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CAMELS Analysis - Breaking Down Finance
CAMELS Analysis - Breaking Down Finance
CAMELS Analysis
A CAMELS analysis, sometimes shortened to CAMEL analysis, is a monitoring
approach that is used by supervisors in many developed countries to determine
the robustness of the banking system. While central banks and other supervisory
bodies are the dominant users of the CAMEL approaches, other important
market players that also use the approach. In particular, rating agencies also say
they use the approach to determine credit ratings. The CAMELS approach is a
risk based supervision approach that has gained popularity since the financial
crisis.
On this page we discuss what is a CAMELs rating system for banks, how to
calculate a CAMELS rating, and discuss the building blocks of the CAMELs
approach.
Capital adequacy
Asset quality
Management quality
Earnings
Liquidity
Sensitivity to the market
Now, let’s discuss all six parts of the approach in more detail.
Capital adequacy
This is probably the easiest to quantify aspect. Here, we look at the capital level
of the bank, its composition, interest and dividend policies, etc. Depending on
the overall state of the capital, CAMELS distinguishes “well capitalized”,
“adequately capitalized”, “undercapitalized,” “significantly undercapitalized,” and
finally “critically undercapitalized.”
Asset Quality
Asset quality looks at the investment policies and the risks the assets are
exposed to. It is important not only to look at present conditions, but also to
quantify the likelihood of future deterioration of the asset quality.
Management Quality
This is a tough one to measure. At the same time, it is the most forward looking
indicator because it tells you whether the company will have the ability to
respond adequately to financial stress. A capable board of directors, good
internal controls, as well as a host of other management-related items are
assessed and scored.
Earnings
Earnings looks at the viability of the business. To do so, CAMELS looks at the
return on assets and whether this return is appropriate enough for the company
to fund projects, remain competitive, and raise capital if necessary. The score is
not only based on past performance, but is also forward looking. Thus the focus
in on the sustainability of earnings.
Liquidity
Another very important element is liquidity risk. Liquidity looks at two aspects.
This is because liquidity under CAMELs is defined quite broadly as asset and
liability management (ALM). First, the rating system looks interest rate risk. This
is the risk that adverse changes in interest rates may have a big impact on
earnings. The interest rate risk is analyzed by looking at the balance sheet
structure, interest-rate exposure, quality of risk management personnel, etc.
Second, liquidity management itself is is also analyzed in detail. Banks are judged
with regard to their balance sheet structure, contingency plans to meet liquidity
shocks, how they handle excess liquidity, and cash flow budgets and projections.
Summary
We discussed CAMEL ratio analysis. It is a very comprehensive method to assess
in a risk-based way individual banks. It is commonly used by banking supervisors
as well as rating agencies.