Catalog

	Table of Contents
p. 116 of 203 BACK | NEXT Foreword 1. Introduction to the Guidelines 2. User Instructions 3. Preparing and Appraising Investment Project 4. Financial Management of Executing Agencies 5. Reporting and Auditing 6. Financial Institutions 6.1. Introduction and Overview 6.2. Reviewing FI Financial Management 6.3. FI Investments 6.4. Assessing FI Performance 6.4.1. Introduction 6.4.2. Assessing Microfinance Institutions 6.4.3. Applying the CAMEL Framework 6.4.4. Assessing FI Risks 6.4.5. Determining FI Credit Ratings 6.4.6. Specialized FI Internal Controls 6.5. Appraisal Checklist 6.6. FI Reporting and Auditing Issues 7. Knowledge Management

Financial Management and Analysis of Projects : 6. Financial Institutions : 6.4. Assessing FI Performance

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6.4.3. Applying the CAMEL Framework

6.4.3.1. Capital Adequacy Ratio

6.4.3.1. The five following subsections describe the components of the CAMEL framework and recommend appropriate performance measures.

6.4.3.1.1. Capital Adequacy is a measure of an FI's financial strength, in particular its ability to cushion operational and abnormal losses. An FI should have adequate capital to support its risk assets in accordance with the risk-weighted capital ratio framework. It has become recognized that capital adequacy more appropriately relates to asset structure than to the volume of liabilities. This is exemplified by central banks' efforts internationally to unify the capital requirements of commercial banks and to generate worldwide classification formulae such as the one proposed here. This indicator requires that assets be classified by reference to their demands on the equity (or capital) structure of the FI.

6.4.3.1.2. The CAR indicator is derived by comparing the ratio of an entity's equity to its assets-at-risk. The covenant specifies that the borrower/EA/FI should not make an advance to a subborrower, if after making the advance, the ratio (the performance indicator) of its equity to its assets-at-risk would be greater than that specified in the covenant.

6.4.3.1.3. Equity is defined as the total of: (i) unimpaired paid-up capital; (ii) retained earnings; (iii) reserves available to meet any losses that may be incurred through the nonrecovery of assets; and (iv) all other capital and revenue reserves, including provisions for bad and doubtful debts and provisions for loan and lease losses.

6.4.3.1.4. Assets-at-risk are defined as the total of the impaired values of assets at the date of making the advance to the subborrower. Assets are typically classified as: (i) risk-free; (ii) minimum risk; (iii) general risk; (iv) substandard; (v) "workout" (or minimal chance of recovery); and (vi) fixed assets, furniture and office equipment, computers, etc. To each of these classifications is awarded a percentage of their values for which an FI's capital is needed to cover risk of losses.

6.4.3.1.5. The BCBS of the BIS recommends a mandatory minimum CAR of 8% for banks in OECD countries. However, the emerging banking regulatory and supervision system in most ADB DMCs, combined with an emphasis on directed lending, results in poor portfolio quality. As such, these Guidelines recommend a minimum Capital Adequacy Ratio (CAR) of 12%.

6.4.3.2. Assessing Asset Quality

6.4.3.2.1. Asset quality has direct impact on the financial performance of an FI. The quality of assets particularly, loan assets and investments, would depend largely on the risk management system of the institution. The value of loan assets would depend on the realizable value of the collateral while investment assets would depend on the market value.

6.4.3.3. Assessing Management Quality

6.4.3.3.1.The performance of the other four CAMEL components will depend on the vision, capability, agility, professionalism, integrity, and competence of the FI's management. As sound management is crucial for the success of any institution, management quality is generally accorded greater weighting in the assessment of the overall CAMEL composite rating.

6.4.3.4. Assessing Earning Performance

6.4.3.4.1. The quality and trend of earnings of an institution depend largely on how well the management manages the assets and liabilities of the institution. An FI must earn reasonable profit to support asset growth, build up adequate reserves and enhance shareholders' value. Good earnings performance would inspire the confidence of depositors, investors, creditors, and the public at large.

6.4.3.5. Assessing Liquidity

6.4.3.5.1. An FI must always be liquid to meet depositors' and creditors' demand to maintain public confidence. There needs to be an effective asset and liability management system to minimize maturity mismatches between assets and liabilities and to optimize returns. As liquidity has inverse relationship with profitability, an FI must strike a balance between liquidity and profitability.

6.4.3.5.2. Current and quick ratios are inappropriate for measuring FI liquidity. A loan-to-deposit ratio is more relevant. However, an FI's liquidity and solvency are directly affected by portfolio quality. Consequently, financial analysts (investment officers) should carefully analyze the FI's portfolio quality on the basis of collectability and loan-loss provisioning. Section 6.4.3.2 suggests appropriate measures in this respect.

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