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101 Concepts for the Level II Exam

Level II Concept 28: The CAMELS approach to analyzing a bank


The ‘CAMELS’ approach has six components which addresses the following questions:

  1. Capital adequacy – Does the bank have sufficient capital given its assets?
  2. Asset quality – What is the quality of the bank’s financial assets?
  3. Management capabilities – Is the management effective? What is its track record?
  4. Earnings – What is the level of earnings? What is the quality of earnings? Are earnings trending up or down?
  5. Liquidity: How strong is the liquidity position of the bank? What are the sources of funding? Are the sources of funding stable?
  6. Sensitivity to market risk: How sensitive are the bank’s earnings to market risk?

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 must be at least 4.5% of risk weighted assets
  • Total Tier 1 Capital must be at least 6.0% of risk-weighted assets
  • Total Capital must be at least 8.0% of risk-weighted assets

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:

  • Subordinate to deposits and other debt obligations.
  • No fixed maturity.
  • Interest or dividend payments, if any, should be at bank’s discretion.
  • Collectively, the above two types are called ‘Total Tier 1 Capital.’

Tier 2 Capital: This is capital which meets criteria such as:

  • Subordinate to deposits and to general creditors of bank.
  • Minimum maturity of 5 years.
  • Collectively, the three types are called ‘Total Tier 1 and Tier 2 Capital’

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:

  • Creditworthiness of borrowers – High creditworthiness implies high asset quality.
  • Adequacy of adjustments for expected loan losses – If the adjustments are not sufficient, then it implies low asset quality.
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:

  • Amortized cost
  • Fair value, where unrealized gains/losses are recorded in OCI (FVOCI)
  • Fair value, where unrealized gains/losses flow through the income statement (FVTPL)
3. Highly liquid financial instruments – for example, T-Bills They are considered the best quality assets.

Asset quality can be evaluated based on:

  • Composition of assets
  • Credit quality

Some ratios used in the analysis are:

  • <Asset type>/total assets
  • Allowance for loan losses / non-performing loans
  • Provision for loan losses / net loan charge-offs

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:

  • Net interest income (the difference between the interest earned on loans and the interest paid to its depositors)
  • Service income
  • Trading income

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:

  • Composition of earnings
  • Earnings quality
  • Earnings trend
  • Loan impairment allowances
  • Fair value estimates

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:

  1. Liquid assets relative to near-term expected cash flows. This is measured by the LCR ratio.
    Liquidity coverage ratio (LCR) = highly liquid assets / expected cash outflows
  2. Stability of the banks funding sources. This is measured by the NSFR ratio.
    Net stable funding ratio (NSFR) = available stable funding / required stable funding

Basel III sets a target minimum of 100% for both ratios

Some other factors to consider when evaluating liquidity position are:

  • Concentration of funding
  • Contractual maturity mismatch

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:

  • Maturity
  • Repricing frequency
  • Reference rates
  • Currency