MINISTRY OF EDUCATION AND TRAINING UNIVERSITY OF ECONOMICS HOCHIMINH CITY -----o0o----- TRẦN ĐÌNH KHẢI BANK INCOME STRUCTURE AND RISK: AN EMPIRICAL ANALYSIS OF VIETNAM COMMERCIAL BANKS MASTER OF BUSINESS ADMINISTRATION HO CHI MINH CITY, 2012 1 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com MINISTRY OF EDUCATION AND TRAINING UNIVERSITY OF ECONOMICS HOCHIMINH CITY -----o0o----- E Â1 TRẦN ĐÌNH KHẢI BANK INCOME STRUCTURE AND RISK: AN EMPIRICAL ANALYSIS OF VIETNAM COMMERCIAL BANKS MAJOR: BUSINESS ADMINISTRATION MAJOR CODE: 60.05 MASTER THESIS SUPERVISOR: Dr. VÕ XUÂN VINH HO CHI MINH CITY, 2012 2 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 1 ACKNOWLEDGEMENT This thesis would not have been possible without the guidance and the help of several individuals who in one way or another contributed and extended their valuable assistance in the preparation and completion of this study. First and foremost, my utmost gratitude to Dr. Vo Xuan Vinh, whose sincerity and encouragement I will never forget.
Vinh has been my inspiration as I hurdle all the obstacles in the completion this research. Vinh has spent plenty of time in many weeks to support me with his fully enthusiasm. I also express my warm gratitude to all professors at Faculty of Business Administration, University of Economics in Hochiminh City for their teaching and sharing during my MBA course. I have many thanks to my classmates who show their sharing and encouragements when I do this thesis.
Last but not the least, I want to thank so much to my beloved wife who always understands and encourages me to complete my thesis especially in the hardly time of taking care of my newborn baby. LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 2 ABSTRACT This paper investigates the relationship between bank risks and product diversification of the Vietnam banking industry. Employing a sample of Vietnam commercial banks for the period 2008–2011, the results indicate that banks expanding into non-interest income activities do not present higher risk than banks that mainly supply loans. However, considering size effects and splitting non-interest activities into both trading activities and commission and fee activities, we show that the link with risk is mostly accurate for small banks and essentially driven by commission and fee activities.
Whereas, for both of small and large banks, a higher share of trading activities is never associated with higher risk. Keywords: Bank risk; Interest income; Non-interest income; Diversification. LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 3 CONTENTS ACKNOWLEDGEMENT. 2 LIST OF TABLES .4 RESEARCH METHODOLOGY AND SCOPE .5 STRUCTURE OF RESEARCH .10 CHAPTER 2: BASIC THEORETICAL BACKGROUND AND LITERATURE REVIEW .4 BANK RISK AND DIVERSIFICATION.18 CHAPTER 3: DATA AND RESEARCH METHODS.2 BANK RISK MEASURES .22 CHAPTER 4: RESULTS AND DISCUSSION.1 UNIVARIATE MEAN TESTS .1 BANK RISK AND INCOME STRUCTURE .27 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.2 INCOME STRUCTURE AND BANK CHARACTERISTICS.2 MULTIVARIATE REGRESSION ANALYSIS.3 RECOMMENDATIONS FOR FUTURE RESEARCH: .49 LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 5 LIST OF TABLES Table 1: Descriptive statistics for Vietnam commercial banks, on average over the period 2008-2011 (%) Table 2: Descriptive statistics for small and large Vietnam commercial banks, on average over the period 2008-2011 (%) Table 3: Income structure and accounting indicators of risk for Vietnam commercial banks (2008-2011) Table 4: Income structure and bank characteristics for Vietnam commercial banks (2008-2011) Table 5: OLS estimations for the sample of 35 banks with M_NNII as the independent variable.
Table 6: OLS estimations for the first cohort of 13 small banks with M_NNII as the independent variable. Table 7: OLS estimations for the second cohort of 22 large banks with M_NNII as the independent variable. Table 8: OLS estimations for the sample of 35 banks with M_COM and M_TRAD as the independent variables. Table 9: OLS estimations for the first cohort of 13 small banks with M_COM and M_TRAD as the independent variables.
Table 10: OLS estimations for the second cohort of 22 large banks with M_COM and M_TRAD as the independent variables. LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 6 ABBREVIATIONS NII _ Net interest income to net operating income. NNII _ Net non interest income to net operating income. COM _ Net commission and fee income to net operating income.
TRAD _ Net trading income to net operating income Q75 _ Third quartile. LOANS _ loans to total assets; DEP _ deposits to total assets; EQUITY_ equity to total assets; EXPENSES _personnel expenses to total assets; ROA_ return on average assets; ROE_ return on average equity; TA _ total assets SDROA_ standard deviation of the return on average assets; SDROE_ standard deviation of the return on average equity; LLP_ ratio of loan loss provisions to net loans; ADZ_ Z-score; ADZP_ ‘‘ZP-score”; ADZP1_ measure of bank portfolio risk; ADZP2_ measure of leverage risk. OLS _ Ordinary least squares HOSE_Hochiminh Securities Exchange HNX_Hanoi Securities Exchange OTC_ Over The Counter LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 7 CHAPTER 1: INTRODUCTION 1.1 BACKGROUND Following more definitions of bank income structure in the world, bank income structures has two main components: interest income that stems from traditional activities such as giving loan and non-interest income that stems from nontraditional activities such as supplying services, trading services. In the context of financial deregulation that took place in the seventies and in the eighties, western banking systems faced major changes in the form of increased competition, concentration and restructuring.
