CAMELS or CAMEL analysis is a supervisory system used by banking regulators across many countries to assess the financial risk or to evaluate the overall performance of the financial institutions. CAMEL analysis sometimes used by companies while studying ratings of banks.
Breaking down CAMELS analysis: CAMELS analysis is based on 6 factors represented by its acronym. Regulators scores financial institutions for each of the 6 factors.
CAMELS acronym stands for:
- Capital Adequacy
- Asset Quality
- Management Quality
- Sensitivity to the market
Let us understand each factor one by one:
Capital Adequacy: Probably easiest one to understand; capital adequacy tries to quantify the bank’s ability to absorb the losses and meet all the obligations of customers while continuing with regular business. If bank has sufficient capital to absorb the losses without any significant probability that bank might not be able to meet withdrawal requests. To get a high capital adequacy rating, institutions must also comply with interest and dividend rules and practices. Depending upon overall rating given bank can be categorized as: “Well Capitalized”, “Adequately Capitalized”, “Under Capitalized”, “Significantly under-capitalized” or “Critically under-capitalized”.
Asset Quality: Asset quality refers to the investment side of the balance sheet. Asset quality refers to the quality of the institutional loans; which helps to assess the probability to collect the money bank which is been lent out. Good asset quality or good credit rating of loan portfolio of any bank reflects the stability of cash flows; thus asset quality not only helps to measure the current financial conditions, but also helps to assess the likelihood of deterioration of asset quality in future.
Management Quality: Top management of any institution is responsible not only for successful functioning of the business but also responsible to lay out policies to effectively tackle any financial crisis. A capable top management or board of directors along with good internal control in placed is always rated high.
Earnings: Earnings give an idea about profitability or viability of doing business in long run. In this analysis; regulators asses not only the earning capacity of the business but also look into capacity of the business to fund new projects or the capacity to switch to new technology available in the market; so that company remains competitive.
Liquidity: Liquidity is defined as the ability of a company to meet its financial obligations as they come due; or liquidity ratios assess the bank’s ability to raise capital or to convert asset into cash without any significant impact of selling asset at lower prices. Liquidity ratios measure a company’s ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio and operating cash flow ratio.
Sensitivity to the Market: Sensitivity to the market risk very complex and still in evolving; Sensitivity to the market captures the impact of interest rate changes on the financial capacity of the banks. This analysis captures the abrupt and sudden changes in the market interest rate and how well equipped a bank is to tackle those changes. Credit concentration is one of the aspect; e.g. if any particular bank is very heavily invested a specific sector or better to say if bank has covered unsystematic risk and has a well-diversified loan portfolio.
Conclusion: We can say that CAMELS analysis is a very comprehensive risk assessment framework used by regulators across several countries.