Solutions to improve effectiveness of consumer credit in Vietnam

INTRODUCTION 1. Rationale: In the context of economic crisis recently, the Government has implemented monetary policy and fiscal policy to encourage domestic demands. Experience from the economic development of Vietnam and of other countries around the world has shown that stable economic growth should be based on the increase in domestic demand rather than the increase in trade, especially import Policy stimulating domestic demand, especially consumption demand, is considered key economic development policy which helps reduce dependence on imports. Therefore, the banking system - which provides channels to meet the needs of the economy’s capital - will play an important role in providing credit for consumer activities. Also, under the situation of harsh competition in the context of international integration, Vietnamese commercial banks must diversify forms of credit in order to spread, limit, and control risks at the lowest level. Although in recent years, the State Bank of Vietnam has paid considerable attention to the field of consumer credit, this form of credit is still underdeveloped, accounting for a modest proportion of total outstanding loans. Therefore, to expand and enhance consumer credit growth, there is a need to promote this type of credit. After consulting my academic supervisor and taking everything into consideration, I decided to title this thesis “Solutions to improve effectiveness of consumer credit in Vietnam”. 2. Research purposes Firstly, the thesis is aimed at generalizing basic fundamentals of consumer credit. Secondly, the thesis targets to outline the overall picture of consumer credit activities in VN. Thirdly, based on the fundamentals and the situation shown, the thesis is expected to give solutions and recommendations which may make a small contribution to the development of consumer credit in VN. Research scope In terms of space, the thesis will focus on studying consumer credit activities in Vietnam’s commercial banks. In terms of time, the thesis will focus on researching consumer credit activities in Vietnam’s commercial banks from 2006 until March 2010. 4. Research methodology This thesis approaches the research topic in combination with comparative analysis, which in one hand, points out common concepts, understandings and practices in Vietnam with appropriate adjustments through quantitative and qualitative methods. With regard to its scope, as an introduction to an emerging industry, this study only concentrates on consumer credit in Vietnam’s commercial banking system. Therefore, “overview” is the word that can tell exactly the scope of this thesis, which in turn, reflects the overall purpose of the thesis. 5. Research structure: This thesis is divided into three main chapters. CHAPTER 1: THE FUNDAMENTALS OF CONSUMER CREDIT. CHAPTER 2: CONSUMER CREDIT ACTIVITIES IN VIETNAM’S COMMERCIAL BANK SYSTEM. CHAPTER 3: SOLUTIONS AND RECOMMENDATIONS TO IMPROVE EFFECTIVENESS OF CONSUMER CREDIT IN VIETNAM. CHAPTER 1: THE FUNDAMENTALS OF CONSUMER CREDIT The first chapter will focus on presenting the theoretical background of the thesis. Key topics in this chapter include: - Definition of consumer credit and its types. - Characteristics and benefits of consumer credit. - Consumer lending process. - Indicators to evaluation credit performance. - Experience and lessons drawn from consumer credit situation in EU. 1. 1. General principles of consumer credit 1.1.1. Definition of consumer credit Not so many decades ago, consumer credit was little known and seldom distinguished from credits granted for business and related purposes. Today it is recognized to be a special type of financing that greatly influences the rate of expansion or contraction of consumer demand and hence the level of business activity. Consumer credit (or consumer loans, consumer lending) can be understood in a broad sense including government, non-profit, and informal credit-debt relationship. For example: student loans and money lent between friends and relatives, government lending to people receiving state benefits, people paying utility and telecoms bills in arrears. These too can be considered forms of consumer credit. However, consumer credit is sometimes defined in a narrower context. One of the pioneers in the field, Rolf Nugent, defined consumer credit in his book as credit extended to individuals to finance the purchase of consumer commodities and services or to refinance debts which had their origin in such purchases. Consumer credit can also be illustrated at the very end of the marketing chain. According to Robert Cole and Lon Mishler, “consumer credit is the use of credit as a medium of exchange for the purchase of finished goods and services by the ultimate user”. In Consumer Credit Fundamentals, Steve Finlay defined consumer credit as ‘money, goods or services provided to an individual in lieu of payment’. All in all, consumer credit can be seen as a credit-debt relationship in which loans are provided to individuals and households to the purchase of automobiles, homes, appliances, and other retail goods; to repair and modernize homes; and to pay the finance the cost of medical care and other personal expenses. 1.1.2. Characteristics of consumer credit Consumer credit is distinguished from business credit by the following characteristics: Firstly, due to small scale of each consumer credit agreement which leads to higher cost of lending operation, interest rate on consumer credit is typically higher than the rate applied for business loans. Secondly, consumer loans tend to be cyclically sensitive. They rise in periods of economic expansion when consumers are generally optimistic about the future. On the other hand, when the economy turns down, many individuals become more pessimistic about the future and as a result reduce their borrowings. Thirdly, household borrowings appear to be relatively interest inelastic. A borrower normally considers the monthly payments required by a loan agreement or the total payment at the end of agreement rather than the interest rate charged on the loan. Fourthly, income and education level have a close relationship with customer’s demand for consumer credit. The higher income the customers earn, the more likely it is that they will ask for consumer loans which they are able to pay at the end of agreement. Both education and income levels do materially influence consumers’ use of credit. Individuals with higher income tend to borrow more in total and relative to