The Effect of Bank Capital on Risk and Profitability in

the Vietnamese Banking System

Dung Tien Nguyen1

Hong Thi Thuy Trinh2

Quy Nhon University

Abstract

This study applies the Two-Step System Generalized Method of Moments on bank-level data
of 22 Vietnamese banks over 2007-2014 to investigate the impacts of capital on profitability
and risk. When the effects from a range of bank-specific and country-specific variables are
taken into consideration, three conclusions are reached. First, the effect of increasing bank
capital on risk is significantly negative, supporting the moral hazard hypothesis. Second, the
findings also indicate that there is significantly negative relationship between the capital and
profitability, supporting structure-conduct-performance hypothesis. Finally, our results also
reveal that risk variables and profitability variables show persistence from one year to the
next, indicating that the previous period of risk and profit will be enhanced in the next period.
Hence, our results suggest that increasing capital can decrease bank’s profitability and risk.

Keywords: Bank capital, Bank Profitability and Risk, Dynamic panel.

JEL codes: G21, G28, G31

1
Corresponding author. Faculty of Finance-Banking and Business Administration, Quy Nhon University, 170 An
Duong Vuong, Quy Nhon, Binh Dinh, Vietnam, 590000. Email: nguyentiendung@qnu.edu.vn
2
Faculty of Finance-Banking and Business Administration, Quy Nhon University, 170 An Duong Vuong, Quy
Nhon, Binh Dinh, Vietnam, 590000. Email: trinhthuyhong@qnu.edu.vn

1
1. Introduction
Over the last 30 years Vietnam has transformed into a dynamic market-based
economy in which industry and services have been playing increasingly important roles. With
a stable political environment and its economic potential, Vietnam is an attractive destination
for foreign investors. The banking sector in Viet Nam is at the center of the development of
financial system and the economy as a whole. Since the 1990s, Vietnam government has
implemented banking reforms towards liberalization by following a gradual approach. Several
rounds of reforms have been started by Vietnam government to increase bank efficiency and
create a competitive environment in the banking sector. On the other hand, increasing in
competition will result in greater risk-taking behavior due to the fact that market power of
banks is reduced and their charter values are decreased (Hellmann, 2000). The capital
adequacy plays a more and more important role for the purpose of counterbalance the risk.

Standard capital market theory states that there is a risk-return tradeoff in equilibrium.
Low levels of uncertainty (low risk) are associated with low potential returns. High levels of
uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is the
balance between the desire for the lowest possible risk and the highest possible return. The
banks have a larger loan portfolio appear to require higher net interest margin to compensate
for higher risk of default. However, when banks enjoy high profit, we can suspect that they
may set too high interest rates on loans. If this happens, bank profitability comes from
financially exploiting borrowers and dampens economic efficiency. Furthermore, if high profits
are the consequence of market power, this would imply some degree of inefficiency in the
provision of financial services. In this case, high returns could be a negative outcome that
should prompt policy-makers to introduce measures to lower risk, remove bank entry barriers
if they exist (as well as other obstacles to competition), and re-examine regulatory costs. On
the other hand, poor profitability can weaken the capacity of the system to absorb adverse
disturbances because capital formation is limited. Lower profitability is also regarded as the
seed of future vulnerabilities. The Central bank can use capital requirement to manage risk
and decrease the probability of bank failures that are the cause of remarkable negative
externalities. The banks operate inefficiently which might endanger another related bank via
interbank loan market or via account of customers expecting fund transfer from the first bank
in payment system, which strongly spreads into overall sector, even whole economy.
Specially, if the large banks know their important position in economy system, they will have
motivation to take higher risks to reach higher profitability. As a result, the Central bank has to
support to stabilize the economy if these banks experience difficult periods. If the support is
not enough, it will be an enormous disaster. Then, in case that the bank goes bankruptcy, all
useful customers’ assessment information for reference may be lost forever, which affects the
entire banking sector (Dao Binh and Ankenbrand, 2014). Finally, we are all aware that
healthy and sustainable banking sector profitability is necessary for maintaining the stability of
the financial system.

The relationship between bank capital and risk-taking is one of the key issues in the
banking literature. A number of studies have investigated the impact of capital on bank risk
(Aggarwal and Jacques, 1998; Agusman et al, 2008; Altunbas et al, 2007; Agoraki et al,
2011…). Furthermore, there are few studies assessing the relationship between capital,
profitability and risk for Asian banking (Lee and Hsieh, 2013), Turkish Banking (Hasan

2
Ayaydin, Aykut Karakaya, 2014) and Vietnamese banking (Dao Binh and Ankenbrand, 2014).
It is thus no surprise that the relationship between bank capital and risk (profitability) has
recently become a cause for concern, especially as the level of capital may give rise to both
beneficial and adverse effects on bank profitability (Lee and Hsieh, 2013). On the other hand,
the investigation on the relationship between them becomes very important because of the
financial crisis happened from 2008.

To investigate this issue, this paper applies the Two-Step System Generalized
Method of Moments technique for dynamic panels using bank-level data for Vietnamese
banking sector over the period 2007 to 2014 to investigate the impacts of bank capital on
profitability and risk. This paper contributes to existing empirical analyses in a few important
ways. First, the existing literature is primarily focused on U.S. or European cases (Brewer and
Lee, 1986; Berger, 1995; Carbo et al., 2009). This is one of the new studies for Vietnamese
banking to examine the relationship between capital, risk and profitability. Especially, the
banking system has played a key role in this stellar performance of the Vietnamese economy
as it has been the main pillar of Vietnam’s financial system (Shimada and Yang 2010) and
bank restructuring programs still continue in Vietnam. Examining the effect of bank capital
over the profitability and risk of the banks in terms of Vietnam’s banks that recently become a
crucial subject.

The Vietnamese banking industry therefore provides an interesting laboratory for

investigation. Second, most studies focus mainly on the relationship between capital and risk
(Aggarwal and Jacques, 1998; Agusman et al., 2008), yet seldom on the relationship
between capital and profitability (Berger, 1995; Goddard et al., 2004). This study discusses
capital, risk, and profitability together. Finally, from the methodology viewpoint, most studies
utilize a static model (Berger, 1995; Demirguc-Kunt and Huizinga, 2000; Rime, 2001;
Agusman et al., 2008). Dynamic panel techniques are adopted to analyze the panel data,
which are designed to check the persistence of profit (or risk) in the study.

The remainder of the paper is organized as follows. Section 2 provides an overview of

the relevant literature and Section 3 describes the methodology and data employed herein.
Section 4 discusses the empirical results, and Section 5 presents our conclusions.

3
2. Literature review
2.1. The relationship between capital and risk

The banks which want to remain successful and increase their market share must use
a great deal more leverage than is the norm in other industries. Banks can use either debt or
equity capital to finance their assets. The best choice is a mix of debt and equity. Debt is less
costly, but more risky for the borrower (the bank) than equity, carries high fixed costs that
must be paid to remain solvent. Bankers that concentrate on safety, as is the case with
closely held banks where the bank might represent the owner’s primary source of income,
typically prefer higher equity to reduce the likelihood of failure. Regulators generally focus on
bank risk and safety, so regulators prefer higher capital adequacy ratios.

The banks differ from non-financial firms as they encompass an additional friction in
the form of prudential capital regulation. Regulators in most jurisdictions around the world are
still planning to implement the new accord (Basel III) to strengthen the soundness and
stability of international banking systems and to reduce competitive in equality primarily via
minimum capital adequacy regulation.

Many studies concentrated on the relationship between risk and capital especially
after the introduction of Basel I. Capital regulation is one of the important tools that are used
to prevent bankrupt of bank. However, theoretical literature offers contradictory results as to
the optimum design of capital adequacy regulation and to the effect of capital regulation on
bank risk taking incentive and performance. It means the theoretical issue of how higher level
of capital structure reduce overall banking risk is not yet entirely solved.

We specifically apply the two-step GMM dynamic panel estimator to assess the
relationships between banking capital, profitability, and risk. Capital, profitability, and risk
should be considered simultaneously when examining the regulatory, SCP, and moral hazard
hypotheses, because a change in capital gives rise to a change in banks’ profitability and risk.
Therefore, the level of capital should be treated as an endogenous variable when we
examine the regulatory and moral hazard hypotheses. The GMM model resolves the possible
simultaneity between the degree of capital and profitability (risk) and takes into account the
causal effect of the exogenous component (Lee and Hsieh, 2013).