Banks have reacted to the new environment by adopting a proactive strategy widening the range of products they offer to their clients. These changes mainly implied an increasing share of non-interest income in profits. Non-interest income stems from traditional service charges (checking, cash management, letters of credit.) but also from new sources. With the decline in interest margins induced by higher competition banks were incited to charge higher fees on existing or new services (cash withdrawal, bank account management, data processing.
As a result, structure of bank income experienced a dramatic change in the world. In the eighties, non-interest income represented 19% of US commercial banks’ total income. This share had grown to 43% of total income in 2001 (Stiroh, 2004) and increased from 10% in 1984 to 31% in 2011. In Europe, non-interest income has increased from 26% to 41% between 1989 and 1998 (European Central Bank, 2000).
In Vietnam, non-interest income represented 20% of commercial banks’ LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 8 total income and its share had increased 9% for period of 2008-2011 (State Bank of Vietnam, 2012). With the adoption of the new universal banking principle, commercial banks can compete on a wider range of market segments (investment banking, market trading. Numerous studies questioned the implications of this new environment on bank risk. The issue is of importance for the safety and soundness of the banking system and a major challenge for supervisory authorities.
The existing literature, mostly based on US banks, either focused on portfolio diversification effects risk return profile (Boyd et al., 1980; DeYoung & Roland, 2001; Kwan, 1998) or on incentives approaches (Boyd et al., 1998; John et al. Few studies were able to show that the combination of lending and non-interest income activities allows for diversification benefits and therefore risk reduction. Conversely, some papers find a significant positive impact of diversification on earnings volatility (DeYoung & Roland, 2001; Stiroh, 2004; Stiroh & Rumble, 2006). As noted by DeYoung & Roland (2001), three main reasons may explain this increase in risk.
Firstly, income from lending activities is likely to be relatively stable over time because switching and information costs make it costly for either borrowers or lenders to walk away from a lending relationship. In contrast, income from non- interest income activities may suffer from larger fluctuations as it might be easier to switch banks for this type of activities than for lending. Secondly, expanding non-interest income activities may imply a rise in fixed costs (for example, additional staff may be required), which increases the operational leverage of banks. Conversely, once a lending relationship is established, the marginal cost LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 9 induced by the supply of additional loans is limited to interest expenses.
Thirdly, because bank regulators do not require banks to hold capital against non-interest income activities, earnings volatility may increase because of a higher degree of financial leverage. Moreover, as mentioned by Stiroh (2004), cross-selling of different products to a core customer does not imply diversification benefits (more products are sold to the same customer) which may explain why interest income growth and non-interest income growth are highly correlated in his study 1.2 RESEARCH PROBLEM An increasing number of papers based on the US context have focus on the effect of earning diversifications of banks on earning volatility (DeYoung & Roland, 2001; Stiroh, 2004; Stiroh & Rumble, 2006). DeYoung and Roland (2001) concludes that fee-based activities increase the volatility of banks revenue in USA. Lepetit et al.
(2008) find that European banks expanding into non- interest income activities present higher risk and higher insolvency risk than banks mainly supply loans. However, no paper has tried to study the effect of the diversification of Vietnam commercial banks’ earning on risks. This paper aims to fill the gap of lacking the empirical analysis of commercial banks in Vietnam.3 RESEARCH OBJECTIVE The aim of this paper is to assess the risk implications of the changing structure of the Vietnam banking industry which has shifted away from traditional activities (deposit funded loans) towards activities generating non-interest income. Using individual bank data from 2008 to 2011 for 35 Vietnam commercial banks, we begin by analyzing the link between bank risk and the degree of output diversification measured by three indicators, the income share LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 10 of: (i) non-interest income, (ii) trading income and (iii) commission and fee income.
We hence start by comparing the risk level of banks which have expanded into nontraditional activities with the risk level of banks which have invested less in those activities. Our results show that higher reliance on non- interest activities is not associated with higher risk, however, higher risk is correlated with commission and fee income for small banks with total assets smaller than 25. Conversely, for banks with a larger share in trading income are not associated with both of risk exposure and insolvency (default) risk.4 RESEARCH METHODOLOGY AND SCOPE The subject of this research is all listed and non-listed banks in Vietnam for the period from 2008 to 2011. The sample size is 35.
This paper uses quantitative research based on Lepetit et al. (2008) model to investigate the link between bank risk and the degree of output diversification. We use various data analysis methods in conducting the research such as descriptive statistics, T-test, correlation test, and OLS regression with Eviews 7 for Windows.5 STRUCTURE OF RESEARCH Section 2 reviews the basic theoretical background and prior work of previous researches. Chapter 3 describes model for this paper, data collection and analysis methodology.
Chapter 4 contains the result and discussion of empirical tests while Chapter 5 concludes. 1 Our criterion for distinguishing large and small banks is similar to Bank scope’s and is frequently used in the literature to categorize banks (Carter & McNulty, 2005) LUAN VAN CHAT LUONG download : add luanvanchat@agmail.com 11 CHAPTER 2: BASIC THEORETICAL BACKGROUND AND LITERATURE REVIEW Chapter 2 is to review the basic theoretical background and literature on bank risk, bank income, diversification and shows the relationship between bank risk and diversification.1 BANK RISK There are multiple definitions of risk. Banks face several types of risk. All the following are examples of the various risks banks encounter: Borrowers may submit payments late or fail altogether to make payments.
Depositors may demand the return of their money at a faster rate than the bank has reserved. Market interest rates may change and hurt the value of a bank’s loans. Investments made by the bank in securities or private companies may lose value.