chapter I
Introduction

1.1 Background

Since 1986 Vietnam has embarked upon the economic reform to transform the economy from centrally-planned to market-oriented. In line with such a general economic reform, financial sector is also conducted a reform in which the commercial banks are separated from the State Bank, and specialised into the commercial activities. To meet the capital requirements for the growth, the commercial banks must play a key role in mobilising domestic resources and providing credits for investments, especially in the absence of the capital markets.

Banking management includes three activities: First, the excessive reserve management is to manage the reserve beyond the reserve required by an authorised state bank. Second, the liabilities management is to find and manage the sources of funds for the bank. Third, the assets management is to manage the investments of the banks, including portfolio investments, holding securities such as bonds, debentures, shares, etc. ; lending; and other banking services.

Regarding to the assets management, lending (or making loans) is the most important task. It is because, first, it accounts for the largest share of banking of investments. Second, it is difficult to manage the risks of bank loans, which could bring about losses for the banks and heavy damages to the economy.

Although there have been successes in the development, the banking system of Vietnam is facing a lot of problems such as high rate of overdue debts, bad loans, poor legal framework, corruption, lacking accuracy of information, and inuniformity of accounting and other things.

1.2 Research question

In theory, the specific conditions such as the stability of the economy, the intervention of government, the legal framework, the pattern of the market etc. have great impact on the behaviour of commercial banks. Vietnam is either a transitional or developing country which is characterised by the dominance of state-owned enterprises (SOEs), new market-type banking system, the intervention by the government into the financial sector, and by a weak legal framework for the market-type economic activities, in general, and for banking system, in particular. This thesis will try to find out what kind of the behaviour of commercial banks in the loan market in the conditions in Vietnam as a transitional economy.

This study suggests that in the context of Vietnam SOCBs have a binary behaviour: one in dealing with the privileged loans, and the other with the non-privileged (or market) loans. For the former, the banks act as they did under the previous mono-bank system as money keeper or manager for the government; on the other hand, for the latter (for the market loans), the banks will not be inclined to risk aversion, contrarily, more likely inclined to risk neutral.

1.3 Scope of study

State-owned commercial banks(SOCBs) account the largest share of banking operation. This study will only focus on the behaviour of state-owned commercial banks. The period of time included in the study is from 1989 when the reform of banking system was started up to now.

1.4 Methodology

There are great deal difficulties in gathering data at micro level such as the number of loans, the size of the loans, the group of clients of each bank. These data are not available because they are classified as secret. The study therefore will not be able to be based on the database to stylise the argument into quantitative mathematical and/or econometric fashion. Contrarily, the study will be mainly based on the institutional and qualitative information to stylise the explanation into the institutional fashion. For example, the cases of bank fraudulence, issues of legal framework, the information about banking operations etc. showing the reality are used as the evidence to back up the conclusion. That is, this study will try to give more of a qualitative-based explanation, rather than a quantitative explanation, on the behaviour of SOCBs of Vietnam.

1.5 Literature review

Though mentioned in other studies, the behaviour of SOCBs are basically considered only as one of the aspects of the weakness of legal framework and supervision. It was not studied under the light of theories about the behaviour of commercial banks and, of the empirience of banking in other developing and transitional countries. Moreover, none of those studies built up a comprehensive explanation of such behaviour in order to understand the ultimate reasons of the behaviour of commercial banks in the context of transitional country as Vietnam.

This chapter presents two theories about the behaviour of commercial banks in the two different context of economy and banking regulation; and the empirience in banking system in developing and transitional economies that could most probably affect the behaviour of commercial banks.

2.1 Stiglitz & Weiss Model.

Stiglitz & Weiss (1981) built up a model in order to explain the behaviour of commercial banks in the loan market of developed economies. This model proves that in the context of economic stability when interest rate increases banks would limit the increase in the interest rate in order to attract the safe borrowers, and not to induce the borrowers to take riskier projects. At the same time, the banks would limit the number of loans rather than the size of each loan, and do not make the interest rate charges as an increasing function of the magnitude of the loan. In other words, banks are inclined to risk aversion.

2.2 McKinnon Model vs. Stiglitz and Weiss Model

However, McKinon (1993) proved that such model does not hold in the loan market of developing countries where there usually are economic instability and the government’s insurance scheme for bank losses. McKinon (ibid.) suggested that in such context banks would suffer moral hazard (or moral risk) within the banks themselves. That is because the banks tend to take riskier projects by raising the interest rate charges with the expectation that if the projects success they would get higher return, and if not, they would be bailed out by the government. In short, the banks are not inclined to risk aversion.