Previous studies offers opposing views on the effect of bank capital on risk. A strand
of literature finds a positive effect, meaning regulators encourage banks to increase their
capital commensurably with the amount of risk taken, which refers to the “regulatory
hypothesis” (Pettway, 1976; Shrieves and Dahl, 1992; Berger, 1995; Demirgüç-Kunt and
Huizinga, 2000; Rime, 2001; Iannotta et al. 2007; etc.).

A pioneer research by Pettway (1976) explores the relation between accounting and
capital market measures of risk by considering the impact of the bank’s capital position and
other accounting variables on market beta and the price-earnings ratio. Using regression
methodologies to examine U.S banks and bank holding companies (77 issues of capital
notes) over the period 1971–1974. He find that a positive relationship between equity-to-total-
assets and risk.

4
 Shrieves and Dahl (1992) analyze the change in relationship between changes in
capital structure and changes in portfolio risk for the US banking sector during the mid-
eighties. Using a two-stage simultaneous equation methodology to account for the
simultaneity of capital and risk, they find a positive relationship between changes in bank
capital and changes in risk-taking. They conclude that this positive relationship is not strictly
the consequence of capital regulation, as banks holding regulatory capital in excess of
minimum requirement tend to emulate positive relationships.

Rime (2001) have examined the Swiss bank’s capital and risk behaviors during the
period 1989-1995 by estimating a modified version of the model developed by Shrieves and
Dahl (1992). They observe a positive and significant relationship between changes in risk and
changes in the ratio of capital to total assets but no significant relationship between changes
in risk and changes in the ratio of capital to risk-weighted assets (RWA). These two finding
are consistent in a regime of risk-based capital standards, as banks constrained by the
capital requirement have to increase their ratio of capital to total assets following an increase
in risk to keep their risk-adjusted capital ratio constant. The positive relationship between
changes in risk and changes in the ratio of capital to total assets should not be interpreted as
an unintended effect of higher capital requirement on bank’s risk-taking, as the recent
evolution of Swiss capital requirement has actually decreased the capital burden for Swiss
bank.

In line with the capital buffer theory, banks aim at holding more capital than required
(i.e., maintaining regulatory capital above the regulatory minimum) as insurance against
breach of the regulatory minimum capital requirement. More capital tends to absorb adverse
shocks and thus reduces the likelihood of failure. Consequently, portfolio risk and regulatory
capital are assumed to be positively related. Banks raise capital when portfolio risk goes up in
order to keep up their capital buffer. Indeed, evidence from the US banking sector by
Shrieves and Dahl, 1992; Jacques and Nigro, 1997; and Aggarwal and Jacques, 1998 as well
as by Rime, 2001 from Switzerland and Heid, Porath, and Stolz, 2003 seems to confirm this
positive relationship. As a matter of fact, Shrieves and Dahl, 1992 and Jacques and Nigro,
1997 emphasize that changes in risk and capital outlook by bank management are
simultaneously determined.

Iannota et al. (2007) using Panel data model methodology to examine a sample of
181 large banks from 15 European countries over the 1999 – 2004. After controlling for size,
output mix, asset quality, country and years effects, they found that Capital is associated with
positive profitability (the ratio of operating profit to total earning assets) and risk, which can be
attributed to the fact that a different asset risk can be compensated by a different level of
capitalization. The coefficients of the GDP growth rate on profit and risk are significantly
positive.

Saibal Ghosh (2014) employing a 3SLS estimation to test the relationship between
risk and capital over 100 GCC banks for 1996-2011. In this paper, risk is measured by the Z-
score, while capital is computed as the ratio of equity to asset. The results indicate that banks
generally increase capital in response to an increase in risk, and not vice versa. In the GCC
banks existing an uneven impact of regulatory pressure and market discipline on banks
attitude towards risk and capital. The findings also reveal that Islamic banks increased their
capital as compared to conventional banks. Besides, the evidence testifies to the fact that
banks with higher dependence on wholesale funds and less diversified income profile have
higher risk.

5
 Dao Binh and Ankenbrand (2014) using regression analysis to examine a sample of
11 Vietnamese commercial banks over the period 2008-2013. They observe a positive and
significant relationship between changes in capital risk and changes in the degree of capital
adequacy. The research indicates that the capital risk variable fluctuates in a high range
during the last 6 years, illustrating the unstable environment of Vietnamese banking industry.
The appropriate cause for this issue might be the different risk management approach under
competition and Government pressure, and the bank’s capital withdrawn trend by depositors
after having the rumors of bank failures. These activities directly affect both invested capital
and risk, which reasonably leads to a large change in capital risk. Hence, the Vietnamese
Central bank attempted to control capital risk of commercial banks by strengthen their
adequate capital level. The researcher suggested that the higher the level of capital
adequacy, the more safely banks might be able to deal with capital risk.

Another strand of literature, in contrast, suggests a negative effect of capital on risk.

These studies refer to the “moral hazard hypothesis” where by banks have incentives to
exploit existing flat deposit insurance schemes (Demirgüç-Kunt and Kane, 2002). For
instance, Jahankhani and Lynge (1980), Brewer and Lee (1986), Karels et al. (1989),
Jacques and Nigro (1997), and Agusman et al. (2008) show that equity-to-total asset is
negatively related to risk. As also indicated by Kahane (1977), Koehn and Santomero (1980),
and Kim and Santomero (1988), banks could respond to regulatory actions, forcing them to
increase their capital by increasing asset risk (Altunbas et al., 2007). However, the puzzle
between capital and risk, as suggested by Hughes and Moon (1995), Hughes and Mester
(1998), and Altunbas et al. (2007), is that capital and risk are likely to be influenced by the
level of profitability in the banking sector.

Jahankhani and Lynge (1980) using panel data model methodology to examine a
sample of 95 commercial banks and bank holding companies in the US over the period
1972–1976. When market beta is used as the dependent variable, they find that the dividend
payout ratio, the coefficient of variation of deposits, and the loan-to-deposits ratio are
statistically significant, and the accounting variables explain 26% of the variability in
systematic risk. When total return risk is used as the dependent variable, all variables except
the loans-to-deposits ratio are found to be statistically significant, and 43% of the variability in
the dependent variable is explained.

Brewer and Lee (1986) also using panel data model methodology to examine a
sample of 44 US bank holding companies over the period 1979–1983. They use a multi-index
market model based on daily return data to derive market, banking industry, and interest rate
risk measures. Risk sensitivities of bank stocks are also investigated by comparing banks in
California, Chicago, New York, and ‘‘Other” geographic areas. They find a significant
correlation between accounting-based measures of equity risk and market-based measures
of equity risk. In particular, the coefficient on the book-capital-to-assets ratio has a negative
sign and is significantly different from zero in both the market and industry equations. The
after-tax-net-in come to-assets variable is positive and only significantly different from zero in
the interest rate equation. In all models, both the purchased funds ratio and the loans-to-
assets ratio are statistically significantly positive. However, neither the standard deviation of
the after-tax-net-income nor the charge-offs ratio have a statistically significant effect on the
three market measures of risk. They also find that the equity values of New York City banks
are relatively more exposed to market and industry sources of risk than are California and
Chicago banks.

Karels et al. (1989) examine the relation between total, systematic, and unsystematic
risk and an accounting measure of risk proxies by the capital adequacy ratio. They use a

6
sample of 24 US banks over 30 quarters during 1977– 1984. They argue that higher capital
adequacy ratios provide a greater buffer against default and, therefore, imply less risk. They
find that, as expected, the coefficients of correlation between the capital adequacy ratio and
systematic risk are negative in each of the thirty quarters. The relation between the capital
adequacy ratio and the total risk measure is also negative but not statistically significant.
However, the signs of the coefficients between the capital adequacy ratio and unsystematic
risk are mixed.

Mansur et al. (1993) examine 59 US banks, selected at random, over the period
1986–1990. Using the market beta as the dependent variable, they report that only the loan
loss-reserve-to-total-loans ratio and the coefficient of variation of deposits are statistically
significant. In this model, the independent variables explain 35% of the variability in
systematic risk. Moreover, using total return risk as the dependent variable, only the liquidity
ratio is found statistically significant, and it explains 24% of the variability in total risk. Overall,
these studies reveal that accounting and capital market risk measures are significantly related
for US banks.

