During an on-site bank exam, supervisors gather private information, such as details on problem loans, with which to evaluate a bank's financial condition and to monitor its compliance with laws and regulatory policies. A key product of such an exam is a supervisory rating of the bank's overall condition, commonly referred to as a CAMELS rating. This rating system is used by the three federal banking supervisors (the Federal Reserve, the FDIC, and the OCC) and other financial supervisory agencies to provide a convenient summary of bank conditions at the time of an exam.
The acronym "CAMEL" refers to the five components of a bank's condition that are assessed: Capital adequacy, Asset quality, Management, Earnings, and Liquidity. A sixth component, a bank's Sensitivity to market risk , was added in 1997; hence the acronym was changed to CAMELS. (Note that the bulk of the academic literature is based on pre-1997 data and is thus based on CAMEL ratings.) Ratings are assigned for each
component in addition to the overall rating of a bank's financial condition. The ratings are assigned on a scale from 1 to 5. Banks with ratings of 1 or 2 are considered to present few, if any, supervisory concerns, while banks with ratings of 3, 4, or 5 present moderate to extreme degrees of supervisory concern.
In 1994, the RBI established the Board of Financial Supervision (BFS), which operates as a unit of the RBI. The entire supervisory mechanism was realigned to suit the changing needs of a strong and stable financial system. The supervisory jurisdiction of the BFS was slowly extended to the entire financial system barring the capital market institutions
and the insurance sector. Its mandate is to strengthen supervision of the financial system by integrating oversight of the activities of financial services firms. The BFS has also established a sub-committee to routinely examine auditing practices, quality, and coverage.
In addition to the normal on-site inspections, Reserve Bank of India also conducts off-site surveillance which particularly focuses on the risk profile of the supervised entity. The Off-site Monitoring and Surveillance System (OSMOS) was introduced in 1995 as an additional tool for supervision of commercial banks. It was introduced with the aim to supplement the on-site inspections. Under off-site system, 12 returns (called DSB returns) are called from the financial institutions, wich focus on supervisory concerns such as capital adequacy, asset quality, large credits and concentrations, connected lending, earnings and risk exposures (viz. currency, liquidity and interest rate risks).
In 1995, RBI had set up a working group under the chairmanship of Shri S. Padmanabhan to review the banking supervision system. The Committee certain recommendations and based on such suggetions a rating system for domestic and foreign banks based on the international CAMELS model combining financial management and systems and control elements was introduced for the inspection cycle commencing from July 1998. It
recommended that the banks should be rated on a five point scale (A to E) based on the lines of international CAMELS rating model.
All exam materials are highly confidential, including the CAMELS. A bank's CAMELS rating is directly known only by the bank's senior management and the appropriate supervisory staff. CAMELS ratings are never released by supervisory agencies, even on a lagged basis. While exam results are confidential, the public may infer such supervisory information on bank conditions based on subsequent bank actions or specific disclosures.
Overall, the private supervisory information gathered during a bank exam is not disclosed to the public by supervisors, although studies show that it does filter into the financial markets.
CAMELS ratings in the supervisory monitoring of banks
Several academic studies have examined whether and to what extent private supervisory information is useful in the supervisory monitoring of banks. With respect to predicting bank failure, Barker and Holdsworth (1993) find evidence that CAMEL ratings are useful, even after controlling for a wide range of publicly available information about the
condition and performance of banks. Cole and Gunther (1998) examine a similar question and find that although CAMEL ratings contain useful information, it decays quickly. For the period between 1988 and 1992, they find that a statistical model using publicly available financial data is a better indicator of bank failure than CAMEL ratings that are more than two quarters old.
