The financial sector plays an important role in any economy of the world. A considerable growth rate and improvement can be observed in the recent past in terms of the number of banks and other financial institutions with several instruments on offer, and a range of services provided. There are several licensed commercial banks operating in the country and regulated by the Central Bank of Nigeria.
For the other sectors of the economy, the banking sector too is faced with the present dynamic changes taking place in the environment to achieve competitive advantages. The banking sector has adopted new technologies to a considerable level to improve its efficiency and performance to achieve its long-term goals. The ability of the banking sector to compete is determined by its financial performance efficiently and effectively. In other to appraise the financial performance is crucial for all organisations. This is especially important for financial institutions like banks because it helps to identify the major strengths and weaknesses of the business. Financial analysis also assists to predict the future performance of the banks. The information obtained from financial analysis shows the financial position of the organization, that will be interested by various internal and external stakeholders such as managers, employees, customers, financial institutions, and the government.
CAMELS approach is widely used to analyse a bank. As for a bank whose primary responsibility is that of taking deposits and makes loans available to corporate and individual. “CAMELS” has six components which include: Capital adequacy, Asset quality, Management capabilities, Earnings sufficiency, Liquidity position, and Sensitivity to market risk.
1. Capital Adequacy
The capital adequacy ratio is a vital requirement for banks to have adequate capital so that potential losses can be absorbed without making the bank become financially weak or insolvent. This represents the overall financial position of the bank. Capital adequacy is expressed in terms of the proportion of the bank’s assets funded with capital.
A systemic bank as is known is one whose failure might trigger a financial crisis in the country.
As for Nigeria, the CBN classified some banks as systemic banks.
These banks are designated as “too big to fail” or Systematically Important Banks (SIBs) in the CBN draft paper include: First Bank of Nigeria, United Bank for Africa, Zenith Bank, Access Bank, Ecobank Nigeria, Guaranty Trust Bank.
However, the assets are these banks are adjusted based on their risk, with riskier assets requiring a higher weighting. Cash has a risk weighting of zero, whereas corporate loans have a risk weighting of 100%. Loans on high volatility commercial real estate and loans that are 90 days past due have a weighting higher than 100%.
A bank’s capital is grouped in hierarchical tiers, with the most vital tier as ordinary share Equity in Tier 1 Capital. This is the most loss-absorbing form of capital because it is permanent and places shareholders’ funds at risk of loss in the event of insolvency. It includes ordinary shares, retained earnings, accumulated other comprehensive income and adjustments such as deduction of intangible assets, and deferred tax assets.
On the other hand, Tier 2 Capital includes instruments that are subordinate to depositors and general creditors of the bank. While these instruments have an original minimum maturity and meet specific other requirements.
The capital adequacy of a bank is assessed through the following ratios:
a) Capital to Risk-weighted Assets Ratio (CRAR)
This ratio ensures that banks can hold a reasonable amount of losses occurring during operations and to ascertain the bank’s loss-bearing capacity. A higher CRAR is indicative of stronger banks and more protection to investors. The CRAR is computed by dividing Tier I and Tier II capital with Weighted Risk Assets.
b) Debt-Equity Ratio
The debt-equity ratio indicates the degree of a bank’s leverage. It expresses the proportion of debt and equity in the total fund structure of the bank. It is computed by dividing the total borrowings of the bank by shareholders’ equity. By shareholders’ equity, it is equity share capital and reserves, and surpluses. A higher ratio indicates that the depositors and creditors are less protected and vice versa.
c) Government Securities to Total Investments Ratio
This ratio reflects the risk associated with the bank’s investments. It is equal to the investment in government securities divided by the total investment of banks. Government securities are risk-free debt instruments, which means that they are the most secure. The higher the investment in government securities, the lower the risk, and vice versa.
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UNDERSTANDING RATIO VALUES