FRAMEWORK OF PEARLS ANALYSIS
ABSTRACT
PEARLS is a financial performance monitoring system designed to offer management guidance for credit unions and other savings institutions. It can be used to rank institutions and can provide comparisons among peer institutions in one country or across countries. PEARLS is a set of financial indicators that help standardize terminology between the institutions. In total, there are 44 quantitative financial indicators that facilitate an integral analysis of the financial condition of any financial institution. The purpose for including a myriad of indicators is to illustrate how change in one ratio has ramifications for numerous other indicators.
Key word: PEARLS, WOCCU, Framework, Credit unions
BACKGROUND OF PEARLS
In the late 1980s, the World Council of Credit Unions (WOCCU) 1 embarked on a new strategy to renovate and strengthen credit unions. WOCCU had come to realize that donor-funded lines of credit, and that donor funding did not provide a good framework around which to build sustainable institutions. Initially, WOCCU staff tried to adapt the US CAMEL2 ranking system to the credit unions in Guatemala, but found that several modifications were needed. CAMEL ratios intend to protect the solvency of institutions and the safety of member deposits. In addition, credit union mangers needed to monitor growth of total assets, seen as key to addressing the problems resulting from monetary devaluations and runaway inflation. In essence, PEARLS was designed first as a management tool, and later became an effective supervisory mechanism. With PEARLS, WOCCU has set international financial standards for credit union performance.
INTRODUCTION
Many different financial ratios and “rules of thumb”3 have been promoted for financial institutions worldwide, but few have been consolidated into an evaluation programs that is capable of measuring both the individual components and the system as a whole. Since 1990, the World Council of Credit Unions, Inc. has been using a set of financial ratios known as “PEARLS.”4 Each letter of the word PEARLS measures key areas of Credit Union
* Ph.D Research Scholar (Part time),PG & Research Department of Commerce, Sri SRNM College Sattur-626203, Tamilnadu, India mail id: [email protected] Ph:81485 18788
** Asst.Professor, PG & Research Department of Commerce, Sri SRNM College Sattur-626203, Tamilnadu, India mail id: [email protected] Ph: 9486286638
operations: Protection, Effective financial structure, Asset quality, Rates of return and cost, Liquidity and Signs of growth. “PEARLS” provides credit union managers with concise, easy-to-read reports that reveal institutional weaknesses and trends. The PEARLS Monitoring System includes: 1.Ranking tool for comparing credit unions, 2.Business planning tool to create strategic plans that help improve performance, 3.Customizable labels that can be adapted to suit local language requirements.
OBJECTIVES OF PEARLS
The use of the PEARLS evaluation system accomplishes the following objectives
Executive Management Tool: Monitoring the performance of the credit union is the most important use of the PEARLS system. For example, the PEARLS system is capable of identifying a credit union with a weak capital base, and can also identify the probable causes (e.g., insufficient gross income, excessive operating expenses, or high delinquency losses). Use of the system permits managers to quickly and accurately pinpoint troubled areas, and to make the necessary adjustments before problems become serious. In essence, PEARLS is an “early warning system” that generates invaluable management information.
Standardized Evaluation Ratios and Formulas: The use of standardized financial ratios and formulas eliminates the diverse criteria used by credit unions to evaluate their operations. It also creates a universal financial language that everyone can speak and understand. One result can be enhanced communication that facilitates a greater understanding of the main concepts along with a commitment to achieve greater uniformity in the quality and strength of each individual credit union, by improving deficient operational areas.
Comparative Rankings: The PEARLS performance indicators produce a completely new type of information: comparative credit union rankings. Historically, it was impossible to compare one credit union with another due to the diverse criteria and reporting formats that existed. One particularly important aspect of the PEARLS comparative rankings is its objectivity. This differs from the U.S. CAMEL system that gives management a numerical rating based upon the examiner’s overall subjective judgment. By avoiding subjective assessments, it is possible to present objective reports to the credit unions that are substantiated by financial information taken from their balance sheets. The objective ranking system permits open discussion of problems with Boards of Directors and management and can also become more focused in seeking solutions to the problems affecting their institutions. It is particularly useful in situations where a credit union is at the bottom of the ranking scale.
