The impact of credit risk on profitability in commercial banks in vietnam

Master’s thesis

Supervisor : Dr Pham Huu Hong Thai

The IMPACT of CREDIT RISK on
PROFITABILITY IN cOMMERCIAL BANKS
in vietnam

By Trong Quoc Tran
Email :
Tel : 0907003639

HOCHIMINH CITY-2010


Master’s thesis

Supervisor : Dr Pham Huu Hong Thai

ACKNOWLEDGEMENT

I would like to express my thankfulness to all those who gave me the possibility
to complete this research project. I am grateful all authors who have given me a
source of referential documents in the process of writing my thesis.
Especially, I am deeply indebted to my supervisor Dr Pham Huu Hong Thai,
whose support, interest, encouragement and suggestion supported me during
the research and writing process of this research project.
I also send to my gratitude to all teachers Financial and banking department
has encouraged and help me this completes my thesis. I would like to thank the
library staff of the University of Economics Ho Chi Minh City for their
relentless effort in making access to research data and literature possible.

Abstract

By: Tran Quoc Trong

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Nowadays, Credit risk management in banks has become more important
because of the financial crisis that the world is experiencing. Since granting
credit is one of the main sources of income in commercial banks, the
management of the risk related to that credit affects the profitability of the
banks. The study evaluates the impact of credit risk on profitability in
Commercial Banks in Vietnam for the period of 2005-2009. Using financial
ratios such as Return on Asset (ROA), Return on Equity (ROE), Nonperforming loan (NPL) analyze. In the study try to find out how the credit risk
management affects the profitability in banks. The study is limited to
identifying the relationship of credit risk management on profitability of twenty
commercial banks in Viet Nam. The results of the study are limited to banks in
the sample and are not generalized for the all the commercial banks in Viet
Nam. Furthermore, as the study only uses the quantitative approach and focuses
on the description of the outputs from SPSS, the reasons behind will not be
discussed and explained. The quantitative method is used in order to fulfill the
main purpose of the study. The study have used regression model to do the
empirical analysis. In the model the study have defined ROE as profitability
indicator while NPLR and CAR as credit risk management indicators. The data
is collected from the sample banks annual reports (2005-2009) and capital

adequacy and risk management on financial reports (20052009) in twenty commercial banks. The findings and analysis reveal that credit
risk has effect on profitability in all twenty banks.

Keywords: credit risk management, profitability, banks

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List of Acronyms

Adj. R2 Adjusted R-squared
BCBS Basel Committee on Banking Supervision
CAR Capital Adequacy Ratio CCF Credit
Conversion Factors
Coef. Coefficient
CRD Capital Requirements Directives
FIRB Foundation Internal Rating-based
FSA Financial Supervisory Authority
ICAAP Internal Capital Adequacy Assessment Process
IFRS International Financial Reporting Standards
IRB Internal Rating-based
LGD Loss Given Default
N Number (of Observations)
NI Net Income
NPL Non-performing Loan

NPLR Non-performing Loan Ratio
PD Probability of DefaultP-value Probability Value
R2 R-squared
ROA Return on Assets
ROE Return on Equity
RORAC Return on Risk Adjusted Capital
RWA Risk Weighted Asset
SFSA Swedish Financial Supervisory Authority
Signif. Significance
TL Total Loan
TSE Total Shareholders’ Equity

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TABLE OF CONTENT
TITLE PAGES

