One of the consequences of the financial crisis of 2008 was a significant increase in the strength of regulatory frameworks for banks. This was, of course, entirely understandable: the banking and financial sector’s roles in the development of any economy cannot be overemphasised, as it’s the sector that fuels economies through mobilisation of deposits and allocation of credit for businesses. Hence, any instability can negatively affect the economy of any country.
Transparency and accountability in banks are enhanced by supervisory regulations as these compel greater attention to be paid to the soundness of the banks. The choice of a suitable rating system for comparability and benchmarking is key. ‘CAMELS’ provides such a system, and indeed the Basel Committee of the Bank for International Settlements recommends the CAMELS rating system as an early warning mechanism for the assessment of the overall soundness of banks.
What is CAMELS?
The CAMEL analysis – Capital Adequacy, Asset Quality, Management, Earnings and Liquidity – was created by bank regulatory agencies in the US in 1979. In 1997, a sixth component was added to measure banks’ ‘sensitivity’ to market risk, thereby becoming CAMELS. It is an international bank supervisory rating system applied to banks using a detailed analysis of ratios from financial statements used by bank regulators to evaluate the overall performance of banks and determine their strengths and weaknesses.
The first variable in the CAMELS rating is Capital Adequacy. It is an important indicator of the financial stability of a bank, and is defined as the minimum statutory reserve that banks are expected to keep. It gives depositors the confidence that the bank can meet any additional capital needs with no interruptions to its operations. It can be measured by ratios such as the capital to risk-weighted assets ratio and the debt-equity ratio. To meet Capital Adequacy requirements, financial institutions must comply with the prescribed risk-based capital requirement as well regulations on risk management, loan and investment portfolio, and growth plans in relation to the economic environment. The issue concerning the Capital Adequacy of internationally active banks is of prime importance to the Basel Committee, which sets minimum standards for Capital Adequacy in the Basel Accords.
Asset Quality is the net indicator after capital adequacy. Banks must be concerned with the quality of the assets on their balance sheets because non-performing assets negatively affect their profitability. The percentage of non-performing assets to total assets; and that of secured assets to total assets are good measures of the quality of a bank’s assets.
The third indicator is Management. How efficiently a bank is managed guarantees its growth and profitability because it is the responsibility of management to execute the strategy for the achievement of the required growth and profitability. The profit per employee (profit after tax/no. of employees) is a good indicator of management efficiency.
As the fourth indicator, Earnings represents how the quality of a bank’s earnings reflects its current performance and is also an indication of its future performance. Net interest margin (NIM) and return-on-assets (ROA) are good indicators of the profitability of a bank.
Liquidity is the fifth indicator and measures the extent to which a bank can meet its short-term financial obligations by converting assets into cash. Whilst investing for profitability, there must also be adequate liquidity for banks to meet their obligation to depositors and customers. Banks must therefore maintain adequate liquidity by keeping cash or assets which are easily convertible to cash. The loan-deposit ratio and liquid-assets to total assets ratios are useful for the assessment of liquidity.
The final indicator is Sensitivity to market risk which refers to the risk that changes in market conditions such as alterations in foreign exchange and interest rates could negatively affect a bank’s earnings or capital or both. This can be measured by the extent to which these changes can affect the bank’s earnings. For instance, a high total securities to total assets ratio is an indication of a high susceptibility to market risk.
Application of the CAMELS rating system
This is done by applying a rating scale of 1 to 5 (1 being the best and 5 the worst) to each of the six components. The overall condition of the bank is measured by bank regulators during the evaluation of the components of the CAMELS rating system. A rating of 1 indicates a strong performance whilst 2 is satisfactory. When performance and risk management practices are flawed to some degree, a rating of 3 is awarded and this generates supervisory concern. A rating of 4 is indicative of poor performance whilst 5 represents a critically deficient and unsatisfactory performance, requiring immediate remedial actions.
The CAMEL rating system is no doubt an essential tool for the identification of the financial strengths and weaknesses of a bank by evaluating the overall financial situation of the bank for any corrective actions to be taken. Results from CAMELS testing can help regulators to direct management of affected banks to formulate policies and strategic initiatives for the improvement of their financial performance.
_________________________________________________________________
About the author:
Patricia Barnett-Quaicoo has 16 years of extensive banking experience in one of Africa’s foremost financial institutions. She holds the internationally recognised Professional Postgraduate Diploma in Governance, Risk and Compliance from the International Compliance Association, as well as a Treasury Dealing Certificate from the Financial Markets Association (ACI). Patricia holds a double MBA in Finance and International Business and is currently working on her Doctorate in Business Administration.
_________________________________________________________________
References:
Bastan, M., Mazraeh, M. B. & Ahmadvand, A., 2016. Dynamics of Banking Soundness Based on the CAMELS Rating System. Delft, s.n.
Jimenez, G., Ongena, S., Peydro, J.-L. & Saurina, J., 2017. Macroprudential Policy, Countercyclical Bank Capital Buffers, and Credit Supply: Evidence from the Spanish Dynamic Provisioning Experiments.. Journal of Political Economy, 125(6), pp. 2126-2177.
Lopez, J. A., 1999. Federal Reserve Bank of San Francisco Economic Research. [Online]
[Accessed 14 December 2018].
NCUA, 2003. Letter to the Credit Unions. Austin: NCUA.
Sahajwala, R. & Bergh, P. V. d., 2000. Supervisory Risk Assessment and Early Warning Systems - Working Paper No. 4, Basel: Basel Committee on Banking Supervision.
______________________________________________________________
This article forms part of the #BigCompConvo - Join us as we explore and debate the latest challenges and issues facing you and regulatory and financial crime compliance professionals all over the world. If you’d like to contribute an article as part of the Big Compliance Conversation get in touch with us at contributions@int-comp.org