CAMELS Rating System

Prepared For
Imtiaz Ahmed Head of Analyst Division Eastern Housing Limited
Prepared By M. Moniruzzaman Moni

CAMELS is an international bank-rating system with which bank supervisory authorities rate institutions according to six factors. The six areas examined are represented by the acronym "CAMELS." The six factors are:

Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market

Performance of the banking sector under CAMELS involves analysis and evaluation of these six crucial dimensions of banking operations. The CAMEL methodology was originally adopted by North American bank regulators to evaluate the financial and managerial soundness of U.S. commercial lending institutions.

Based on the conceptual framework of the original CAMEL, ACCION International developed its own instrument. Although the ACCION CAMEL reviews the same five areas as the original CAMEL, the indicators and ratings used by ACCION reflect the unique challenges and conditions facing the micro finance industry. To date, ACCION has used its CAMEL primarily as an internal assessment tool, which has contributed to setting performance standards both for the ACCION Network and for the micro finance industry as a whole. The MFI is required to gather the following information for a CAMEL examination

(1) Financial statements; (2) Budgets and cash flow projections; (3) Portfolio aging schedules; (4) Funding sources; (5) Information about the board of directors; (6) Operations/staffing; and (7) Macroeconomic information

Financial statements form the basis of the CAMEL's quantitative analysis. MFIs are required to present audited financial statements from the last three years and interim statements for the most recent 12-month period. The other required materials provide programmatic information and show the evolution of the institution. These documents demonstrate to CAMEL analysts the level and structure of loan operations and the quality of the MFI's infrastructure and staffing.

Once the financial statements have been compiled, adjustments need to be made. These adjustments serve two purposes: first, they place the MFI's current financial performance in the context of a financial intermediary; second, they enable comparisons among the different institutions in the industry. The CAMEL performs six adjustments, for the scope of micro finance activity, loan loss provision, loan write-offs, explicit and implicit subsidies, effects of inflation, and accrued interest income.

The ACCION CAMEL analyzes and rates 21 key indicators, with each indicator given an individual weighting. Eight quantitative indicators account for 47 percent of the rating, and 13 qualitative indicators make up the remaining 53 percent. The final CAMEL composite rating is a number on a scale of zero to five, with five as the measure of excellence. This numerical rating, in turn, corresponds to an alphabetical rating (AAA, AA, A; BBB, BB, B; C; D; and not rated). Based on the results of the adjusted financial statements and interviews with the MFI's management and staff, a rating of one to five is assigned to each of the CAMEL's 21 indicators and weighted accordingly

CAMEL Rating Framework

A. Capital Adequacy Leverage: the relationship between the risk-weighted assets of the MFI and its equity. Ability to raise equity: assessment of an MFI's ability to respond to a need to replenish or increase equity at any given time. Adequacy of reserves: measure of the MFI's loan loss reserve and the degree to which the institution can absorb potential loan losses.

B. Asset Quality Portfolio Quality: Portfolio at risk: measures the portfolio past due over 30 days. Write offs/write off policy: measures adjusted write-offs on CAMEL criteria. Portfolio classification system: review of portfolios aging schedules; assesses institution's policies associated with assessing portfolio risk. Fixed Assets: Productivity of long-term assets: evaluates MFI's policies for investing in fixed assets Infrastructure: -evaluation of whether it meets the needs of both staff and clients.

C. Management Governance: how well the institution's board of directors functions, including the diversity of its technical expertise, its independence from management, and its ability to make decisions flexibly and effectively. Human Resources: evaluates whether the department of human resources provides clear guidance and support to operations staff, including recruitment and training of new personnel, incentive systems for personnel, and performance evaluation system. Processes, controls and audit: the degree to which the MFI has formalized key processes and the effectiveness with which it controls risk throughout the organization, as measured by its control environment and the quality of its internal and external audit. Information Technology System: assesses whether computerized information systems are operating effectively and efficiently, and are generating reports for management purposes in a timely and accurate manner. Strategic planning and budgeting: whether the institution undertakes a comprehensive and participatory process for generating short- and long-term financial projections and whether the plan is updated as needed and used in the decision-making process.

