CAMELS Modeling and Scoring : Financial Institutional Risk Analysis

Risk Training Session#1- Apr/2010 Dept. of Local Investments Department of Quantitative Risk Analytics

 CAMELS stands for : C for Capital Adequacy A for Asset Quality M for Management Capacity E for Earnings Base L for Liquidity Availability S for Sensitivity towards Market Risks

 Banks Capital Adequacy : Total Bank Capital can be divided into two components : (Core Capital ) Tier 1 Capital (Supplementary Capital) Tier 2 Capital

 Tier 1 (Core Capital) Consists of : Allotted , called up , and fully paid , ordinary Share capital/ common stock net of share held, Perpetual and preferred shares , disclosed equity reserves in the form of general and other reserves created by appropriation of retained earnings and share premiums less certain deductions as per BASEL 2 Guidelines.

 Tier 2 Supplementary Capital consists of : Undisclosed reserves , reserves arising from the revaluation of tangible fixed assets and financial fixed assets , hybrid capital instruments.

 Total Eligible Bank Capital :

TIER 1

Total Capital

TIER 2

,
CAR CAPITAL ADEQUACY RATIO % : TIER 1 + TIER 2 /TOTAL RISK WEIGHTED ASSETS

As per Basel II Capital Accord , the minimum CAR of a commercial bank should be at least 8.00%
Similarly the Tier 1 Risk Adjusted Ratio should be at least 4.00% as per the New Capital Accord guidelines.

 What a credit analyst has to remember when assigning scores to key bank capital ratios ? Check Basel II guidelines and minimum threshold scores recommended by the accord Calculate capital growth rate of the bank Calculate and compare CAR % ratios with local regulatory requirements Banks with higher CAR % should be assigned higher score on a scale of 1-5 and vice versa.

 Banks Asset Quality : A credit analyst has to breakdown & scrutinize all asset side transactions/ratios/indicators such as: Goodwill, Investments, Total Sector wise Loan exposures, Non Performing Loans ,provisioning expenses, NPL coverage ratio, net interest income margins, receivables , fee incomes , non fee incomes, operating incomes, maturity of assets, weighted earnings for each portfolio, cost to operating ratios, contingent asset claims etc.

 What a credit analyst has to remember when assigning scores to key asset ratios/ indicators ? Certain asset ratios can be analyzed on standalone basis; whereas other require peer group comparative data for analysis and scoring Bad Loan Coverage Ratio should strictly not be less than 1.00 and ideally at least upto 1.5x. Overdue loans report should be matched by total provisions set aside to meet losses from defaults.

 Cost to operating ratio should in excess of 50% should be assigned a lower score and vice versa Portfolio of securities should be analyzed as per their accounting classification and proportion of total investments Operating income should be separately analyzed from total earnings after tax deductions Provisioning expenses should be analyzed in relation to total loans, assets and expenses , with higher ratios to be assigned lower risk scores and vice versa

 Management Capacity: Qualitative analysis of bank management capacity is as important as quantitative analysis of financials Well qualified staff at banks always add values to the latters brand equity, service quality and market reputation Group strength and sponsor reputation matters!

 What a credit analyst has to remember when assigning scores to Management indicators ? Analyze the External Management Ratings as assigned by external rating agencies like S&P and Moodys Group Support Ratings are a sign of Sponsor strength and group management quality; hence brand equity and management quality of the group to which the bank may belong, should also be assigned scores External and Internal Auditor reports should be analyzed to pick up traces of adverse opinion about the management team (if any)

 Banks Earnings Base : The overall underlying earnings trend of a bank are a key risk driver and determinant of default risk in itself Bank earnings are derived from asset side of the balance sheet in terms of revenues and from liability side of the balance sheet in terms of cost reductions and controls

 Return on Asset - ROA is a key earnings driver. A positive ROA should be assigned a positive score and the higher it is the higher the score that needs to be assigned ROE - is the Return on Equity and also the opportunity costs of providing funds to different arms of the bank .Higher ROE should be assigned a higher score ROSF Return on Shareholder Funds is the ratio of net income after tax to capital employed

 Operating income to Net Income attributed to shareholders is key to understanding contributions of revenues from direct business operations Fee Income to Net Income ratio should be analyzed separately Income from investments and that from financing should be analyzed separately

