The ‘CAMELS’ approach has six components which addresses the following questions:
For each component a rating is assigned on a scale of 1 to 5 (where 1 is the best rating and 5 is the worst). After the components are rated, weights are assigned, and a weighted average is taken to calculate the overall CAMELS score.
Capital adequacy
Capital adequacy is based on the portion of assets funded by capital. It indicates whether bank has enough capital to absorb losses without severely damaging financial position.
Basel III’s minimum capital requirements are:
Common Equity Tier 1 Capital: This is the safest type of capital. It includes common stock, issuance surplus related to common stock, retained earnings, OCI, and certain adjustments.
Other Tier 1 Capital: This includes instruments issued by bank which meet criteria such as:
Tier 2 Capital: This is capital which meets criteria such as:
Risk weighted assets: Assets are weighted based on risk. For example, cash has a weight of 0%, corporate loans may be given a weight of 100% and non-performing loans may be given a weight of 150%.
Asset quality
Asset quality is based on credit quality and diversification. The credit policies and overall risk management processes of a bank impact its asset quality.
The three major asset categories for a bank are:
| 1. | Loans – Generally the largest component of overall assets | The quality of loans depends on:
|
| 2. | Investments in securities issued by other entities – for example, a bond issued by another company. | They are measured differently depending on categorization. The investments can be measured at:
|
| 3. | Highly liquid financial instruments – for example, T-Bills | They are considered the best quality assets. |
Asset quality can be evaluated based on:
Some ratios used in the analysis are:
Management capabilities
Management capability refers to bank management’s ability to identify and exploit profit opportunities while managing risk.
Other factors related to management capabilities are: governance structure, compliance with laws and regulations, internal controls, transparency of management communications, financial reporting quality.
Earnings
Earnings refers to a bank’s return on invested capital relative to cost of capital.
The major earnings components for banks are:
Of these sources, net interest income and service income are more stable, whereas trading income is the most volatile.
While evaluating earnings we should consider:
Liquidity
A bank’s failure to honor a current liability could have a systemic impact. Therefore, it is extremely important for banks to maintain a strong liquidity position.
There are two major considerations when evaluating liquidity:
Basel III sets a target minimum of 100% for both ratios
Some other factors to consider when evaluating liquidity position are:
Sensitivity to market risk
Sensitivity to market risk deals with how adverse market movements impact a bank’s earnings and financial position; measured using trading portfolio VaR and credit portfolio VaR.
Market risk is the exposure to changes in interest rates, exchange rates, equity prices, or commodity prices.
All entities have exposure to market risk. However, for banks the exposure to changes in market prices arise because of mismatches in the maturity of banks’ deposits and loans.
Mismatches could be with respect to:
Sign up to get more!