Jacques and Nigro (1997) using 3SLS methodology to study the relationship between
changes in capital and changes in risk-taking in the US subsequent to the adoption of Basel
Committee’s minimum capital regulation in 1991. They conduct a study on 2,570 U.S. FDIC-
insured commercial banks during 1990 and 1991. They find increases in book capital ratios
and decreases in risk exposure consistent with the findings of Shrieves and Dahl.

Hughes and Moon (1995) and Hughes and Mester (1998) thus stress the importance
of analyzing the impact of efficiency on risk and capital. They observe a positive relationship
between risk and the level of capital (and liquidity), perhaps signaling regulators’ preference
for capital as a means of restricting risk-taking activities but a negative relationship between
inefficiency and bank risk-taking

Altunbas et al. (2007) investigated the relationship between capital, risk and efficiency
for a large sample of European banks between 1992 and 2000. They did not find any strong
relationship between inefficiency and bank risk-taking. Evidence from the full sample
suggests that inefficient European banks do not seem to have an incentive to take on more
risk. Stronger empirical evidence is found showing the positive relationship between risks on
the level of capital, possibly indicating regulator’s preference for capital as a means of
restricting risk-taking activities. They also find evidence that the financial strength of the
corporate sector has a positive influence in reducing bank risk-taking and capital levels.
There are no major differences in the relationships between capital, risk and efficiency for
commercial and savings banks although there are for co-operative banks. In the case of co-
operative banks we do find that capital levels are inversely related to risks and they find that
inefficient banks hold lower levels of capital.

Agusman et al. (2008) applying a panel data analysis that includes a control for
country-specific factors to examines the relation between accounting and capital market risk
measures for a sample of 46 listed Asian banks during the period 1998–2003. The results
show that the standard deviation of the return-on-assets and loan-loss-reserves-to-gross-
loans are significantly related to total risk. Also gross loans-to-total-assets and loan-loss-
reserves-to-gross-loans are significantly related to non-systematic risk. The results indicate
that in these Asian countries firm specific risk is more important than systematic risk. It
appears that concentrated managerial control and specific country dummy variables subsume
systematic risk. Also, because banks are the primary source of financing, other firms in the
market index are impacted by the behavior of banks.

7
 Abdul Mongid et al. (2012) applying a three-stage least squares (3SLS) method to
examines the relationship between inefficiency, risk and capital in ASEAN banking.
They test whether bank inefficiency is related to risk taking and its capital position. The
sample comprises a large set of panel data of 668 banks over the six years under
consideration. The sample covers banks from 8 countries in ASEAN; Indonesia, Malaysia,
Thailand, the Philippines, Singapore, Cambodia, Brunei and Vietnam. The empirical results
show that the relationship between capital adequacy ratio and bank risk is negative. This
relationship provides further evidence that the banking sector in ASEAN behaves similarly to
other studies that provide negative coefficient. It means that the possibility of moral hazard by
increasing risk to get higher return on the cost of depositors is valid.

Dao Binh and Hoang Giang (2012) studied about Corporate Governance and
Performance in Vietnamese Commercial Banks. They applied the ordinary least square
(OLS) method to test the effect of capital adequacy ratio on bank performance ROE. The
sample of the study includes 11 Vietnam commercial banks over the period 2010-2012. They
found that the relationship between capital adequacy levels and return on shareholders’
investment is significantly negative. The results of model have revealed that if the banks want
to maintain a moderate capital adequacy ratio, banks need to carefully evaluate all requested
loans as well as strengthen capital utilization efficiency, which affects bank profit. The study
also suggested the banks should develop a strong internal control system with clear policies
and procedures that help ensure that necessary actions are taken to address risk at the right
time. Vietnamese banks should learn from other foreign counterparts that have a great deal
of experience in risk management.

Yong Tan and Christos Floros (2013) using 3SLS methodology to assess the
relationship between bank efficiency, risk and capital for a sample of 101 Chinese
banks over the period 2003–2009 with totally over 170 observations. The empirical
results indicated that there is a significant and negative relationship between risk(Z-
score) and capitalization, while the relationship between risk (LLPTL) and technical/pure
technical efficiency of Chinese banks is significant and positive. In the context of the
Chinese banking industry, the finding can be explained by the fact that banks with
higher levels of capital are more capable of absorbing the losses accumulated from
non-performing loans which reduces the risk, while banks with higher levels of risk
need larger amounts of capital to compensate the losses which leads to lower levels
of capital.

8
2.2. The relationship between capital and profitability

The relationship between capital and profitability cannot be ignored because the
improvement in the profitability is necessary for the long-term survivability of the banks.
Furthermore, since banks' optimal capital ratios are likely to vary over the cycle, typically
rising when there are higher expected costs of distress, the relationship between capital and
profitability is likely to be highly cyclical, becoming more positive during periods of distress as
banks that increase their capital ratios provide reassurance to investors and improve their
profitability.

The theoretical background of the relationship between capital and profitability is

briefly as follows. Higher capital is often give rise to be costly for banks due to capital market
imperfections and tax advantages of debt, but according to the popular “trade-off” view higher
capital may also decrease risk and hence lower the premium demanded to compensate
investors for the costs of bankruptcy. Therefore, there may be a positive or negative
relationship between capital and profitability in the short run depending on whether a bank is
above or below its optimal capital ratio. Indeed if banks are successful in achieving their
optimal capital ratios there may in fact be no short-run relationship at all, since standard first
order conditions imply that any change in capital has no impact on profitability. In the long
run, regulatory capital requirements may exceed the bank’s optimal capital ratio and drive a
negative relationship between capital and profitability, if they are binding. This implies that
higher capital only reduces profitability if banks are above their optimal capital ratios, for
example due to capital requirements or unexpected shocks.

The previous section were demonstrated for the puzzle about the relationship
between capital and risk, as suggested by Hughes and Moon (1995), Hughes and Mester
(1998), and Altunbas et al. (2007), risk and capital are also influenced by bank’s level of
profitability. However, the extant literature on capital structure and risk seldom takes
profitability into consideration. Capital is found to be associated with positive profitability
(Berger, 1995; Jacques and Nigro, 1997; Demirgüç- Kunt and Huizinga, 2000; Rime, 2001;
Iannotta et al, 2007; Naceur and Omran, 2011).

Berger (1995), by applying Granger-causality methodology, found a strong positive

relationship between capital and earnings (ROE), meaning well capitalized firms face lower
expected bankruptcy costs, which in turn reduce their cost of funding and increase their
profitability in U.S. commercial banks during the period 1983 to 1989. Differing from the
positive relationship between capital and profitability, Altunbas et al. (2007) find that inefficient
European banks appear to hold more capital.

Goddard et al. (2004) using Dynamic panel model to investigate a sample of 665
banks from six European countries between 1992 and 1998 and founded that the relationship
between the capital-assets ratio and profitability is positive during this period. Goddard et al
(2010) then extend the analysis to eight European Union member countries between 1992
and 2007. They explore that a negative relationship between the capital ratio and profitability
reflects the standardized risk-return payoff.

Dao Binh and Ankenbrand (2014) also research about the relationship between
degree of capital adequacy and profitability indicators of Vietnamese commercial banks over
the period from 2008 to 2013. They explored a negative correlation between return on equity

9
and the degree of capital adequacy. The researcher explained that when the risks are
considered to increase for some reasons, banks tend to adjust their risky project to a
reasonable level, lowering the degree of capital adequacy. As a result, the increase in
owner’s equity risky assets ratio enhances the banks’ capital adequacy ratio. However, the
empirical findings for return on assets show that it has a positively significant effect for the
capital adequacy. As cited in previous literature sections, the equity level directly influences
on the profitability of banks. In order to adapt SBV’s safety and soundness regulations,
Vietnamese banks are forced to increase their capital amount or reduce the level of risk
assets. Since the cost of equity is much higher than cost of debt, the former drives the
average cost to increase, reducing the net profit. On the other hand, the latter one decreases
the probability of abnormal returns, directly declining the earning ability. Therefore, arise of
capital ratio makes the return on equity lower.