PAGES

ACKNOWLEDGEMENT
Abstract
List of Acronyms

CHAPTER ONE
1.Introduction
1.1

Statement of problems

1.2

Problem Discussion

1.3

Research question

1.4

Objective of the study

1.5

Scope of the study

1.6

Layout of the study

CHAPTER TWO LITERATURE REVIEW
2.1

The relationship between profitability and capital

2.2

The relationship between capital and risk

2.3

The relationship between risk and profitability

2.4

Previous Studies

2.4.1

ROE – profitability indicator

2.4.2

Credit risk management indicators

2.4.3.Capital and profitability :
2.5 Theories
2.5.1

Risks in banks

2.5.2

Credit risk management in banks

2.5.3

Bank Profitability

2.6 Regulations
2.6.1

The Basel Accords

CHAPTER THREE METHODOLOGY

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3.1

Research approach

3.2. Hypothesis
3.3

Sampling

3.4

Data Collection

3.5

Data analyzing instruments

3.6

Applied regression model

3.6.1

Dependent variable

3.6.2

Independent variables

3.6.3

Regression analysis explained

3.7.Reliability and validity
CHAPTER FOUR : OVERVIEW OF THE COMMERCIAL BANKING
SYSTEM IN VIETNAM
4.1.The commercial banking system of Vietnam was the process of
transition from mono-banking system to commercial banking system. (39)
4.2

Role of commercial banks in the economy

4.3

Banking system of the role of trade in Vietnam after 20 year

4.4.Opportunities for Vietnam's commercial banking system
4.5

The difficulties and challenges for Vietnam's banking system

CHAPTER FIVE : EMPIRICAL RESULT AND DISCUSSION
5.1Overview of the banks studied
5.2 Return on Equity (ROE)
5.3 Non-Performing Loan (NPLR)
5.4 Capital Adequate Ratio (CAR)

5.6.Basel I and basel II application affect
CHAPTER SIX : CONCLUSION AND SUGGESTIONS
6.1. Conclusion
6.1. Conclusion

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CHAPTER ONE

INTRODUCTION

1. Introduction
In this chapter, we present the background of the thesis followed by the problem
statement. The discussion also contains the motivation for our thesis. Finally,
we present the research question, the purpose of this thesis and limit the area of
the study.
1.1 Statement of problems
Credit activities are crucial of Vietnam banking system, They bring 80-90% to
income for each bank, but the risks are not less. Credit risk will be higher than
the enormous influence to business banking. Facing the opportunities and
challenges of the process of international economic integration, the issue of
raising the competitiveness of the domestic commercial banks with foreign
commercial banks, in particular improving the quality of credit, risk reduction
has become urgent. Besides, the world economic situation is complicated and
the risk of increasing the credit crisis. Vietnam is a country with open economy
should not avoid the effects of the world economy. Facing this situation,
requires commercial banks of Vietnam must improve the management of credit
risk, limited to the minimum possible risks, causing potential risks.
Managing credit risk in financial institutions is critical for the survival and
growth of the financial institutions. In the case of banks, the issue of credit risk
is even of greater concern because of the higher levels of perceived risks
resulting from some of the characteristics of clients and business conditions that
they find themselves in. Credit risk refers to the risk of loss because of debtor’s
non-payment of a loan or other forms of credit. As they default, delay

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in repayments, restructuring of borrower repayments and bankruptcy are also
considered as additional risks. When it comes to banking, credit risk is apparent
on lending services to clients. There is the need for an effective employment of
credit scorecard for the purpose of ranking potential and existing customers
according to risk. In this will be based the appropriate measures to be applied by
the banks. Nevertheless, banks charge higher price for higher risk customers.
Credit limits and faced by lenders to consumers, lenders to business, businesses
and even individuals. Credit risks, nevertheless, are most encountered in the
financial sector particularly by the institutions such as banks. Credit risk
management therefore is both a solution and a necessity in the banking setting.
The global financial crisis also requires the banks to regain enough confidence
by the public not only for the financial institutions but also the financial system
in general and to not just rely on the financial aid by the governments and
central banks. It is critical for the banks to engage in better credit risk
management practices. Banks are not an exemption.
The banks of Vietnam as well as the other over all the World are required to
follow Basel II capital adequacy framework from 2007. Basel II aims to build
on a solid foundation of prudent capital regulation, supervision, and market
discipline, and to enhance further risk management and financial stability.
However, it is worth mentioning that regulatory and deregulatory transitions
usually end up with the same result. The exposed risk – the main and most
difficult one to identify – is the credit risk in the particular current case. The
importance of this risk is increased by the fact that it is linked to the problem of
collateral. Therefore, it is in need of being deliberately examined and studied.