the size of their annual incomes. Those households in which principal breadwinner has more years of formal education also tend to borrow more heavily relative to their income level. Fifthly, the borrower’s main source of payment may be subject to considerable fluctuation because it depends on the customer’s employment history, skills, working experience, health, etc. Many of these factors change over the time. Sixthly, customers’ personalities and behaviors which are quite challenging to define take a significant part in determining the debt payment. Normally, the lender must be assured that the borrower has moral responsibility to repay a loan on time. 1.2. Benefits of consumer credit As for the bank, regardless of two drawbacks which are risk and high cost, consumer credit covers significant advantages. Firstly, consumer credit helps build up relationships with customer which might raise possibilities of attracting capital for the bank itself. Secondly, consumer credit helps diversify bank’s businesses which consequently help boost revenue and spread the bank’s risks. As for consumers, consumer credit provides a source of assistance in times of financial stress. Thanks to this type of credit, they have opportunities to enjoy conveniences even before they accumulate enough money for personal expenditure. Particularly, consumer credit is essential for unexpected expenses such as on health care and education. However, misuse of consumer credit may bring about insidious effects, which means borrowers may spend an excessive amount of money, leading to limited capacity for saving and consuming in the future. More seriously, borrowers might get themselves into trouble for being unable to pay the debts. Finally, as for the economy, consumer credit exerts a dramatic effect on economic stimulus as well as creates positive conditions for accelerating economic growth; leading to sustainable development. It performs a supporting role in boosting household and individual consumption by granting loans to cover essential expenses, particularly in times when the economy is weak. Domestic demand including consumption and investment consequently is fueled. Besides, the growth in the volume and diversity of consumer credit products has resulted in a thriving consumer credit industry providing employment for millions of people around the world. Moreover, consumer credit helps diminish wealth gap by providing credit access to all kinds of customers. 1.3. Types of consumer credit Credit categorizing is arranging loans into specific groups according to certain criteria. A science-based classification is the precondition for organizing a proper credit-granting process and improving credit risk management. Credit classifying is based on the following criteria: 1.3.1. Based on the purposes of a loan Residential Mortgage Loan A residential mortgage loan is used to purchase, build, or renovate a fixed asset such as land or buildings, with the loan secured against the asset. In most cases this will be the borrower’s home. A standard mortgage is offered as a fixed term agreement. In the UK this is commonly 20 or 25 years and in the US it is 15 or 30 years. In Japan, terms as long as 50 years are not unusual, with the debt being passed on to the next of kin if the original borrower dies. When a mortgage has been fully repaid it is said to have been redeemed. Non-residential Mortgage Loan A nonresidential mortgage loan is taken out to buy a new car; and consumer durables such as a sofa, washing machine or a television. This type of credit is also used to cover things such as household bills, travel and entertainment. 1.3.2. Based on methods of payment Instalment Consumer Loan Installment consumer loan is a loan in which repayments cover both principal and interest, with the debt having been amortized at regular intervals during a fixed period of time and repaid in full by the end of the agreement. This method of payment is applied for outstanding loans or in case customer’s regular income cannot cover a lump sum payment (paid gradually over the time). Non-installment Consumer Loan Short-term loans individuals and families draw upon for immediate cash needs that are repayable in a lump sum are known as non-installment loans. This type of loan is frequently used to cover the cost of vacations, medical care, the purchase of home appliances, and auto and home repairs. Such loans may be for relatively small amounts and include charge accounts that often require payment in 30 days or some other relatively short time period. Non-installment loans may also be made for a short period, usually six months or less, to wealthier individuals and can be quite large. Revolving Consumer Credit A revolving loan, sometimes called a flexible loan or a budget account, is a form of revolving credit. A borrower agrees to make a fixed monthly payment and in return has the ability to draw cash up to a maximum limit, which is a multiple of the monthly payment amount. For example, an account with a 15 times multiplier will allow a customer who agrees to pay $200 a month to draw funds up to a maximum of $3,000. 1.3.3. Based on the origin of the loan Indirect Consumer Loan This is the type of loan in which lending relationships occur in order as shown in the Figure 1. Figure 1: Indirect Lending Relationships
(Source: Paul Beares, Richard E. Beck, Susan M. Siegel (2001), Consumer Lending, American Banker Association, p. 67). Direct Consumer Loan Direct consumer loan is a loan in which a representative of the bank has a face-to-face meeting to assess the creditworthiness of individuals applying for credit. This person is known as an underwriter or a credit officer. A credit officer from the bank often receives better training in assessment of the likelihood of the applicant repaying the debt than one from a retailer does. Therefore, a bank usually produces a more prudent credit granting decision. 