Another literature stream concentrating on the relationship between capital and

profitability focuses on the macro prospective, structure-conduct-performance Hypothesis
(SCP). The findings of previous research indicate that the relationship between operating
performance and market structure is significant. Structure-Conduct-Performance paradigm
(SCP) links between structure and performance of industries. Structure accounts for degree
of concentration in the market. Conducts refers to the behavior of firms in setting pricing,
making research and development... Performance refers to efficiency of firms, defined by the
market power, with greater market power implying lower efficiency. The paradigm is based on
the hypotheses that structure influences conducts (lower concentration leads to more
competitive behavior of firms); conducts influences performance (more competitive behavior
leads to less market power, then greater efficiency) and structure therefore influence
performance (lower concentration leads to lower market power and then greater efficiency).
As a result, competition in the sector could be measured by the degree of concentration. One
of the most popular approaches is the use of “3-bank” concentration ratio (CR3). A number of
papers have applied Structure-Conduct-Performance paradigm to investigate the degree of
concentration and competition as well as the impact of market concentration and competition
in banking sector in developed countries but just a few of them targeted on developing
countries.

Gelos and Roldos (2002) focused on the market structure in emerging markets
banking systems and found that market competition in banking sector was not decrease due
to a significant process of bank merger and acquisition wave during 1990s. They also
proposed that lowering barriers to entry have prevented a decline in competitive pressures.

Claessens and Laeven (2004) were computed H-statistic for 50 developed and
developing countries for the period 1994 – 2001 and found that a multi-country analysis of
banking competition with the largest bank data. They explored a monopolistic competition in
the banking sectors of all countries under consideration. They are then regressing the
estimated H-statistic on a number of country-specific characteristic with the presence of
foreign banks, activity restrictions, entry regime, market structure and some general
macroeconomic condition being under review. They do not found a clear relationship between
competition and concentration; but they explored that fewer entry and activity restrictions
result in more competition.

Weil (2004) measure the banking competition for a sample of 12 EU countries over
period from 1994 – 1999 and explored that there is a decreasing pattern of monopolistic
competition. After that, he found relationship between competition and efficiency measured
by efficiency scores being estimated using a stochastic frontier approach, together with a set
of macro factors and geographical dummies. He also found that relationship between

10
competition and efficiency tends to negative. This result was supported with the research of
Casu and Girardone (2006) on a sample containing 15 EU members’ countries. The only
difference was that Casu and Girardone used non-parametric Data Envelopment Analysis to
estimate the efficiency of banks by efficiency scores.

11
3. Methodology and data

3.1. Methodology and Empirical Models

We rely on the two-step dynamic panel data approach suggested by Arellano and
Bover (1995) and Blundell and Bond (2000) and also use dynamic panel GMM technique to
investigate the effect of bank capital on profitability and risk. GMM estimation was formalized
by Hansen (1982), and since has become one of the most widely used methods of estimation
for models in economics and finance. Anderson and Hsiao (1981 and 1982) adapted GMM
method to panel data. This method uses the first difference model, which eliminates the time-
invariant firm-specific effect, and instrumental variables for the endogenous variables were
generated by lags of their original level (Mueller, 1977). After that, both dynamic panel GMM
estimators-Arellano-Bond difference and Blundell-Bond system GMM are specifically
developed to capture the joint endogeneity of some explanatory variables through the
creation of a matrix of “internal” instruments. Arellano-Bond difference GMM uses lagged
level observations as instruments for differenced variables. Blundell-Bond system GMM uses
both lagged level observations as instruments for differenced variables and lagged
differenced observations as instruments for level variables. Both estimators have one set of
instruments to deal with endogeneity of regressors and another set to deal with the
correlation between lagged dependent variable and the induced error term.

The GMM approach is superior to traditional OLS in examining financial variable

movements. For instance, Driffill et al. (1998) explore that a conventional OLS analysis of the
actual change in the short rate on the relevant lagged term spread yields coefficients with
some wrong signs and wrong size. Thus, this study applied the proposed models using the
two-step GMM dynamic system panel estimator that is particularly well-suited for Vietnam’s
banking situation where I have (i) few time periods (8 year) and many individuals (22 banks);
(ii) a linear functional relationship (between capital and profitability(risk)); (iii) more
importantly, in a period of economic and financial behavior is largely influenced by past
experiences and old patterns of behavior, economic or financial relations lagged values of the
variables examined in the research model. Linear GMM estimators have one- and two-step
variants. The two-step estimator is generally more efficient than the one-step estimator,
especially for the system GMM. We employ Windmeijer’s (2005) finite-sample correction to
report standard errors of the two-step estimation, without which those standard errors tend to
be severely downward biased.

The independent variables with lagged periods are included in Eq. (1) and (2) as
shown below. Beyond the dynamic panel data, the model that establishes the relationship
between bank capital and profitability (risk) is based on the earlier literature. According to the
earlier literature discussion and this study’ purpose of research, we modify the works of
Hasan Ayaydin and Aykut Karakaya (2014), Lee and Hsieh (2013), Naceur and Omran
(2011), Altunbaset al. (2007) and Goddard et al.(2004) to establish the relationship between
bank capital and profitability (risk). The relationship between bank capital and profitability
(risk) can be specified as follows:

𝜋𝑖𝑡 = 𝛼0 + 𝛼1 𝜋𝑖𝑡−1 + 𝛼2 𝑐𝑎𝑝𝑖𝑡 + 𝛼3 𝑋𝑖𝑡 + 𝛾𝑖 + 𝑛𝑖𝑡 ∀𝑖, 𝑡 Eq. (1)

𝜎𝑖𝑡 = 𝛽0 + 𝛽1 𝜎𝑖𝑡−1 + 𝛽2 𝑐𝑎𝑝𝑖𝑡 + 𝛽3 𝑋𝑖𝑡 + 𝜇𝑖 + 𝜗𝑖𝑡 ∀𝑖, 𝑡 Eq. (2)

12
 Here, t and i denote time period and banks, respectively, 𝛾𝑖 (𝜇𝑖 ) is an unobserved
bank-specific effect, and 𝑛𝑖𝑡 (𝜗𝑖𝑡 ) is the idiosyncratic error term.

Eq. (1) and (2) are designed to examine the impact of bank capital on bank
profitability and risk, respectively.

Term 𝑐𝑎𝑝𝑖𝑡 is the level of bank capital, proxied by the equity-to-assets ratio (Berger,
1995; Goddard et al., 2004; Agusmanet al., 2008; Naceur and Omran, 2011; Fungacova and
Poghosyan, 2011; Lee and Hsieh, 2013); 𝜋𝑖𝑡 refers to the bank’s profitability in year t, proxied
by four profitability variables: return on assets (ROA), return on equities (ROE), interest
income (IITA), and net interest revenue against average assets (NIM). Here, 𝜎𝑖𝑡 denotes the
bank’s risk in year t, proxied by three risk variables (Lee and Hsieh, 2013; Lepetitet al., 2008):
variance of ROA (VROA), variance of ROE (VROE), and loan loss reserves to total assets
(LLR). Term 𝑋𝑖𝑡 includes the set of explanatory variables, while 𝛼1 and 𝛽1 are the estimated
persistence coefficient for profitability and risk, respectively. Lee and Hsieh (2013) suggests
that banks are always accompanied by the feature of profitability persistence, difficulty in
entry-and-exit, a monopoly on resources, and a special ability for management resource
allocation. Thus, it is crucial to consider the persistence of profitability through the dynamic
panel model.

As for the related internal control variables, according to Short (1979), Smirlock
(1985), Naceur and Omran (2011), Lee and Hsieh (2013) they include loan loss reserves to
gross loans (LLGL), net loans to total assets (NLTA), liquid assets to customer and short-term
deposits (LAD).

Two macro control variables are set as the related external control variables: inflation
(INF), GDP growth rate (RGDP). The coefficient of INF is uncertain because in high-inflation
countries, banks may charge customers more, yet at the same time they face due loans that
are shrinking.

In this paper, we will control for local market power by including the “3-bank”
concentration ratio. It is measure by the sum of market share of 3 largest banks in the sector.
The higher the ratio, the more concentration in the banking sector with larger market power to
largest banks in the banking sector. According to Barry et al. (2010), Haw et al. (2010),
Laeven and Levine ( 2009); Chen et al. (1998), Anderson and Fraser (2000), Fama and
Jensen (1983), Hasan Ayaydin and Aykut Karakaya (2014), we add the models total the
percentage of foreign ownership (FO) to estimate effect of foreign ownership structure on
profitability and risk.

