer look at the credit risk that commercial banks may suffer from their loaning activities. I will first define the credit risk and state the origin, i.e. the sources, of this risk. This study will also show the credit risk management process in the loan product of the Asia Commercial Bank of Vietnam, analyze this process, note its strengths, weaknesses and show to which extent it is incorporated with Principle 3 in the Principles for Management of Credit Risk by the Bank for International Settlement.
Introduction
Commercial banks, by the nature of their activities, suffer greatly from credit risk. According to Arunkumar (2005), credit risk takes about 70% and 30% remaining is shared between the other risks. Credit risk can cause great losses to the banking industry, like how Italian banks suffered a total loss of 2266 million Euro in the Parmalat and Parmatour default case in 2003 (The Economist, 2004). This is the reason why in the Principles for the Management of Credit Risk, the Basel Committee on Banking Supervision (2000) stipulates that "Banks should identify and manage credit risk inherent in all products and activities". The Asia Commercial Bank of Vietnam (ACB) understands this thoroughly, and deliberately tries to incorporate this principle with its loan products. It implements an intensive credit granting process in the effort to eliminate the credit risk in its operation. The process is mainly made for the bank's loan activities, as it is considered to be one of the greatest threats to ACB's operations.
The rest of this study is organized as follows: Section II defines the credit risk and identifies its components. An analysis of ACB's credit granting process will be portrayed at Section III. And Section IV is the conclusion of this study.
Credit risk and its components:
Credit risk is the risk that a bank's borrower "will not pay their debt obligations in full when they are due" (Lopez, 2003). A bank's main activities are taking deposits and granting loans, so it is always exposed to credit risk. The event which the borrower is unable to pay the debt on time (commonly after three months of the requirement date) is called "default". The default of a small number of customers may result in a very large loss for the bank (Bessis, 2003). There are many events that can lead to a default: when the borrower is in a difficult financial situation and may be facing a bankruptcy procedure; when the borrower is having a fraudulent act where it does not comply with its debt obligations; etc. In the case of default, banks do not always suffer great losses. The loss can be recovered from collaterals and/or guarantees. The objective of credit risk management is to minimize the risk and maximize bank's risk adjusted rate of return by assuming and maintaining credit exposure within the acceptable parameters (Raghavan, 2003).
Credit risk consists of pre-settlement risk and settlement risk. Pre-settlement risk is the potential loss due to the counterpart's default during the life of the transaction (van Gestel, Baesens, 2009). It exists from the beginning of the credit contract until settlement, which can be a long period, often years. Banks are also exposed to settlement risk where the debt payment is not made directly but via other banks that may default at the moment of the payment. Payments in large amount and in different time zones and currencies are more susceptible to settlement risk. One simple method to reduce settlement risk is netting as it reduces the transfer amount, and, subsequently, the settlement risk.
Credit risk is represented by four factors: Probability of Default (PD), Loss given Default (LGD), Exposure at Default (EAD) and Maturity. In these four factors, the PD, the LGD and the EAD are the most important components. While Maturity is required to calculate the required capital, it plays a minor role in exposure review. The PD is the probability that a default event occurs, and is mostly defined not on a product but a counterpart. When a counterpart defaults on one loan or obligation, it is likely to default on its other loans (van Gestel, Baesens, 2009). However, in certain situations, the PD of one product can be higher than another's. For example: the PD on credit cards may be higher than it is on mortgages. In the event of default, the actual loss of the bank is determined by the LGD and the EAD. The LGD represents the percentage of loss over the total exposure in the case of default. When the default generates no loss, the LGD is zero percent, and when the bank loses full exposure amount, it is 100 percent. The LGD can also have a negative value due to penalty fees and interest rate, as well as the value of above 100% due to litigation costs and tiny to zero recovery from counterparty's default. The value of LGD is not fixed and can be different between products depend upon the type of default and its resolution: whether to cure, restructure or liquidate the counterpart. When banks use LGD to measure credit risk, they can either use it separately or combine it with PD to form the expected lost rating scale, which is calculated as EL = PD x LGD. The last component of credit risk is EAD, which is the Exposure at Default. The EAD may not be known beforehand. Some products have a fixed amount of EAD while some others vary with the liquidity needs of the counterpart. To minimize the EAD, banks often use credit limit or require approval when additional drawing is made. In certain events, the bank may protect itself against such additional drawing by using covenants. Covenants are additional clauses in the contract that allow reduced limits or contract renegotiation (van Gestel, Baesens, 2009).