For this reason, Basel II considers varieties of credit risk measurement
techniques, wider than Basel I did. The goal is to improve the credit risk

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management quality without constraining banks’competitiveness. Regulations
should be interactive or flexible to be successful because of rapidly changing
technological, political, and economical circumstances. Credit risk measurement
tools presented in Basel II intended to be flexible. The banks can either choose
from the proposed options or employ their own as long as it gives sound and
fair results. The importance of the credit risk management and its impact on
profitability has motivated us to pursue this study. We assume that if the credit
risk management is sound, the profit level will be satisfactory. The other way
around, if the credit risk management is poor, the profit level will be relatively
lower. Because the less the banks loss from credits, the more the banks gain.The
profitability is the indicator of credit risk management. The central question is
how significant is the impact of credit risk management on profitability.
1.2 Problem Discussion
The importance of the credit risk and its impact on profitability has motivated
us to pursue this study. We assume that if the credit risk management is sound,
the profit level will be satisfactory. The other way around, if the credit risk
management is poor, the profit level will be relatively lower. Because the less
the banks loss from credits, the more the banks gain. Profitability is the

indicator of credit risk management. The central question is how significant is
the impact of credit risk management on profitability. This thesis is an endeavor
to find the answer.
1.3 Research question
The discussed background and problem formulation make us to have the
following research question: How does credit risk affect the profitability in
commercial banks in Vietnam ?
1.4 Objective of the study

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The purpose of the research is to describe the impact level of credit risk on
profitability in twenty commercial banks in Vietnam.
The study is to test the following hypothesis by econometric model :
H1: Banks with higher profitability (ROE, ROA) have lower loan losses (NonPerforming Loans/ Total Loans).
H2: Banks with higher interest income (net interest/Average total assets, interest
net /total income) also have lower bad loans (NPL).
H3: The growth of ROE/ ROA may also depend on the capitalization of the
banks and operating profit margin. If a bank is highly capitalized through the
risk-weighted capital adequacy ratio (RWCAR) or Tier 1 capital adequacy ratio
(CAR), the expansion of ROE will be retarded.
we test the hypothesis using the following regression model:
P(ROA/ROE)= α+β1NPLR+ β2CAR+ ε

Using data on 20 commercial banks in Vietnam and our results show no
rejection by ourhypothesis
1.5 Scope of the study
The research is limited on evaluate the impact of credit risk on profitability in
the twenty Banks in Vietnam. Thus, the other risks mentioned in Basel Accords
are not discussed. Due to the unavailability of information in annual reports, our
sample only contains twenty largest commercial banks and their 5 years’ annual
reports from 2005 to 2009 respectively. Since the banks in sample rejected to
participate in our internet based survey, the primary data was not possible to
obtain. Considering the above mentioned circumstances, the results of the study
are limited to twenty commercial banks in the sample and are not generalized
for all the banks in Vietnam. Finally, as the study only uses the quantitative
approach and focus on the description of the outputs from

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SPSS, The study will not go deep to discuss the reasons and give our own
explanation.
1.6 Layout of the study : This study is divided into six chapters :
•

The chapter one : Introduction

•

Chapter two : Literature review

•

Chapter three : Methodology

•

Chapter four : Introduces in general of Vietnam, Jointstock banks and
commercial banks

•

Chapter five : Empirical result and discussion

•

Chapter six : Conclusion and suggestions

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CHAPTER TWO

LITERATURE REVIEW
In this chapter, we provide theoretical foundation to our study by presenting
relevant literature.
2.1 The relationship between profitability and capital
It is generally accepted (see Berger, 1995; Barth et al., 1998) that the Capital
Asset Ratio (hereafter CAR) is negatively correlated with Return On Capital
(here after ROC). According to this hypothesis, the negative relationship is
obtained, in a one-period model where deposit rates are not influenced by bank
risks. However, assuming information symmetry between the depositors and the
bank i.e., ‘market discipline` exists and deposit and stock markets are perfect, a
rise in CAR due, for example, to the substitution of equity and debt, should
entail a reduction of the bank's risk to fail. In such a case, risk-averse depositors
who regard capital as a cushion against unexpected losses will be satisfied with
a lower interest rate on deposits. This in turn, ceteris paribus, should increase
Net Interest Margin (hereafter NIM) and thus ROC. On the other hand, a rise in
CAR increases capital, and therefore may reduce profitability either due to the
increase in the denominator of ROC or due to the perception that the bank is
safer. Thus, an increase in CAR might have an ambiguous effect on ROC.
According to the Expected Bankruptcy Costs Hypothesis , if a bank’s capital is
below its optimum level, a rise in capital should reduce the yield required on
deposits. Consequently, the increase in net income (the numerator in ROC) will
have a greater effect than the rise in