1.4. Consumer lending process 1.4.1. Steps in lending process There is similarity in lending process between consumer credit and business credit. The steps in the process are shown in order from a-f as below: Finding prospective loan customers: Most loans to individuals arise from a direct request from a customer who approaches a member of the lender’s staff and asks to fill out a loan application. Sometimes loan officers will call on the customers for months before they finally give the lending institutions a try by filling out a loan application. Evaluating a prospective customer’s character and sincerity of purpose: Once a customer decides to request a loan, an interview with a loan officer usually follows, giving the customer the opportunity to explain his or her credit needs. The interview also provides a chance for the loan officer to assess the customer’s character and sincerity of purpose. If the customer appears to lack sincerity in acknowledging the need to adhere to the terms of a loan, this must be recorded as weighing against approval of the loan request. Making site visit and evaluating a prospective customer’s credit record: In case a mortgage loan is applied for, a loan officer often makes a site visit to assess the condition of the property. The loan officer may contact other creditors who have previously loaned money to this customer to see what their experience has been. Evaluating a prospective customer’s financial condition: If all if favourable to this step, the customer is asked to submit several crucial documents the lender needs in order to fully evaluate the loan request. Once all documents are on file, the lender’s credit analysis department conducts a thorough financial analysis of the applicant, aimed at deciding whether the customer has sufficient cash flow and backup assets to repay the loan. Assessing possible loan collateral and signing the loan agreement: If the loan committee approves the customer’s request, the loan officer or the credit committee will usually check on the property or other assets to be pledged as collateral. Once the loan officer and loan committee are satisfied that both the loan and the proposed collateral are sound, the note and other documents that make up a loan agreement are prepared and signed by all parties to agreement. Monitoring compliance with the loan agreement and other customer service needs: The new agreement must be monitored continuously to ensure the terms of the loan are being followed and all required payments of principal and interest are being made as promised. A new loan customer’s information is also saved as a customer profile to show and monitor a customer’s condition and financial service needs. 1.4.2. Credit analysis Credit analysis is considered the most important step in a lending process. Result of credit analysis will mainly determine the approval of loan committee towards granting decision. Credit scoring system Credit scoring can be defined as any quantitative method, technique or practice used in the granting, management or recovery of consumer credit. The basic principle is to assign some rating, or score, to an individual based on the information that is known about them at the time of application. The score is then taken as indicative of the future behavior of the applicant; that is, the likelihood that the applicant will prove to be an acceptable risk. In general, the higher the score is, the lower the risk is . In fact, there are many factors that make up a score card. Data such as the applicant’s monthly income, outstanding debt, financial assets, how long the applicant has been in the same job, whether the applicant has defaulted or was ever delinquent on a previous loan, whether the applicant owns or rents a home, and the type of bank account the applicant has are all potential factors that may relate to loan performance and may end up being used in the scorecard. Based on statistics in the past on possible risks of those customers with similar credit score, the bank offers a wide range of credit limit to customers in different groups of score. The following is a sample of credit limits offered to customers with different credit score at the mentioned US bank. Table 1: Point-Scoring Schedule of Approved Credit Amounts Point Score Value or Range  Credit decision   280 points or less  Reject application   290-300 points  Extend credit up to $1,000   310-330 points  Extend credit up to $2,000   340-360 points  Extend credit up to $3,000   370-380 points  Extend credit up to $4,000   390-400 points  Extend credit up to $6,000   410-430 points  Extend credit up to $10,000   (Source: Peter Rose (2001), Commercial banking management, Irwin McGraw-Hill, p. 602) The main downside of credit scoring is its reliance upon the information from which the original credit scoring system was constructed. If there are certain types of application that were not considered or not available at the time the system was developed, these cases will not be assessed in an optimal capacity. Often this will affect small groups within the population who are overshadowed by the characteristics of the majority. For example, most credit scoring systems will give low scores to people who have not lived very long at their address, have recently started a new job, rent instead of own, or do not have some previous credit history. Credit scoring system is designed to work in tandem with Judgment Method. Judgment Method Judgment Method is a method in which the bank carries out qualitative and quantitative analysis and judgment of the borrower so as to limit the number of non-performing loans. In each case the aim of the underwriter was to come to a somewhat subjective view as to whether or not the individual was creditworthy. While credit scoring is the norm, there are always some cases that require manual review. There are also some non-mainstream lenders, particularly in the sub-prime and door-to-door market, who do not apply credit scoring. Thus the role of the underwriter remains, albeit in a specialist or minority capacity, and is likely to do so for the foreseeable future. It is also worth noting that while credit scoring is an accepted practice in many developed countries, in areas where banking systems are less well developed, judgmental decision making is still heavily relied upon. At the core of the decision making process was the concept of the ‘Six Cs’ of credit which the lender looks for to review the borrower’s creditworthiness when analyzing a loan package. The "Six C's" which consist of Character, Capacity, Cash, Collateral, Conditions, and Control are the basic components of credit analysis. To establish if each of the Cs were satisfied, an underwriter would examine the information supplied by the applicant, which might then be combined with a credit report from a credit reference agency detailing the applicant’s repayment record with other lenders. They would then use their intuition and experience to make a decision. As credit organizations developed, it was common practice for the accumulated wisdom of the senior underwriters to be distilled into a formal statement of lending practice. 1.5. Consumer credit performance A