D. Earnings Adjusted return on equity: measures the ability of the institution to maintain and increase its net worth through earnings from operations. Operational Efficiency: measures the efficiency of the institution and monitors its progress toward achieving a cost structure that is closer to the level achieved by formal financial institutions. Adjusted Return on Assets: measures how well the MFI's assets are utilized, or the institution's ability to generate earnings with a given asset base. Interest rate policy: assess the degree to which management analyzes and adjusts the institution's interest rates on micro finance loans (and deposits if applicable), based on the cost of funds, profitability targets, and macroeconomic environment

E. Liquidity Management Liability structure: review of the composition of the institution's liabilities, including their tenor, interest rate, payment terms, and sensitivity to changes in the macroeconomic environment. Availability of funds to meet credit demand: measures the degree to which the institution has delivered credit in a timely and agile manner. Cash flow projections: evaluate the degree to which the institution is successful in projecting its cash flow requirements. Productivity of other current assets: evaluates extent to which the MFI maximizes the use of its cash, bank accounts, and short-term investments by investing in a timely fashion and at the highest returns, commensurate with its liquidity needs.

F. Sensitivity to Market risk To assess the degree to which a bank might be exposed to adverse financial market conditions, the Bangladesh Bank added a new Characteristic named as Sensitivity to Market risk to what was previously referred to as the CAMELS rating. Performance rating includes individual ratings of capital adequacy, asset quality, and management efficiency, earning capacity, liquidity management and sensitivity to market risks. Each of these component areas is to be evaluated on numerical scale of 1 to 5. A 1 indicates the highest rating, the strongest performance, best risk management practices and least supervisory concerns. Similarly,2 represents satisfactory performance, 3 fair and 4 marginal performance. The remaining component of the scale i.e. 5 is the lowest rating
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indicating the weakest performance, worst risk management practice worst and highest degree of supervisory concern.

Every individual rating, assigned on the basis of performance of the banking companies, is given weight separately to obtain the composite rating. Weights for individual component ratings of CAMELS are assigned in the following manner:

Name of Component Capital Adequacy Asset Quality Management Soundness Earnings and Profitability Liquidity Sensitivity to Market risk

Weight 20 20 25 15 10 10

The banks being rated 3 or 4 are supervised and monitored with a different system named Early Warning System to help improve its performance. Similarly, the banks being rated 5 are termed as problem bank. Overall activities of the problem banks are closely monitored by the Bangladesh Bank with special guidance and care with a view to improving their position.

The numerical ratings assigned to the criteria are:

Rating Scale 1 2 3

Rating Range 1.0-1.4 1.6-2.4 2.6-3.4

Rating Analysis Strong

Rating Analysis interpretation

3.6-4.4

4.6-5.0

Sound in every respect, no supervisory responses required Satisfactory Fundamentally sound with modest correctable weakness, supervisory response limited. Fair (watch Combination of weaknesses if not redirected category) will become severe. Requires more than normal supervision Marginal (some Immoderate weakness unless properly risk of failure) addressed could impair future viability of the bank. Needs close supervision. Unsatisfactory High risk of failure in the near term. Under (high degree of constant supervision/cease and desist order. failure evident)

CAMEL Numerical Rating: Rating Description 1. STRONG: It is the highest rating and is indicative of performance that is significantly higher than average. 2. SATISFACTORY: It reflects performance that is average or above; it includes performance that adequately provides for the safe and sound operation of the banks. 3. FAIR: Represent performance that is flawed to some degree. It is neither satisfactory nor unsatisfactory but is characterized by performance of below average quality. 4. MARGINAL: Performance is significantly at below average; if not changed, such performance might evolve into weaknesses or conditions that could threaten the viability of the bank. 5. UNSATISFACTORY: Is the lowest rating and indicative of performance that is critically deficient and in need of immediate remedial attention. Such performance by itself, or in combination with other weakness, threatens the viability of the institution.