2.3 The empirience in developing and transitional markets

"Financial repression" was defined by McKinnon and Shaw (1973) as the distortion of financial markets in developing countries due to the government intervention and control. Government intervention and control very often induces prices in financial and banking sector out of market-clearing points. All this would lead to inefficiency of credit allocation which, in turn, causes the inefficiency of the economy as a whole. Financial repression is understood to include lending requirements by governments, refinance schemes, credit guarantees, development finance institutions, preferential interest rates, interest rate ceilings and high reserve requirement.

Banking systems in developing and transition countries are often characterised by the high concentration. The concentration ratio of banking system is defined as the percentage share of assets of largest banks over the total assets of banking system. In Argentina four largest banks account for 82 percent of total assets of the banking system, in Chile the ratio is 54 percent. In Malaysia five largest banks account for 69 percent of total assets of banking system, in Taiwan 63 percent. In Hungary the share of the total assets of four largest banks was 37.75 percent, and 55 percent in financing corporate. In Poland albeit more than half of the banks are the private, nine state-owned banks still account for nearly 90 percent of the credit market in 1992.

Banking systems of former socialist countries are characterised by high geographic or sectoral concentration. It means that the banking activities are usually focused on specific sector or geographic area. In other words, there can be said to be, to some extent, the oligopoly in loan market in particular sectors. Agriculture bank, for example, would deal with the loans for agriculture, housing bank would specialise on housing funds, and industrial bank would focus in lending to industrial investment, etc.

The most notable aspects of market imperfection which affects the behaviour of lenders and borrowers is the asymmetry of information of financial and loan market. That is one of the main reasons for moral hazard and adverse selection in bank lending activity. In addition, poor accounting and auditing system, the weakness of legal framework and of law enforcement with respect to information transparency exaggerate the asymmetry of information. Under such market imperfection there is a so-called "barriers to contracting" among lenders and borrowers. Lacking information makes it difficult for the partners (the lenders and the borrowers) to write completed (or detailed) contracts. It is even worse in the developing countries where there are lots of unexpected events or contingencies during the contract period, especially when the contracts involve in complex transactions and long period. On the one hand, it would lead to moral hazard problem due to a so-called "opportunistic behaviour". On the other hand, moral hazard is also exaggerated by the weakness of law enforcement and punishment, which may not prevent borrowers from changing and making it their projects riskier.

Bad loan problems and financial crises could emerge in developing countries because of inadequate supervisory regulations. Another concern in banking systems in transitional economies is the lack of autonomy of supervisors at the banks due to day-to-day political influence.

Another issue is the so-called 'in-house' lending practices and 'off-balance-sheet' financial transactions. These are unregulated activities, and emerge as a major area of autonomy and looking for profit. It is said that in the context of strong government intervention or political interference, the supervision over and the autonomy of the banks are in conflict. The unregulated operations such as 'in-house' lending and 'off-balance-sheet' financial transactions are therefore to become common and vital for banks to keep safe and profitable. Such a thing is most likely happening in Vietnam where government and political interference are prevailing.

The existence of state-owned enterprises (SOEs) put commercial bank lending under pressure of high risk. In Hungary and in Poland, SOEs are the one of the main sources of bad loan problems. And Vietnam is also a good evidence for that. Being assigned to play a leading role in the economy, SOEs account for a large share of the whole economy. On the one hand, the dominance of SOEs and the political support for them make it difficult for commercial banks to have free hand to choose borrowers. On the other hand, these SOEs are operating inefficiently, bad loan problems of SOEs in transition countries seem to be inevitable and the solvency is in the deadlock.

Thus the analysis about the private, liberalised and SOEs in transition economies demonstrates that the lending of the commercial banks in these countries, including Vietnam, tend not to follow the principles of lending activities in normal market economies.

2.4 Summary and Comments

Theories by Stiglitz & Weiss and by McKinnon, and the empirience in developing and transitional markets implicitly reveal that the macroeconomic condition, government intervention, state-owned enterprise, the weakness of legal framework strongly affect the behaviour of commercial banks.

As a result, in order to explain the behaviour of state-owned commercial banks in Vietnam as a transitional economy, this study will focus on the aspects mentioned above.

3.1 The dominance of SOCBs and the excess demand for loans

Banking system in Vietnam is also characterised by high concentration of SOCBs. Only four SOCBs accounted for almost 87 percent of banking operations in 1994. In terms of total assets of the whole banking system these four SOCBs account for almost 75 percent.

