CAMEL Analysis: Introduction
The CAMEL analysis framework was made as part of the “Uniform Financial Institutions Rating System” and it is developed by three federal banking supervisors of the U.S. in the 1970s. The Federal Reserve, Federal Deposit Insurance Corporation, and the Office of the Comptroller of the currency developed the CAMEL system to provide an effective and overall condition of banking and financial institutions. CAMEL stands for Capital Adequacy, Asset Quality, Management, Earnings, and Liquidity Position.
CAMEL analysis is an effective and efficient tool for the performance evaluation of the organization. For the banking industry, the CAMEL framework additionally assists to anticipate the future and relative risk associated with the business.
CAMEL Framework
CAPITAL ADEQUACY
Basel Committee on Banking Supervision has developed the Capital accord to align the capital adequacy requirements. Also, the committee has developed various frameworks for Capital Measurement and Capital Standards. Basel- I defined capital adequacy for G-10 countries, whereas, Basel II updated the Capital Adequacy requirement by increasing the sensitivity of capital to key bank risk and Basel III improves the banking sector’s ability to absorb shocks arising from financial and economic stress reducing the risk of spillover from the financial sector to the real economy. A sound capital base strengthens the confidence of depositors. Also, a sound capital position is able to pursue business opportunities more effectively and has more time and flexibility to deal with problems arising from unexpected losses thus achieving increased profitability.
Capital Adequacy (C) refers to the statutory minimum reserves of capital which banks and other financial institutions must have available. Capital Adequacy Ratio (CAR) and Core Capital Ratio (CCR) are two major ratios to measure and analyze Capital adequacy. Capital Adequacy Ratio (CAR) is the ratio of Total Capital Fund to Total Risk-Weighted Assets. It is the measure of the amount of a bank’s capital as a percentage of its risk-weighted credit exposure.
Capital Adequacy Ratio(CAR) = Total Capital Fund/ Total Risk Weighted Asset Core Capital Adequacy Ratio(CCAR) = Core Capital Fund/ Total Risk Weighted Asset
Total Capital Fund = Core Capital (Tier I Capital) +Supplementary Capital (Tier II Capital)
Total Risk-Weighted Assets = On Balance Sheet Risk-Weighted Items + Off-Balance Sheet Risk-Weighted Items
Some of the ratio measuring capital adequacy are:
- Capital Adequacy Ratio
- Core Capital Ratio
- Debt to Equity Ratio
ASSET QUALITY
Asset quality is an aspect of bank management that assists the evaluation of a firm’s assets. Assets can reflect and cause operational and financial problems if not managed properly. The world economy has reflected various incidents which had been caused by the poor asset quality in the portfolio. The weakening value of assets can be reflected in the net income of the banks.
Loans and Advances are the major assets for the company also they are the primary source of revenue for the banks hence the selection of asset portfolio impacts the revenue of the bank. Loans and advances, loan loss provisions, and non-performing loans are major variables in determining the asset quality of the bank.
Some of the ratios reflecting Asset Quality are:
- Non- Performing Loan Ratio
- Loan Loss Provision Coverage Ratio
- Loan Loss Provision Ratio
NPA Ratio = (Total Non−Performing Loans /Total Loans and Advances)∗100
Loan Loss Reserve Ratio = Loan Loss Provision / Total Loans and Advances Loan
Loan Loss Coverage Ratio = Loan Loss Provision / Total Non−Performing Loan
MANAGEMENT EFFICIENCY
High performing management is one of the most crucial components for financial institutions’ performance. Indicators of quality of management, however, are primarily applicable to individual institutions, and cannot be easily aggregated across the sector. Management of financial institutions is generally evaluated in terms of asset quality, earnings, risk sensitivity, etc. Management efficiency also means how management responds to changing environments, leadership, and administrative capability of the bank.
Management efficiency covers management’s ability to ensure the safe operation of the institution as they comply with the necessary and applicable internal and external regulations. Efficient management of banking institutions must have the following qualities;
- Qualitative human resource management
- Well defined structure and capability of the management team
- Favorable working environment
- Coordinated internal management system
Some of the ratios measuring management efficiency are:
- Business per Employee: Deposit and Advances / No. of Employees
- Profit per Employee: Net Profit / No. of Employees
- Total Loan to Total Deposit
EARNINGS
Earning is important for every business. Profit maximization and wealth maximization are the two aspects of earning in any organization. Earning is important as it is necessary for stockholders and investors as well as for the company to execute future plans.
Earning also shows the ability and capacity of banks to absorb losses by building up an adequate level of capital. A higher-earning or profitability profile reflects the higher performance of the bank. Higher earnings per share, higher return on asset, higher return on equity, dividend pay-out ratio, etc. shows better performance of the banks.
No business can survive without thriving for-profit or earning. Without sufficient financial resources, business failure is imminent. Some of the ratios that reflect the earnings are:
- Dividend Payout Ratio
- Return on Asset
- Return on Equity
- Earnings Per Share
- Interest Income to Total Income
LIQUIDITY
Liquidity can be described as the degree to which an asset can be quickly bought or sold in the market at a price reflecting its intrinsic value. Liquidity position refers to the difference between the sum of liquid assets and incoming cash flows on one side and outgoing cash flows resulting from commitments on the other side.
Liquidity position is very crucial to every organization. Higher liquidity shows the inefficiency of the bank to utilize its cash position into more productive and profitable decisions whereas lower liquidity position shows the inability of the bank to manage its future short-term obligation and operational needs. Liquidity risk measures an institutions ability to meet unanticipated funds that are claimed by the depositors. Liquidity ratios are expected to be both positively and negatively related to the likelihood of failure that are set in the model. The liquidity of an institution depends on:
- Cash on hand o Available lines of credit
- The institution’s short-term need for cash
- The liquidity of the institution’s assets
- The institution’s reputation in the marketplace—how willing will counterparty is to transact trades with or lend to the institution?
Some of the ratios suggested to measure liquidity under CAMEL Model are:
- Net-Liquidity Ratio
- Government Securities to Total Asset
- Approved Securities to Total Asset