August 2005
Sectoral

Ranking of Commercial Banks:
The Missing M Factor

Rating the commercial banks of the country on the basis of some internationally accepted parameters, the central bank has done a good job, but it could have been improved if the management aspect was included in these parameters.

K antipur of 27 Asadh 2062 published a news item on the ranking of the Nepali commercial banks reportedly conducted by the Nepal Rastra Bank’s Bank Supervision Department. It is a welcome step in the right direction. Such transparency will not only open up the possibility for the general public to evaluate the performance of the banks, it will also certainly inflict an ever essential sense of fair competition among the banks to earn credibility based on their performance. It is understood that although such a ranking exercise was being conducted regularly based on the quarterly and yearly performance of the commercial banks and circulated internally within NRB, it was never made public in the past.

The model (CAELS) on which the ranking was based comprises five financial parameters namely Capital Adequacy, Assets Quality, Earnings, Liquidity, and Sensitivity to Market Risks. Although these parameters provide reasonable basis for the analysis, there is at least one more parameter that may be worth taking into account, that is: Management Quality. Yes, the overall performance of the banks indirectly reflects their Management Quality as well, but a model that takes this M parameter into account can result in a more well-rounded view. Judging a bank’s management capability could be a subjective exercise, yet it is one that should be conducted to validate reliability of other aspects including integrity of financial information on which the other parameters are based. Incorporating the M factor enhances the model to CAMELS.

CAMELS is an ideal rating system, practised worldwide by Central Banks and rating agencies, to evaluate and analyse safety and soundness of a bank. The acronym CAMELS refers to six components namely Capital Adequacy, Assets Quality, Management Quality, Earnings, Liquidity, and Sensitivity to Market Risks.

Capital Adequacy: Any commercial bank should have adequate capital to support the stability and sustainability of its operation. Capital Adequacy is a measure of a commercial bank’s capital as a percentage of its risk weighted assets, such as the loans it has provided and the securities it holds. Thus, this parameter indicates whether a particular bank has enough capital to absorb unexpected losses. This is required to maintain depositor confidence and preventing the bank from going bankrupt.

Asset Quality: This is one of the most critical factors in determining overall condition of any bank. Primary factors that can be considered are the quality of loan portfolio, mix of risk assets and credit administration system.

Management Quality: This parameter evaluates management quality so as to assign premium to better quality banks and discount poorly managed ones. As management quality is a subjective measure, it is very difficult to prescribe any specific rating method for this parameter, leaving this parameter open to subjective judgements.

Earning Quality: This parameter lays importance on how a bank earns its profit. This also explains the sustainability and growth in earnings in the future.

Liquidity: Banks are in a business where liquidity is of prime importance. Banks must be able to manage demand and supply of funds. Cash balance, bank balance, and investment in government bonds are the most liquid form of assets.

Sensitivity to Market Risks: This parameter refers to the risk conditions in the market such as exchange risk, interest rate risk, portfolio risk, etc, which could adversely impact earnings and/or capital of the bank.

A comparison of analysis carried out, based on published financial figures as of third quarter end 2061/62 (Chaitra end 2061), using these two models (with and without M parameter) is presented in the accompanying table. NRB ranking as published in Kantipur have been taken as it is.

The difference in analysis carried out for the same period but with different models (with and without M factor) can be observed here. While the other factors can be quantified fairly easily from current financial statements, management quality is a subjective measure, yet one that is crucial to a bank's success. A camel's hump helps it survive for weeks without food and water. Likewise, the hump in the CAMELS rating (the quality of bank's management) is a key to a bank's long-run survival. Suppose two banks of roughly the same size conduct business in a market with essentially the same customer base and economic conditions, but one survives and the other fails.

What accounts for the diverging results? It is not that simple to answer this question. As it turns out, the tangible success or failure of a bank is largely dependent on intangible factors. Yes, the disparate outcome is likely due to the differences in the management quality of these two banks. Accurate and timely measurement that approximates management quality shows that strong and consistent relationships exist between efficiency and independent measures of performance and reveals relationships between efficiency and soundness. Since management quality is inextricably tied to a bank's success or failure, it is important to develop and improve methods for grading management efficacy. The size of a bank does not matter, nor does the profitability of that bank. What matters is a right mix of these factors.

In the CAMEL rating shown above, feedback obtained from a mixed sample on three main aspects of management have been taken, which are: board members / promoters, market perception and proactiveness of the management. One could consider a number of other aspects but these three aspects broadly represent this parameter. Also, the CAMEL ratings tabled above are completely independent of the ratings released in Kantipur. Detailed basis of the NRB rating is not available and therefore the attributes within each parameter under the above two models could be different. Also, the ratings computed by this scribe does not consider "S" for lack of information on portfolios of individual banks, which NRB is in a unique position to have access to.

Coming back to the NRB ranking, it is inevitable that a process in its initial stage invites a wide range of opinions, appreciation and criticisms from various areas. This is what provides the space for improvement and refinement in the process so that unbiased results can be obtained through it. NRB has indeed done a commendable job in this regard. It would have given this piece of initiative more weight and applause if NRB had "officially" released the rating, rather than informally making it available to news media. Again if the rating process and the methodology used could be made more transparent, it would give the banks and the market more grounds for its reliability and consistency as the erratic and unreasonable swing in the ranks of banks in three months have raised questions on the reliability of the NRB analysis.

All said and done, NRB must be credited for releasing this information for public information. With this step of publicising bank ranking, NRB has helped in public (depositors and investors in bank's securities) monitoring of commercial banks. Such disclosures could help influence pricing of the bank's securities and increase the efficiency of the market discipline brought to banks. The future will largely belong to those who, through self-discipline, make the effort to achieve good CAMELS ratings. Banks, journalists and investors should all join hands in helping NRB fine-tune its rating mechanism and making this a worthwhile cause.

(Brinda Shrestha is a Treasury Dealer at Laxmi Bank Ltd. The ideas and opinions expressed in this article are solely her own and do not necessarily reflect those of her organisation.)