Facilitate Supervisory Control: In addition to its usefulness as a management tool, the PEARLS system provides the framework for a supervisory unit at the National Federation. National Associations can use the financial ratios generated by PEARLS to conduct quarterly or monthly analyses of all key areas of credit union operations.
COMMERCIAL AND SOCIAL IMPACT OF PEARLS
The PEARLS monitoring system has the unique ability to measure financial performance while simultaneously promoting social impact. This is possible because each of the areas measured by PEARLS has both business and social consequences. Table-1 illustrates this point by linking each of the areas analyzed by PEARLS with the commercial and social impact it creates5.
Table 1
Commercial and Social Impact of PEARLS
| Pearls | Commercial Impact | Social Impact |
| Protection | Measures the complete process of credit administration:- Delinquency control ·Loan-loss reserves ·Loan charge-offs ·Loan recoveries | Provides members with a safe place to deposit their money.
|
| Effective
Financial Structure |
Helps to optimize institutional solvency, profitability and liquidity.
|
Encourages community loans to members, community savings from either rich or poor members. |
| Asset
Quality
|
Optimizes profitability by minimizing non-earning assets, and seeking to finance those assets with funds that have no explicit interest cost. | Applies pressure on delinquent members to cancel their debts without obligating others to pay. It also restricts the acquisition of fixed assets that are not affordable. |
| Rates of
Return and Cost |
Optimizes the balance between portfolio yields, savings deposit yields, dividends on shares, operating efficiency, and the capitalization of net earnings.
|
Institutional profitability is limited to recovering all costs instead of maximizing profits. It provides savers and shareholders with real rates of return on their capital. Employees are paid competitive wages for their services. |
| Liquidity
|
Optimizes the level of liquidity needed to satisfy member withdrawal requests. Minimizes idle liquidity. | Provides members with instant liquidity whenever needed. Promotes the timely payment of all debt obligations. |
| Sings of
Growth
|
Enables balance sheet account comparisons between structure and yield, while simultaneously trying to achieve real growth.
|
Promotes the affiliation of any person who follows the rules. Promotes thrift and savings among the membership. Promotes the acquisition of needed goods and services via loans to creditworthy members. |
Source:”The Commercialization of Credit Unions”, woccu.
PEARLS V/S. CAMEL
The PEARLS system can be adapted to the specific needs of mature or emerging Credit Union Movements. An early attempt was made to adapt the U.S. CAMEL ranking system to credit unions by the World Council of Credit Unions, Inc., but too many modifications were needed6. In particular, the CAMEL system possessed two major deficiencies that limited its effectiveness:
- The CAMEL system does not evaluate the financial structure of the balance sheet. This was a critical area of concern in many countries since modernization implies a major restructuring of credit union assets, liabilities and capital. Balance sheet structure has a direct impact on efficiency and profitability. These areas are critically important for effective and sustainable credit union operations in a competitive environment.
- CAMEL does not consider growth rates. In many countries, growth of total assets is a key strategy used to address the problems that accompany monetary devaluations and runaway inflation. In a relatively hostile macro-economic environment, the credit unions have to sustain aggressive growth if they are to preserve the value of their assets.
The failure of the CAMEL system to evaluate financial structure and growth is indicative of its current application in the United States. CAMEL was created as a supervisory tool, not a management tool. The main concern of the CAMEL ratios is to protect the solvency of the institution and the safety of member deposits. It is not designed as a tool for the analysis of all key areas of credit union operations.
COMPONENTS OF PEARLS
The PEARLS system is uniquely different. It was first designed as an effective supervisory mechanism. Each letter of the name “PEARLS” looks at a different, but critical aspect of the credit union.
P = Protection: The PEARLS system evaluates the adequacy of protection afforded to the credit union by comparing the allowance for loan losses to loan delinquency. There are six sub ratios under Protection7 which are explained as under Table 2 with its formula and standard of excellence.
Table 2
Ratios under Protection
| Title | Description of Ratio | Standard |
| P-1 | Allowance for Loan Losses/Delinquency > 12 months | 100% |
| P-2 | Net Allowance for Loan Losses/Delinquency of 1-12 months | 35% |
| P-3 | Total Write-off of Delinquent Loans > 12 months | 100% |
| P-4 | Annual Loan Write-offs/Average Loan Portfolio | Minimal |
| P-5 | Accumulated Loan Recoveries/Accumulated Loan Write-offs | 100% |
| P-6 | Solvency (Net Value of Assets/Total Shares and Deposits) | >=100% |
Source: The World Council of Credit Unions: Monogram 4.
