CAMELS Rating System – Definition

Cite this article as:"CAMELS Rating System – Definition," in The Business Professor, updated September 20, 2019, last accessed August 10, 2020, https://thebusinessprofessor.com/lesson/camels-rating-system-definition/.

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CAMELS Rating System Definition

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.

A Little More on What is the CAMELS Rating System

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.

CAMEL Ratings

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 analyse 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.

Asset Quality – 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.

General Administration – 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.

Earnings – 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 indice 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 favour 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.

Liquidity Management – 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.
  • Bank’s 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.

References for CAMEL Rating System

http://www.businessdictionary.com/definition/CAMELS-Rating-System.html

https://www.investopedia.com/terms/c/camelrating.asp

https://en.wikipedia.org/wiki/CAMELS_rating_system

https://businessjargons.com/camels-rating.html

Academic Research on CAMELs Rating System

A comparative study of financial performance of banking sector in Bangladesh. An application of CAMELS rating system, Nimalathasan, B. (2008). Universitatii Bucuresti. Analele. Seria Stiinte Economice si Administrative, 2, 133. This article makes a comparative analysis of CAMEL (Capital, Assets, Management, Earning, Liquidity) rating system and its application in Bangladesh. It also investigates what is the financial performance of the banking sector in this country with respect to the CAMEL parameters.

CAMELS rating system in the context of Islamic banking: A proposed ‘S’for Shariah framework, Sarker, A. (2005). Journal of Islamic Economics and Finance, 1(1), 78-84. In Bangladesh, Islamic banking needs more attention and implementation of proper regulations. For the last 2 decades, the central bank has made no effort to follow Shariah supervision system in banking. Instead, they are based on the secular regulatory system. This paper examines the CAMEL standard setting, introduced by BASEL Committee, to supervise banks offsite according to Shariah. This research follows S after CAMEL to add Shariah Rating System, i.e. CAMELSS. The authors expect that this research will help the regulators to obtain a Shariah benchmark for the supervision of Islamic banks and enhance their strength and confidence towards new banking paradigm.

Dynamics of banking soundness based on CAMELS rating system, Bastan, M., Mazrae, M. B., & Ahmadvand, A. (2016). In The 34th International Conference of the System Dynamics Society. Delft, Netherlands.  In Iran, banking is a highly important sector related to macroeconomics aspects of the country. CAMEL Rating System is used to analyze the banking soundness. It contains 6 performance parameters. They have further many components and variables affecting the system, their impact and interaction, together, they form a complex monetary system. This paper applies the Qualitative System Dynamics method to address the issues related to the systemic analysis of the framework. Consequently, In Iranian banks, Asset Quality, Capital Adequacy and Quality Management are the most significant issues. Their proper development and management can overcome the issues.

Evaluating the productive efficiency and performance of US commercial banks, Barr, R. S., Killgo, K. A., Siems, T. F., & Zimmel, S. (2002). Managerial Finance, 28(8), 3-25. This study analyzes the performance and efficiency of financial institutions and evaluates the comparative productive efficiency of the United States commercial banks using data from 1984 to 1998 applying DEA (Data Envelopment Analysis) technique presented by Siems and Barr’s. The authors elaborate on the methodology, take the measures of input and output into consideration relate performance measure to efficiency. They explain the CAMELS rating system and conclude that for the banks having great efficiency scores, the credit goes to high CAMELS ratings. They suggest using CAMELS for designing monitoring tools and then, make policy.

An Empirical Study to Evaluate CAMELS Rating System on Indian Banks, Bhatt, S. (2013). Journal of Applied Management and Investments, 2(3), 156-167.  This paper is related to the examination of the most popular technique to gauge the quality of Indian Bank. In order to face the challenges of an advanced banking system and come out of the supreme crisis, it suggests following CAMELS Rating System. The author implements this method on eight Indian banks, i.e. IDBI, HDFC Bank, SBI, BOB, Union Bank, AXIS Bank, PNB (a mixture of private & public banks) and IndusInd Bank. This method evaluates banking measures, stability, Asset Quality Ratio, Liquidity Ratio, Management Quality Ratio, Capital Adequacy Ratio, Earning Ratio, and Sensitivity Ratio. The results show that the CAMELS Rating method is critical not to check the bank stability but also to make initial investment decisions.

Efficiency ratios and community bank performance, Hays, F. H., De Lurgio, S. A., & Gilbert, A. H. (2009). Journal of Finance and Accountancy, 1(1), 1-15. This paper considers the importance of efficiency ratios used in the CAMELS Rating System, i.e. Asset Quality Ratio, Liquidity Ratio, Management Quality Ratio, Capital Adequacy Ratio, Earning Ratio, and Sensitivity Ratio. It also evaluates the performance of the community bank with respect to these parameters and suggests to apply these techniques for bank stability and development.

CAMELS-based Determinants for the Credit Rating of Turkish Deposit Banks, Dincer, H., Yuksel, S., & Hacioglu, U. (2015). International Journal of Finance & Banking Studies, 4(4), 1. This research has been carried out to estimate the performance of Turkish Deposit Banks. Also, what is their credit rating and how to determine it using the CAMELS rating system, i.e. Capital, Assets, Management, Earning, Liquidity and Shariah System?

Camels and performance evaluation of banks in Malaysia: conventional versus Islamic, Rozzani, N., & Rahman, R. A. (2013). Journal of Islamic Finance and Business Research, 2(1), 36-45. This paper evaluates the performance of banks in Malaysia. It compares both the approaches in this regard, that are, conventional and Islamic banking. The findings are that the implementation of CAMELS technique (Capital, Assets, Management, Earning, Liquidity and Shariah System) is equally effective for the Malaysian banks.

A multicriteria decision support system for bank rating, Doumpos, M., & Zopounidis, C. (2010). Decision Support Systems, 50(1), 55-63.  Bank Rating actually means to analyse the performance, risk exposure and total viability of a bank. The importance of bank rating has become more crucial in the latest financial turmoil. It is typically performed using statistical procedures combining qualitative and financial information into a total performance index. This article proposes a case study on the application of a multimedia methodology to bank rating on the basis of the PROMETHEE II technique. It is applied to an integrated decision support system. It focuses on the parameters and criteria of the evaluation process.

 

Predicting bank CAMELS and S&P ratings: the case of the Czech Republic, Derviz, A., & Podpiera, J. (2008). Emerging Markets Finance and Trade, 44(1), 117-130.  This research investigates on how to determine the movements in the bank rating systems of CAMELS (Capital, Assets, Management, Earnings, Liquidity and sensitivity to market risk) and S & P (Standard and Poors) in the Czech Republic when the 3 largest banks were 1st privatized in 1998 to 2001. They got enough time to be operated under the supervision of new owners. To analyse these ratings, the authors use an ORLM (Ordered Response Logit Model). Findings are that there is considerable explanatory power for funding spread, total loans to total assets ratio, capital adequacy, leverage and the value at risk for total assets.

A CAMELS analysis of the Indian banking industry, Dash, M., & Das, A. (2009). Since 1991 in India, the banking sector is subject to a restructuring phase to make it efficient, sound and developed. The CAMELS rating system is a natural framework to analyse capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risks. This paper makes a comparison of the performance between public and private banks. They used audited financial statements of the past 5 years. As a result, the private banks showed better performance than the public ones based on the factors of CAMELS, especially, the sound management, profitability and earnings played the role of contributing factors.

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