MINISTRY OF EDUCATION AND TRAINING
UNIVERSITY OF ECNOMICS HOCHIMINH CITY
---- K ---

BÙI NGUYÊN NGỌC

CREDIT RISK MANAGEMENT:
CASE STUDY OF BIDV

MASTES’S THESIS
In Banking
Ology code: 60.31.12
Supervisor: Dr. Nguyễn Văn Phúc

Ho Chi Minh City – 2010


ACKNOWLEDGMENT

I owe a debt of gratitude to many people who helped me complete this thesis. I
would like to acknowledge the help of all.
First of all I would like to express my deepest acknowledgement to my supervisor,
Doctor Phóc Nguyễn Văn, for his valuable advice and recommendations.
Then, I would like to thank my superiors and colleagues who agreed to be
interviewed and/or completed the survey questionnaires. The information they
provided, especially from managers/vice managers, allowed me to get deeper
understanding about credit risk management in BIDV and deriving the findings of
this study.
Finally, I want to express my sincere thanks to every member of my family for their
encouragement and support during the time I devoted to this dissertation.

Page i


ABSTRACT
Credit risk is one of the most popular risks in banks due to their intermediary
functions: lending and borrowing. An excessive level of credit risk may destroy not
only banks’ profitability but also the stability of global banking system. Therefore, it
is necessary for banks to develop an effective credit risk management strategy not
only to protect themselves but also to prevent banking crises.
In case of BIDV, BIDV is one of four State Banks established when Viet Nam
banking system is at a very early stage of development. For a long time, BIDV was
controlled in allocating loans by government. Therefore, credit risk management has
been the main challenge facing the board of BIDV managers. With the best try of
this board, since 2008, BIDV has controlled credit risk that comply with
international standard (non-performing-loan ratio was less than 3%). This is the
main reason that drove this study to describe credit risk management in BIDV, to
know why non-performing loan ratio in BIDV has been sharply reduced from 38.3%
in 2004 to 2.82% in 2009.
Both secondary data and primary data are needed for this study. Collected data is
analyzed by Statistical Package for Social Studies version 16.0 (SPSS). Cronbach
alpha is used to measure coefficient of reliability and t-test technique is used to test
the hypotheses about the four factors influence reduction of non-performing-loan
ratio in BIDV. These techniques and tools help collected data transform into
information that will answer the researcher’s questions.

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LIST OF FIGURES


Figure 1.1: Structure of chapter 1................................................................................ 2
Figure 1.2: Field of research problem ........................................................................ .4
Figure 1.3: Method of secondary data........................................................................ .7
Figure 1.4: Population and sampling.......................................................................... .8
Figure 1.5: Quota sampling method........................................................................... .9
Figure 1.6: Structure of the study.............................................................................. 12
Figure 3.1: BIDV Organization Chart ....................................................................... 40
Figure 3.2: BIDV’s non-performing loans ................................................................ 45
Figure 3.3: BIDV’s loan structure by collateral ........................................................ 46
Figure 3.4: BIDV’s loan structure by economic sector............................................. 47
Figure 4.1: Respondents’ position............................................................................. 57
Figure 4.2: Respondents’ working years in BIDV .................................................... 58

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LIST OF TABLES
Table 2.1: Level of specific provision ....................................................................... 20
Table 2.2: Example of a loan rating system and bond rating mapping ..................... 23
Table 2.3: Strategies for reducing and scoping with portfolio credit risk ................. 26
Table 3.1: BIDV’s key performance indicators......................................................... 41
Table 3.2: BIDV’s credit indicators .......................................................................... 43
Table 3.3: Loan classification in BIDV..................................................................... 49
Table 3.4: Summarize four factors influencing NPL ratio in BIDV.......................... 52
Table 4.1: Four variables with different aspects ....................................................... 58
Table 4.2: Level of agreement in survey questionnaire ............................................ 59
Table 4.3: The overall score of Cronbach’s alpha..................................................... 60
Table 4.4: The t-test result......................................................................................... 61
Table 4.5: Summary of hypotheses testing results .................................................... 64