3.2. Data

Data are mainly collected from audited annual reports of Vietnam commercial bank
and macroeconomic data obtains from General Statistics Office of Vietnam. This study
focuses on 22 domestic commercial banks which account for above 70% of the banking
system’s assets and 80% of domestic commercial banks’ assets in Vietnam. Finally, we have
a balanced panel of 176 samples of 22 banks from Vietnam Banking Sector. We have
selected over the period of 2007-2014 because during this time the process of restructuring
the banking system has been conducted and Basel I has been applied to manage risk in
commercial banks. Especially, the banks are forced to increase its charter capital during this
period which will help us to examine the relationship between capital, risk and profitability.
The dependent and independent variables are shown in Table 1.

13
 Table 1.Variables Description

Variables Descriptions

Net interest margin (NIM) Net interest revenue against

average Earning assets

Return on assets (ROA) Net income / total assets

Profitability
Return on equities (ROE) Net income / equity
Dependent Variables

Interest income (IITA) Interest income /total assets

Variance of ROA (VROA) Variance of ROA is calculated

using the overlapping ROA data
averaged every three years

Variance of ROE (VROE) Variance of ROE is calculated

Risk
using the overlapping ROE data
averaged every three years

Reserves rate (LLR) Loan loss reserves / total

assets

Bank Capital rate (CAR) Equity to total assets

Variables Loan loss reserve rate (LLGL) Loan loss reserve to gross
loans

Loans rate (NLTA) Net loans to total assets

Independent Variables

Liquidity rate (LAD) Liquid assets to customer and

short-term Deposits

Foreign ownership (FO) Total the percentage of foreign

Ownership

Competition “3-bank” concentration ratio Assets of three largest

(CR3) commercial banks as a share of
total commercial banking
assets. Total assets include
total earning assets, cash and
due from banks, foreclosed real

14
 estate, fixed assets, goodwill,
other intangibles, current tax
assets, deferred tax,
discontinued operations and
other assets.

Macro Inflation rate (INF) The change of Consumer Price

Index
control
(CPI) from General Statistics
variables Office of Vietnam

Real GDP growth rate GDP growth rate from General

(RGDP) Statistics Office of Vietnam

According to the previous studies (Naceur and Omran, 2011; Fungacova and Poghosyan,
2011; Lee and Hsieh, 2013; Hasan Ayaydin and Aykut Karakaya, 2014), for the explanatory
variables, we use a range of bank-specific and country-specific variables that are believed to
be important in explaining the performance and risk-taking propensity of banks. There are
three the dependent risk variables and four of them measures profitability. Profitability is
measured in terms of net interest income, interest income and net return, risk is measured in
the context of non-performing loans as well as changes in profitability. We therefore try to
observe that the effects of bank capital, loan policy, liquidity, foreign ownership, competition
structure and macroeconomic variables such as inflation, GDP growth on profitability and risk
in Vietnamese banking sector.

Table 2: Descriptive Statistics

Variable Obs Mean Std. Dev. Min Max

Nim 176 0.03231 0.011949 0.004363 0.075028

Roa 176 0.01008 0.006202 0.000101 0.047289

Roe 176 0.100498 0.062523 0.000683 0.284644

Iita 176 0.083246 0.025794 0.011092 0.158845

Vroa 176 0.002717 0.002321 4.75E-05 0.014852

15
 Vroe 176 0.026185 0.016801 0.000322 0.096243

Llr 176 0.006708 0.004305 0.000521 0.031126

Car 176 0.11455 0.062158 0.042556 0.370971

Llgl 176 0.01325 0.007217 0.001397 0.044064

Nlta 176 0.504036 0.142139 0.061724 0.844766

Lad 176 0.089501 0.060768 0.005806 0.285794

Fo 176 0.062784 0.086643 0 0.3

cr3 176 0.422246 0.054347 0.343135 0.498374

Inf 176 0.107325 0.055213 0.0409 0.1989

Rgdp 176 0.061413 0.010279 0.0503 0.0848

The summary statistics of all variables are presented in Table 2. NIM (Net interest
revenue against average Earning assets) variable observes a range from 0.44% to 7.5%
during the last 8 years, with 3.2% on average. ROA variable has a minimum value of 0.01%
with NCB bank, a maximum value of 4.73% with Saigonbank in this period. ROE (Net income
/ equity) variable fluctuates from 0.6% to 28.46%, with a mean of 10.04%. IITA (Interest
income /total assets) variable varies from 1.1% of OCB bank to 15.88% Saigon bank during a
period of 2007 to 2014. VROA (Variance of ROA is calculated using the overlapping ROA
data averaged every three years) variable generally reaches a maximum value of 1.49%,
drops to a minimum level at 0,005%, and takes the average amount of 0.27%. VROE
(Variance of ROE is calculated using the overlapping ROE data averaged every three years)
observations range between 0.03% and 9.6%, with a mean of 2.6%. LLR (Loan loss reserves
/ total assets) variable reaches its highest value, at 3.1%, and its lowest value, about 0.05%,
with a mean and standard deviation of 0.67% and 0.43% respectively during last 8 years. The
mean of Loan loss reserve rate (Loan loss reserve to gross loans) is 0.01325 (higher than
1%) which indicated that the risk management of Vietnam commercial banks existed many
restrictions. CAR (Capital adequacy ratio) variable reaches the highest value of 37.1% by
Banviet bank and has the lowest value of 4.26% by ACB during 8 years. It can be seen from
NLTA (Net loans to total assets) where the mean is 54.4% and the maximum value is
84.47%. LAD (Liquid assets to customer and short-term Deposits) observations range
between 0.58% and 28.57%, with a mean of 8.95%. FO (Total the percentage of foreign
Ownership) variable reaches its highest value, at 30%, and its mean and standard deviation
of 6.28% and 8.66% respectively during last 8 years. CR3 (“3-bank” concentration ratio
(CR3)) observations fluctuate from 34.31% to 49.84%, with a mean of 42.22%. INF (the
change of Consumer Price Index (CPI) from General Statistics Office of Vietnam) has mean
value of 10.73% with standard deviation of 5.52%. The minimum value is 4.09% and

16
maximum value is 19.89%. For RGDP (GDP growth rate from General Statistics Office of
Vietnam), the mean value is 6.14% and standard deviation is 1.02%. The lowest value of
RGDP is 5.03%. The highest value of RGDP is 8.48%, meaning that Vietnam's economy
grew rapidly during this period.

17
4. Empirical Results and Discussion
4.1 The Correlations of Variables

In Table 3, 4, 5 the matrix of correlation coefficients between the variables is provided. The
correlation coefficient is a normalized measure of the strength of the linear relationship
between two variables. Uncorrelated data results in a correlation coefficient of 0; equivalent
data sets have a correlation coefficient of 1.

Table 3: The Correlations of Dependent Variables

Nim Roa Roe Iita vroa vroe Llr

Nim 1

Roa 0.5527*** 1

Roe 0.2061*** 0.6169*** 1

Iita 0.4421*** 0.1567 -0.0404 1

Vroa 0.3068*** 0.3739*** -0.0285 0.1738** 1

Vroe 0.0238 0.0916 0.2081*** 0.1501** 0.4631* 1

Llr 0.0747 -0.0857 0.0955 0.1046 -0.1213 -0.0355 1

In Table 3, the correlation coefficients between the dependent variables are given the
correlation coefficients show the level of relationship between the dependent variables. As
seen at the correlation coefficients, it is seen that, there is positive and negative relation
between the profitability and risk indicators. There is a positive relation between net interest
margin, equity capital and return on assets and there is a negative relation between return on
equity and the ratio of interest incomes. In spite of that, the correlation between return on
equity and the ratio of interest incomes, return on assets and the ratio of interest incomes is
not statistically significant. By the other hand, only the positive relation between variance of
return on assets and variance of return on equity is significant in the relationships between
risk dependent variables. Thus, it could be said that the return on assets and net interest
margin, return on assets and return on equity of the banks are strong. The highest correlation

18
coefficient is 0.6169 that show the positive relation between return on assets and return on
equity capital and this correlation is statistically significant. The correlation among the
independent variables is in Table 4.

