Approaches to Evaluation of Banks’ Financial Sustainability

Abstract

Financial sustainability of a bank characterizes its ability to profitable activity provided that all commitments made to the bank are fulfilled in a timely and all regulatory requirements are met. Financial stability of the bank is assessed by all its interested parties: shareholders, managers, clients, counterparty banks, investors, regulator and the state. As a rule, these processes use a set of indicators, which can be divided into two large groups: financial indicators and business characteristics. Key financial indicators include capital adequacy, asset quality, composition and structure of the resource base, liquidity, risks, profitability and efficiency. They are all quantified and calculated from accounting reports. On the other hand, there are business characteristics, among which the quality of management, bank competitive position on the market, image of bank, bank’s credit history and business reputation. Business characteristics allow to take into account the impact on the bank’s sustainability of such events of its activity, the financial consequences of which are difficult to estimate on the basis of financial information only. However, these events can generally significantly affect the bank’s future cash flows. Therefore, it is necessary to use both financial indicators and its business characteristics to assess the bank’s financial sustainability. In this paper, the authors proposed a scoring methodology for the assessment of a bank, based on the CAMEL evaluation system, made calculations, using this methodology as well as defined rating of Latvian commercial banks. Using the CAMEL methodology, the authors evaluate 5 important parameters in the activity of banks, namely, capital adequacy (C), asset quality (A), management level (M), earnings (E) and liquidity (L). To obtain experts’ opinions and assessments authors have conducted a survey among banks’ specialists. The aim of the research is to develop, based on expert estimates, a rating scoring system for assessing the stability of banks, evaluate Latvian commercial banks using the proposed scoring methodology and assign a corresponding rating to each commercial bank of Latvia.