In addition, these four SOCBs are specialised in certain areas, Vietcombank specially dealing with external transactions, Agribank with rural and agriculture activities, Indebank with the projects for development purposes, and Incombank with industrial and commercial transactions. With such high concentration and specialisation of banking system these four SOCBs can be said to have monopoly power in each specialised areas, despite of the presence of other non-state banks.

This situation is exaggerated by the high demand, or excess demand, for capital in Vietnam. Excess demand for loans to banking system is defined as a situation in which the banks are under pressure of shortage of capital from the borrowers, especially, in the absence of capital markets

High concentration and/or sectoral monopoly, and excess demand for loans from borrowers result into a high competition among the borrowers, which in turn, leads to a pressure of raising lending interest rate by the banks. This is proved by the fact that almost branches of SOCBs in Southern provinces broke the interest rate ceiling during 1997.

3.2 Government intervention schemes and privileged loans

Though Vietnam has declared a transformation of the economy in the market orientation, the state-owned enterprises remain to be assigned by the government a key role in the economy. They are given a lot of favourable conditions to assess to bank credits despite the fact that such conditions could make it difficult for the financial position of commercial banks.

The intervention by the government into credit market is implemented not only in the indirect manners as above, but also in the direct ones. The so-called privileged loans (to the public sector) is the evidence for that. However, the mechanism of management of privileged loans is complex and poor, which creates lots of holes for banks looking for illegal commission.

3.3 Behaviour of SOCBs in relation to the privileged state sector

Facing privileged loans SOCBs seem to have no autonomy in making decisions of their own on who deserve to get credits, how much the credits are, and what the lending interest rate is. In other words, for the privileged loans, the SOCBs can be considered money keeper and/or manager for the government and take no risk consideration. Their expected return also seems to be highly dependent on the privileged interest rate and the compensation by the government in case (very often) such interest rate is lower than the market ones.

In addition, the poor management of privileged loans seems to create lots of holes for corruption in the sense that paying illegal commission becomes common for borrowers who want to get the privileged credits on time.

legal framework, government guarantee and Market behaviour of Socbs

This chapter is to address the behaviour of SOCBs in the loan market with respect to non-privileged loans in the context of weak legal framework.

4.1 Weakness of legal framework

In this study the concept of legal framework embraces not only the legal and/or jurisdictional aspects but also the others such as accounting system, auditing system, managerial mechanism. The legal framework in Vietnam is characterised by poor legislation on collateral, poor law and its enforcement, inadequate accounting and auditing system, poor supervision and regulation. All these put the banks in a strong threat of fraud. On the one hand, bad borrowers find it easy to make fraud, and on the other hand, banks find it difficult to prevent it and, prevent corruption within banks themselves.

4.2 Government guarantee and behaviour of SOCBs

4.2.1 Government guarantee for SOEs - the dominating borrowers

The government support for SOEs are basically exercised as follows:

1. SOEs are allowed to borrow from the banks without meeting collateral requirements, or if any, it is easy requirements such as using the production line and/or equipment bought with the borrowed money as collateral
1. Debt maturity extension (gian no)
1. Debt rolling-over (dao no)
1. Debt writing-off (xoa no)

Thus, the SOEs in Vietnam are given by the government a no-bankruptcy guarantee.

4.2.2 Government guarantee for SOCBs - the dominating lenders

Favourable conditions to SOEs to get loans from the banks mean unfavourable conditions to the banking system in their balancing account position. However, the government also gives strong support to the banking system. The fact that all the above manners of solving debt problems with SOEs are accepted by the government is the evidence for that. This says that the government also gives SOCBs a guarantee of no bankruptcy.

For the credits provided in accordance with the so-called policy priorities such as credits for poor students, flooding, poverty alleviation and so on, if any risk happens, very often, the losses are written off by the government.

Recapitalization for the banks is another kind of government support for the banks. This action is considered to enhance the capacity of banks, in practice, however, it is said to survive loss-making banks.

In terms of law enforcement, SOCBs have their own internal guidelines for their dealing with defaults, liquidation, and enforcement of collateral. This is to say that the SOCBs are classified as special and given bias in terms of law and jurisdiction.

Thus, similar to the guarantee for SOEs, those supports of government for the SOCBs are by a mean a strong guarantee of no bankruptcy for any SOCBs, which certainly has some effect on the market behaviour of SOCBs.

With such support and guarantee, the banks would most likely behave as suggested by McKinnon explanation. That is, the banks would choose riskier borrowers for higher expected return if the projects success; and in case the borrowers are insolvent, the losses will be bailed out by the government. In short, the banks are not risk averse.