LIST OF APPENDICES
Appendix A .............................................................................................................. 74
Appendix B................................................................................................................ 75
Appendix C................................................................................................................ 79

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TABLE OF CONTENTS
Acknowledgment ......................................................................................................... i
Abstract ....................................................................................................................... ii
List of figures .............................................................................................................iii
List of tables ............................................................................................................... iv
List of appendices....................................................................................................... iv
Table of contents ......................................................................................................... v
Chapter 1: Introduction ........................................................................................... 1
1.1 Introduction ........................................................................................................... 1
1.2 Rationale of the study............................................................................................ 2
1.3 Statement of the problem and the scope of the study ............................................ 3
1.4 Research questions and objectives ........................................................................ 4
1.5 Methodology ......................................................................................................... 5
1.5.1 Research design ............................................................................................ 5
1.5.2 Data collection .............................................................................................. 6
1.5.3 Data analysis............................................................................................... 10
1.6 Significance of the study ..................................................................................... 12
1.7 Structure of the study........................................................................................... 12
Chapter 2: Literature review ................................................................................. 14
2.1 Introduction ......................................................................................................... 14
2.2 Basic functions of banks...................................................................................... 14
2.3 Lending business................................................................................................. 15

2.3.1 The board of directors’ written loan policy ................................................. 15
2.3.2 Lending procedure ....................................................................................... 16
2.4 Credit risk in banks ............................................................................................. 17
2.4.1 Credit risk ................................................................................................... 17
2.4.2 Loan classification ...................................................................................... 19
2.4.3 Loan loss provision ..................................................................................... 20
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2.4.4 Non-performing loan .................................................................................. 21
2.5 Credit risk measurement...................................................................................... 21
2.5.1 Traditional approaches................................................................................ 21
2.5.2 Modern approaches..................................................................................... 24
2.6 External factors that affect the level of credit risk .............................................. 27
2.6.1 Financial deregulation ................................................................................ 28
2.6.2 Supervision and re-regulation ..................................................................... 28
2.6.3 Competition................................................................................................. 29
2.6.4 The recent financial crisis........................................................................... 30
2.7 Internal factors that affect the level of credit risk ............................................... 30
2.7.1 Credit information....................................................................................... 30
2.7.2 Technology ................................................................................................. 32
2.7.3 Credit staffs................................................................................................. 33
2.7.4 Loan policy ................................................................................................. 34
2.8 Summary.............................................................................................................. 35
Chapter 3: Case study of BIDV ............................................................................. 37
3.1 Introduction ......................................................................................................... 37
3.2 Overview of BIDV............................................................................................... 37
3.2.1 Introduction................................................................................................. 37
3.2.2Organization structure ................................................................................. 37
3.2.3 BIDV business performance ....................................................................... 41

3.3 Lending business................................................................................................. 43
3.3.1 Overview..................................................................................................... 43
3.3.2 Non-performing loans and loan loss provision ........................................... 44
3.3.3 Loan structure ............................................................................................. 45
3.4 Internal factors that influence non-performing-loan ratio in BIDV .................... 47
3.4.1 Credit information....................................................................................... 47
3.4.2 Technology ................................................................................................. 48
3.4.3 Credit staff .................................................................................................. 50
3.4.4 Loan policy ................................................................................................. 51
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3.4.5 Suggesting hypotheses ................................................................................ 52
3.5 Summary.............................................................................................................. 55
Chapter 4: Data analysis and findings .................................................................. 56
4.1 Introduction ......................................................................................................... 56
4.2 Data collection results ......................................................................................... 56
4.3 Data analysis ....................................................................................................... 57
4.3.1 Descriptive statistic..................................................................................... 57
4.3.2 Measures of reliability ................................................................................ 58
4.3.3 Statistical hypotheses testing (t-test)........................................................... 60
4.4 Comparison and discussion of findings............................................................... 62
4.4.1 Credit information....................................................................................... 62
4.4.2 Technology ................................................................................................. 62
4.4.3 Credit staffs................................................................................................. 63
4.4.4 Loan policy ................................................................................................. 63
4.5 Result of hypotheses testing................................................................................ 64
4.6 Summary.............................................................................................................. 64
Chapter 5: Recommendation and Conclusion...................................................... 66
5.1 Introduction ......................................................................................................... 66

