Question

discuss parts of CAMEL- how can bank examiners use numbers to interpret how a financial institution is doing?

Answer 1

Breaking down the Camel framework into its constituents:

Capital Adequacy

Organisations are given a rating between 1 and 5 both included depending on whether if they maintain a level of capital in accordance with their current and expected risk profiles and can absorb any present or anticipated loses. A 1 would mean the financial institution is adequately capitalized and a 5 would mean the financial institution is critically under capitalized.

Asset Quality

The asset quality and portfolio risks are taken into consideration while assigning a rating for asset quality. The lending and investment policies and procedures are also scrutinized. A rating of 1 is awarded when the asset quality is the best and portfolio risks are at a minimum and 5 in case the asset quality is the worst and portfolio risk maximum

Management

This aspect checks if the institution has the ability to correctly diagnose and respond to financial stress. It checks the level at which internal controls are in place, the robustness of the information systems, the effectiveness of the firm's audit program, how accurately does the firm keep its book of records and how well are the physical asset safeguarded. A rating of 1 is awarded when the firm is most compliant of what is above mentioned and a rating of 5 is awarded when the firm is least compliant

Earnings

Evaluates the revenues generated by the financial institution which is mostly driven by the return on investments. If there is sufficient cash flow to up-size or down-size capital as  economic conditions keep fluctuating. A rating of 1 is awarded when the firm has very robust earning cycles and 5 when the firm posts very poor earnings

Liquidity asset and liability management

Evaluates the asset and liability management framework in the financial institution, which would be the process of evaluating, monitoring and controlling the balance sheet risk. Balance sheet risk constitutes primarily the interest rate risk and liquidity risk. If a firm has a very minimal balance sheet risk it would be awarded a 1 rating otherwise if the exposure to balance sheet risk is high and no proper asset and liability management framework is in place a 5 rating would be awarded.

Sensitivity to market risk

Measures the sensitivity of the bank to changes in interest rates, foreign exchange rates, changes in price of commodities etc. A rating of 1 would mean less sensitive and rating of 5 would mean most sensitive.

A composite score is arrived at by using the above parameters. Given below are the weights assigned to different parameters depending on their importance.

1. Capital Adequacy 20%
2. Asset Quality 20%
3. Management 25%
4. Earnings 15%
5. Liquidity 10%
6. Sensitivity 10%

A composite rating of 1 would mean the financial health of the organisation is at its best and a rating of 5 would mean that the financial health of the organisation is at its worst.