The Asia Commercial Bank of Vietnam's credit management process in loan product
The Asia Commercial Bank (ACB) is one of the leading banks in Vietnam. It is founded in 1993 and soon became well-known and is acknowledged by many experts. As a retail bank, the ACB's main customers are individual customers and small and medium firms. In 2011, the amount of credit granted to individual customers took up to 35% and to small and medium firms is 60% of total amount granted by ACB. However, these types of customers require close inspections both before and after the loans are granted, as they are highly susceptible to the fluctuation of economy and social environment. This is why the ACB has developed an intensive credit granting process to avoid bad debts in general, and specifically from small and medium enterprises.
The internal credit rating system takes an important position in ACB's credit risk management process. The purpose of this system is the same as other credit rating systems of credit rating agencies such as Moody's, Standard & Poor: to evaluate the credit risk in the bank's operation. However, due to the differences in methodology as well as economic condition, the design of ACB's internal credit rating system is somewhat different to other systems. The system classifies the customers into four groups, including standard, attention required, sub-standard doubtful and defaulting customers. The groups of the system are defined as the table below:
Rating
Group
AAA
Standard customers
AA
A
BBB
Attention required customers
BB
B
CCC
Sub-standard customers
CC
C
Doubtful customers
D
Defaulting customers
The rating is based upon several criteria, such as the field of business the firm is operating in, the size of the firm, financial status of the firm, etc. ACB will base on the rating, along with other assessments, including sources of funds for settlement, collateral, infrastructure of the customer, to decide whether to approve or deny the loan request. This decision will be taken in five steps in the credit granting process:
First, customers that request loans from ACB will contact the bank and will be instructed about the procedure, conditions and necessary documents. This step will be done by the bank's Customer Relationship Agent.
Second, when the bank receives the loan request file from the firm, the Credit Analyst and the Collateral Assess Agent will together assess customer's collaterals. A collateral assessment report will be filed by the Collateral Assess Agent. The Credit Analyst at the same time will file in a report on the financial status and capability of the customer. This report includes legal document check, customer's credit history check with the bank and other credit institutions via the Vietnam National Bank's Credit Information Center to assess the creditability of the customer, as well as checking the firm's financial capability by assessing the financial reports provided by the firm.
Third, after the procedure is completed, the loan request will be approved or denied by authorized personnel. This personnel is decided base on the amount of credit that will be granted as noted in ACB's regulations, for example a four billion Vietnam Dong loan (approximately 200,000 US Dollar) or an equivalent amount denominated in foreign currency must be approved by the branch director or higher authorities.
Forth, if the loan request is approved, the Loan Agent, represents the bank, will make the loan contract and proceed the disbursement procedure. The customer will not receive all of the funds at once in cash. Instead, they are required to keep the funds in a loan account at ACB and may withdraw a certain amount in a specific period of times, depend on the amount of loan and the credit standing of the firm. After the contract is made, the Legal Document Officer will proceed to receive and manage the collateral and register the collateral in accordance with the banking regulations of Vietnam.
Lastly, after the funds are disbursed, the Customer Relationship Agent and the Loan Agent will periodically inspect the repayment status and loan deadlines of the customer. They will also check the credit usage status and operating status of the firm to ensure that the credit granted to them is being used for the purposes specified in the loan request. If ACB's personnel notice that the disbursed funds are being used for wrongly purposes, they will report the matter and suggest solutions to the higher-ups.
During the loan period, depend on the customers' requests and regulations set up by the bank, the deadlines, interest discounts, withdrawal limit, etc. may be adjusted in each individual case.
From ACB's credit granting process, we can see that the bank has been doing its best to avoid credit risk and incorporate the Principle 3 in Principles for the Management of Credit Risk of the BIS. Firstly, the internal credit rating system and the intensified analyses on various aspects of the customer help the bank separate customers who have good credit standings from those who do not in the first two steps of the process. This way, ACB can pick trustworthy customers and thus reduce the PD. Secondly, the third and forth step of the process reduce the LGD and EAD significantly. Each level of authorization can only approve a certain amount of credit, and the existence of loan accounts limit the exposure of the bank at credit risk as well as the loss the bank has to incur if its customer defaults. And lastly, after ACB grants the loans to its customer, its personnel still closely track the status of the loan to ensure moral hazard, which is one of the main causes of credit risk, doesn't occur. This credit granting process helps ACB avoid having a large number of bad debts resulting from credit risk.
Conclusion:
ACB, like any other bank, always have to face vital threats originating from credit risk. Credit risk may cause great losses to any bank that neglects on hedging against such risk. Credit risk is also linked to many other risks, such as interest rate risk, funding risk, capital risk, etc. Therefore, attention to credit risk is required to have a sound banking operation. By constructing a very thorough credit granting process, ACB has been effectively avoided credit risk and limited the amount of bad debt to a small number in relation to the total amount of funds granted to its customer, with the bad debt ratio of 0.85% in 2011. However, this number also means that the process does not give ACB immunity to credit risk. Periodic revision is needed to perfect this credit granting process, as well as to keep up with the ever-changing financial state of Vietnam.