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capital (the denominator in ROC), and altogether one can expect a positive
relationship between capital and profitability. On the other hand, if capital is
above its optimum level as perceived by depositors, the increase in capital
reduces the interest rate required on deposits, so that the relationship between
capital and profitability is expected to be negative. According to the Signaling
Hypothesis (see Acharya, 1988), managers have ‘inside information’ regarding
future performance. If their compensation packages include stocks it will be
cheaper for a safe bank than for a risky bank to signal expected improved
performance in the future by increasing capital today. Therefore, capital entails
profitability.
Stiroh (2000) gives another argument for this causation. When banks overcome
high entry barriers by increasing their capital levels, they gain access to
profitable activities such as issuing guarantees and subordinated notes, and
acting as intermediators in derivative markets.
2.2 The relationship between capital and risk
A negative relationship between capital and risk is expected when all deposits
are insured with a flat premium rate i.e., there is no ‘market discipline’. In this
case, the marginal cost of increasing bank risk and/or reducing the level of
capital is zero. This is because in the view of the regulators, the insurance
premium does not change with risk or capital, and for the insured depositors the
interest demanded on their deposits is the same as that on a riskless asset. On
the other hand, when the insurance premium is adjusted to risk, e.g., including
the level of financial leverage, there is less incentive to change the financial
leverage (Osterberg and Thomson, 1989). The "optimum capital buffer theory"
suggests that banks have an incentive to hold more capital than required as an
insurance against a violation of the regulatory minimum capital

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requirements (Heid et al., 2004). Hence, banks with relatively large capital
buffers expected to maintain their capital buffers (increase both capital and risk)
while banks with small capital buffers aim at rebuilding an appropriate capital
buffer (increase capital and decrease risk). Alfon et al. (2004), who found a
negative relationship between capital and risk in U.K. banks and building
societies, mention several explanations for the actual capital levels, which are
substantially higher than required. The parameters mentioned are: the distance
from minimum capital requirements, the internal risk assessments by bank
managers and their sophistication in managing risk, the level perceived as
appropriate by rating agencies and depositors (market discipline), and the costs
of raising extra capital. Flannery and Rangan (2004) explain the capital build-up
of US banks during the 90s by increased capital requirements such as the FDIC
Improvement Act (1991), high profitability of the banking industry along with
higher risk levels, and the withdrawal of implicit government guaranties
(increased market discipline). Cebenoyan and Strahan (2004) found that banks
which used the loan sales market for risk management purposes held less capital
and were more profitable but riskier than other banks. This evidence is in line
with the Froot and Stein (1998) model that active risk management can allow
banks to hold less capital and to invest in riskier assets.
2.3 The relationship between risk and profitability

Stone (1974), Booth and Officer (1985) and Flannery and James (1984) applied
a Two-Index Model in banking. They found a positive correlation between the
yield on bank shares and changes in stock and bond indices (reflecting risks). In
a competitive business environment where symmetrical information between
the bank and its borrowers prevails, one can expect

