Institute of Integrated Learning and Management

BANK LENDING PROJECT CAMEL CREDI RATING SYSTEM

Submitted to: Dr. Anubha Gupta

Submitted By: Abhishek Kumar PGD-FS 11-13 FT-FS-11-381 SEC-D

CAMEL Credit Rating System The CAMEL ratings system is a method of evaluating the health of credit unions by the National Credit Union Administration(NCUA). The rating, adopted by the NCUA in 1987, is based upon five critical elements of a credit union's operations:

(C) Capital (A) Asset quality (M) Management (E) Earnings (L) asset Liability management

This rating system is designed to take into account and reflect all significant financial and operational factors examiners assess in their evaluation of a credit union's performance. Credit unions are rated using a combination of financial ratios and examiner judgment.

The CAMELS ratings or Camels rating is a United States supervisory rating of the bank's overall condition used to classify the nations fewer than 8,000 banks. This rating is based on financial statements of the bank and on-site examination by regulators like the Federal Reserve, the Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation. The scale is from 1 to 5 with 1 being strongest and 5 being weakest. These ratings are not released to the public but only to the top management of the banking company to prevent a bank run on a bank which has a bad CAMELS rating. It is a tool being used by the United States government in response to the global financial crisis of 2008 to help it decide which banks to provide special help for and which to not as part of its capitalization program authorized by the Emergency Economic Stabilization Act of 2008. Capital Requirment: capital requirement (also known as Regulatory capital or Capital adequacy) is the amount of capital a bank or other financial institution has to hold by its financial regulator. This is in the context of fractional reserve banking and is usually expressed as a capital adequacy ratio of liquid assets that must be held compared

to the amount of money that is lent out. These requirements are put into place to ensure that these institutions are not participating or holding investments that increase the risk of default and that they have enough capital to sustain operating losses while still honoring withdrawals. Regulatory capital In the Basel II accord bank capital has been divided into two "tiers", each with some subdivisions. Tier 1 capital Main article: Tier 1 capital Tier 1 capital, the more important of the two, consists largely of shareholders' equity and disclosed reserves. This is the amount paid up to originally purchase the stock (or shares) of the Bank (not the amount those shares are currently trading for on the stock exchange), retained profits subtracting accumulated losses, and other qualifiable Tier 1 capital securities (see below). In simple terms, if the original stockholders contributed $100 to buy their stock and the Bank has made $10 in retained earnings each year since, paid out no dividends, had no other forms of capital and made no losses, after 10 years the Bank's tier one capital would be $200. Shareholders equity and retained earnings are now commonly referred to as "Core" Tier 1 capital, whereas Tier 1 is core Tier 1 together with other qualifying Tier 1 capital securities. In India, the Tier 1 capital is defined as "'Tier I Capital' means "owned fund" as reduced by investment in shares of other non-banking financial companies and in shares, debentures, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group exceeding, in aggregate, ten per cent of the owned fund; and perpetual debt instruments issued by a Systemically important non-deposit taking non-banking financial company in each year to the extent it does not exceed 15% of the aggregate Tier I Capital of such company as on March 31 of the previous accounting year;" (as per Non-Banking Financial (Non - Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007) In the context of NBFCs in India, the Tier I capital is nothing but Net Owned Funds.

Owned funds stand for paid up equity capital, preference shares which are compulsorily convertible into equity, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of asset, excluding reserves created by revaluation of asset, as reduced by accumulated loss balance, book value of intangible assets and deferred revenue expenditure, if any. Tier 2 (supplementary) capital Main article: Tier 2 capital Tier 2 capital, or supplementary capital, comprises undisclosed reserves, revaluation reserves, general provisions, hybrid instruments and subordinated term debt. Undisclosed Reserves Undisclosed reserves are not common, but are accepted by some regulators where a Bank has made a profit but this has not appeared in normal retained profits or in general reserves. Most of the regulators do not allow this type of reserve because it does not reflect a true and fair picture of the results. Revaluation reserves A revaluation reserve is a reserve created when a company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its headquarters and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve. General provisions A general provision is created when a company is aware that a loss may have occurred but is not certain of the exact nature of that loss. Under pre-IFRS accounting standards, general provisions were commonly created to provide for losses that were expected in the future. As these did not represent incurred losses, regulators tended to allow them to be counted as capital.