E = Effective Financial Structure
The financial structure of the credit union is the single most important factor in determining growth potential, earnings capacity, and overall financial strength. The PEARLS system measures assets, liabilities and capital, and recommends for an “ideal” structure for credit unions. The following Table-3 illustrates the promoted ideal targets of effective financial structure.
Table-3
Ratios under Effective Financial Structure
| Title | Description of Ratio | Standard |
| E-1 | Net Loans/Total Assets | 70-80% |
| E-2 | Liquid Investments / Total Assets | Max 20% |
| E-3 | Financial Investments / Total Assets | Max 10% |
| E-4 | Non-Financial Investments / Total Assets | 0% |
| E-5 | Savings Deposits / Total Assets | 70-80% |
| E-6 | External Credit / Total Assets | Max 5% |
| E-7 | Member Share Capital / Total Assets | 10-20% |
| E-8 | Institutional Capital / Total Assets | Min 10% |
| E-9 | Net Institutional Capital/ Total Assets | Min 10% |
Source: The World Council of Credit Unions: Monogram 4.
The indicators in this section measure the composition of the most important accounts on the Balance Sheet. An effective financial structure is necessary to achieve safety, soundness, and profitability, while at the same time, positioning the credit union for aggressive real growth.
A = Assets Quality
A non-productive or non-earning asset is one that does not generate income. An excess of non-earning assets affects credit union earnings in a negative way. The indicator in this section measures the percentage of non-earning assets that negatively impact profitability and solvency. The following PEARLS Table-4 elucidates those PEARLS indicators that are used to identify the impact of non-earning assets:
Table-4
Ratios under Asset Quality
| Title | Description of Ratio | Standard |
| A-1 | Total Loan Delinquency / Gross Loan Portfolio | < or equal to 5% |
| A-2 | Non-Earning Assets / Total Assets | < or equal to 5% |
| A-3 | Net Institutional & Transitory Capital + Non Interest-Bearing Liabilities / Non-earning Assets | >200% |
Source: The World Council of Credit Unions: Monogram 4.
R = Rates of Return and Costs
These indicators measure the average income yield for each of the most productive assets of the Balance Sheet. In addition, they measure the average yield (cost) for each of the most important liability and capital accounts. The yields are actual investment returns and not the typical “spread analysis” yields that are figured on the basis of average assets. The corresponding yields indicate whether the credit union is earning and paying market rates on its assets, liabilities and capital. There are twelve sub ratios under Rates of Return and Costs which are explained as under Table 1.5 with its formula and standard of excellence.
Table 1.5
Ratios under Rates of Return and Costs
| Title | Description of Ratio | Standard |
| R-1 | Net Loan Income / Average Net Loan Portfolio | Entrepreneurial Rate |
| R-2 | Total Liquid Investment Income /
Average Liquid Investments |
Market Rates |
| R-3 | Total Financial Investment Income /
Average Financial Investments |
Market Rates |
| R-4 | Total Non-Financial Investment Income /
Average Non-Financial Investments |
> R-1 |
| R-5 | Total Interest Cost on Savings Deposits /
Average Savings Deposits |
Market Rates > Inflation |
| R-6 | Total Interest Cost on External Credit /
Average External Credit |
Market Rates |
| R-7
|
Total Interest (Dividend) Cost on Shares /
Average Member Shares |
Market Rates > or Equal to R-5 |
| R-8 | Total Gross Income Margin / Average Total Assets | Variable – Linked to R9, R11, R12 |
| R-9 | Total Operating Expenses / Average Total Assets | 5% |
| R-10 | Total Loan Loss Provision Expense /
Average Total Assets |
Dependent on
Delinquent Loans |
| R-11 | Non-Recurring Income or Expense /
Average Total Assets |
Minimal |
| R-12 | Net Income / Average Total Assets | Linked to E-9 |
Source: The World Council of Credit Unions: Monogram 4
L = Liquidity
The liquidity indicators show whether the Credit Union is effectively managing its cash so that it can meet deposit withdrawal requests and liquidity reserve requirements. In addition, idle cash is also measured to insure that this non-earning asset does not unduly affect profitability. There are three sub ratios under Liquidity which are explained as under Table 1.6 with its formula and standard of excellence.