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positive relationships between profitability and risk. This should be the result of
risk premium demanded by the bank from its borrowers and by the bank
stakeholders (See also Saunders et al., 1990; Shrieves and Dahl, 1992). The
trade-offs between pricing credit risk and setting capital aside are mainly related
to parameters such as regulation, competition, sophistication in risk
management, and the type of credit portfolios. In particular, a bank might not
fully price its loan portfolio for the following reasons: (a) Cost of data
collection for each borrower or project is usually greater than the benefit. A case
in point is mortgages or standard loans, (b) The population of borrowers is
relatively
homogeneous but not correlated, the amount of the particular loan is not
significant, and the distribution of loan repayments is relatively known, (c) The
risk is not directly connected to the borrower e.g., management or operational
risks. In practice, banks price credit risk and simultaneously set aside capital so
the differences between various banking sectors e.g., commercial and

saving/mortgage banks are related maily to the dosages of capital and
profitability. This is true despite the blurring of the distinction between
commercial and saving/mortgage banks during the past few years. Below we
link profitability, capital, and credit risk based on Froot and Stein (1998) and
EBCH adjusted to credit risk. In this chapter, we provide theoretical foundation
to our study by presenting relevant literature.
2.4 Previous Studies
2.4.1 ROE – profitability indicator
ROE as an important indicator to measure the profitability of the banks has been
discussed extensively in the prior studies. Foong Kee K. (2008) indicated that
the efficiency of banks can be measured by using the ROE which

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illustrates to what extent banks use reinvested income to generate future
profits1. The measurement of connecting profit to shareholder’s equity is
normally used to define the profitability in the banks. Furthermore, the paper
“Why Return on Equity is a Useful Criterion for Equity Selection” has
mentioned that ROE provides a very useful gauge of profit generating
efficiency. Because it measures how much earnings a company can get on the
equity capital. The ROE is defined as the company’s annual net income after tax
divided by shareholder’s equity. NI is the amount of earnings after paying all
expenses and taxes. Equity represents the capital invested in the company plus

the retained earnings. Essentially, ROE indicates the amount of earnings
generated from equity. The increased ROE may hint that the profit is growing
without pouring new capital into the company. A steadily rising ROE also refers
that the shareholders are given more each year for their investment. All in all,
the higher ROE is better both for the company and the shareholders. In addition,
ROE takes the retained earnings from the previous periods into account and tells
the investors how efficiently the capital is reinvested. In accordance with the
study Waymond A G. (2007), profitability ratios are often used in a high esteem
as the indicators of credit analysis in banks, since profitability is associated with
the results of management performance. ROE and ROA are the most commonly
used ratios, and the quality level of ROE is between 15% and 30%, for ROA is
at least 1%. The study of Joetta C (2007) presented the purpose of ROE as the
measurement of the amount of profit generated by the equity in the firm2 . It is
also mentioned that the ROE is an indicator of the efficiency to generate profit
from equity. This capability is connected to how well the assets are utilized to
produce the profits as well. The effectiveness of assets utilization is
significantly tied to.
2.4.2 Credit risk management indicators

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In response to recent corporate and financial disasters, regulators have increased
their examination and enforcement standards. In banking sector, Basel II has

established a direct linkage between minimum regulatory capital and underlying
credit risk, market risk and corporate risk exposure of banks. This step gives an
indication that Capital management is an important stage in risk mitigation and
management. However, development of effective key risk indicators and their
management pose significant challenge. Some readily available sources such as
policies and regulations can provide useful direction in deriving key risk
indicators and compliance with the regulatory requirement can be expressed as
risk management indicators. A more comprehensive capital management
framework enables a bank to improve profitability by making better riskbased
product pricing and resource allocation. The purpose of Basel II is to create an
international standard about how much capital banks need to put aside to guard
against the types of risk banks face. In practice, Basel II tries to achieve this by
setting up meticulous risk and capital management requirements aimed at
ensuring that a bank holds capital reserves appropriate to the risks the bank
exposes itself to. These rules imply that the greater risk which bank is exposed
to, the greater the amount of capital a bank needs to hold to safeguard its
solvency. The theoretical banking literature is, however, divided on the effects
of capital requirements on bank behavior and consequently, on the risks faced
by the institutions. Some academic works point toward that capital requirement
clearly contributes to various possible measures of bank stability. On the
contrary, other works conclude that capital requirements make banks riskier
institutions than they would be in the absence of such requirements. Jeitshko
and Jeung (2005) have discovered numerous aspects that explain the differing
implications of portfolio-management models