5.2 Reviewing research questions ............................................................................. 66
5.3 Recommendation for BIDV ................................................................................ 66
5.3.1 Credit information ................................................................................. 66
5.3.2 Technology............................................................................................ 67
5.3.3 Credit staffs ........................................................................................... 67
5.3.4 Loan policy............................................................................................ 68
5.4 Recommendation for other banks ....................................................................... 68
5.5 Limitation of the research ................................................................................... 69
5.6 Summarizing and concluding the dissertation..................................................... 69
References ................................................................................................................. 70

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CHAPTER
ONE

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 seven sections as
presented by figure 1.1.
Section 1.1 provides a general introduction to the chapter and section 1.2 examines
the research background where the research problem is identified. Section 1.3
defines the statement of the problem and scope of the study.
Section 1.4 which includes two subsections 1.4.1 and 1.4.2 defines the research
questions and research objectives. Subsection 1.4.1 addresses the research questions
that will be respectively answered in chapters of the study. Subsection 1.4.2 presents
research objectives that the study covers in the process of solving the research

problem defined.
Section 1.5 discusses the aspects of research methodology such as selecting from
alternative types of research, research design and research techniques. Section 1.6
points out the significance and scope of the study, and finally section 1.7 describes
overall structure of the thesis.

Chapter 1: Introduction

Page 1


Section 1: Introduction
Section 2: Rationale of the study

Section 3: Statement of the problem and
scope of the study

Section 4: Research questions and objectives

Section 5: Methodology

Section 6: Significance of the study
Section 7: Structure of the study

Figure 1.1: Structure of chapter 1
1.2 Rationale of the study:
In today’s world, in order to meet customers’ requirements, there is a need for banks
to diversify their business including other activities such as payments, leasing, and
investments besides the two traditional functions of lending and borrowing.
However, lending still plays an important role in banks because banks’ revenue

primarily comes from lending revenue which contributes over a half of bank total
operating (about 70% in case of BIDV).
The traditional way that banks make their profit is to take risk in exchange for an
acceptable return to not only cover the cost of funding but also maintain their
profitability. Thus, the main business of banks is not, as everyone might assume,
taking deposits and making loans but minimizing the risk in collecting interest and
principle from the loans which is known as managing credit risk (Burton & Lombra
2006).
Chapter 1: Introduction

Page 2


Credit risk is usually associated with banks because of their intermediary function
which is channeling funds from people who have fund surplus to those who have
fund deficit for their investment opportunities (Mishkin & Eakins 2006).
Historically, financial crises are usually derived from the failure of banks to manage
credit risk from poor quality loans or high probability of customers’ default
(Yarbrough & Yarbrough 2006).
In case of BIDV, BIDV is one of four State Banks established when Viet Nam
banking system is at a very early stage of development. For a long time, BIDV was
controlled in allocating loans by government. Therefore, credit risk management has
been the main challenge facing the board of BIDV managers. With the best try of
this board, since 2008, BIDV has controlled credit risk that comply with
international standard (non-performing-loan ratio was less than 3%). This is the
main reason that drove this study to describe BIDV credit risk management, to know
why non-performing loan ratio in BIDV has been rapidly reduced from 38.3% in
2004 to 2.82% in 2009.
1.3 Statement of the problem and scope of the study
This study conducts with particular emphasis on why non-performing-loan ratio in

