CAMELS Rating System - Explained
What is the CAMELS Rating System?
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Table of ContentsWhat is the CAMELS Rating System?How Does the CAMELS Rating System Work?CAMEL RatingsCapital Adequacy or Sustainability Asset Quality General Administration Earnings Liquidity Management
What is the CAMELS Rating System?
The CAMEL Rating System is an international rating system that bank regulators use in evaluating the overall financial performance of banks and financial institutions. The CAMEL rating system is a tool which is internationally recognized, regulators and examiners in the financial sector use the rating system for risk measurements. CAMEL stands for: C: Capital A: Assets M: Management E: Profits L: Liquidity. The CAMEL rating system is adopted in the United States, financial institutions are evaluated based on the five parameters listed above in addition to the Sensitivity of these financial institutions.
How Does the CAMELS Rating System Work?
More explicitly, the CAMELS rating system assesses how financial institutions manage their Capital, assets, management, earnings, liquidity as well as Sensitivity to contribute to overall performance. This rating system is used for commercial entities and financial institutions in the United States. Below is the vital information needed for a CAMELS evaluation:
- Financial statements
- Sources of capital or financing
- Budgets and cash flows
- Board of directors setup
- Information on operations and personnel
- Macro-economic information and portfolio amortization table.
There are five basic parameters for analysis when using the CAMEL rating system, they are: Capital, Assets, Management, Profits, and Liquidity. From these parameters, there are 21 indices identifies by CAMEL, each of the indices is assigned a rate of 1-5 depending on their performance. The CAMEL rating system embodies a lot of factors including interviews conducted with top personnel of commercial entities and financial institutions. Each of the parameters is outlined and explained below;
Capital Adequacy or Sustainability
This parameter seeks to analyze how solvent a financial institution or commercial entity is. Solvency of financial institutions refers to their ability to pay their debts or possession of assets that can aid in debt offset. The sustainability of capital helps to evaluate how well an institution can manage or sustain its capital after incurring many losses or debts. There are three major indexes that this parameter uses, they are;
- Capital leverage which reflects the relationship between the assets of a (microfinance institution) MFI, its equity and risks.
- The response of the institution to the need to increase its equity.
- The ability of the MFI to sustain its capital especially when confronted by liabilities, debts or losses. This index also measures the ability of the institution to absorb likely losses.
Another parameter that the CAMEL rating system analyses is the quality if asset that a company owns. This analysis has three components namely;
- Portfolio Quality- This assesses whether the portfolio of a company is at risk or not. Using the CAMEL rating criteria, the portfolio quality assessment considers the sanctions and cancellations policy of the company on loans beyond 30 days.
- Classification System - This examines the classification of portfolio, the makeup of portfolio amortization tables, and what policies are put in place by the company towards portfolio classification and portfolio risk management.
- Fixed Assets - This component of evaluating asset quality measures how the infrastructure of the company suffice for the needs of the company, its staff and clients.
The CAMEL rating system uses five indexes when evaluating how general administration contribute to the performance of a firm, they are;
- Administration - this examines the functions of the board of directors, how well they are able to make decisions pertaining to the growth of the company, their technical skills and management skills.
- Human Resources - This index checks whether the HR department hires competent personnel, train existing employees and provide all round support for maximum performance of employees.
- Processes, Controls and Auditing - This index checks the effectiveness of the key processes, controls and audit that the company adopts.
- Technology System - This evaluates the computer technology system of the company and how well it functions.
- Strategic Planning and Budgeting- This is the fifth index and it examines the processes adopted by the company for budgeting and strategic planning. This index checks whether the plans are appropriate and suitable for the needs of the company.
In evaluating the earnings of a company and how it contributes to its performance, three quantitative indices are applicable, these are;
- Adjusted Return on Equity (ROE)- this evaluates how the company realizes profits through operational processes, thereby increasing its net value.
- Adjusted Return on Assets (ROA) - this index checks how adequately the assets of the company generates profits.
- Interest Rate Policy -This examines the interest rates that the company has adopted and how well these policies favor the company in profit generation.
Another important thing that is considered is operational efficiency which entails the efficiency of the institution in attaining progress and realizing a favorable cost structure.
This parameter deals with how efficiently an institution increases its assets and minimizing sourcing for funds through external means. There are five indexes that the CAMEL rating system uses in measuring liquidity management, they are;
- Structure of liabilities- this index considers the liabilities of the institution, payment conditions, interest rates among others. Also, the types of credit available to the institution and various credit guarantees are examined.
- Banks capitalization - this addresses the availability of finance to meet the demand for credit in the institution.
- The capacity of the institution in terms of cash flow statement, this is the cash projection index.
- Productivity of Other Current Assets - this entails the analysis of both short and long-term assets that produce value for the institution.