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for the responsiveness of bank portfolio risk to capital regulation. Results
depend on banks being either value-maximizing or utility-maximizing firms;
bank ownership (if limited liability) and whether banks operate in complete or
incomplete asset markets. Moreover, the effects of capital regulation on
portfolio decisions and therefore on the banking system’s safety and soundness
eventually depend on which perspective dominates among insurers,
shareholders, and managers in the principal-agent interactions.
2.4.3.Capital and profitability :
Theory provides contradictory forecast on whether capital requirements limit or
enhance bank performance and stability. The soundness of the banking system
is important because it limits economic downturn related to the financial
anxiety. Also, it avoids unfavorable budgetary consequences for governments
which often bear a substantial part of bailouts cost. Prudential regulation is
expected to protect the banking system from these problems by persuading
banks to invest prudently. The introduction of capital adequacy regulations
strengthen bank and therefore, enhance the resilience of banks to negative
shocks. However, these rules may cause a shift of providing loans from private
sector to public sector. Banks can comply with capital requirement ratios either
by decreasing their risk-weighted assets or by increasing their capital. Goddard,
Molyeux and Wilson (2004) analyzed the determinants of profitability of
European banks. The authors found a considerable endurance of abnormal
profits from year to year and a positive relationship between the capital-to-asset
ratio and profitability. Demirguc-Kunt and Huizinga (1999) examined how
capital requirement alter the incentives that banks face. An increase in capital
requirement necessitates banks to substitute equity for deposit financing, reduce
shareholder’s surplus. The

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decline in surpluses intensifies the probability of loss, driving a rise in the cost
of intermediation to sustain profitability. In support of this hypothesis, authors
have provided empirical evidence showing a significant effect on interest
margins pursuant to higher capital holdings and the share of total assets held by
banks. The evidence also supports higher net interest margins and more
profitability for well-capitalized banks. This is in harmony with the fact that
banks with high capital ratio have low interest expenses due to less probable
bankruptcy costs.
Samy and Magda (2009) focus on the impact of capital regulation on the
performance of the banking industry in Egypt. The study provides a
comprehensives framework to explicitly measure the effects of capital adequacy
on two specific indicators of bank performance: cost of intermediation and
profitability. The results provide a clear illustration of the effects of capital
regulations on the cost of intermediation and banks’ profits. As CAR
internalizes the risk for shareholders, banks increase the cost of intermediation,
which supports higher return on assets and equity. These effects appear to
increase progressively over time, starting in the period in which capital
regulations are introduced and continuing 2 years after the implementation.
Nonetheless, the evidence does not support the hypothesis of a sustained effect
of capital regulations over time, or variation in the effects with the size of

capital across banks. The authors have concluded that a number of factors
contributed positively to banks’ profitability in the post-regulation period:
higher capital requirements, the reduction in implicit cost, and the increase in
management efficiency. Countering effects on banks’ profitability were
attributed to the reduction in economic activity and, to a lesser extent, to the
reduction in reserves. An improvement of cost efficiency is not reflected in a
reduction in the cost intermediation or an improvement in

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profit. The effect of better efficiency is likely to have been absorbed in banks’
fees and commissions. Non-performing loans. Why NPL occurs? The
International Monetary Fund (2001) presents two main reasons for that: poor
risk management and plain bad luck in form of external independent factors.
The inflation, deregulation and special market conditions can lead to poor credit
lending decision which in turn leads to NPLs. In fact, many NPL studies are
conducted in the countries with financial market recession. In prior studies, NPL
is usually mentioned in East Asian countries’ macroeconomic studies, while
they run into serious economic downturn, as one of the financial and
economical distress indicators. Japan and China, are those of most mentioned in
this regard. Moreover, IMF working paper from December 2001 encourages
better account of NPL for macroeconomic statistics which makes NPL to be
widely used in macroeconomic statistics. Moreover, Hippolyte F. (2005)

advocates that macroeconomic stability and economic growth are associated
with declining level of NPLs, while the adverse macroeconomic situation is
associated with rising scope of NPLs. Ongoing financial crises suggest that NPL
amount is an indicator of increasing threat of insolvency and failure. However,
the financial markets with high NPLs have to diversify their risk and create
portfolios with NPLs along with Performing Loans, which are widely traded in
the financial markets. In this regard, Germany was one of the leaders of NPL
markets in 2006 because of its sheer size and highly competitive market. Also,
Czech Republic, Turkey and Portugal are noticeable NPL markets in EU
according to Ernst &Young’s Global Non-performing Loan report (2006).
Nonetheless, not many studies have done research on NPL market in Western
Europe or Scandinavia. Empirical study of Petersson J et al. (2004), states that
during the crises in the early 1990’s in Sweden, the Swedish government
created the workout units in order to improve the situation with

