1 INTRODUCTION CAMELS rating is a financial performance evaluation system often applied to the banking industry, which is originally developed by the Uniform Financial Institutions Rating System (UFIRS). • It is a composite rating system based on the financial ratios of the bank’s financial statements. • CAMELS model combining financial management and systems and control elements was introduced for the inspection cycle commencing from July 1998. • The banks under evaluation are rated from 1 (best) to 5 (worst) in each of the CAMELS dimensions in order to identify the best and worst banks. 2 Rating Provisions Each element is assigned a numerical rating based on five key components: 1. 2. 3. 4. 5. Strong performance, sound management, no cause for supervisory concern Fundamentally sound, compliance with regulations, stable, limited supervisory needs Weaknesses in one or more components, unsatisfactory practices, weak performance but limited concern for failure Serious financial and managerial deficiencies and unsound practices. Need close supervision and remedial action Extremely unsafe practices and conditions, deficiencies beyond management control. Failure is highly probable and outside financial assistance needed 3 SCORING • Bank supervisory authorities assign each bank a score on a scale of 1 (best) to 5 (worst) for each factor. • If a bank has an average score less than 2 it is considered to be a high-quality institution while banks with scores greater than 3 are considered to be less than-satisfactory establishments. • The system helps the supervisory authority identify banks that are in need of attention. 4 SCORING 5 Purpose of CAMELS ratings The purpose of CAMELS ratings is to determine a bank’s overall condition and to identify its strengths and weaknesses: Financial Operational Managerial 6 key components of CAMELS ratings Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market 7 key components of CAMELS ratings Capital adequacy • Capital adequacy refers to the adequacy of the amount of own fund (capital) available to support the bank’s business and act as a buffer in case of adverse situation or any shock. • CAR shows the internal strength of the bank to withstand losses during the crisis. • Capital adequacy is measured by the ratio of capital to riskweighted assets . 8 Capital is rated based on the following considerations • Nature and volume of assets in relation to total capital and adequacy other reserves • Balance sheet structure including off balance sheet items, market and concentration risk • Nature of business activities and risks to the bank • Asset and capital growth experience and prospects • Earnings performance and distribution of dividends • Capital requirements and compliance with regulatory requirements • Access to capital markets and sources of capital 9 key components of CAMELS ratings Asset quality • Asset quality refers to the quality of the bank’s loan which is the major asset that generates the major share of its income. • It is measured by the nonperforming loan ratio (NPLR). • It measures the risk facing a bank, i.e., the loss derived from delinquent loans. • The lower the ratio the better the bank performing. 10 Rating factors Asset quality is based on the following considerations: • Volume of problem of all assets • Volume of overdue or rescheduled loans • Ability of management to administer all the assets of the bank and to collect problem loans • Large concentrations of loans and insiders loans, diversification of investments • Loan portfolio management, written policies, procedures internal control, Management Information System • Loan Loss Reserves in relation to problem credits and other assets • Growth of loans volume in relation to the bank’s capacity 11 key components of CAMELS ratings Management • Management efficiency refers to the quality of the bank’s management in deploying its resources efficiently, income maximization, and reducing operating costs. • It can be captured by different financial ratios like total asset growth, loan growth rate, and earnings growth rate. 12 Rating factors Management is the most important element for a successful operation of a bank. Rating is based on the following factors: • Quality of the monitoring and support of the activities by the board and management and their ability to understand and respond to the risks associated with these activities in the present environment and to plan for the future • Development and implementation of written policies, procedures, MIS, risk monitoring system, reporting, safeguarding of documents, contingency plan and compliance with laws and regulations controlled by a compliance officer • • • • Availability of internal and external audit function Concentration or delegation of authority Compensations policies, job descriptions Overall performance of the bank and its risk profile 13 key components of CAMELS ratings Earnings • Earnings ability refers to how losses are absorbed and capital is augmented. Strong earnings profile of banks reflects the ability to support present and future operations. • All income from operations, non-traditional sources, extraordinary items • It can be measured as the return on asset ratio 14 Rating factors Earnings are rated according to the following factors: • Sufficient earnings to cover potential losses, provide adequate capital and pay reasonable dividends • Composition of net income. • Level of expenses in relation to operations • Reliance on extraordinary items, securities transactions, high risk activities Non traditional or operational sources • Adequacy of budgeting, forecasting, control MIS of income and expenses Adequacy of provisions • Earnings exposure to market risks, such as interest rate variations, foreign exchange fluctuations and price risk 15 key components of CAMELS ratings Liquidity • Liquidity management refers to the ability of the bank to fulfill its obligations, mainly of depositors. • It can be measured by different ratios such as, ceteris paribus, customer deposit to total assets, total loan to customer deposit, and cash to deposit. • Cash maintained by the banks and balances with central bank, to total asset ratio is an indicator of bank's liquidity • In general, banks with a larger volume of liquid assets are perceived safe, since these assets would allow banks to meet unexpected withdrawals. 16 Rating factors Liquidity is rated based on the following factors: • Sources and volume of liquid funds available to meet short term obligations • Volatility of deposits and loan demand • Interest rates and maturities of assets and liabilities • Access to money market and other sources of funds • Diversification of funding sources • Reliance on inter-bank market for short term funding • Management ability to plan, control and measure liquidity process. • Contingency plan 17 key components of CAMELS ratings Sensitivity to market Sensitivity to market risk reflects the degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect a financial institution’s earnings or economic capital. 18 Rating factors Market risk is based primarily on the following evaluation factors: • Sensitivity to adverse changes in interest rates, foreign exchange rates, commodity prices, fixed assets • Nature of the operations of the bank • Trends in the foreign currencies exposure • Changes in the value of the fixed assets of the bank • Importance of real estate assets resulting from loans write off 19 20 21 22