Hirtle and Lopez (1999) examine the usefulness of past CAMEL ratings in assessing banks' current conditions. They find that, conditional on current public information, the private supervisory information contained in past CAMEL ratings provides further insight into bank current conditions, as summarized by current CAMEL ratings. The authors find that, over the period from 1989 to 1995, the private supervisory information gathered during the last on-site exam remains useful with respect to the current condition of a bank for up to 6 to 12 quarters (or 1.5 to 3 years). The overall conclusion drawn from academic studies is that private supervisory information, as summarized by CAMELS ratings, is clearly useful in the supervisory monitoring of bank conditions.
CAMELS ratings in the public monitoring of banks
Another approach to examining the value of private supervisory information is to examine its impact on the market prices of bank securities. Market prices are generally assumed to incorporate all available public information. Thus, if private supervisory information were found to affect market prices, it must also be of value to the public monitoring of banks.
Such private information could be especially useful to financial market participants, given the informational asymmetries in the commercial banking industry. Since banks fund projects not readily financed in public capital markets, outside monitors should find it difficult to completely assess banks' financial conditions. In fact, Morgan (1998) finds that rating agencies disagree more about banks than about other types of firms. As a result, supervisors with direct access to private bank information could generate
additional information useful to the financial markets, at least by certifying that a bank's financial condition is accurately reported.
The direct public beneficiaries of private supervisory information, such as that contained in CAMELS ratings, would be depositors and holders of banks' securities. Small
depositors are protected from possible bank default by FDIC insurance, which probably explains the finding by Gilbert and Vaughn (1998) that the public announcement of
supervisory enforcement actions, such as prohibitions on paying dividends, did not cause deposit runoffs or dramatic increases in the rates paid on deposits at the affected banks.
However, uninsured depositors could be expected to respond more strongly to such information. Jordan, et al., (1999) find that uninsured deposits at banks that are subjects of publicly-announced enforcement actions, such as cease-and-desist orders, decline during the quarter after the announcement.
The holders of commercial bank debt, especially subordinated debt, should have the most in common with supervisors, since both are more concerned with banks' default
probabilities (i.e., downside risk). As of year-end 1998, bank holding companies (BHCs) had roughly $120 billion in outstanding subordinated debt. DeYoung, et al., (1998) examine whether private supervisory information would be useful in pricing the subordinated debt of large BHCs. The authors use an econometric technique that estimates the private information component of the CAMEL ratings for the BHCs' lead banks and regresses it onto subordinated bond prices. They conclude that this aspect of CAMEL ratings adds significant explanatory power to the regression after controlling for publicly available financial information and that it appears to be incorporated into bond prices about six months after an exam. Furthermore, they find that supervisors are more likely to uncover unfavorable private information, which is consistent with managers' incentives to publicize positive information while de-emphasizing negative information.
These results indicate that supervisors can generate useful information about banks, even if those banks already are monitored by private investors and rating agencies.
The market for bank equity, which is about eight times larger than that for bank subordinated debt, was valued at more than $910 billion at year-end 1998. Thus, the academic literature on the extent to which private supervisory information affects stock prices is more extensive. For example, Jordan, et al., (1999) find that the stock market views the announcement of formal enforcement actions as informative. That is, such announcements are associated with large negative stock returns for the affected banks.
This result holds especially for banks that had not previously manifested serious problems.
Focusing specifically on CAMEL ratings, Berger and Davies (1998) use event study methodology to examine the behavior of BHC stock prices in the eight-week period following an exam of its lead bank. They conclude that CAMEL downgrades reveal
unfavorable private information about bank conditions to the stock market. This information may reach the public in several ways, such as through bank financial statements made after a downgrade. These results suggest that bank management may reveal favorable private information in advance, while supervisors in effect force the release of unfavorable information.
Berger, Davies, and Flannery (1998) extend this analysis by examining whether the information about BHC conditions gathered by supervisors is different from that used by the financial markets. They find that assessments by supervisors and rating agencies are complementary but different from those by the stock market. The authors attribute this difference to the fact that supervisors and rating agencies, as representatives of
debtholders, are more interested in default probabilities than the stock market, which focuses on future revenues and profitability. This rationale also could explain the authors' finding that supervisory assessments are much less accurate than market assessments of banks' future performances.
