What is the CAMELS Rating System?
The CAMELS Rating System was developed in the United States as a supervisory rating system to assess a bank’s overall condition. CAMELS is an acronym that represents the six factors that are considered for the rating. Unlike other regulatory ratios or ratings, CAMELS rating is not released to the public. It is only used by top management to understand and regulate possible risks.
Quick Summary Points
- CAMELS rating system assesses the strength of a bank through six categories.
- CAMELS is an acronym for capital adequacy, assets, management capability, earnings, liquidity, sensitivity.
- The rating system is on a scale of one to five, with one being the highest and five being the lowest.
What does CAMELS stand for?
The components of CAMELS are:
- (C)apital adequacy
- (M)anagement capability
Capital adequacy asses an institution’s compliance with regulations on the minimum capital amount. Regulators establish the rating by assessing the financial institutions capital position currently and over the next several years. Future capital position is predicted based on the institution’s plans in the future, such as whether they are planning to give out dividends or acquire another company. The CAMELS examiner would also look at trend analysis, the composition of capital, and liquidity of the capital.
This category assesses the quality of a bank’s assets. Asset quality is important as the value of the assets can decrease rapidly if they are high risk. For example, loans which are a type of asset can become impaired if it is lent to a high-risk individual. Therefore, the bank would not be able to collect on the payment. The examiner would look at the investment policies and practices and credit risks such as interest rate and liquidity risk. Also, the quality and trends of major assets are considered too. If a financial institution has a trend of major assets losing value due to credit risk, they would have a lower rating.
Management capability measures the ability of an institution to identify and then react to financial stress. The category depends on the quality of the business strategy and financial performance area and internal controls. In the business strategy and financial performance area, the CAMELS examiner looks at the institution’s plans for the next few years. It includes the capital accumulation rate, growth rate, and identification of the major risks.
For internal controls, the exam tests the institution’s ability to track and identify potential risks. Areas within internal controls include information systems, audit programs, and record keeping. Information systems ensure the integrity of computer systems to protect customer’s personal information. Audit programs check if the company’s policies are being followed. Lastly, record keeping should follow accounting principles and include documentation for ease of audits.
Earnings look at an institutions ability of long term viability. A bank needs an appropriate return to be able to grow its operations and maintain its competitiveness. The examiner specifically looks at the stability of earnings, return on assets (ROA), net interest margin (NIM), and future earning prospects under harsh economic conditions. While assessing earnings, the core earnings are the most important. The core earnings are the long term and stable earning of an institution that is only affected by the expense of one-time items.
For banks, liquidity is especially important as the lack of liquid capital can lead to a bank run. This category of CAMELS examines the interest rate risk and liquidity risk. Interest rate affects the earnings from a bank’s capital markets business segment. If the exposure to the interest rate is large, then the institution’s investment and loan portfolio’s value will be volatile. Liquidity risk is defined as the risk of not being able to meet the present or future cash flow needs without affecting day-to-day operations.
Sensitivity is the last category and measures an institution’s sensitivity to market risks. The institution can be broken down into different groups, usually depending on the S&P sectors. For example, assessment can be on energy sector lending, medical lending, and agricultural lending. Sensitivity reflects the degree to which earnings are affected by interest rates, exchange rates, and commodity prices, all of which can be expressed by Beta.
How does the CAMELS rating work?
For each category, a score is given from one to five. One is the highest score and indicates strong performance and risk management practices within the institution. On the other hand, five is the lowest rating. It indicates a high probability of bank failure and the need for immediate action to ratify the situation. A higher rating will impede a bank’s ability to expand through investment, merger, or adding more branches. Also, the institution will be required to pay more in insurance premiums.
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