Facing high demand for loans, SOCBs tend to raise the interest charges to their borrowers. The phenomenon of breaking interest rate ceiling is the evidence for that. This is to say that the banks seem to look for riskier borrowers who are prepared to accept higher interest charges for their loans.

A series of the soundness ratios of the banks such as low ratio of Capital/Assets, low ratio of Capital/Outstanding Loans , high ratio of Total Loans/Total Deposit, high ratio of Overdue debts/Total Credit of SOCBs reveal that SOCBs tend to maximise their lending and have risk neutral attitude.

4.4 Summary and comments

Thus, the government back up and guarantee for SOCBs and SOEs seem to induce SOCBs to behave more in risk neutral rather than risk aversion. In the context of excess demand for loan the banks would most likely raise their interest rate charges to their borrowers and maximise their lending without carefully taking risk consideration. Doing so the banks expect higher return if their lending success and government bail-outs if their lending fail.

This kind of behaviour is highly similar to that mentioned by McKinnon. However, the behaviour of CBs suggested by McKinnon takes place in the context of macroeconomic instability, whilst the similar one of Vietnam SOCBs appears in the macroeconomic stability. This difference is attributable to the fact that the risks in McKinnon case are brought about by the economic instability, meanwhile the risks in Vietnam case by the weakness of legal framework.

As given, the economic and legal conditions have great impact on the behaviour of commercial banks. Among those factors that affect behaviour of commercial banks, the government intervention, the pattern of loan market (relation between the lenders and borrowers), and the legal framework are probably the most important that shape the behaviour of SOCBs in Vietnam.

In developed market economies, the commercial banks are private, well regulated and have to scope with a high competition environment. The existence and development of the banks almost entirely depend on their capability in maximising profitability and preventing risks. In developing countries, in contrast, the operations of commercial banks are usually affected by the government intervention. The banking system is considered the key apparatus to boost the economy in order to achieve targeted economic growth and development tasks. The operations and/or the behaviour of commercial banks are therefore distorted. The banks behave not only in accordance with market signals but also in accordance with policy and/or government intervention signals. This phenomenon is known as the financial repression.

With the context of either a developing or transition economy, Vietnam banking system possesses characteristics in these two groups of countries. Those characteristics are strong government intervention, the dominance of SOEs as lenders in the loan market, the high concentration and/or sectoral monopoly of SOCBs, the government bail-out to both SOCBs and SOEs, the weakness of legal framework, and others. In practice, those factors as analysed are the ones that directly dictate the behaviour of SOCBs.

The government intervention into the loan market that have great impacts on the behaviour of Vietnam SOCBs can be stylised as follows:

1. The presence of the so-called privileged loans granted by government to the state privileged sectors (direct intervention)
1. Strong support for and back up by the government to SOEs in dealing with SOCBs, giving them a lot of favourable conditions to get the loans from SOCBs and to solve their bad debts with SOCBs, i.e., almost a guarantee of no-bankruptcy to SOEs.
1. Also, the government bail-outs to SOCBs in various manners, meaning a guarantee of no-bankruptcy to SOCBs.

The existence of privileged loans is a key element creating a binary behaviour of SOCBs. On the one hand, SOCBs behave in accordance with the privileged loans, on the other hand, they behave in accordance with non-privileged (or market) loans.

Regarding the privileged loan framework, SOCBs behave as if they were the money manager for the government. They have to provide loans in accordance with the government requirements as much as they can. SOCBs in this case do not take risk consideration in their making loans. Their expected return seems to entirely depend on the fixed-by-government interest rates. Besides, the illegal commission seems to become an extra earning for them owing to poor administration mechanism of privileged loans.

With respect to non-privileged loans, the weakness of legal framework has brought about risks to bank loans. There have been many frauds, and collaboration between banking corrupt officials and bad borrowers which caused huge losses for SOCBs in couple recent years. This happens even in the period of relatively stable macroeconomic conditions. It is different from the case suggested by McKinnon where risks are brought about by macroeconomic instability. Another difference is that the risk brought about by the weakness of legal framework is administrative, managerial and lawful, whilst the risks suggested by McKinnon are brought about by macroeconomic instability, and naturally such risks are economic. Facing risks brought about by macroeconomic instability, as suggested by McKinnon, banks would behave in risk aversion if they are well regulated. Only with government bail-outs, do banks behave in risk neutral fashion.