Table 4: The Correlations of Independent Variables

Car llgl Nlta Lad fo cr3 Inf

Llgl -0.3189***

Nlta 0.1855 -0.0766

Lad 0.1808 -0.0523 0.2007***

Fo -0.1066 0.0817 -0.0514 0.0173

cr3 0.0946 -0.3007*** -0.001 0.1901 -0.1645

Inf 0.1584 -0.1970*** -0.0345 0.2309*** -0.1103 0.7425***

Rgdp 0.068 -0.3226*** 0.0113 0.1088 -0.1733 0.6138*** 0.3614***

At seen at the matrix of correlation coefficients, the highest correlation coefficient is

0.7425 that show the positive relation between the “3-bank” concentration ratio and the
Inflation rate and this correlation is statistically significant. The relation between “3-bank”
concentration ratio and Inflation rate is strong. In case of the high correlation (± 0.80 and
higher) among those independent variables, they will not been estimated in the same
equation. Instead of this, they will take a part in different equations. While look at the
Correlations of Independent Variables, it is seen that this multi collinearity problem is not valid
for any kind of independent variable. Mutli-colineartiy appears when 2 or more explanatory
variables are correlated and positive similar information. In this situation, the coefficient
estimates may change erratically in response to small change in the model or data. This
finding expresses that it could take a part in estimating of all independent variables. The rest
of correlation coefficients are usually small (less than 0.3), indicating that the correlation
between the rest of variables is not strong.

19
 Table 5: The Correlations between Dependent and Independent Variables

Car Llgl Nlta Lad Fo cr3 Inf rgdp

nim 0.4350*** -0.0817 0.3445*** 0.1399 0.0449 0.1176 0.1085 -0.0279

roa 0.3567*** -0.2226*** 0.1931 0.2789*** -0.0596 0.4069*** 0.2626*** 0.2695***

roe -0.3707*** 0.0002 0.0421 0.1737 -0.0006 0.3970*** 0.2535*** 0.2119***

iita 0.2606*** 0.0106 0.2555*** 0.0931 -0.0219 0.0473 0.4285*** -0.2947***

vroa 0.4981*** -0.2383*** 0.1764** 0.1584** -0.0762 0.1114 0.0842*** 0.0848

vroe -0.1083 -0.1125 0.0781 0.0896 0.1203 0.0955 0.1335* -0.0185

llr -0.2343*** 0.8419*** 0.4103*** 0.055 0.0065 -0.2111*** -0.155 -0.2546***

The correlations between the dependent and independent variables are seen in
Table 5. The correlation coefficients show both the direction and greatness of the relations
between dependent variables and independent variables. The findings show there is
significant correlation between the capital rate and all the dependent variables, except
variance of return on equity, that mean the capital rate has a crucial effect on all the
dependent variables in the estimations. The highest correlation coefficient is 0.8419 that
show the positive relation between the Reserves rate and the Loan loss reserve rate. This
correlation is statistically significant. It is said that the Reserves rate and the Loan loss
reserve rate as one of the findings from the correlation analysis have important effect
on the estimates of the models.

20
4.2. Results

4.2.1. Panel Unit Root Results

Before we conducted the estimation, we did unit root tests to see if the data is
stationary or not. In case of the econometric model exist unit root, this model will meet
problem which named spurious regression. In order to examine this problem, panel unit root
test is done to determine whether each variable is stable or not. The non-stable
variables are kept out of the analysis and the analysis is realized only with the variables that
are identified as stable. We applied the Harris–Tzavalis (1999) test to examine whether the
variables stable or not. The Harris–Tzavalis (1999) test has as the null hypothesis that all the
panels contain a unit root. If the coefficient is different than zero significantly, it will be
considered that regarding units do not include the root and they are stable on their level. The
unit root tests are presented below in Table 6 and 7.

Table 6: Harris and Tzavalis Unit Root Test Findings of Dependent Variables

Dependent Variables Z Statistics p- value Decision

Return on assets (ROA) -9.2560*** 0.0000 Stationary

Return on equities (ROE) -5.4349*** 0.0000 Stationary

Profitability
Net interest margin (NIM) -5.4902*** 0.0000 Stationary

Interest income (IITA) -10.3260*** 0.0000 Stationary

Variance of ROA (VROA) -4.3692 *** 0.0000 Stationary

Risk Variance of ROE (VROE) -6.0004*** 0.0000 Stationary

Reserves rates (LLR) -2.1681** 0.0151 Stationary

*, **and ***show respectively the level of statistical significance on the levels of 0.10,
0.05 and 0.01

21
 Table 7: Harris and Tzavalis Unit Root Test Findings of Independent Variables

Independent Variables Z p- value Decision

Statistics

Capital Capital rate (CAR) -2.5533*** 0.0053 Stationary

Bank Loan loss reserve rate (LLGL) -2.1383** 0.0162 Stationary

variables
Loans rate (NLTA) -5.2821*** 0.0000 Stationary

Liquidity rate (LAD) -5.1180*** 0.0000 Stationary

Foreign ownership (FO) -1.6516** 0.0493 Stationary

Competition “3-bank” concentration ratio -6.7761 *** 0.0000 Stationary

(CR3)

Macro control Inflation rate (INF) -7.4361 *** 0.0000 Stationary

Variables Real GDP growth rate (RGDP) -3.4042 *** 0.0000 Stationary

*, **and ***show respectively the level of statistical significance on the levels of 0.10, 0.05 and
0.01

According to the results of Harris and Tzavalis unit root test in Table 4 and 5, We can
reject the null hypothesis. The results indicate that both all the dependents and independent
variables do not include unit root on original level in other words the variables are stable.
Thus, the models will be established with seven dependent variables that all are on original
level and eight independent variables and they will be used in panel data estimate.

22
4.2.2. Dynamic Panel Data Analysis Results

This section presents results derived from the two-step GMM dynamic system panel
estimator described above where capital is the endogenous variable. We have adopted the
“balanced panel” approach, whereby each bank is always represented in each time period.
Our testable hypotheses are based on the SCP, Moral Hazard, or Regulatory hypotheses.

In order to examine the validity of the model and indeed the SCP, Moral Hazard, or
Regulatory hypothesis, we perform two tests, notably: the Hansen test which examines the
over-identification restrictions which assesses the null hypothesis is the position that the
instruments as a group are strictly exogenous (do not suffer from endogeneity) and; the
Arellano and Bond test for autocorrelation which assesses the null hypothesis of no
autocorrelation. Both Hansen test and Arellano and Bond test which are required for the
validity of the GMM estimator.

We give priority to the second order autocorrelation: AR (2) test in first difference
because it is more relevant than AR (1) as it detects autocorrelation in levels. For almost all
estimated models, we are unable to reject the AR (2) null hypotheses for the absence of
autocorrelation.

Profitability Models:

Table 8. Summary table of Profitability Models (Robust Standard Errors)

Models NIM (1) ROA (2) ROE (3) IITA (4)

NIM (-1) 0. 7445612***

ROA (-1) 0.5858348***

ROE (-1) 0.3801932***

IITA (-1) 0.1550921

CAR -0. 0327303 -0.0753748*** -0.832991** -0.0375425

LLGL 0. 0177307 -0.1308558** -0.9702078 0.0487463

NLTA 0. 0037926 0.0036139 0.0379371 0.034729*

LAD 0. 0256273 0.0097718 0.0886367 -0.011559

FO 0. 0019763 0.0012168 -0.0243461 0.0070233

CR3 0. 0904322*** 0.036773*** 0.5030079*** -0.1746047***

23
INF -0.0250571 -0.0106224 -0.1336706 0.4525312***

RGDP -0.171039 0.0104928 0.0948634 -1.094463***

Wald Test (p-value) 267.53 (0.000) 210.54(0.000) 145.6(0.000) 479.37(0.000)

AR(1)= 0.003; AR(1)= 0.106; AR(1)=0.009; AR(1)=0.025;

Autocorelation Test (p-value) AR(2)= 0.368 AR(2)= 0.257 AR(2)= 0.685 AR(2)=0.392

Hansen Test (p-value) 0.116 0.298 0.071 0.255

***, **,*: significance levels of 1%, 5% and 10% respectively. AR(1): First Order Autocorrelation test
AR(2):Second Order Autocorrelation test. Hansen Test: Over identifying Restrictions test. Wald: test for
the joint significance of estimated coefficients. The validity of the GMM estimator was determined
when: 1) The significance of estimated coefficients and the Wald statistics. 2) The failure to reject the
null hypotheses of: a) no autocorrelation in the AR (1) and AR (2) tests and; b) the validity of the
instruments in the Hansen test

In the Table 8, the findings of Profitability models are presented. The results of the
Wald test shows that all Profitability models are significant (p-vlalue = 0.000). Also the second
order correlation test of Arellano and Bond is not significant statistically. Thus, there is no
second order correlation. The Hansen tests obtained from all profitability models is not
significant statistically. It is therefore found that the instrumental variables are valid. That is,
the Hansen and the serial correlation tests do not reject the null hypothesis of correct
specification, which means that I have valid instruments and no serial correlation.

