What is CAMELS Rating System in Financial Institutions?

 What is CAMELS Rating System in Financial Institutions?

1. Meaning

It is a recognized international rating system that bank supervisory authorities use in order to rate financial institutions according to six factors denoted by its acronym. 

CAMELS stands for Capital, Assets, Management, Earnings,  Liquidity, and Sensitivity. Supervisory authorities assign each bank a score on a scale in each of the above categories. 

A rating of one is considered the best, and a rating of five is considered the worst for each factor.

In today's scenario in addition to the regulators, different credit rating agencies also performs CAMELS analysis to rate a credit instrument and make an overall credit decision.

2. Different rating aspects

The examiners focus on the following aspects.

a)    Capital: The capital may be external or internal. The capital is normally comprised of external funds raised and retained earnings. The examiners assess institutions' capital adequacy through trend analysis. The examiners check whether the banks comply with the capital, interest, and dividend requirements as prescribed by the regulators. The inclusive examples are fixed dividend components for preference shares and fluctuating components of equity shares and adequacy of long-term funds adjusted for gearing levels, the ability of the issuer to raise further borrowings.

In addition, growth plans, economic environment, ability to identify, assess and mitigate risks, and loan and investment concentrations are examined by the examiners.

b)   Assets: Under this aspect, the examiner assesses the revenue-generating capacity of existing or proposed assets, fair values, technological/physical obsolescence, linkage of assets to turnover, consistency, appropriations of the method of depreciation and adequacy of charge to revenues, size aging and recoverability of monetary assets like receivables and its linkage to total assets.

The examiner also assesses the efficiency of the bank's investment policies and practices.

The examiner rate the investment risk factors that the bank may face and balance those factors against the bank's capital earnings. This shows how much is the stability of the bank when encountering a risky situation.

c)     Management:  The examiner determines the ability of the bank's management to deal with financial stress. E.g. how management identifies assesses, and responds to risks of the daily activities. It covers management's ability to ensure safe operations of the institutions and how they comply with the applicable internal and external regulations. Apart from the above, the extent of involvement of management personnel, teamwork, authority, timeliness, effectiveness, and efficiency of decision making along with directing management to achieve corporate goals are also assessed.

d)   Earnings: The examiner assesses the ability of the bank to generate earnings that can sustain its activities, make it competitive, help in expansion and ensure its long-term viability. Key aspects covered by the examiner are earning rate, growth rate, absolute levels, trend, stability, adaptability to cyclical fluctuations, valuation allowances, net margins, net worth levels, the ability of the entity to service existing and additional debts proposed, and quality of the bank's existing assets.

e)    Liquidity: The examiner assesses interest rate risk sensitivity, the effectiveness of working capital management, corporate policies for stock and creditors, management and ability of the corporate to meet their commitment in the short run, availability of assets that can readily be converted into cash, and dependence on short-term volatile financial resources.

f) Sensitivity: Sensitivity covers how particular risk exposures can affect institutions. Examiners assess institutions' sensitivity to market risk by monitoring the management of credit concentrations. In this way, examiners are able to see how lending to specific industries affects an institution. These loans include agricultural lending, medical lending, credit card lending, and energy sector lending. Exposure to foreign exchange, commodities, equities, and derivatives are also included in rating the sensitivity of a company to market risk.

These six aspects become the six core bases for estimating the creditworthiness of an issuer/bank which leads to the rating of an instrument. The rating agencies determine the predominance of positive/negative aspects under each of these six categories and these are factored in for making overall credit decisions.

4. Vital information required for CAMELS evaluation

In order to perform CAMEL evaluation by the regulator, the following vital is required

a)    Financial statements

b)    Sources of capital or financing

c)     Board of Directors structure, composition, and set up

d)   Operating and human resource information

e)     Information on macro-economic indicators and portfolio amortization table

5. What do different ratings indicate?

The rating score given to banks and their indications are as follows:

SN	Rating Score	Indication
1	One	-robust performance -complies with all risk management practices
2	Two	-financially satisfactory -risk management practices satisfactory  with some lags on both aspects
3	Three	Supervisory concern in several domains including -financial performance and -risk management practices
4	Four	-unsound financial performance -weak risk management practices
5	Five	-fundamentally unsound financial performance -weak and insufficient risk management practices

5. Numerical rating system in CAMELS

The following table depicts the numerical rating system in CAMEL evaluation:

Rating	Range	Analysis	Evaluation
1	1.0 to 1.4	Strong	Suitable in all dimensions
2	1.5 to 2.4	Satisfactory	Favorable with  lags in few dimensions
3	2.5 to 3.4	Less satisfactory	Lags that require supervisory attention
4	3.5 to 4.4	Deficient	Lags at an alarming stage
5	4.5 to 5.0	Critically deficient	Critical lags that may lead to the bank run

6. Numerical rating system in CAMELS

The CAMELS system also covers the composite rating system wherein each factor is assigned a weight factor as below:

SN	Aspects	Weight
1	Capital	20%
2	Asset Quality	20%
3	Management	25%
4	Earnings	15%
5	Liquidity	10%
6	Sensitivity	10%

7. Purpose of CAMELS Rating System

The CAMELS rating system is highly effective in determining the risks levels of the banks. Its purposes are:

a)    Operational conditions: It evaluates the bank's liquidity position and manages risk to a level necessary to conduct operating activities.

b)   Management condition: It ensures management efficiency to handle risk, liquidity position, and managing sources of funds.

c)     Financial soundness: It determines the financial soundness and stability of the banks.

  

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