In the case of Vietnam, however, the weakness of legal framework not only brought about risks but also means that the regulation on banking operation is not good. Thus, the weakness of legal framework alone seem to provide both necessary and sufficient conditions for risk neutral behaviour of SOCBs. And, in practice, the corrupt collaboration between banking officials and risky borrowers in recent years is the evidence for that. In other words, the weakness of legal framework, first, brings about risks to the banks; second, puts the banking operations in bad regulation; and third, therefore reduces the capability of the banks in preventing risks.

The matter is much even worse with the presence of government support for and guarantee to both SOCBs as the lenders and SOEs as the borrowers in the loan market. Under this context, SOCBs likely behave in the fashion suggested by McKinnon (1993). SOCBs tend to raise their interest charges and maximise their lending in order to get higher return if the projects success, and to be bailed out by the government if the projects fail. Thus, the banks have to suffer from moral hazard within themselves. In other words, with the government intervention of that kind the behaviour of SOCBs is risk neutral rather than risk averse.

The policy implications can be derived fairly easily from above analysis.

First, there should be reduction and/or dismantling of the government bail-outs and guarantee for the SOCBs. Also, more autonomy should be given to the banks in their making decisions correspondent to the market signals. These modification and remedies should be carried out in the direction in which SOCBs must be based on the market signals and their risk aversion capability rather than on the government support and bail-out in making their own business decisions.

To do so the government’s actions such as requiring credits, writing off bad loans of banks, and giving subsidies to making-loss banks due to their co-operation with the government should be stopped, or at least limited as much as possible. However, it is difficult to know to what extend such actions should be limited. The idea of formulating such actions might be helpful. For example, only a certain share of bad loans in the total outstanding loans can be allowed to be written off or subsidised with required certain conditions. Such measure seems to require simultaneously formulating the involvement of the banks into the so-called policy operations, i.e., each bank only have to involve into policy operation in a certain level. This formulating the policy-based banking operation would be helpful to know well how much of the overall operation of the banks can be backed up by the government if facing risks.

This reform thus is to separate clearly policy-based from market-based operations of SOCBs, whereby the banks should and could know what their responsibilities for the operations are, and not rely upon the government bail-outs. The idea of separating the policy-based operation of banks by creating a so-called "policy bank" may be much stronger and more meaningful. However, this action might touch the most delicate thing that is the ideology. The question is whether SOEs are considered to belong policy-based operation area or not. If they are, the government exposes itself to be the guarantor for the SOEs - the biggest and largest number borrowers - and therefore left the market with only small and small number of non-state borrowers. And if not, most SOEs - the core of socialism - would be pushed to bankruptcy and disappear, and therefore no more socialism. In short, the extend to which the separation between policy-based and non-policy-based (market-based) operations of SOCBs depends heavily on the political will of the government. Nevertheless, separating the policy-based operation of SOCBs from the market-based one seem essential in order to improve the accountability of the banks, and therefore the efficiency of banking system in general. This kind of measure can be done in a short time because the technical aspects in this area are not so difficult, provided that the politician should be prepared to do.

Second, the improvement of the legal framework is needed so as to reduce risks and opportunities for corruption in banking system. At the same time, this improvement also means an improvement of risk assessment, and therefore, risk aversion capability of banks. The improvement in this area might take a long period of time. The complement of law, jurisdiction and law enforcement, accounting and auditing system requires much of work to be done. For example, the preparation of documents, the approval by the National Assembly, the training of contingents and other complex technical aspects required a long period of time.

However, the improvement of supervision by the State Bank over the banking operation may be done immediately because this kind of action mainly requires administrative activities. More restrictive supervision by the State Bank could largely prevent corruption within banks. Also, technical and consulting support by the State Bank could help the banks prevent risky lending.

Finally, the government support for SOEs in their dealing with SOCBs, including getting the loans from and solving their bad loan problems with SOCBs, should be limited so as the relation between SOEs and SOCBs should follow the rule of game applied equally to other economic parts. Perhaps, there should be two steps in this reform. The first step is to solve decisively the heritage of bad debts of SOEs with SOCBs in the past, and the second one is dismantling gradually the government support to SOEs in dealing with SOCBs. However, to make a such reform in this area, as mentioned above, depends heavily on the political will of the government with respect to the role of SOEs.

In short, the reforms to improve the accountability of SOCBs and to make them follow market rules can be done in three directions. The first one is the relation between government and SOCBs (meaning the government bail-outs to SOCBs), the second is the government support for SOEs in dealing with SOCBs, and the final one is the improvement or complement of legal framework. The two first reforms do not seem to take long time, however, they are heavily dependent on the political will of politician circle, whilst the third reform require a much longer period of time./.