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loan losses in banks and succeeded. The same paper claims that no NPL market
exists in Sweden since four major banks showed loan losses below 0.25% for
the year 2003. We wonder whether the situation has changed nowadays.
Brewer et al. (2006) use NPLR as a strong economic indicator. Efficient credit
risk management supports the fact that lower NPLR is associated with lower
risk and lower deposit rate. However it also implies that in long run, relatively

high deposit rate increases the deposit base in order to fund relatively high risk
loans and consequently increases possibility of NPLR. NPL is a probability of
loss that requires provision. Provision amount is “accounting amount” which
can be further, if the necessity rises, deducted from the profit. Therefore, high
NPL amount increases the provision amount which in turn reduces the profit.
The above stated discussion proves that NPLR and CAR are reasonably
considered as credit risk management indicators. Thereby, they can be used in
our study.
2.5 Theories
2.5.1 Risks in banks
Risks are the uncertainties that can make the banks to loose and be bankrupt.
According to the Basel Accords, risks the banks facing contain credit risk,
market risk and operational risk. Credit risk is the risk of loss due to an
obligator's non-payment of an obligation in terms of a loan or other lines of
credit. The Basel committee proposes two methodologies for calculating the
capital requirements for credit risk, one is to measure the credit risk in a
standardized manner and the other is subject to the explicit approval of the
bank’s supervisor and allows banks to use the IRB approach. Market risk is
defined as the risk of losses in on and off-balance sheet positions arising from

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movements in market prices. The capital treatment for market risk addresses the

interest rate risk and equity risk pertaining to financial instruments, and the
foreign exchange risk in the trading and banking books. The value at risk (VaR)
approach is the most preferred to be used when the market risk is measured.
Operational risk is defined as the risk of direct or indirect loss resulting from
inadequate or failed internal processes, people and systems or from external
events. There are three approaches applied to the operational risk measurement:
Basic Indicator Approach (BIA), Standardized Approach (SA), and Advanced
Measurement Approach (AMA).
2.5.2 Credit risk management in banks
Bank loan is a debt, which entails the redistribution of the financial assets
between the lender and the borrower. The bank loan is commonly referred to the
borrower who got an amount of money from the lender, and need to pay back,
known as the principal. In addition, the banks normally charge a fee from the
borrower, which is the interest on the debt. The risk associated with loans is
credit risk. Credit risk is perhaps the most significant of all risks in terms of size
of potential losses. Credit risk can be divided into three risks: default risk,
exposure risk and recovery risk. As the extension of credit has always been at
the core of banking operation, the focus of banks’ risk management has been
credit risk management. It applied both to the bank loan and investment
portfolio. Credit risk management incorporates decision making process; before
the credit decision is made, follow up of credit commitments including all
monitoring and reporting process. The credit decision isbased on the financial
data and judgmental assessment of the market outlook, borrower, management
and shareholders. The follow-up is carried out through periodic reporting
reviews of the bank commitments by customer. Additionally,

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Supervisor : Dr Pham Huu Hong Thai

