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Thursday, October 21, 2021

Credit risk provision and backup profit

By Tue Nhien

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As bad debt is now a looming threat in some cases, the provisioning for potential losses due to credit risks has become the focus of attention. Perhaps, now is the time to review how banks should tackle this risk management.

The State Bank of Vietnam (SBV) has recently promulgated Circular 11/2021/TT-NHNN, replacing Circular 02/2013/TT-NHNN on classification of assets, risk provisioning, and use of provisions to handle risks in the operations of credit institutions and foreign bank branches.

New points

A notable addition in this circular is that from now on, banks have to classify and make provisions for assets acquired from the following activities: debt trading, trading of government bonds on the stock market, forward trading of valuable papers between banks, purchase of promissory notes, treasury bills, certificates of deposit and bonds sold by other credit institutions in the country.

Therefore, aside from outstanding loans, off-balance sheet commitments or corporate bonds, those assets considered safe such as government bonds or valuable papers issued by banks must now also be regularly reviewed, classified and taken into risk assessment in order to work out a mechanism for provisioning.

Regarding collateral for loans, the new circular clearly defines the re-valuation period at least once every quarter for movables and every six months for real estate, at least once a year for those worth VND200 billion or more.

In the context that the value of various assets has changed constantly, and collateral was commonly overestimated far beyond their true value in the past, the regulation concerning the re-valuation period is to oblige banks to take more prudent steps when extending loans.

The biggest change is that credit institutions must classify their debts at least once a month, within the first seven days of the month, instead of every quarter, within the first 15 days of the first month of each quarter as stipulated in Circular 02.

On the basis of debt classification according to the Credit Information Center (CIC), banks must set aside a sufficient amount as a provision and use it to deal with risks as prescribed, and refer to the results of their previous debt classification to do the same for the next period. According to the SBV, the additional regulation is to make sure all credit institutions act in sync.

In addition, the new circular revises the concepts of specific provision, general provision, bad debt, and on-balance sheet bad debt ratio, while supplementing the concept of debt restructuring. It also adjusts the principle of classification of syndicated loans, sold debts, entrusted loans, and purchased debts to be done by lenders themselves.

Divergence of provisions

As bad debt is now a looming threat in some cases, the provisioning for potential losses due to credit risks has become the focus of attention. In fact, there have been quite a few differences between banks over the years. While some banks were serious and careful about provisioning, certain others chose to ignore the risks and did not make enough provisions for fear this would affect their profits.

Statistics show that by the end of June 2021, the gap between banks when it comes to the ratio of bad debt coverage (a gauge of the level of provisioning against bad debt) had widened.

While the majority of banks have this ratio below 100%, with only 30-40% as the lowest, the figure is very high at a handful of banks, above 100%, such as Vietcombank, Techcombank, MBBank, ACB, TPBank, BacABank, Agribank, BIDV, VietinBank, SCB and Sacombank.

Apparently, most of the aforesaid banks are the large-scale ones, with some of them achieving handsome profits and impressive growth in recent years, a helpful factor for this group to boldly make provisions.

It should be clarified why the bad debt coverage ratio, which results from the division of the estimation for credit losses on the balance sheet at the end of an accounting period by the figure of bad debt, can go higher than 100%. Those without knowledge of the banking industry may have the same question: can a bank’s provision for credit losses be greater than their bad debt?

As per the regulation on the level of provisioning, which has been unchanged in the new circular, the specific provisioning rate for each debt group is as follows: 0% for standard debt (Group 1), 5% for debt needing special attention (Group 2), 20% for subprime debt (Group 3), 50% for doubtful debt (Group 4), and 100% for potentially irrecoverable debt (Group 5).

However, additionally, banks have so far had to make a general provision for their total outstanding loans (applicable to the first four debt groups) at the rate of 0.75%. In other words, every loan worth VND100 billion requires banks to immediately set aside VND750 million as a provision. As Group 1 debts are currently making up a major part of the total outstanding loans of banks, the 0.75% provision for this group alone and for first four groups in general proves to be a heavy burden on the estimation for credit losses.

Therefore, given the specific provision included, it is normal for the credit loss estimation to be bigger than a bank’s bad debt. For this reason, besides the bad debt coverage ratio, to calculate the size of provision against bad debt more accurately, general provision may be excluded, at least for Group 1, from the closing provision balance, before it is divided by the figure of bad debt.

Backup profit?

These days, people often talk about how some banks are taking swift action to make provisions, which have become a tradition, as a way to save profits for the future. Indeed, all the provisions they make means that if banks manage to resolve and recover their bad debts, these provisions will someday be paid back as a source of extraordinary income and contribute to their annual profits.

It should be reminded that, according to the regulation on provisioning, the specific amount to be set aside as a provision is determined via the subtraction of the value of the collateral from the principal balance of a loan, which is then multiplied by the specific provisioning rate depending on the debt group. In case the value of the collateral is even greater than the principal balance, the specific provision to be made is zero.

This has significantly affected the provisioning mechanism currently adopted by banks. Those who do not want to make too large a provision (which will likely scale down their profit) may deliberately value the collateral higher than its market price, thereby reducing the level of provisioning.

On the contrary, some banks choose to set the value of collateral assets to a lower level than their actual worth, which thus increases the figure of provision to be made. These are usually banks that generate relatively high profit and better growth than in the preceding period. They therefore take the initiative to make big provisions to repress profits and save room for growth in the following period. It is because excessive profit growth may badly affect their reputation, especially when the economy and the business community are mired in troubles, while also exerting considerable pressure on profit growth in the coming years.

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