BIDV has been rapidly reduced from 38.3% in 2004 to 2.82% in 2009.
Stemming from the reason mentioned in the rationale part, this research will focus
two main parts: First is credit risk management background; second is case study of
BIDV credit risk management. The first part provides some background knowledge
about credit risk, credit risk measurements, management and the factors that
influence credit risk. The second part analyses BIDV’s case in reducing nonperforming-loan ratio. This part presents three main subparts including overview of
BIDV; analysis credit activities, application of credit risk management theory to its
credit activity practice; consideration of four factors including credit information,
technology, credit staff and loan policy during the period 2004-2009, and suggesting
hypotheses. These analysis and consideration help the researcher realize that credit
risk management is one of significant achievements of BIDV because at the end of
2009, BIDV has controlled credit risk under international standard (non-performingChapter 1: Introduction

Page 3


loan ratio was less than 3%). Maybe there are many reasons leading the success of
BIDV. In scope of this study, four factors including credit information, technology,
credit staff, and loan policy will be examined as the main positive factors that
influence credit risk management of BIDV.
The four factors will be presented throughout this study. Firstly, this study reviews
literature related to the four factors and credit risk management theory. Secondly, by
analyzing BIDV’s credit business practice, this paper shows how the four main
factors influence BIDV on reducing non-performing-loan ratio. Finally, findings
from the survey by questionnaires confirm the above relationships.

Credit staffs

Credit


NPL ratio in

information

BIDV

Technology

Loan policy

Figure 1.2: Fields of the research problem
1.4. Research Questions and Research Objectives:
1.4.1 Research Questions
Research questions involve the research translation of “problem” into the need for
inquiry (Zikmund, 1997, p.88). The research problem defined above leads to the
following research questions:
•What are factors that influence non-performing-loan ratio in BIDV?

•How has BIDV applied credit risk management theory to practice?
Chapter 1: Introduction

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1.4.2 Research Objectives
This study is conducted with the purpose of:
•To know the main factors leading to BIDV success in reducing non-performing
loan ratio,
•To consider whether BIDV applies theory to manage its credit risk or not.
1.4.3 Research hypotheses

Aiming to confirm the influence of four factors including credit information,
technology, credit staffs and loan policy on reducing non-performing-loan ratio in
BIDV, the researcher assumes hypotheses as follows:
H1: Credit information variable influences non-performing-loan ratio in BIDV.
H2: Technology variable influences non-performing-loan ratio in BIDV.
H3: Credit staffs variable influences non-performing-loan ratio in BIDV.
H4: Loan policy variable influences non-performing-loan ratio in BIDV.
1.5 Methodology
The research methodology includes research design, data collection and data
analysis.
1.5.1 Research design: provide a road map of the whole research,
The researcher undertakes both qualitative and quantitative approach to this study
since both numerical data (BIDV’s performance indicators, BIDV’s business
lending indicators, level of agreement about factors that influence non-performingloan ratio, ) and non-numerical data (respondents’ background, position and their
suggestion to help BIDV continuously reduce non-performing-loan ratio, ) are
needed to answer the research questions.
According to G.Zikmund (1997), there are four basic design techniques: survey,
experiment, secondary data and observation. This research utilizes both survey and
secondary data methods. Based on the objectives of the research, survey method
helps the researcher collect primary data in order to indentify of four factors
influencing non-performing-loan ratio in BIDV while secondary data methods is
necessary for the researcher to understand credit risk background and describe
BIDV’s situation in managing credit risk or reducing non-performing-loan ratio.
Chapter 1: Introduction

