Tuesday, May 30, 2023

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

In the year 1968, a financial economist named Edward Altman, who was then an assistant professor of finance at New York University, published what is popularly known in the global finance community as the Z-score formula for predicting corporate bankruptcy . With the published formula, it was possible to use historical accounting data to predict the failure of publicly quoted US manufacturing firms two (2) years prior to their declaration of bankruptcy. In fact, the predictive accuracy of the model was found to range from seventy-two percent (72%) to eighty percent (80%).

For four (4) decades since the publication of the original Z-score model and with a great deal of adjustments/revisions, the predictive value of Z-scores has remained outstanding to date. Although the original Z-score model was designed for publicly quoted US manufacturing firms, adjustments were later made to the model to meet the needs of the non-manufacturing sector, privately owned companies, and firms that Strictly involved in the service business.

Professor Altman developed the Z-score model as a financial analysis tool for use in academia. However, its practical relevance to a wide range of firms and industries has stood the test of time. The model was developed using a sample of 66 (66) US manufacturing firms, half of which (33) were bankrupt at that time. From the financial statements of all these firms, some key accounting ratios were calculated and examined over time. The patterns and effects of these ratios were brought together in the Z-score model, which is then used to determine whether a firm is headed for bankruptcy.

This is about the year 2009. Nigeria, like most countries, is currently grappling with a banking crisis. However the Central Bank of Nigeria insists that no Nigerian bank will be allowed to fail. I take this to mean that no Nigerian bank will be allowed to go under (or be declared bankrupt). Given the vital importance of banking to our national economy, this is a logical and humane position to take. But that does not mean that things have not or will not go wrong in Nigerian banking. In fact, the Famous Five technically failed in my opinion. Because there is a lifeline opportunity (whether requested or forced upon the institution), they certainly won’t be allowed to go down.

After the superintendence bank failures, I believe it is time for the CBN to become more proactive in regulating the industry. Some analysts have argued that it is a failure of regulation that has led to this situation. How do you explain the hundreds of billions of naira of lifeline support through the extended discount window? As if that was insufficient, another 420 billion Naira is needed to stabilize the chronic mismanagement.
Imagine what could happen if other vital sectors of the Nigerian economy such as education and health had access to this kind of lifeline support?

The above analogy is intended to draw attention to some of the financial costs of the ongoing banking crisis. They say one soldering time saves nine. Now, just imagine the benefits that could have accrued to the entire Nigerian economy if the CBN had correctly predicted the bank failures two (2) years ago. Perhaps there would have been no need for the extended discount window and no need for the 420 billion naira bailout fund! That money could have been used for other important needs of the economy.

The traditional model for assessing 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. While the Camels rating is an excellent measure, I believe it is time for the regulator to develop a reliable model to predict bank failures in the country once and for all. This will enable the regulator to closely and easily monitor the performance of banks and take remedial action much before things get out of hand.

Because there have been enough cases of bank failures in Nigeria in the past, it would not be too difficult to come up with a model similar to Professor Altman’s Z-score. But adjustments have to be made to the unique nature of banking services, the Nigerian economy, the peculiarities of the industry and the manner and manner in which banks present financial statements. Banking thrives on sound liquidity management. This assertion itself can serve as a foundation for any type of analysis or modeling framework that can be developed for industry.

It is important to note that I am not proposing a wholesale adoption of the Z-score model. A different model can be developed for our own unique environment using the same basic principles as those used for the Z-score model. I know it is sometimes argued that bank financial statements are difficult to understand and that banks use many off-balance sheet items. Regulation is the best response to the above problems. Financial statement reporting needs to be simplified, streamlined and standardized. Adequate disclosure of off-balance sheet items is also required. That is why full disclosure and full provisioning for bad debts is a step in the right direction. Eventually, the boys would be separated from the men.

Last but not the least, Garbage in Garbage out situation should be avoided. It is important as the financial statements (especially the balance sheet and income statement) which will serve as the source documents for computing the financial ratios on which the analytical model will be based, have to show a true and fair view. The accuracy and integrity of the financial statements should not be in doubt. This again presents further challenges for regulation. However, I conclude that this moment and time is probably best to address some of the key issues raised above.

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