CAMELS Analysis

A CAMELS analysis, sometimes shortened to CAMEL analysis, is a monitoring approach that is used by supervisors in many developed countries to determine the robustness of the banking system. While central banks and other supervisory bodies are the dominant users of the CAMEL approaches, other important market players that also use the approach. In particular, rating agencies also say they use the approach to determine credit ratings. The CAMELS approach is a risk based supervision approach that has gained popularity since the financial crisis.

On this page we discuss what is a CAMELs rating system for banks, how to calculate a CAMELS rating, and discuss the building blocks of the CAMELs approach.

CAMELs rating system definition

What is the CAMELS rating system for banks? Essentially, the CAMELS approach is a kind of ratio analysis for banks. Anyone with knowledge of ratio analysis for banks will quickly identify which ratios each of the elements of CAMELS looks at. CAMELS is an acronym and stands for:

  • Capital adequacy
  • Asset quality
  • Management quality
  • Earnings
  • Liquidity
  • Sensitivity to the market

Now, let’s discuss all six parts of the approach in more detail.

Capital adequacy

This is probably the easiest to quantify aspect. Here, we look at the capital level of the bank, its composition, interest and dividend policies, etc. Depending on the overall state of the capital, CAMELS distinguishes “well capitalized”, “adequately capitalized”, “undercapitalized,” “significantly undercapitalized,” and finally “critically undercapitalized.”

Asset Quality

Asset quality looks at the investment policies and the risks the assets are exposed to. It is important not only to look at present conditions, but also to quantify the likelihood of future deterioration of the asset quality.

Management Quality

This is a tough one to measure. At the same time, it is the most forward looking indicator because it tells you whether the company will have the ability to respond adequately to financial stress. A capable board of directors, good internal controls, as well as a host of other management-related items are assessed and scored.

Earnings

Earnings looks at the viability of the business. To do so, CAMELS looks at the return on assets and whether this return is appropriate enough for the company to fund projects, remain competitive, and raise capital if necessary. The score is not only based on past performance, but is also forward looking. Thus the focus in on the sustainability of earnings.

Liquidity

Another very important element is liquidity risk. Liquidity looks at two aspects. This is because liquidity under CAMELs is defined quite broadly as asset and liability management (ALM).  First, the rating system looks interest rate risk. This is the risk that adverse changes in interest rates may have a big impact on earnings. The interest rate risk is analyzed by looking at the balance sheet structure, interest-rate exposure, quality of risk management personnel, etc.

Second, liquidity management itself is is also analyzed in detail. Banks are judged with regard to their balance sheet structure, contingency plans to meet liquidity shocks, how they handle excess liquidity, and cash flow budgets and projections.

Sensitivity To the Market

Finally, there is sensitivity to market risk. The measurement of this aspect is quite complex and still evolving. Sensitivity to the market was mainly added to capture the impact of abrupt and unexpected shifts in interest rates. With time, this has been expanded further. Today, sensitivity to the market looks at exposure to market-based price changes (e.g. equities, commodities, FX) as well as credit concentrations in particular types of lending (e.g. energy sector lending, medical lending, credit card lending,…)

How to calculate CAMELS rating?

Now that we have discussed all the parts of the CAMELS rating system, how does one come up with a CAMELS bank rating? First, it is important to keep in mind that the lower the score, the better. In particular, a score of 2 or lower is good. A score of three or higher is a bad sign. For more details on camel rating formula, we encourage the reader to collect the official documents that outline CAMELS

Summary

We discussed CAMEL ratio analysis. It is a very comprehensive method to assess in a risk-based way individual banks. It is commonly used by banking supervisors as well as rating agencies.

FACEBOOK
TWITTER
GOOGLE
https://breakingdownfinance.com/finance-topics/risk-management/camels-analysis">