Page 5


Since this study applies perception survey which investigates the feeling of
respondents about the research problem, the findings are influenced by subjective

judgment of respondents. However, the researcher also utilizes secondary technique
for the purpose of exploring evidences to confirm the research problem.
1.5.2 Data collection
This section will describe the way in which data including both primary and
secondary data from a variety source of information was collected. Secondary data
was collected from available sources such as books, previous researches, BIDV’s
annual reports, financial journals and magazines while primary data was obtained
through surveys and interviews conducted by the author.
1.5.2.1 Secondary data
There are many advantages by using secondary data in conducting a research. First,
it is economical in the way that collecting available data is almost always less
expensive than collecting firsthand data through a study. In addition, collecting
secondary data help researcher save a huge amount of time spending analyzing and
interpreting the data collected. Second, in some cases, secondary data is the only
source that researcher can collect from the previous periods. Finally, unlike primary
data, secondary data is generally permanent and available in a form that is easily
checked and collected by others (Zikmund, 1997).
There are many types of secondary data such as documentary secondary data,
multiple source secondary data and survey based secondary data (Saunders, Lewis
& Thornhill 2007). However, this study focuses only on the documentary secondary
data source which includes BIDV internal materials (like BIDV regulations and
annual reports which collected from the internet and intranet website of BIDV) and
other written materials (such as previous researches, books, journals, newspapers
and magazines). These kinds of secondary data are important raw data sources for
this study.
For this study, the information from written materials like previous
researches, books, financial magazines, journals were used to build up
literature review while BIDV s annual reports and regulations which collected
Chapter 1: Introduction


Page 6


from the official internet and intranet websites of BIDV were used to provide a
clear picture about credit risk management of BIDV.

Secondary data
Previous researches, books,
journals, newspapers

Annual reports, regulations
(BIDV internal data)

Figure 1.3: Method of secondary data collection
Based on the above advantages of secondary data, the researcher decided to use
secondary data as one of the sources of information in order to conduct this
study.
1.5.2.2 Primary data
Beside secondary data, the researcher uses primary data in order to get the
feelings of respondents about the problem of the study. The purpose of this study
is to know the factors leading to BIDV success in credit risk management.
Therefore, the target population in this research is all BIDV credit staff whose daily
work relevant to lending business
It would be impracticable for this study to collect all data available from the entire
population of all BIDV credit staffs because of the limited time and financial
sources. Thus, this research will be conducted with a sample size of 100 BIDV
credit staffs including 20 managers/vice managers, 30 credit department leaders and
50 credit officers.

Chapter 1: Introduction


Page 7


20
managers

30 credit

Population

dept leaders

(BIDV credit
staffs)

50 credit

Sampling

officers

Figure 1.4: Population, sample and sampling methods
Source: Adapted from G.Zikmund (1997)
The quota sampling technique is used in this study because of its advantages in term
of time, finance and convenience. Three steps of the technique are described as
below:
•First, the whole population of BIDV credit staffs is divided into three
significant classes: managers/vice managers, credit department leaders and
credit officers. This classification is based on the researcher judgment that

the higher position the credit staffs are in, the more reasonable feeling they
have.
•Secondly, each class is determined the desired proportion. Managers/vice
managers group occupies 20% of the sample, credit leaders group occupies
30% of the sample and 50% of the sample is credit officers group. The
determination is based on the researcher judgment mentioned in the first step.
Since this is a perception survey, the findings are influenced by subjective
judgment of respondents. Therefore, a half of selected sample are credit staffs
with high positions. Thanks to the advantage of being a member of BIDV, it
is quite easy for the researcher to communicate with managers/vice managers
and credit department leaders about the research problem.

Chapter 1: Introduction

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In this study, number of credit officers occupies only 50% of sample while it
is 90% in Chau’s (2009). This is the main reason leads the researcher retest
the four hypotheses conducted by Chau (2009).
•Finally, quota sample (100 respondents) is fixed. The sample of this study is
about 100 respondents (over 5 times of observed variables) including 20
managers/vice managers, 30 credit department leaders and 50 credit officers.
This number was decided after considering some previous researches. For
example, see Tho & Trang (2008, p.35) or Trong & Ngoc (2008, p31).
To obtain the desired sample size, a total of 150 self-administered questionnaires
were distributed to the respondents by the researcher. Of these, 100 questionnaires
were returned making effective response rate 67%.