As seen at the results of the models in Table 8, the lagged values of the dependent
variables are positive with IITA (Interest income to total assets) and significantly positive with
NIM (Net interest margin), ROA (Return on assets), ROE (Return on equities) variables. This
result shows that the previous period profitability is important for the bank profitability.

We find significantly negative relationships between capital and profitability which

proxied by ROA (Return on assets), ROE (Return on equities) for Vietnam’s commercial
bank, indicating that structure-conduct-performance (SCP) holds. The relationships between
capital and profitability which proxied by NIM (Net interest margin), IITA (Interest income to
total assets) is negative but not significant for Vietnam’s commercial bank. In this period, the
Vietnamese domestic commercial banks are forced to increase their charter capital. This
results may be due to the increasing in cost of raising capital to reach the minimum charter
capital (VND 3000 billion), resulting in increased operating costs thereby reducing the
profitability of banks. The findings are consistent with the findings of Modigliani and Miller
(1963), Altunbas et al., (2007), Goddard et al., (2010) and Lee and Hsieh (2013). The capital
coefficient is around (-0.0327) – (- 0.8330), implying a 1% increase in capital decreases
profitability by 0,032–0,833%.

The positive effect of CR3 (3-bank concentration ratio) on profit abilities proxied
by ROA (Return on assets), ROE (Return on equities) and NIM (Net interest margin), except

24
for IITA (Interest income to total assets) (due to the fact that lower concentration leads to
more competitive behavior of firms, more competitive behavior leads to less market power,
then greater efficiency and lower concentration leads to lower market power and then greater
efficiency) show the fact that the reducing on the competition in the market increases the
profit abilities. This results is consistent with the SCP hypothesis states that increased market
power yields monopoly powers and the larger is CR3 (3-bank concentration ratio), the greater
is a bank’s market power and higher product market concentration and higher product market
concentration is associated with lower competition and vice versa. Thus, structure-conduct-
performance (SCP) hypothesis that claims there is a positive relation between the activity
performance and market structure is supported.

Among the other explanatory variables, the coefficients of the ratio of Loan loss
reserves to gross loans (LLGL) are negative on ROA (Return on assets) and ROE (Return
on equities) and positive on NIM (Net interest margin) and IITA (Interest income to total
assets). A negative relationship between loan loss reserves to gross loans and probability
can be explained by using the market discipline argument for Russia (Karas et al., 2010).
That mean, when depositors enjoy a higher premium for depositing their savings in the riskier
banks (i.e. banks with higher non-performing loan ratios). An increase in deposit rates would
contribute to the decline in Return on assets and Return on equities, establishing a negative
relationship between nonperforming loans and the profit. Lee and Hsieh (2013) also find the
coefficients of the ratio of loan loss reserves to gross loans is significantly negative on
profitability (ROA and ROE) for 42 Asian countries banking.

Net loans total assets ratio (NLTA) is positive on all profit variables, matching our
expectations. Agusman et al., (2008) used net loans to total assets as a measure of
bank credit risk. This is suitable with standard asset pricing demonstrates that imply a positive
relationship between risk and profits. Empirical researches find that a higher loan ratio is
associated with higher returns, which indicate that risk averse shareholders seek larger
earnings to compensate higher credit risk (Demirguc-Kunt and Huizingua, 1999 and
Flaminiet al.,2009). Lee and Hsieh (2013) also find the coefficients of the ratio of net loans to
total assets are significantly positive on profitability (ROA and ROE) for 42 Asian countries
banking.

Liquid assets to customer and short-term deposits (LAD) also perform differently. The
coefficient of the ratio of liquid assets to customer and short-term deposits (LAD) are positive
on ROA (Return on assets), ROE (Return on equities) and NIM (Net interest margin), but the
same coefficient is negative on IITA (Interest income to total assets). Those two different
results show that the liquidity does not affect the bank profit variables uniformly. This results
suitable with the finding of Lee and Hsieh (2013), Hasan Ayaydin et al (2014) and Fungacova
and Poghosyan (2011) find a negative relationship between the ratio of liquid assets to total
assets and IITA (Interest income to total assets) for Russia. The empirical result in IITA
(Interest income to total assets) model also consistent with Fungacova and Poghosyan
(2011) state that the more the demand liabilities of the bank are backed up by liquid assets,
the lower the liquidity risk of the bank and its returns.

The foreign ownership is positive on all profit abilities, except for ROE (Return on
equities). This result is corroborating the agency theory predictions and affirms that the
institutional shareholders should influence positively the performance of the firm. The cause
of this result may be due to when the banks have foreign shareholders, they can learn about
management experience and have a plentiful source of funding for the implementation of
business strategies in order to make more profit for banks in this period. This finding is

25
consistent with the research of McConnell and Servaes (1990) who found a statistically
significant positive relation between ownership and performance.

We employed 2 proxies for macro-economic environment; inflation, real GDP growth

that obtains from General Statistics Office of Vietnam. Inflation rate (INF) is negative on all
profit abilities (ROA (Return on assets), ROE (Return on equities) and NIM (Net interest
margin)), except for IITA (Interest income to total assets). The negative affect present the loss
of purchasing power and also the positive affect is the result reducing of interest income and
interest expenses. The negative relationship might be explained that a higher inflation rate
increases uncertainty and decrease demand for credit. This negative coefficient also may be
linked to slower adjustment of revenues compared with costs for inflation. Because if
inflation is not anticipated and banks are sluggish in adjusting their interest rates, there
is a possibility that bank costs may increase faster than bank revenues and hence adversely
affect bank profitability.

On the other hand, among the another macro control variables, the coefficients of
real gross domestic product (RGDP) are negative on NIM and IITA, and positive on ROA
and ROE, the results not matching my expectations. We expected that when the increase
on real gross domestic product will increases the profitability. In this situation, there could
have been occurred a negative relation between the growth and NIM (Net interest margin),
IITA (Interest income to total assets) due to the result of behaving more competitive of the
banks in order to get more market share from the Vietnamese market. This finding is
consistent with the findings of Demirguc-Kuntet al. (2004); Hasan Ayaydin et al (2014), but
contravene the findings of Goddard et al. (2004), Demirguc- Kunt and Huizinga (1998). Thus,
bad economic conditions can worsen the quality of the loan portfolio, generating credit losses,
which eventually reduce banks’ profits. The effects of macro variables on bank profit abilities
are naturally originating from the sensitivity of the banking sector against the changes in
economy.

Risk Models:

Table 9. Summary table of Risk Models (Robust Standard Errors)

Models LLR VROA VROE

LLR(-1) 0.1320471

VROA (-1) 0. 4549987***

VROE (-1) 0. 2629307***

CAR -0.0054518*** 0. 0012576 -0. 1081392**

LLGL 0.4361806*** -0. 0223681 -0. 5329787**

NLTA 0.0131082*** 0. 0014684 0. 0128833

26
LAD 0.0018989 0. 0013882 0. 0207368

FO -0.0009668 -0. 0002294 0. 0159507

CR3 -0.0003529 0. 0059507 -0. 0236988

INF 0.002914 -0. 002465 0. 0676133

RGDP 0.0003939 -0. 0192942 -0. 1845817

Wald Test 1836.58(0.000) 406.60(0.000) 70.58(0.000)

AR(1)= 0.070; AR(1)= 0.029; AR(1)= 0.028;

Autocorelation Test (p-value) AR(2)= 0.603 AR(2)= 0.986 AR(2)= 0.059

Hansen Test (p-value) 0.417 0.224 0.105

***, **,*: significance levels of 1%, 5% and 10% respectively. AR(1): First Order Autocorrelation test
AR(2): Second Order Autocorrelation test. Hansen Test: Over identifying Restrictions test. Wald: test
for the joint significance of estimated coefficients. The validity of the GMM estimator was determined
when: 1) The significance of estimated coefficients and the Wald statistics. 2) The failure to reject the
null hypotheses of: a) no autocorrelation in the AR (1) and AR (2) tests and; b) the validity of the
instruments in the Hansen test.

