Camel Analysis Framework-Bank

Components - Framework
Components Details
• Capital Adequacy: The capital adequacy measures the bank’s capacity to
handle the losses and meet all its obligations towards the customers
without ceasing its operations.This can be met only on the basis of an
amount and the quality of capital, a bank can access. A ratio of Capital to
Risk Weighted Assets determines the bank’s capital adequacy.
• Asset Quality: An asset represents all the assets of the bank, Viz. Current
and fixed, loans, investments, real estates and all the off-balance sheet
transactions. Through this indicator, the performance of an asset can be
evaluated. The ratio of Gross Non-Performing Loans to Gross Advances is
one of the criteria to evaluate the effectiveness of credit decisions made
by the bankers.
• Management Quality: The board of directors and top-level managers are
the key persons who are responsible for the successful functioning of the
banking operations. Through this parameter, the effectiveness of the
management is checked out such as, how well they respond to the
changing market conditions, how well the duties and responsibilities are
delegated, how well the compensation policies and job descriptions are
designed, etc.
• Earnings: Income from all the operations, non-traditional and
extraordinary sources constitute the earnings of a bank.
Through this parameter, the bank’s efficiency is checked with
respect to its capital adequacy to cover all the potential losses
and the ability to pay off the dividends.Return on Assets
Ratio measures the earnings of the banks.
• Liquidity: The bank’s ability to convert assets into cash is
called as liquidity. The ratio of Cash maintained by Banks and
Balance with the Central Bank to Total Assets determines the
liquidity of the bank.
• Sensitivity to Market Risk: Through this parameter, the bank’s
sensitivity towards the changing market conditions is checked,
i.e. how adverse changes in the interest rates, foreign
exchange rates, commodity prices, fixed assets will affect the
bank and its operations
• 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.

• 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.
 Camel Implementation in Pakistan
• Reforms After 1997 to enhance and strengthen banks capital
base through Camel
• On site and off site surveillance by SBP for regular check and
balance
• Unfortunate freeze of FCA set into motion a process of
weakening financial system
• Continued Stagnation in economy affected the demand for
credit provided by banks.
• Default loans and recovery after the expansion of consumer
banking brought major changes.
 Capital Adequacy Ratio
• Introduced Risk based system in Nov 1997 and asked banks to maintain 8
percent Capital to Risk Weighted Assets. Minimum paid up capital was 500
Million which was changed to Rs 1 Billion in 2003
 Asset Quality
• Asset quality is generally measured in relation to the level and severity of non-
performing assets, recoveries, the adequacy of provisions, distribution of assets,
etc. Although, the banking system is infected with a large volume of Non-
Performing Loans (NPLs), its severity has stabilized to some extent. This is not to
say that the problem of NPLs has taken a secondary position. Unfortunately, it still
remains the most dominant factor affecting the earning capacity of banks.
However, marginal improvements in various ratios indicate that this problem is
manageable, and continues to be addressed with more vigor, using stringent
requirements for provisioning and disclosure.
Management Efficiency

The management efficiency signifies the ability of banks top management

to take right decisions. It enables the evaluation of better management
quality and discounting poorly managed ones and helps a bank to achieve
sustainable growth. It sets vision and goals for the business and checks out
that it achieves them. The ratios in this element encompass subjective
analysis to determine the efficiency and effectiveness of management. The
ratios used to evaluate management efficiency are:-
Earning Quality

• The sustainability in income and growth of future earnings indicates the

quality of earnings. Interest rate policies and sufficiency of provisioning
help to evaluate the earnings and profitability. The ratios that are used to
evaluate earning quality are:-
Liquidity

• Liquidity is the capability of banks to meet its financial obligations. Too low
liquidity hampers the capacity of banks to meet its current financial liabilities. On
other hand, too high liquidity indicates that banks are not making the proper use
of their cash and hence blocking the way of profitability. Thus a proper equilibrium
is necessary in liquidity to balance high profit as well as liquidity. The ratios
suggested to measure liquidity under CAMEL Model are:-
 6-15