Managers/Vice


20

managers

staffs

Population
(BIDV credit staffs)

Credit department

30

leaders

staffs

Credit officers

50
staffs

Population

Strata

Sample

Figure 1.5 Quota sampling method

Source: Adapted from Adapted from G.Zikmund (1997)
This study utilizes two techniques to obtain primary data: interview (telephone
interview and face to face interview) and self administered questionnaire. Interview
method is used to gather response of manager group while self administered
Chapter 1: Introduction

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questionnaire is used to collect response of credit department leader group and
credit officer groups.
Before conducting survey, the researcher carries out depth-interview and pretest in
order to increase quality of data collection.
Depth-interview
Beside reviewing different aspects of four factors including credit information,
technology, credit staff and loan policy via books, previous researches, the
researcher will also carry out an depth interview in order to draw other practical
aspects of the four factors such as: credit information selecting and systemizing,
credit staff competence and technology matching, frequency of facility
maintenance, important role of board of directors. The objects of this interview are
one manager and three credit department leaders.
Pretest
A list of questions used for getting information from respondents (Appendix A) was
created. In order to improve the response rate, the researcher implemented a pilot
test to refine the questions and make sure that respondents have no problems in
understanding or answering those questions.
This pilot test was conducted through a group of 10 people including one professor
and four classmates from UEH, one manager and 4 BIDV credit officers. The
feedback from these people who have practical experience and academic knowledge
helped the researcher to improve the questions in order to get the highest response

rate from respondents.
1.5.3 Data analysis
The process of analysis begins after the data have been collected (G.Zikmund, 1997,
p.507). Data collected must be analyzed in order to create meaningful findings for
the study. Data analysis plays an important role in analyzing the data. If the
collected data is not properly analyzed, the result may be invalid. SPSS software
version 16.0 was used for data analysis because of its many powerful statistical
features. The main objectives of the data analysis are to test the quality of the data
collected and the hypotheses studied (Sekaran, 2003).
Chapter 1: Introduction

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•Firstly, collected data must be recorded by using numerical codes. By doing so,
the researcher can input the data quickly into the system using the numeric
keypad on the keyboard with very few errors.
•Second, once the collected data is input and coded, the researcher can then
enter them into the computer manually.
•Finally, when the data has been already recorded and entered, the researcher
can proceed to the data analysis phase.
Data analysis technique
The study uses descriptive statistics to summarize the background information of
respondents’ in the survey questionnaires. The detail about the frequency and
percentage of respondents’ working years, positions and backgrounds will be
showed in this section.
Reliability measures were used to test the meaning of the different variable
combinations. The four hypotheses in this study are the assumptions about the
effects of four variables to the effectiveness of credit risk management strategy.
Therefore, the survey questionnaire consists of 19 questions related to these four

variables. However, as it was difficult to test these hypotheses based on separate
individual aspects, the researcher decided to combine different aspects of each
variable into one. Therefore, it was necessary for the researcher to test the meaning
of this combination process. Cronbach’s alpha is a commonly used number to test
the reliability of the combination of different individual variables. The value of
Cronbach’s alpha varies between 1 (perfect internal reliability) and 0 (no internal
reliability). According to Bryman and Bell (2003), the value of 0.80 is an acceptable
level of internal reliability. However, many writers accept a slightly lower figure
like Vogt (2007) argued that an alpha of 0.70 or higher is often considered
satisfactory for most studies.
An application of hypothesis testing is used to quantify respondents’ perception of
research problem on a five-point scale, where 1 indicates strongly disagree and 5
indicates strongly agree. The scale is assumed to be an interval scale. T-test
technique is used to estimate confidence intervals for the mean.
Chapter 1: Introduction

Page 11


The later chapter, chapter four: “Data analysis and findings” will discuss about
analysis technique in detail.
1.6 Significance of the study
This study helps readers realize the crucial importance of credit risk management
and know the main factors that influence the reduction of non-performing-loan ratio
in BIDV.
1.7 Structure of the study
Chapter 1: Introduction
Chapter 2: Literature Review

