Introduction: What does a Bank have to do with CAMELS? Plenty! It could be the deciding factor in a Bank being allowed to function, or even being shut up. The higher the Bank climbs up the CAMELS, more the chances of it being done in! This is one score a Bank would do well to keep low!
Actually, CAMELS is the acronym for the six factors that form the basis for an international Bank rating system. These six factors are: Capital Adequacy, Asset Quality, Management Quality, Earnings, Liquidity, and Sensitivity to Market Risk.
Under this rating system, Banks are rated in relation to the quality of these six factors. The strength of these six factors would determine the overall strength of the Bank. The quality and strength of these six factors underlines the inner strength of the Bank and how far it can take care of itself against the market forces. Further, it also enables the regulatory authorities to focus on the Banks that are not doing well and to pay special attention to them.
The regulatory authorities not only study the financial statements of the Bank, but also carry out on site inspection, and thereafter rate the Bank. The rating system is based on a scale of 1 to 5 with 1 being the highest score and 5 the lowest. Banks scoring 1 would be considered as among the top bracket in regard to their financial soundness, and those scoring 5 would be seen to be at the bottom of the ladder.
Purpose: The purpose of this rating system is to examine the financial and other soundness of the Bank, and alert the top management of the Bank to take timely measures to address any deficiencies and stop the Bank from sliding to the bottom of the heap.
The CAMELS rating is carried out with reference to the following factors:
1) Capital Adequacy: Every Bank is expected to have sufficient capital to address its needs in relation to the risk it undertakes in its operations. The ratio of the capital of a Bank in relation to its risk weighted assets must meet the minimum requirements.
The Basel II Accords promoted by the Bank for International Settlements, Basel, Switzerland, stipulates a minimum Capital Adequacy Ratio of 8%. This is the bare minimum required, and Banks are strongly recommended to have a comfortable Capital Adequacy Ratio that takes care of any untoward occurrences.
The need for sufficient capital cannot be overestimated. It is the base on which the Bank stands, and its strength can be gauged by the strength of its base. The edifice of the Bank draws its strength and succor from the foundation of capital.
In line with the need for a strong capital base of a Bank, the Bank for International Settlements has come out with an elaborate set of recommendations that are expected to put in place, a mechanism that is proactive and responsive to the needs of the Bank in countering the threat to its well-being from the elements of risk. For this purpose, weights are allotted to each type of risk the Bank faces in its day to day operations, and accordingly, the amount of capital required to face up to this risk is worked out.
2) Asset Quality: The term Asset Quality refers to the quality of the loan portfolio of the Bank. Lending being one of the primary activities of a commercial Bank, the welfare of the Bank is dictated to a large extent, by the quality of its loan portfolio. A sound loan portfolio means a steady income for the Bank, apart from adding to the solvency of the Bank and consequently its rating.
To ensure asset quality, the Bank has to follow a sound lending regimen that ensures compliance of all the related norms. Some of the parameters for judging the soundness of a loan account are the components of safety, security, liquidity, purpose, profitability, etc.
In the process of lending, Bank has to take all reasonable precautions to ensure the safety of its funds. The evaluation of credit proposals must focus on the technical feasibility and the financial viability of the project, or venture under consideration. The purpose of the loan must be in consonance with activities that relate to productive application of capital. The result of such application should be the generation of a stream of income necessary for repayment of the loan. The quality of loan assets, to a large extent determines the viability of a Bank as a running concern.
3) Management: By Management is meant the art and science of accomplishing the goals of the institution by deploying all the necessary resources appropriately. Management includes Planning, Organizing, Staffing, Directing, and Controlling functions.
Planning is concerned with drawing up the blueprint for the objectives and goals of the Bank, and lay the path to reach them. Planning is a all encompassing activity that touches upon all the activities of the Bank.
Organizing is the next step after planning, and is concerned with putting in place the necessary infrastructure, including human resources to achieve the Bank's corporate goals.
Staffing, as the term indicates, is concerned with filling up the various positions in the Bank with suitable people.
Directing means channeling the energies of the employees towards achieving the Bank's corporate goals, by motivating the employees with rewards, both monetary, as well as in terms of their career goals.
Controlling is a function of management that involves establishing a performance standard for the employees and taking suitable steps in regard to the principle of reward and punishment.
A Bank that scores high in this area, namely, management, is bound to come up with a strong performance, and also contribute to the solidity of the Banking industry, as a whole.
4) Earnings: The earnings of a Bank refer to the net profit made by it. Profit is the difference between income and expenditure. The major sources of income for the Bank are interest earned on the loans and other income derived from general banking activities like, remittances, bills, etc. Apart from these, related activities undertaken by the Bank like Bancassurance, etc, also contribute to the Bank kitty.
The expenditure of the Bank may relate, among other things, to salaries, wages, administrative overheads, rents, rates, taxes, etc. The net surplus that remains after taking care of all the expenses is the net profit.
A healthy Bank should be able to generate decent profits regularly and keep itself, as well as its investors, in good health.
5) Liquidity: Liquidity is simply the ease with which an asset of the Bank can be encashed in times of need, or its fair value. It is that quality of an asset that enables a Bank to respond to any financial situation requiring urgent infusion of money or money's worth. This quality of the asset ensures that a Bank faces the minimum stress in dealing with such situations.
Apart from a financial crisis or crisis like situations, liquidity is also required to meet regular financial obligations of the Bank, especially without dipping into its reserves. Liquidity marks the ability of the Bank to field expected as well as unexpected financial problems and issues.
6) Sensitivity to Market Risk: Market forces are a major reason for shifts in the fortunes of businesses. Favorable movements can boost the fortunes of a Bank, while unfavorable ones can send the Bank packing to the cleaners. Market forces generally relate to the changes in Interest Rates, Currency Rates, Commodity Rates, and Stock Prices. Further these changes are inter-related in a complex way, and disturbances in one area are usually accompanied with the same in other areas.
A sound Bank is expected to have sound risk management practices in place, to take care of both known and unknown risks. The asset-liability match of the Bank must be in consonance with risk management principles.
Conclusion: The current Banking Crisis, which is quite unprecedented, underlines the importance of regulatory issues and the affects of incompetence in this area.
CAMELS, as a rating system for judging the soundness of Banks is a quite useful tool, that can help in mitigating the conditions and risks that lead to Bank failures.
Article Source: http://EzineArticles.com/?expert=Muhammad_Haidar
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