Common capital ratios

Tier 1 capital ratio = Tier 1 capital / Risk-adjusted assets >=6% Total capital (Tier 1 and Tier 2) ratio = Total capital (Tier 1 + Tier 2) / Riskadjusted assets >=10% Leverage ratio = Tier 1 capital / Average total consolidated assets >=5% Common stockholders equity ratio = Common stockholders equity / Balance sheet assets

ASSET QUALITY:
An evaluation of an asset to measure the credit risk associated with it Asset quality is related to the left-hand side of the bank balance sheet. Bank managers are concerned with the quality of their loans since that provides earnings for the bank. Loan quality and asset quality are two terms with basically the same meaning. Government bonds and T-bills are considered as good quality loans whereas junk bonds, corporate credits to low credit score firms etc. are bad quality loans. A bad quality loan has a higher probability of becoming a non-performing loan with no return. The ratio of non-performing loans in Japan is expected to be as high as 25% of the overall bank assets. The prime motto behind measuring the assets quality is to ascertain the component of Non-Performing Assets (NPAs) as a percentage of the total assets. This indicates what types of advances the bank has made to generate interest income. Thus, assets quality indicates the type of the debtors the bank is having. Ratios of asset quality: Gross NPAs to Net Advance Net NPAs to Net Advance Percentage change in net NPAs Gross & Net NPA to Net advances: It is a measure of the quality of assets in a situation, where the management has not provided for loss on NPAs. The Gross NPAs are measured as a percentage of Net Advances. The lower the ratio, the better is the quality of advances. Net NPAs to Net Advances: It is a measure of the quality of assets in a situation where the management has not provided for loss on NPAs.

 Net NPAs are Gross NPAs - net of provisions on NPAs . In this ratio, Net NPAs are measured as a percentage of net advances Percentage Change in Net NPAs This measure gives the movement in Net NPAs in relation to Net NPAs in the previous year. The higher the reduction in Net NPAs levels, the better is for the bank. It is given by the formula: %Change in Net NPAs = (Net NPAs at the end of the year Net NPAs at the beginning of the year)/Net NPAs at the beginning of the year

MANAGEMENT EFFICIENCY:
The ratios in this segment involve subjective analysis and efficiency of management. The management of the bank takes crucial decisions depending on the risk perception. It sets vision and goals for the organization and sees that it achieves them. This parameter is used to evaluate management efficiency as to assign premium to better quality banks and discount poorly managed one Ratios: Total Advances to Total Assets Business per Employee Profit per employee Total Advances to Total Assets: The ratio measures the efficiency of management in converting the deposits available with the bank (excluding other funds like equity capital, etc.) into high earning advances. Total deposits include demand deposits, savings deposits, term deposits and deposits of other banks. Total advances also include the receivables Business per Employee: This tool measures the efficiency of all the employees of a bank in generating business for the bank. It is arrived at by dividing the total business by total number of employees. By business, it means the sum of total deposits and total advances in a particular year. Profit per Employee: This ratio measures the efficiency of employees at the branch level. It also gives valuable inputs to assess the real strength of a banks branch network.

 It is arrived at by dividing the Profit after Tax (PAT) earned by the bank by the total number of employees. The higher the ratio, higher is the efficiency of the management. Return on Net Worth: It is a measure of the profitability of a bank. Here, PAT is expressed as a percentage of Average Net Worth

EARNING:
Earnings are the net benefits of a corporation's operation.Earnings is also the amount on which corporate tax is due. For an analysis of specific aspects of corporate operations several more specific terms are used as EBIT -- earnings before interest and taxes, EBITDA - earnings before interest, taxes, depreciation, and amortization. Many alternative terms for earnings are in common use, such as income and profit. These terms in turn have a variety of definitions, depending on their context and the objectives of the authors. For instance, the IRS uses the term profit to describe earnings, whereas for the corporation the profit it reports is the amount left after taxes are taken out. Many economic discussions use principles derived from Karl Marx and Adam Smith However the rise of the importance of intellectual capital affects such analyses. Routine earnings Routine earnings or commodity-based earnings are those that can be achieved by application of assets that are those that can be achieved by any business that employs sufficient capital and manpower. These conditions are commonly assumed in economic analyses of profit (economics) Non-routine earnings: The use of intellectual property generates non-routine profits. Those are often an order-of-magnitude greater than routine earnings. Non-routine profits are essential to warrant the high investments needed for high-technology industries. Earning quality reflects quality of a banks profitability and its ability to earn Consistently. It basically determines the profitability of the bank. It also explains the sustainability and growth in earnings in the future. This parameter gains importance in the light of the argument that much of banks income is earned through non-core activities like investments, treasury operation, and corporate advisory service and so on. The following ratios try to assess the quality of income in terms of income generated by core activity-income from lending operation.