Chapter 3: Case study of BIDV

Chapter 4: Data analysis and findings

Chapter 5: Recommendations and conclusions

Figure 1.6: Structure of the study
This main purpose of the study is to understand the impact of credit information,
technology, loan policy and credit staffs on reduction of non-performing-loan ratio
in BIDV. Beside this chapter one currently discussed, the study also consists of the
following five chapters:
Chapter 2: Literature Review: This chapter will provide general theories related to
credit risk management. Furthermore, the researcher’s insights on these theories will
also be discussed.
Chapter 3: Case study of BIDV: This chapter provides an overview of bank for
investment and development of Vietnam (BIDV) and BIDV’s credit risk
management is the main part of this chapter.
Chapter 4: Data analysis and findings: analyzing the collected data in order to get
results to test the hypotheses and answer the research questions in chapter one.
Chapter 1: Introduction

Page 12


Chapter 5: Recommendation and conclusion: based on these analysis and
findings from chapter five, some suggestions or recommendations about the credit
risk management strategies that BIDV can adopt to manage credit risk will be given.

Chapter 1: Introduction

Page 13



CHAPTER
TWO

LITERATURE REVIEW
2.1. Introduction:
This chapter provides an introduction to the extant literature on commercial banks’
main business. Theories related the credit risk derived from lending activities will be
discussed. In particular, both external factors such as financial deregulation,
supervisory and re-regulation, competition and recent financial crisis and internal
factors such as information, loan policy, credit staff, and technology which affect
the level of credit risk in banks will be reviewed. In addition, credit risk
measurements will be taken into consideration. Excessive credit risk may limit not
only the profitability of the bank itself but also the stability of the whole banking
system and the global economy. The recent financial crisis is a convincing evidence
for this statement, the fast rising risks in banks resulted in the global recession, the
downturn of not only the U.S economy but also many other countries worldwide, as
well as the instability of the global financial system (Anita & Hawser 2008).
Therefore, banks should recognize the importance of credit risk management and
employ an effective strategy to manage credit risk in order to protect themselves
from credit losses.
2.2. Basic functions of banks:
In general term, a bank is an organization that engages in the business of banking it accepts deposits and makes loans. Banks perform three basic functions: (1) They
provide a leading role in the payment system; (2) They intermediate between
depositors and borrowers by offering deposit and loan products; and (3) They
provide a variety of financial services, encompassing fiduciary services, investment
banking (underwriting original issues of stocks and bonds), and off-balance sheet
risk taking (E.Gup & W.Kolari 2005)

Chapter 2: Literature Review


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Traditionally, the main activity of banks is to mobilize funds from those with
surplus money to lend to those with shortage of money. In other words, banks play
an intermediary role between suppliers of funds (depositors) and the users of funds
(borrowers) (Ritter, Silber & Udell 2000).
2.3. Lending business
2.3.1. The board of directors written loan policy
According to Benton E.Gup & James W.Kolari (Commercial banking, 2005, p250251), a bank’s board of directors has the ultimate responsibility for all of the loans
made by the bank. Because the board delegates the task of making loans to others, it
must have a written loan policy that establishes the guidelines and principles for the
banks’ credit risk strategies and polices. The credit risk strategy must recognize the
goals of credit quality, earnings, and growth-that is the risk/reward tradeoff.
Loan policies vary widely from bank to bank. The loan policy for a small bank that
lends primarily to local customers is going to differ from the policy of a large bank
that specializes in lending to business concerns. In either case, the policy would
state that the bank is in the business of making sound and profitable loans.
Therefore, the loan policy must make it clear that an important part of lending
process is that all loans should have a repayment plan at the time the loan is made.
Other parts of the loan policy deal with:
•Loan authority: Who has the authority to make loans; the lending limits relative
to capital, deposits, or assets; the lending approval process.
•Loan portfolio: the types of loans the bank wants to make, such as consumer
loans, loan to start up businesses, loans to large businesses, farm loans,
international loans, and so on. The policy should also put limits on the
concentration of particular types of loans.
•Geography limits of the bank’s trade area where it may grant loans. The
overwhelming majority (97 percent) of small and medium-sized business use

financial institutions within 30 miles of their principal office.
•Policies for determining interest rates, fees, and contractual terms of the loans.