CAMELS Rating System of Bangladesh

In Bangladesh, since the early nineties, the same 5 components of CAMEL have been used for evaluating the five crucial dimensions of a banks operations that reflect in a comprehensive fashion an institutions financial condition, compliance with banking regulations and statutes and overall operating soundness. Recently, Bangladesh Bank has upgraded the CAMEL into CAMELS effective from June, 2006. After inserting S or sensitivity to market risk, it is presumed that this off-site supervision technique of central bank would make it a more effective tool in rating banks. The present system requires that a banks condition and performance be regularly appraised according to predetermined stress testing on asset and liability and foreign exchange exposures, procedures, rules and criteria and on the basis of the results obtained through risk-based audits under core risk management guidelines. A single CAMEL rating for each bank is the result of both off-site monitoring, which uses monthly financial statement information, and an on-site examination, from which bank supervisors gather further private information not reflected in the financial reports.

These examinations result in the development of "credit points" ranging from 0 to 100. As noted above, the six key performance dimensions - capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk - are to be evaluated on a scale of 1 to 5 in ascending order. Following is a description of the graduations of rating:

Rating 1 indicates strong performance: BEST rating. Rating 2 reflects satisfactory performance. Rating 3 represents performance that is flawed to some degree. Rating 4 refers to marginal performance and is significantly below average and Rating 5 is considered unsatisfactory: WORST rating.

Analysis on CAMELS in Bangladesh Perspective

Capital Adequacy In the standard CAMELS framework, capital adequacy focuses on the total risk weighted capital intended to protect the depositors from the potential shocks of losses that a bank might incur. It is assessed according to: the volume of risk assets, the volu me of marginal and inferior assets, bank growth experience, plans, and prospects; and the strength of management in relation to all the above factors. Thereby it helps absorbing major financial risks (like credit risk, foreign exchange risk, interest rate risk and risk involved in off-balance sheet operations). Basel Committee on Banking Supervision also stipulates the CAMELS components. As regards the capital adequacy, they grouped the factors like a) size of the bank, b) volume of inferior quality assets, c) banks growth experience, plans and prospects, d) quality of capital, e) retained earnings, f) access to capital markets, and g) non-ledger assets and sound values not shown on books (real property at nominal values, charge -offs with firm recovery values, tax adjustments). Banks in Bangladesh have to maintain a minimum capital adequacy ratio (CAR) of not less than 9.0 percent of their risk weighted assets (RWA, with at least 4.5 percent in core capital) or Taka 1 billion, whichever is higher. Asset Quality In the standard CAMELS framework, asset quality is assessed according to: the level,

distribution, and severity of classified assets, the level and composition of nonaccrual and reduced rate assets, the adequacy of valuation reserves; and the demonstrated ability to administer and collect problem credits (Sundarajan and Errico, 2002). As regards the asset quality, Basel Committee on Banking Supervision highlights the factors a) volume of transactions, b) special mention loansratios and trends, c) level, trend and comparison of nonaccrual and renegotiated loans, d) volume of concentrations, and e) volume and character of insider transactions (Sahajwala and Bergh, 2000). In Bangladesh, the asset composition of all banks shows a high proportion of loans and advances in 2004 (60.7 percent) in total -05 assets. A high proportion of loans and advances indicate vulnerability of assets to credit risk, especially since the portion of non-performing assets is significant. A large non-performing loan portfolio has been the major predicament of banks, particularly of the state-owned banks. The most important indicator used to identify problems with asset quality in loan

portfolio is the percentage of gross and net non-performing loans to total assets and total advances. Management Soundness Sound management is a key pre-requisite for the strength, profitability and growth of any financial institution. Since indicators of management quality are primarily specific to individual institution, these cannot be easily aggregated across the sector. In addition, it is difficult to draw any conclusion regarding management soundness on the basis of monetary indicators, as characteristics of good management are generally qualitative in nature. The capabilities of the Board of Directors and internal management personnel to identify, measure, monitor and control different risks associated in the activities and to ensure a safe, sound and efficient operation in compliance with all applicable laws, regulations and especially the core risk management guidelines introduced by the central bank might be a measuring rod of that. In the standard CAMELS framework, management is evaluated according to: technical competence, leadership, and administrative ability; compliance with banking regulations and statutes; ability to plan and respond to changing circumstances; adequacy of and compliance with internal policies; tendencies toward self-dealing; and demonstrated willingness to serve the legitimate needs of the community. As regard management factors, Basel Committee on Banking Supervision highlights the aspects like a) technical competence, leadership etc. of middle and senior management, b) compliance with banking laws and regulations, c) adequacy and compliance with internal policies, d) tendencies towards self-dealing, e) ability to plan and respond to changing circumstances, f) demonstrated willingness to serve the legitimate needs of the community, g) adequacy of directors, and h) existence and adequacy of qualified staff and programs. However, ratios such as total expenditure to total income, operating expenses to total expenses, earnings and operating expenses reemployed, and interest rate/markup spread are generally used to gauge management soundness. In particular, a high and increasing expenditure to income ratio indicates the operating inefficiency that could be due to weaknesses in management.