In summary, on-site bank exams seem to generate additional useful information beyond what is publicly available. However, according to Flannery (1998), the limited available evidence does not support the view that supervisory assessments of bank conditions are uniformly better and more timely than market assessments.
(A) Capital Adequacy
Capital base of financial institutions facilitates depositors in forming their risk perception about the institutions. Also, it is the key parameter for financial managers to maintain adequate levels of capitalization. Moreover, besides absorbing unanticipated shocks, it signals that the institution will continue to honor its obligations. The most widely used indicator of capital adequacy is capital to risk-weighted assets ratio (CRWA). According to Bank Supervision Regulation Committee (The Basle Committee) of Bank for
International Settlements, a minimum 8 percent CRWA is required.
Capital adequacy ultimately determines how well financial institutions can cope with shocks to their balance sheets. Thus, it is useful to track capital-adequacy ratios that take into account the most important financial risks—foreign exchange, credit, and interest rate risks—by assigning risk weightings to the institution’s assets.
A Capital Adquecy Ratio is a measure of a bank's capital. It is expressed as a percentage of a bank's risk weighted credit exposures.
Also known as ""Capital to Risk Weighted Assets Ratio (CRAR).
Capital adequacy is measured by the ratio of capital to risk-weighted assets (CRAR). A sound capital base strengthens confidence of depositors.
This ratio is used to protect depositors and promote the stability and efficiency of financial systems around the world.
(B) Asset Quality:
Asset quality determines the robustness of financial institutions against loss of value in the assets. The deteriorating value of assets, being prime source of banking problems, directly pour into other areas, as losses are eventually written-off against capital, which ultimately jeopardizes the earning capacity of the institution. With this backdrop, the asset quality is gauged in relation to the level and severity of non-performing assets, adequacy of
provisions, recoveries, distribution of assets etc. Popular indicators include
non-performing loans to advances, loan default to total advances, and recoveries to loan default ratios.
The solvency of financial institutions typically is at risk when their assets become impaired, so it is important to monitor indicators of the quality of their assets in terms of overexposure to specific risks, trends in nonperforming loans, and the health and
profitability of bank borrowers— especially the corporate sector. Share of bank assets in the aggregate financial sector assets: In most emerging markets, banking sector assets comprise well over 80 per cent of total financial sector assets, whereas these figures are much lower in the developed economies. Furthermore, deposits as a share of total bank liabilities have declined since 1990 in many developed countries, while in developing countries public deposits continue to be dominant in banks. In India, the share of banking assets in total financial sector assets is around 75 per cent, as of end-March 2008. There is, no doubt, merit in recognising the importance of diversification in the institutional and instrument-specific aspects of financial intermediation in the interests of wider choice, competition and stability. However, the dominant role of banks in financial intermediation in emerging economies and particularly in India will continue in the medium-term; and the banks will continue to be “special” for a long time. In this regard, it is useful to emphasise the dominance of banks in the developing countries in promoting
non-bank financial intermediaries and services including in development of debt-markets.
Even where role of banks is apparently diminishing in emerging markets, substantively, they continue to play a leading role in non-banking financing activities, including the development of financial markets.
One of the indicators for asset quality is the ratio of non-performing loans to total loans (GNPA). The gross non-performing loans to gross advances ratio is more indicative of the quality of credit decisions made by bankers. Higher GNPA is indicative of poor credit decision-making.
NPA: Non-Performing Assets
Advances are classified into performing and non-performing advances (NPAs) as per RBI guidelines. NPAs are further classified into sub-standard, doubtful and loss assets based on the criteria stipulated by RBI. An asset, including a leased asset, becomes non-performing when it ceases to generate income for the Bank.
