Ihab Salloum[ad_1]
In the year of our Lord 1968, the esteemed financial economist Edward Altman, who at the time was an Assistant Professor of Finance at the prestigious New York University, put pen to paper and published the world-renowned Z-Score formula for predicting corporate bankruptcy. With this formula, it became possible to divinate the demise of publicly-quoted American manufacturing firms up to two (2) years in advance of bankruptcy. As a result, the predictive accuracy of the model ranged from a high of eighty percent (80%) to a low of seventy-two percent (72%).
For a succession of four (4) decades, the Z-Score model has remained an unflaggingly outstanding tool for predicting corporate bankruptcy. Although its initial iteration focused on publicly-quoted American manufacturing firms, the model was subsequently adjusted to include other sectors such as privately-owned companies and firms exclusively in the service sector. Professor Altman originally intended the Z-Score model as a tool for academics. However, the model’s practical implications and far-reaching impact on a plethora of industries has stood the test of time.
The model’s development was based on a sample of sixty-six (66) American manufacturing firms, thirty-three (33) of which had already gone bankrupt at that time. From the financial statements of each, a variety of key accounting ratios were calculated and scrutinized over time. Taking into account the demonstrated pattern and effect of these ratios led to the creation of the Z-Score model, which powerfully predicts whether a firm is on the precipice of financial ruin.
Skip ahead to the year 2009 and Nigeria is wracked with a banking crisis. While the Central Bank of Nigeria proclaims, “No Nigerian Bank Will be Allowed to Fail,” this really means no Nigerian bank will be allowed bankruptcies to take place. Given the critical importance of the banking industry to the country’s economy, it is both logical and humane to adopt this stance. However, it is a certainty that things have gone awry in Nigerian banking. In my view, the famous five Nigerian banks have technically failed. Because they have the opportunity of a lifeline, whether solicited or imposed, they will never be permitted to go bankrupt.
Having overseen bank failures, I believe that it is time for the Central Bank of Nigeria to be more proactive in regulating the country’s banking industry. Many analysts have concluded that a failure of regulation has led to the banking crisis. How else do you explain the hundreds of billions of Naira of lifeline support provided through the Expanded Discount Window? As if that was insufficient, an additional 420 billion Naira is required merely to stabilize chronic mismanagement.
Consider the benefits that could have accrued to the Nigerian economy if the bank failures had been correctly predicted two (2) years prior to now. Perhaps there would have been no need for the Expanded Discount Window and no need for the aforementioned 420 billion Naira bailout fund! These funds could have been directed towards other critical needs of the Nigerian economy.
The previous model for assessing the financial performance of banks was the CAMELS Rating. CAMELS stands 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 that it is high time for the financial regulator to develop a reliable model specific to Nigeria for predicting future bank failures. This would allow for closer monitoring and remedial actions taken long before things spiral out of control.
Designing a predictive model unique to Nigeria is feasible since there are plenty of historical examples of bank failures to use as a data set. However, adjustments must be made to incorporate the specificities of banking services, the Nigerian economy, industry peculiarities, and the way in which banks’ financial statements are presented. Liquidity management is the backbone of banking. This very precept serves as the starting point for any analytical or modeling framework developed for the industry.
It’s important to note my proposal is not a call to wholesale adoption of the Z-Score model. Instead, a distinct model can be created based on fundamental principles similar to those used in the Z-Score model that would be suitable for our unique Nigerian environment. I’m aware that financial statements produced by banks are often incomprehensible and that banks use an abundance of off-balance sheet items. Regulation is the ideal way to tackle the issues raised. We need to simplify, streamline, and standardize financial statement reporting while also emphasizing full disclosure and full provision for bad debts. This strategy is a step in the right direction since it separates the wheat from the chaff.
Finally, a “Garbage In Garbage Out” scenario must be avoided at all costs. Since a bank’s financial statements (especially the balance sheet and income statement) serve as the primary documents used to calculate financial ratios, the accuracy and integrity of these statements must not be doubted. Furthermore, regulation is critical for ensuring banks adhere to such standards. In conclusion, now is the ideal moment to tackle the significant issues raised above.
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