Balance Sheet Is Based Upon Which Of The Following Formula Beyond the CAMELS Rating – A Model For Predicting Bank Failures in Nigeria

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Beyond the CAMELS Rating – A Model For Predicting Bank Failures in Nigeria

In 1968, financial economist Edward Altman, then an assistant professor of finance at New York University, published the Z-Score, a formula for predicting corporate bankruptcy known in the world’s financial circles. The published formula was able to use historical accounting data to predict the failure of publicly traded American manufacturing companies two (2) years before bankruptcy was declared. In fact, the model’s predictive accuracy was found to range from seventy-two percent (72%) to eighty percent (80%).

Four (4) decades after the publication of the original Z-score model and with many adaptations/modifications, the predictive value of the z-score remains outstanding. Although the original z-score model was prepared for publicly traded US manufacturing firms, the model was later adjusted to account for non-manufacturing firms, privately held firms, and those firms that were strictly in the service business.

Professor Altman developed the z-score model as a financial analysis tool for use in academia. However, its practical importance to many businesses and industries has stood the test of time. The model was developed based on a sample of sixty-six (66) US manufacturing firms, half of which (33) had gone bankrupt at the time. From the financial statements of each of these companies, some key accounting ratios were calculated and studied over time. The pattern and effect of these ratios were aggregated into a z-score model, which is later used to determine whether or not a company is going bankrupt.

It is 2009. Like most countries, Nigeria is currently in a banking crisis. Although the Central Bank of Nigeria insists that no bank in Nigeria will be allowed to fail. What I mean by this is that no bank in Nigeria is allowed to go under (or declare bankruptcy). Considering the critical importance of banking to our national economy, this is a logical and humane position. But that is not to say that things do not or do not go wrong in Nigerian banking. In fact, I think the famous five technically failed. Because there is a lifeline (whether mandated or forced by the institution), they are never allowed to go down.

With bank failures under surveillance, I believe it is time for the CBN to regulate the sector more proactively. Some analysts have argued that this situation has been caused by a failure of regulation. How to explain the bailout of hundreds of billions of Naira through the extended rebate window? As if this is not enough, another 420 billion Naira is needed to stabilize the chronic mismanagement.

Imagine what could happen if other critical sectors of the Nigerian economy like education and health have access to such a lifeline?

The purpose of the above analogy is simply to draw attention to some of the financial costs of the ongoing banking crisis. A stitch at the right time saves nine, they say. Now imagine how the entire Nigerian economy could have benefited if the CBN had correctly predicted bank failures two (2) years earlier. Perhaps there would have been no need for an extended discount window or a 420 billion Naira bailout fund! These funds could have been directed to other critical needs of the economy.

The traditional model for evaluating the performance of financial institutions has been the CAMELS Rating. CAMELS is an acronym for capital adequacy, asset quality, management quality, earnings potential, liquidity and sensitivity to market risk. Although the CAMELS rating is an excellent metric, I believe it is time for the regulator to finally develop a reliable model for predicting bank defaults in the country. This allows the regulator to closely and easily monitor banks’ activities and take corrective action long before things get out of hand.

Since Nigeria has had many bank failures in the past, it is not too difficult to find a model similar to Professor Altman’s z-score. But adjustments need to be made taking into account the unique nature of banking services, the Nigerian economy, the specifics of the industry and the way and manner in which banks present their financial statements. Banking thrives on sound liquidity management. This statement itself can form the basis of any analysis or modeling framework that can be developed for industry.

It is important to note that I am not proposing wholesale adoption of the z-score model. A separate model can be developed for our own unique environment using principles similar to the z-score model. I am aware that it is sometimes argued that bank financial statements are difficult to understand and that banks use a lot of off-balance sheet items. Regulation remains the best solution to the above problems. Financial statement reporting needs to be simplified, streamlined and standardized. Adequate disclosure of off-balance sheet items is also required. Therefore, full disclosure and a full bad debt undertaking is a step in the right direction. Finally, the boys are separated from the men.

Last but not least, avoid a Garbage In Garbage Out situation. This is key because the financial statements (especially the balance sheet and income statement) used to calculate the financial ratios underlying the analytical model MUST present a true and fair view. There SHOULD be NO doubt about the accuracy and completeness of the financial statements. This again poses additional challenges to regulation. However, I conclude that this moment and time is perhaps the best to address some of the key issues raised above.

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