Ratios: Operating Profit to Average Working Funds Ratio: This ratio indicates how much a bank can earn from its operations net of the operating expenses for every rupee spent on working funds. This is arrived at by dividing the operating profit by average working funds. Average Working Funds (AWF) are the total resources (total assets or liabilities) employed by a bank. It is daily average of total assets / liabilities during a year. The better utilization of funds will result in higher operating profit. Thus, this ratio will indicate how a bank has employed its working funds in generating profit. Spread or Net Interest Margin (NIM) to Total Assets: NIM, being the difference between the interest income and the interest expended as a percentage of total assets. It is an important measure of a banks core income (income from lending operations). A higher spread indicates the better earnings given the total assets. Interest income includes dividend income and interest expended included interest paid on deposits, loan from the RBI, and other short-term and longterm loans Net Profit to Average Assets / Return on Average Capital Employed This ratio measures return on assets employed or the efficiency in utilization of assets. It is arrived at by dividing the net profit by average assets, which is the average of total assets in the current year and previous year. Thus, this ratio measures the return on assets employed. Higher ratio indicates better earning potential in the future.

Interest Income to Total Income:

 Interest income is a basic source of revenue for banks. The interest income to total income indicates the ability of the bank in generating income from its lending. This ratio measures the income from lending operations as a percentage of the total income generated by the bank in a year. Interest income includes income on advances, interest on deposits with the RBI, and dividend income.

Non- interest Income to Total Income: This measures the income from operations other than lending as a percentage of the total income. A fee-based income account for a major portion of a banks other incomes. The bank generates higher fee income through innovative products and adapting the technology for sustained service levels. Non-interest income is the income earned by the banks excluding income on advances and deposits with the RBI.

LIQUIDITY:
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value. Money, or cash, is the most liquid asset, and can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs. However, currencies, even major currencies, can suffer loss of market liquidity in large liquidation events. For instance, scenarios considering a major dump of US dollar bonds by China or Saudi Arabia or Japan, each of which holds trillions in such bonds, would certainly affect the market liquidity of the US dollar and US dollar denominated assets. There is no asset whatsoever that can be sold with no effect on the market. An act of exchange of a less liquid asset with a more liquid asset is called liquidation. Liquidity also refers both to a business's ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves. Liquidity is defined formally in many accounting regimes and has in recent years been more strictly defined. For instance, the US Federal Reserve intends to apply quantitative liquidity requirements based on Basel III liquidity rules as of fiscal 2012. Bank directors will also be required to know of, and approve, major liquidity risks personally. Other rules require diversifying counterparty risk and portfolio stress testing against extreme scenarios, which tend to identify unusual market liquidity conditions and avoid investments that are particularly vulnerable to sudden liquidity shifts. Ratios: Liquid Assets to Total assets Govt. Securities to total assets Liquid Assets to Total Deposits Liquid Assets to Demand Deposits Approved securities to total assets Liquid assets to total assets: Liquid Assets include cash in hand, balance with the RBI, balance with other banks (both in India and abroad), and money at call and short notice.

 This ratio is arrived by dividing liquid assets by total assets. The proportion of liquid assets to total assets indicates the overall liquidity position of the bank. Govt. securities to total assets Government securities are the most liquid and safe investment. This ratio measures the proportion of risk-free liquid assets invested in government securities as a percentage of the assets held by the bank and is arrived by dividing investment in government securities by the total assets. This ratio measures the risk involved in the assets held by a bank Liquid Assets to Demand Deposits: This ratio measures the ability of a bank to meet the demand from demand deposits in a particular year. It is arrived at by dividing the liquid assets by total demand deposits. The liquid assets include cash in hand, balance with the RBI, balance with other banks (both in India and abroad), and money at call and short notice. Liquid assets to total deposits: This ratio measures the liquidity available to the depositors of a bank. Liquid assets include cash in hand, balance with the RBI, balance with other banks (both in India and abroad), and money at call and short notice. Total deposits include demand deposits, savings deposits, term deposits and deposits of other financial institutions. Approved securities to total assets This is arrived at by dividing the total amount invested in approved securities by total assets. Approved securities are investments made in the state-associated bodies like electricity boards, housing boards, corporation bonds, share of regional rural banks.