“warning systems” signal the deterioration of the condition of the borrower
before default, whenever possible.
Basel II (2006) International Convergence of Capital Measurement and Capital
Standards, A Revised Framework Comprehensive Version. Basel II (2006)
International Convergence of Capital Measurement and Capital Standards, A
Revised Framework Comprehensive Version. The terms of the default rate in
loans are defined by each bank. Usually, loan becomes non-performing after
being default for three months but this can depend on contract terms. NPLR
shows the proportion of the default or near to default loans to the actual
performing loans. It indicates the efficiency of the credit risk management
employed in the bank. Therefore, the less the ratio the more effective the credit
risk management.
2.5.3 Bank Profitability
In our study, we try to examine the profitability of the banks. The profitability in
our case is presented and measured using ROE. In other words, the amount of
NI returned as a percentage of TSE. We choose it as profitability indicator
because ROE comprises aspects of performance, such as profitability and
financial leverage. ROE in banks. The measurement of bank performance has
been developed over time. At the beginning, many banks used a purely
accounting-driven approach and focused on the measurement of NI, for
example, the calculation of ROA. However, this approach does not consider the
risks related to the referred assets, for instance, the underling risks of the
transactions, and also with the growth of off-balance sheet activities. Thus the
riskiness of underlying assets becomes more and more important. Gradually, the
banks notice that equity has become the scarce resource. Thereby, banks turn to

focus on the ROE to measure the net profit to the book equity in order

By: Tran Quoc Trong

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Master’s thesis

Supervisor : Dr Pham Huu Hong Thai

to find out the most profitable business and to do the investment. ROE is
commonly used to measure the profitability of banks. The efficiency of the
banks can be evaluated by applying ROE, since it shows that banks reinvest its
earnings to generate future profit. The growth of ROE may also depend on the
capitalization of the banks and operating profit margin. If a bank is highly
capitalized through the risk-weighted capital adequacy ratio (RWCAR) or Tier 1
capital adequacy ratio (CAR), the expansion of ROE will be retarded. However,
the increase of the operating margin can smoothly enhance the ROE. ROE also
hinges on the capital management activities. If the banks use capital more
efficiently, they will have a better financial leverage and consequently a higher
ROE. Because a higher financial leverage multiplier indicates that banks can
leverage on a smaller base of stakeholder’s fund and produce higher interest
bearing assets leading to the optimization of the earnings. On the contrary, a rise
in ROE can also reflect increased risks because high risk might bring more
profits. This means ROE does not only go up by increasing returns or profit but
also grows by taking more debt which brings more risk. Thus, positive ROE
does not only represent the financial strength. Risk management becomes more
and more significant in order to ensure sustainable profits in banks.
Profitability ratios : Generally, accounting profits are the difference between

revenues and costs. Profitability is considered to be the most difficult attributes
of a firm to conceptualize and to measure (Ross, Westerfield, and Jaffe 2005).
These ratios are used to assess the ability of the business to generate earnings in
comparison with its all expenses and other relevant costs during a specific time
period. More specifically, these ratios indicate firm’s profitability after taking
account of all expenses and income taxes, the efficiency of operations, firm
pricing policies, profitability on assets and to shareholders of the firm

By: Tran Quoc Trong

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Master’s thesis

Supervisor : Dr Pham Huu Hong Thai

(Van Horne 2005). Profitability ratios are generally considered to be the basic
bank financial ratio in order to evaluate how well bank is performing in terms of
profit. For the most part, if a profitability ratio is relatively higher as compared
to the competitor(s), industry averages guidelines, or previous years’ same
ratios, then it is taken as indicator of better performance of the bank. Study
applies these criteria to judge the profitability of the twenty banks: Return on
assets (ROA), Return on Equity (ROE)
a.. Return on assets (ROA)
Return on assets indicates the profitability on the assets of the firm after all
expenses and taxes (Van Horne 2005). It is a common measure of managerial
performance (Ross, Westerfield, Jaffe 2005). It measures how much the firm is
earning after tax for each dollar invested in the assets of the firm. That is, it
measures net earnings per unit of a given asset, moreover, how bank can convert

its assets into earnings (Samad & Hassan 2000). Generally, a higher ratio means
better managerial performance and efficient utilization of the assets of the firm
and lower ratio is the indicator of inefficient use of assets. ROA can be
increased by firms either by increasing profit margins or asset turnover but they
can’t do it simultaneously because of competition and trade-off between
turnover and margin. ROA is calculated as under:
Net profit after tax
ROA =
Total assets
b.. Return on Equity (ROE)

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