Finance

CAMELS Rating System

CAMELS Rating System

The CAMELS rating system is a supervisory rating system that was developed in the US and is used by bank supervisory authorities to rate financial institutions on six factors. It is applied to all banks and credit unions in the United States. It is also used in other countries by banking supervisory regulators.

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The six rating factors:

The name CAMELS is an acronym that stands for Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity. These are the factors on which banks are rated.

1. Capital Adequacy: The capital adequacy of an institution is assed by examiners through capital trend analysis. They also assess the institution’s compliance with regulations on the minimum risk-based net worth requirement. For a high capital adequacy rating, an institution also has to comply with some interest and dividend rules. Regulars assess the institution’s capital position over a period of time and give their rating. There are also other factors like the institution’s growth plans, risk controlling ability, economic environment, liquidity of capital, and investment concentrations that are taken into consideration while rating the organization.

2.Asset Quality: Here, the bank’s asset quality is assessed. This involves rating investment risk factors faced by the bank and balancing it with capital earnings. It shows how stable the bank is while taking specific risks like credit risks. If the bank shows a trend of bigger assets losing value because of credit risk, the ratings will below. Regulators also compare the market value of investments with the bank’s book value to check how the banks are affected. An institution’s investment policies and practices also mirror its asset quality.

3.Management: This factor assesses the institution’s management team and their ability to deal with financial stress. Here, the rating is based on whether the management is capable to point out, measure and manage risks on a day-to-day basis. It also assesses the bank’s strategy and financial performance. The audit committee checks if the company’s policies are being followed. Compliance with necessary and applicable internal and external regulations is also checked.

4. Earnings: This factor helps evaluate a bank’s long-term viability by looking at the stability of earnings, net interest margin (NIM), return on assets(ROA), and future earning prospects under tedious economic scenarios. A key factor in the rating is the institution’s ability to produce earnings to be able to sustain its activities and expand. The core expenses which are the long-term and stable earnings of an institution play an important role in rating.

5. Liquidity: Liquidity is more important particularly for banks because a lack of liquid capital can drive the bank into a bank run. Examiners take into consideration interest-rate sensitivity, availability of liquid assets, dependence on short-term volatile financial resources, and application life cycle management (ALM) technical compliance while assessing a bank’s liquidity.

6. Sensitivity: The last factor is sensitivity which measures a bank’s sensitivity to market risks. It does so by checking the management of credit concentrations. Hence, examiners can see how lending to particular industries can affect the bank. These loans can be agricultural lending, energy sector lending, credit care=d lending as well as medical lending.

How does this rating system work?

Examiners rate banks according to the above-mentioned six factors. It is essentially assessing the strength of a bank through these six categories. The rating system ranges from one to five, where one is the best rating given and five being the worst rating. Ratings are given on each of the six categories. Banks that get an average score of less than two are said to be of high quality. Whereas, banks with scores higher than three are said to be less than satisfactory institutions.

Purpose of CAMELS Rating System:

The CAMELS rating system was developed in the US to judge the strength of an institution on six parameters. These ratings are not released in the public and are only generally used by top management to assess and regulate potential risks. The CAMELS can identify which financial institutions will survive and which will fall. Banks with low ratings have a high probability to fail and need to take immediate action to reverse the situation. On the other hand, banks that have a high rating will expand through investments, mergers, or more branches.

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Conclusion

The CAMELS rating system measures the overall condition of a financial institution. Examiners assess and rate the institutions across six parameters. Banks with higher ratings are more likely to expand and are in exceptional conditions whereas those with a lower rating are heading towards shutting down and need to work on their situations.

Author – Abha Shetty

About the author – Abha is a second-year BMS student and FRM level 1 candidate. She is very intrigued by the world of financial markets and hopes to master the art of investing and trading.

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