 What a credit analyst has to remember when assigning scores to Earnings ratios/ indicators? Weighted yield on funded facilities should not be below ROE Return on Equity ROE Return on Equity should be analyzed in light of WACC Weighted Average Cost of Capital. Banks with higher ROE should not always be assigned a higher score without properly studying the risk driven earnings structure of the bank

 Benchmark return driven ratios with industry figures All return ratios should be assigned scores PIT (Point in Time) and credit risk view should not ignore TTC (Through the Cycle) performances Return ratios and indicators should be assigned scores in light of other balance sheet ratio trends to check linearity and correlation with other risk drivers . It may be possible that a bank with a higher risk appetite and higher rate of asset booking transactions may end up with a higher return on equity but in the long run may experience downturn in performance over business cycles

 Banks Liquidity Position : Banks liquidity risk drivers are the most potent downside risk factor Majority of the failed banks in our times, had defaulted on fixed rate commitments due to liquidity mismanagement Recent global credit crisis has shown that liquidity risk was a major factor behind failure of big banks and Asset Management Companies

 CAR Capital Adequacy Ratio is a major indicator of liquidity availability Banks with higher CAR have higher liquidity resources and vice versa Cash Flow Statement in another important analytical tool . A negative cash flow from either operating , financing and investing activities could result in overall liquidity crunch and expensive borrowing from markets

 Liquid assets proportion to total assets determines availability of readily available funding Liquid assets proportion to liquid liabilities ascertains short term funding position Overall Asset Liability Liquidity and Maturity Gaps over various time intervals are key risk drivers. Huge On the Book mismatches can bring about serious cash flow problems

 What a credit analyst has to remember when assigning scores to Liquidity ratios/ indicators? On Balance sheet and Off- Balance Sheet exposures should be analyzed separately Higher availability of liquid assets in relation to total assets should be assigned a higher score Operating income to total liabilities ratio should be analyzed , with a higher multiple getting a higher score and vice versa

 ADR- Advance to Deposit Ratio or Net Lending to Deposit Ratio should be analyzed and a higher ratio should be assigned a lower score and vice versa Maturity Gaps/ mismatches should be analyzed in context of cumulative liquidity gaps for each bucket . Higher gaps should get lower scores and vice versa

 Banks Sensitivity to Market Risks: Credit and market risks factors are integrated Banks have witnessed an increase in loan defaults due to interest rate hikes Overall increase in market risks may reduce CAR Capital Adequacy Ratio and default probability Price Duration Gaps should be actively managed

 What a credit analyst has to remember when assigning scores to Market Risk Indicators? Duration of Assets should be subtracted from Duration of Liabilities to do overall gap analysis If Weighted Duration of Assets exceeds Weighted Duration of Liabilities , than the bank has a Duration surplus and vice versa Hence banks reduce the duration of their assets when interest rates rise to reduce adverse economic impact on market value of equity and vice versa

 A fall in Market Value of Equity will reduce CAR and a rise will do the opposite A higher score should be assigned to duration surpluses (WDA>WDL) in a falling interest rate environment A lower score should be assigned to duration deficits (WDA<WDL) in rising interest rate environment

 Country PEST (Political , Economic, Social and Technological) Risks : Sovereign Risk Analysis should be carried out if counterparty (bank) is based overseas Country Risk can be quantified using External Ratings However internal risk scoring should be done to develop proactive risk monitoring systems

 Macroeconomic indicators should be compared at least over the last five years Social issues should be analyzed with its impact on banking industry Political situation should be analyzed by studying the economic policy stance of governments towards the financial sector

 What a credit analyst has to remember when assigning scores to Country Risk Ratios/ Indicators? All sources of foreign exchange inflows and outflows should be studied All factors that contribute to FX price changes and impact translation losses should also be studied Historical Macroeconomic trends should be regressed External Country ratings should be analyzed in context of both local and foreign currency

 Merchandise Trade Ratio and Import to Foreign Exchange Coverage Ratios should be positive and always on the higher side External Debt to GDP ratio should be on the lower side. The lower the ratio the higher the score to be assigned and vice versa Current Account to GDP overall Balance of Payments to GDP ratio should be analyzed with breakup details . Higher the surplus the higher should be the assigned score and vice versa

 Conclusion : Going forward at TIIB , we shall incorporate CAMELS modeling at all levels , where FI Risk is analyzed either in context of funded and non funded correspondent banking transactions or Treasury transactions