An NPA is a loan or an advance where:
1. Interest and/or instalment of principal remains overdue for a period of more than 90 days in respect of a term loan;
2. The account remains "out-of-order'' in respect of an Overdraft or Cash Credit (OD/CC);
3. The bill remains overdue for a period of more than 90 days in case of bills purchased and discounted;
4. A loan granted for short duration crops will be treated as an NPA if the installments of principal or interest thereon remain overdue for two crop seasons; and
5. A loan granted for long duration crops will be treated as an NPA if the installments of principal or interest thereon remain overdue for one crop season.
The Bank classifies an account as an NPA only if the interest imposed during any quarter is not fully repaid within 90 days from the end of the relevant quarter.
This is a key to the stability of the banking sector. There should be no hesitation in stating that Indian banks have done a remarkable job in containment of non-performing loans (NPL) considering the overhang issues and overall difficult environment. For 2008, the net NPL ratio for the Indian scheduled commercial banks at 2.9 per cent is ample testimony to the impressive efforts being made by our banking system. In fact, recovery management is also linked to the banks’ interest margins. The cost and recovery
management supported by enabling legal framework hold the key to future health and competitiveness of the Indian banks. No doubt, improving recovery-management in India is an area requiring expeditious and effective actions in legal, institutional and judicial processes.
(C) Management Soundness
Management of financial institution is generally evaluated in terms of capital adequacy, asset quality, earnings and profitability, liquidity and risk sensitivity ratings. In addition, performance evaluation includes compliance with set norms, ability to plan and react to changing circumstances, technical competence, leadership and administrative ability. In effect, management rating is just an amalgam of performance in the above-mentioned areas.
Sound management is one of the most important factors behind financial institutions’
performance. Indicators of quality of management, however, are primarily applicable to individual institutions, and cannot be easily aggregated across the sector. Furthermore,
given the qualitative nature of management, it is difficult to judge its soundness just by looking at financial accounts of the banks.
Nevertheless, total expenditure to total income and operating expense to total expense helps in gauging the management quality of the banking institutions. Sound management is key to bank performance but is difficult to measure. It is primarily a qualitative factor applicable to individual institutions. Several indicators, however, can jointly serve—as, for instance, efficiency measures do—as an indicator of management soundness.
The ratio of non-interest expenditures to total assets (MGNT) can be one of the measures to assess the working of the management. . This variable, which includes a variety of expenses, such as payroll, workers compensation and training investment, reflects the management policy stance.
Efficiency Ratios demonstrate how efficiently the company uses its assets and how efficiently the company manages its operations.
Asset Turnover Ratio
= Revenue
Total Assets
Indicates the relationship between assets and revenue.
Things to remember
Companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover - it indicates pricing strategy.
This ratio is more useful for growth companies to check if in fact they are growing revenue in proportion to sales.
Asset Turnover Analysis:
This ratio is useful to determine the amount of sales that are generated from each
dollar of assets. As noted above, companies with low profit margins tend to have high asset turnover, those with high profit margins have low asset turnover.
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(D) Earnings & Profitability
Earnings and profitability, the prime source of increase in capital base, is examined with regards to interest rate policies and adequacy of provisioning. In addition, it also helps to support present and future operations of the institutions. The single best indicator used to gauge earning is the Return on Assets (ROA), which is net income after taxes to total asset ratio.
Strong earnings and profitability profile of banks reflects the ability to support present and future operations. More specifically, this determines the capacity to absorb losses, finance its expansion, pay dividends to its shareholders, and build up an adequate level of capital. Being front line of defense against erosion of capital base from losses, the need
for high earnings and profitability can hardly be overemphasized. Although different indicators are used to serve the purpose, the best and most widely used indicator is Return on Assets (ROA). However, for in-depth analysis, another indicator Net Interest Margins (NIM) is also used. Chronically unprofitable financial institutions risk insolvency.
Compared with most other indicators, trends in profitability can be more difficult to interpret—for instance, unusually high profitability can reflect excessive risk taking.
ROA-Return On Assets
An indicator of how profitable a company is relative to its total assets. ROA gives an
An indicator of how profitable a company is relative to its total assets. ROA gives an