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Earnings and Profitability Strong earnings and profitability profile of a bank reflect good health and banks enhance their ability to support present and future operations. More specifically, this determines the capacity to absorb losses by building an adequate capital base, finance its expansion and pay adequate dividends to its shareholders. In the standard CAMELS framework, earnings are assessed according to: the ability to cover losses and provide for adequate capital; earnings trend; peer group comparisons; and quality and c omposition of net income. As regards the earnings and profitability factors, Basel Committee on Banking Supervision highlights the aspects like a) return on assets compared to peer group averages and the banks own trends, b) material components and income and expenses compared to peers and the banks own trends, c) adequacy of provisions for loan losses, d) Quality of earnings, and e) dividend payout ratio in relation to the adequacy of bank capital (Sahajwala and Bergh, 2000). Although there are various measures of earning and profitability, the best and widely used indicator is returns on assets (ROA), which is Supplemented by return on equity (ROE) and net interest margin (NIM). Liquidity In the standard CAMELS framework, liquidity is assessed according to: volatility of deposits; reliance on interest-sensitive funds; technical competence relative to structure of liabilities; availability of assets readily convertible into cash; and access to inte r-bank markets or other sources of cash, including lender-of-last-resort (LOLR) facilities at the central bank. As regards the liquidity factors, Basel Committee on Banking Supervision highlights the aspects like a) adequacy of liquidity sources compared to present and future needs, b) availability of assets readily convertible to cash without undue loss, c) access to money markets, d) level of diversification of funding sources: on- and off-balance sheet, e) degree of reliance on short-term volatile sources of funds, f) trend and stability of deposits, g) ability to securities and sell certain pools of assets, and h) management competence to identify, measure, monitor and control liquidity position. At present, commercial banks deposits are subject to a statutory liquidity requirement (SLR) of 18 percent inclusive of 5 percent cash reserve requirement (CRR). The CRR is to be kept with the Bangladesh Bank and the remainder as qualifying secured assets under the SLR, either in cash or in government securities. Till date, SLR for the banks operating under the Islamic Shariah is 10 percent and the specialized banks are exempted
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from maintaining the SLR. Liquidity indicators measured as percentage of demand and time liabilities (excluding inter-bank items) of the banks indicate whether the banks have excess or shortfall in maintenance of liquidity requirements. The basic indicators of sound liquidity position are: deposits are readily available to meet the banks liquidity needs; assets are easily convertible into cash; compliance with SLR; and easy access to money markets etc. Sensitivity to Market Risk The sensitivity to market risk is assessed by the degree to which changes in market prices, notably interest rates, exchange rates, commodity prices, and equity prices adversely affect a banks earnings and capital. The following factors may be taken into consideration to measure the sensitivity to market risk: The sensitivity of the banks earnings or the economic value of its capital base or net equity value due to adverse effect in the interest rates of the market. The amount of market risk arising from trading and for eign operations. As regards the sensitivity to market risk, Basel Committee on Banking Supervision highlights the aspects like a) sensitivity of the financial institutions net earnings or the economic value of its capital to changes in interest rates under various scenarios and stress environments, b) volume, composition and volatility of any foreign exchange or other trading positions taken by the financial institution, c) actual or potential volatility of earnings or capital because of any changes in market valuation of trading portfolios or financial instruments, and d) ability of management to identify, measure, monitor and control interest rate risk as well as price and foreign exchange risk where applicable and material to an institution.

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