Table 1.6
Ratios under Liquidity
| Title | Description of Ratio | Standard |
| L-1 | Short term Investments + Liquid Assets –
Short term payables/ savings deposits |
Min 15% |
| L-2 | Liquidity Reserves / Savings Deposits | 10% |
| L-3 | Non-Earning Liquid Assets / Total Assets | < 1% |
Source: The World Council of Credit Unions: Monogram 4.
S = SIGNS OF GROWTH
The indicators of this section measure the percentage of growth in each of the most important accounts on the financial statement, as well as growth in membership. In inflationary economies, real growth (after subtracting inflation), is a key to the long run viability of the Credit Union. The Signs of Growth ratios are shows as under Table 1.7.
Table 1.7
Ratios under Signs of Growth
| Title | Description Of Ratio | Standard |
| S-1 | Growth in Loans to Members | Dependent on E1 |
| S-2 | Growth in Liquid Investments | Dependent on E2 |
| S-3 | Growth in Financial Investments | Dependent on E3 |
| S-4 | Growth in Non-Financial Investments | Dependent on E4 |
| S-5 | Growth in Savings Deposits | Dependent on E5 |
| S-6 | Growth in External Credit | Dependent on E6 |
| S-7 | Growth in Share Capital | Dependent on E7 |
| S-8 | Growth in Institutional Capital | Dependent on E8 |
| S-9 | Growth in Net Institutional Capital | Dependent on E9 |
| S-10 | Growth in Membership | > 12% |
| S-11 | Growth in Total Assets | > Inflation |
Source: The World Council of Credit Unions: Monogram.
CONCLUSION
PEARLS is a financial performance monitoring system designed to offer management guidance for credit unions and other savings institutions. PEARLS is also a supervisory tool for regulators. PEARLS can be used to compare and rank institutions. PEARLS is a set of financial ratios or indicators that help to standardize terminology between institutions. In total, there are 44 quantitative financial indicators that facilitate an integral analysis of the financial condition of any financial institution. The purpose for including a myriad of indicators is to illustrate how change in one ratio has ramifications for numerous other indicators. Each indicator has a prudential norm or associated Standard. The target Standard, or standard of excellence for each indicator is put forth by the World Council of Credit Unions, Inc. (WOCCU) based on its field experience working to strengthen and modernize credit unions and promote savings-based growth. Depositors can have confidence that savings institutions that meet the standards of excellence are safe and sound. PEARLS, primarily a management tool for institutions, can also be used as a supervisory tool by regulators.8 As a management tool, PEARLS signals problems to managers before the problems become detrimental. For boards of directors, PEARLS provides a tool to monitor management’s progress toward financial Standards. For regulators, PEARLS offers indicators and standards to supervise the performance of savings institutions.
REFERENCES
- WOCCU is a US-based NGO that was incorporated in 1970 to promote, support, represent, and serve credit unions worldwide.
- There are many different CAMEL systems in circulation around the world with varying key formulas and ratios. (CAMEL stands for Capital Adequacy, Asset Quality, Management, Earnings, and Liquidity.) The CAMEL system used by WOCCU in 1988 came from the National Credit Union Administration in Washington, D.C.
- “Analysis of Microfinance Development in Russia,” SME Resource Center, Moscow, 2003.
- The Microfinance Revolution: Sustainable Finance for the Poor (Volume 1), World Bank and Open Society Institute, 2003.
- In 2002, BancoSol was the largest bank in Bolivia in terms of number of clients, with 35 percent of all borrowers. In 2003, it had a loan portfolio of approximately $91 million. (Source: Gail Buyske.)
- David C. Richard (2008), “Teaching Old Dogs new Tricks: The Commercialization of Credit Unions”, WOCCU.
- Barham, Bradford, L., Stephen R. Boucher, and Michael R. Carter (1996). “Credit Constraints, Credit Unions, and Small Scale Producers in Guatemala,” in World Development 24:5, pp. 793-806.
- David C. Richard (2008), “Teaching Old Dogs new Tricks: The Commercialization of Credit Unions”, WOCCU.