In the Table 9, the findings of risk models are existing. As seen at the results of the
Wald test that is done for examining the significance of all models of profitability in Table
(p-value= 0.000), it is seen that all models have general meaning. Also, for testing the
presence of second order autocorrelation, the autocorrelation test of Arellano and
Bond is not significant statistically. Next, the Hansen test which is done for the validity of
vehicle variables that are obtained from the non-resistant models is not significant
statistically. The Hansen and the serial-correlation tests do not reject the null hypothesis of
correct specification, which means that we have valid instruments and no serial
correlation.

It is seen from the Table 9 that the lagged values of dependent variables are positive
with LLR (Reserves rate) and significantly positive with (Variance of ROA) and VROE
(Variance of ROE). This shows the fact that the previous period risk is important over the
bank risk.

The significantly negative relationship between capital and VROE (variance of ROE),
LLR (Reserves rate) are consistently found for the Vietnamese banking. This implies that an
increase in capital might be decreases VROE (variance of ROE) and LLR (Reserves rate).
Some studies find a negative relationship between capital and risk may refer to the “moral
hazard hypothesis”, meaning banks have incentives to exploit existing flat deposit insurance
schemes (Demirgüç-Kunt and Kane, 2002; Jahankhani and Lynge, 1980; Brewer and Lee,

27
1986; Altunbas et al., 2007 and Agusman et al., 2008). The results in VROE (variance of
ROE) model and LLR (Reserves rate) model indicate that a 1% increase in capital decreases
risk by 0.0055 – 0.1081%.

The impact of CR3 (3-bank concentration ratio) on the bank risks are negatively and
positively. It is identified that the increase on the market’s concentration increases VROA
(Variance of ROA) and decreases VROE (variance of ROE) and LLR (Reserves rate). Those
finding obtained for Vietnamese commercial Banks look like the results of the studies done by
Aggarwal and Jacques (1998). The results reached are negative as in the studies done
by de Jacques and Nigro (1997), Agusmanet al., (2008), and Demirguc-Kunt and Kane
(2002) and also they are positive as in the studies done by Shrieves and Dahl (1992), Berger
(1995), Demirguc-Kunt and Huizinga (2000), and Iannotta et al.,(2007).

The relationship between LLGL (Loan loss reserve to gross loans) and LLR (Reserves
rate) is positive, the relationship between LLGL (Loan loss reserve to gross loans) and VROA
(Variance of ROA), VROE (variance of ROE) are negative. The net loans to total assets
(NLTA) affect VROA (Variance of ROA), VROE (variance of ROE) and LLR (Reserves rate)
positively. The fact that the credit and collection policies of Vietnamese commercial Banks
increase the bank risks indicates that especially the credit policies should be tighter.
Because, the effort and losses for the collection of the credits given to the sections who has
the low credit worthiness will increase the bank risk. This finding matches the empirical
results of Brewer and Lee (1986), Mansur et al.,(1993), Agusmanet al.,(2008), Lee and Hsieh
(2013).

The liquidity ratio, liquid assets to customer and short-term deposits (LAD) has the
positive affect on all the bank risk variables proxied by VROA (Variance of ROA), VROE
(variance of ROE) and LLR (Reserves rate). This results show that the liquidity ratio affects
the bank risks stably. This positive finding is consistent with “regulatory hypothesis” states
that regulators encourage banks to increase their capital commensurably with the amount of
risk taken. However, these results do not match my expectation because I thought that high
cash holding can reduce liquidity risk for banks and could help them survive, but they can
also be associated with agency problems. It is not consistent with Fungacova and Poghosyan
(2011) states that the more the demand liabilities of the bank are backed up by liquid assets,
the lower the liquidity risk of the bank and its margins.

The shares of the foreigners in the banks decrease the risks in the VROA (Variance of
ROA) model and the LLR (Reserves rate) model, but increase the risk in VROE (variance of
ROE) model. The finding of VROA (Variance of ROA) model and the LLR (Reserves rate)
model reveal that when the Vietnam commercial banks have foreign owners, the risk
management capability will greater to help banks reducing risk and increasing profits. The
finding of VROE (variance of ROE) model is consistent with “Agency theory” indicates that
shareholders with a diversified portfolio are incentive to take more risk for a higher
expected return whereas managers take less risk to protect their position and personal
benefits and to preserve their acquired human capital. Additionally, the banking sector is also
affected by the well-known owner-manager agency conflict according to Fama and Jensen
(1983). Many authors agree that owner-manager agency conflict may counteract the
increase in risk-taking arising from the moral hazard problem, indicating that there is a
conflict of interest between managers and shareholders. As we can understand from here,
due to the fact that the foreign shareholders indicate the agency problem, thesis finding
also supports the agency problem hypothesis.

28
 As seen at the effects of the macroeconomic variables on risk in Table 16, it is seen
that RGDP (Real GDP growth rate) and INF (Inflation rate) affects in both ways as positively
and negatively. The inflation ratio affects the risks except for VROA (Variance of ROA)
negatively and affects VROE (variance of ROE), LLR (Reserves rate) positively. RGDP (Real
GDP growth rate) affects the risks except for LLR (Reserves rate) positively and affects
VROA (Variance of ROA), VROE (variance of ROE) negatively.

Due to the fact that the inflation is a macro risk element, it has positive affect on
VROE (variance of ROE) and LLR (Reserves rate). Against this fact, it could be told that the
decrease of it on VROA (Variance of ROA) arises of the strict follow-up of The State Bank of
Vietnam on capital adequacy and credit provisions. On the other hand, the increasing on real
gross domestic product (RGDP) improves the risks. The banks are undertaking more risks as
the result of the more competitive behaviors of the banks in order to get more shares from the
markets with the expansion in economy. Finally, those effects of the macro variables on
bank risks show that the sector has a high sensitivity towards the economic developments.

29
5. Conclusion
This paper applies the recent two-step system GMM dynamic panel data techniques
to examine the relationship between bank capital, profitability and risk, using bank-level data
for 22 Vietnam domestic commercial banks with the latest and a wider range of panel data
over the period from 2007 to 2014. We look into this relationship deeply and differently by
including four proxies for profitability and three for risk. We contribute to existing the empirical
analyses in several ways. First, the existing literature is primarily focused on U.S. or
European cases (Brewer and Lee, 1986; Berger, 1995; Carbo et al., 2009). This is, to the
best of my knowledge, this is one of the early studies for Vietnams’ banking to examine the
relationship between capital, risk and profitability. Especially, the banking system has played
a key role in this stellar performance of the Vietnamese economy as it has been the main
pillar of Vietnam’s financial system (Shimada and Yang 2010) and bank restructuring
programs still continue in Vietnam. Examining the effect of bank capital over the profitability
and risk of the banks in terms of Vietnam’s banks that recently become a crucial subject. The
Vietnamese banking industry therefore provides an interesting laboratory for investigation.

Second, most studies focus mainly on the relationship between capital and risk
(Aggarwal and Jacques, 1998; Agusman et al., 2008), yet seldom on the relationship
between capital and profitability (Berger, 1995; Goddard et al., 2004). This study discusses
capital, risk, and profitability together. Finally, from the methodology viewpoint, most studies
utilize a static model (Berger, 1995; Demirguc -Kunt and Huizinga, 2000; Rime, 2001;
Agusman et al., 2008). Dynamic panel techniques are adopted to analyze the panel data,
which are designed to check the persistence of profit (or risk) in the study.

The empirical results shows that the effect of increasing bank capital on risk is
significantly negative, supporting the moral hazard hypothesis. There has been reached
significantly negative relation between the capital and profitability. Thus, the sample supports
also structure-conduct-performance hypothesis. Our results also reveal that profitability
variables and risk variables show persistence from one year to the next, indicating that the
previous period of profit and risk will be enhanced in the next period. Important policy
implication emerging from our empirical results is that Vietnamese banking supervisor or
regulators should improve their banking system by mending the financial efficiency of
commercial banks to implement the suggestions proposed by Basel II and Basel III.

30
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