Chapter 2: Literature Review

Page 15


•Limits and guidelines for off-balance sheet exposures from loan commitments,
letters of credit, securitized loans, and derivative products (swaps, options,
and futures, etc.)
•A loan review process to evaluate lending procedures and the quality of the
loan portfolio.
2.3.2. Lending procedure:
Lending procedure is the process that banks loans are provided to borrowers through
proper evaluation of customers’ financial condition and credit worthiness (Rose &
Hudgins 2008). According to Hempel and Simonson (1999), although different
banks employ different methods to make their final lending decision, they normally
follow the standard lending procedure described in the following basis steps:
Step 1: Receiving application: Customers including individuals and corporations
apply for a loan from banks by filling out a loan application.
Step 2: Evaluating application: Bank credit officers evaluate the loan application.
Evaluating loan request or by interviewing customers in order to investigate their
characters and borrowing purpose. Furthermore, the banks can collect customers’
information or credit history from the banks’ database when customers have
existing relationship with the banks. Other banks and credit information agencies
are also other sources for banks to gather customers’ credit information.
Step 3: Lending decision: Refusing application or Granting credit
Refusing application: If credit officers realize that the customer is ineligible for
receiving the bank loan, they may reject the loan application. Credit officers will

then issue a formal announcement on the loan application status to the customers
within a certain period of time.
Granting credit: If the loan application satisfies the requirements from the banks
then a loan agreement may be issued and signed between customers and authorized
bank officer. Other activities must be taken into account when the agreement is
signed such as checking and collecting the property or other asset types considered
as collateral for the loans.

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Step 4: Monitor loan: After granting credit, credit officers must monitor customers
in order to ensure that customers use the loan accordingly with the purpose stated on
the loan agreement. In addition, as credit officers can quickly assess customers’
financial condition or their ability to pay the loan back by a proper monitoring
process, banks managers and credit officers who are aware of the importance of this
process can effectively help preventing their banks from credit losses.
Step 5: Collecting loan: The duty of credit officers has not finished upon granting
the loan to customers. Their last and important mission is to collect debt and
liquidate credit agreement. However, one of four things can happen to an
outstanding loan: (1) It can be repaid on schedule; (2) It can be renew and extend;
(3) The bank can sell the loan to another investor; (4) The loan can go into default
and the bank may sustain losses. The first three are desirable outcomes. The last is
the worst-case scenario for the bank.
Before loans are granted, banks must evaluate the creditworthiness of the
prospective borrowers (step 2). The borrower’s character, financial condition, and
ability to repay the loan from future income or the sale of assets are of primary
importance. When the banks decide to grant a loan, all of the terms of the loan

(credit facility, amount to be borrowed, the term of loan, method and timing of
repayment, interest rate and fee, collateral if required, covenants or promises by the
borrower to take or not to take certain actions during the term of the loan) are put
into a contract called a loan agreement. After the loan is granted, the bank must
monitor the loan to assure repayment. The best outcome is that the loan is repaid in
full. The worst outcome is that it is charge of as a loss.
2.4 Credit risk in banks
2.4.1 Credit risk
Banking is the management of risk. Banks accept risk in order to earn profits. They
balance alternative strategies in terms of their risk/return characteristics with the
goal of maximizing shareholder wealth.
According to Jane E.Hughes and Scott B.MacDonald (2002, p.297), a banker’s job
is to manage risk, not avoid it. Banks face a variety of risks in their operations such
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