Value of the Bank’s Stock

 6-16

Value of a Bank’s Stock Rises When:

• Expected Dividends Increase

• Risk of the Bank Falls
• Market Interest Rates Decrease
• Combination of Expected Dividend Increase
and Risk Decline
 6-17

Value of Bank’s Stock if Earnings Growth is

Constant

D1
P0 
r-g
 6-18

Key Profitability Ratios in Banking

Net Income
Return on Equity Capital (ROE) =
Total Equity Capital
Net Income
Return on Assets (ROA) =
Total Assets
(Interestincome
- Interestexpense) Net InterestIncome
Net InterestMargin  
T otalAssets T otalAssets

Noninterest revenue
- PLLL
- Noninterest expenses Net Noninterest Income
Net Noninterest Margin  
T otalAssets T otalAssets
 6-19

Key Profitability Ratios in Banking (cont.)

Total Operating Revenues -

Total Operating Expenses
Net Bank Operating Margin 
Total Assets

Net IncomeAfterT axes

EarningsPer Share (EP S) 
CommonEquity Shares Outstanding

Total Interest Income __ Total Interest Expense

Earnings Spread = Total Earning Assets Total Interest Bearing Liability
 6-20

Breaking Down ROE

ROE = Net Income/ Total Equity Capital

ROA = Equity Multiplier =

Net Income/Total Assets x Total Assets/Equity Capital

Net Profit Margin = x Asset Utilization =

Net Income/Total Operating Revenue Total Operating Revenue/Total Assets
 6-21

ROE Depends On:

• Equity Multiplier=Total assets/Total equity capital
▫ Leverage or Financing Policies: the choice of sources of
funds (debt or equity)

• Net Profit Margin=Net income/Total operating revenue

▫ Effectiveness of Expense Management (cost control)

• Asset Utilization=Total operating revenue/Total assets

▫ Portfolio Management Policies (the mix and yield on assets)
 6-22

Determinants of
ROE in a Financial
Firm
 6-23

Components of ROE for All Insured U.S. Banks

(1992-2007)
 6-24

A Variation on ROE
Net Income Pre-Tax Net Operating Income
ROE =  
Pre-Tax Net Operating Income Total Operating Revenue
Total Operating Revenue Total Assets

Total Assets Total Equity Capital
ROE = Tax Management Efficiency 
Expense Control Efficiency 
Asset Management Efficiency 
Funds Management Efficiency
 6-25

Breakdown of ROA
• mong the key financial ratios, investors and market analysts
specifically use to evaluate companies in the retail banking industry
are net interest margin, the loan-to-assets ratio, and the return-on-
assets (ROA) ratio. The analysis of banks and banking stocks has
always been particularly challenging because of the fact banks
operate and generate profit in such a fundamentally different way
than most other businesses. While other industries create or
manufacture products for sale, the primary product a bank sells is
money.
• The financial statements of banks are typically much more
complicated than those of companies engaged in virtually any other
type of business. While investors considering bank stocks look at
such traditional equity evaluation measures as price-to-book (P/B)
ratio or price-to-earnings (P/E) ratio, they also examine industry-
specific metrics to more accurately evaluate the investment
potential of individual banks.
• KEY TAKEAWAYS
• The analysis of banks and banking stocks is particularly challenging
because they operate and generate profit in a different way than
most other businesses.
• Net interest margin is an important indicator in evaluating banks
because it reveals a bank’s net profit on interest-earning assets,
such as loans or investment securities.
• Banks with a higher loan-to-assets ratio derive more of their
income from loans and investments.
• Banks with lower levels of loan-to-asset ratios derive a relatively
larger portion of their total incomes from more-diversified, non-
interest-earning sources, such as asset management or trading.
• The return-on-assets ratio is an important profitability ratio,
indicating the per-dollar profit a company earns on its assets