No easy medicine to cure banking woes

Most of the macroeconomic indicators for the Vietnamese economy have been on a rollercoaster ride in recent years, prompting international ratings agencies to downgrade its credit rating.
 
Once an economy with impressive growth rates and a relatively stable business environment, it is now widely acknowledged as facing multiple challenges in sustaining growth. In 2012, the trade-off between growth and stability has been revisited, and as the pace of growth slowed to more sustainable levels, the economic situation has gradually improved. By the end of this year, GDP growth is expected to top 5 per cent. However, is this the end of the rollercoaster? Or just the calm in the eye of the storm with more instability to come?  

That is hard to predict. The financial sector offers some important insights into the future of the Vietnamese economy, because the stability of the financial system is critical not only to reducing macroeconomic risk, but also to encouraging robust savings growth and productive investment for the longer term.

If we examine two metrics that have often triggered crises in other countries, Vietnam’s financial sector appears vulnerable. The first of these signals is the rapid expansion in bank lending. Total outstanding bank loans increased sharply, at a rate of 33 per cent a year from 2000 to 2010, the strongest growth rate recorded in any ASEAN country, China, or India. By the end of 2010, the value of loans outstanding had reached almost 90 per cent of GDP, compared with only 22 per cent in 2000.

The second metric is non-performing loans (NPLs) on the back of rapid loan growth. While the central bank has adjusted NPL figures upwards – from 2.1 per cent in 2010, to 3.3 per cent in 2011 and most recently to 8.8 per cent, further efforts need to be taken to ensure a proper workout of the bad loans. The option of establishing an asset management company which could assume responsibility for NPLs – or a “bad bank” – has been floated. If the real economy shows further improvements, the volume of NPLs can be expected to fall. That may, however, simply mask the ongoing structural problems in the system until the next downturn.

In 2011 the Vietnamese government introduced several banking regulations including a 20 percent cap on annual credit growth and limits on non-productive bank activities such as real estate. It also capped deposit rates at 6 and 14 per cent—firmly in negative real interest territory at that time. Yet these measures were challenging to enforce. For example, the actual credit growth exceeded the annual target rates in both 2009 and 2010. And the aggregate limits on credit growth have not addressed the accumulated risk in existing bank portfolios or the broader liquidity risk arising from a mismatch between short-term deposits and medium-term lending.

We see three long term systemic risks facing the banking sector today. To reduce these risks, the government will need to take major steps to encourage structural change in the industry.

The first of these is that, while the reported level of NPLs appears under control and has been adjusted upwards, there is still uncertainty about the true volume. Given that the volume of NPLs was officially around the 2 per cent mark for several years prior to the recent adjustment, it is hard for investors to have confidence that the current figures are accurate. Addressing that perception problem will be a challenge.

The key source of risk here is the misallocation of capital to poorly performing real sectors, particularly by Vietnam’s large  state-owned banks, the fact that cross-holdings are prevalent and these weaken corporate governance, and that the sector has a large number of sub-scale banks. In response, Vietnam needs to enforce stricter standards for recognising bad loans, further equitise state banks and enforce rules on cross-holding. Vietnam should also enforce minimum capital requirements to drive the consolidation of sub-critical players. In other words, true restructuring that is being led by actions not just words.

The second systemic risk is that of a liquidity crisis. Vietnam’s funding market is heavily skewed toward the short term, driven by customers who invest money in the short term. Term deposits with durations of a month or less are Vietnam’s most popular product. Regulations capping interest rates – like those imposed in the past – may only exacerbate the situation. They are particularly difficult for smaller banks which cannot use pricing to attract deposits. On the other hand, controlling interest rates might be used to further encourage the development of investment products, thinking through the standards and guidelines on how to regulate commodities trading, mutual funds or creating a market for structured products.

The third systemic risk is Vietnam’s foreign-exchange position, measured by the stability of its foreign reserves. Vietnam will need to strike the right balance in its exchange-rate policy to maintain cost competitiveness in the face of inflation and help ensure that hidden foreign reserves are brought back into the official economy so these funds can be invested productively.

Many of the issues that Vietnam faces today come down to limited governance and transparency.

Laying out a clear roadmap for the adoption of international standards such as Basel would improve the long-term stability of the sector and boost investor confidence. Today, the financial reporting standards and risk management techniques practised by Vietnamese banks are still a long way from Basel II or Basel III standards.

Vietnam could usefully run a series of bank stress tests to identify banks that are struggling and separate them from those that are performing well. Beyond these immediate measures, regulators and policy makers should consider articulating a clear vision for the banking sector that enables the sector to transition over the next three to five  years to a stronger and stable end state, on the back of four core principles.

* Ensure adequate coverage and competition: The banking sector needs to ensure that all customer segments and geographical areas are adequately serviced, no segment is over-concentrated by any player, there is effective competition in each segment that drives real customer benefits and there are well defined norms for entry and exit to encourage competition

* Maximise efficiency and minimise intermediation costs: This can be achieved through scale benefits enabled by consolidation of banks with highly overlapping customer focus and capabilities, and by creating pressure on banks to invest in building more efficient technologies and business processes. In addition, over time allowing entry of newer non-traditional competitors will spur change.

* Build strong management skills: Invest in training and development of bankers by establishing a world class banking institute, leverage the strong management capability in the well-managed domestic banks and open access to foreign players for skills transfer.

* Create a stable and strong regulatory framework that differentiates between strong and weaker institutions, supports building of institutional capabilities in capital and risk management, focuses on customer protection and ensures stability of the overall system, aligning it to international standards.
   
The banks themselves also need to take steps to enhance their competitiveness and longer term resilience. In Vietnam’s state owned banks, the priority should be to rapidly improve their IT capabilities while strengthening their risk management. Developing a more highly skilled labour force will be necessary to make that happen. For the joint stock banks, management should look to build innovative business models, develop world class customer capabilities and sustain growth through domestic acquisitions.  For foreign banks doing business in Vietnam, this requires adopting a long term view, and exploring creative franchising options.

In conclusion, transformation of the financial services sector in Vietnam will require a phased approach over the long term, with a strong focus not only on building infrastructure and capabilities but balancing the imperative for growth with the need for enhanced risk management and regulation for stability.