CAMELS RATING MODEL ” A TOOL FOR PERFORMANCE EVALUATION OF BANKING INSTITUTIONS ” A CONCEPTUAL STUDY Parvathy C N Sooraj A M Swathy N PG Student PG Student PG Student SVTB College, SVTB College, SVTB College,Mannampatta, Palakkad, Mannampatta, Palakkad, Mannampatta, Palakkad, Kerala. Kerala. [email protected] [email protected] [email protected] 9400089773 9847341191 9995667927ABSTRACT OF THE DISSERTATIONThe banking sector, being a fundamental component of financial system is the backbone of the modern economic system. Banks are one of the oldest financial institutions in the financial system, which play a crucial role in the mobilization of deposits and disbursement of credit among the various sectors of the economy.
The function and significance of banking sector cannot be under-estimated in the development of an economy. The strength of economy of any country basically hinges on the strength and efficiency of financial system, which, in turn, depends upon a sound banking system. Reserve Bank of India recommended two supervisory rating models named as CAMELS (Capital Adequacy, Assets Quality, Management, Earning, Liquidity, Systems and Controls) for rating of Indian commercial, private and foreign banks operating in India.
The present study describes the various financial ratios used in the above mentioned models to measure the financial performance of banking sector. Key Words: Financial Institution, Bank, Banking System, CAMELS. INTRODUCTIONPeople earn money for a variety of reasons including food, clothing, education of children, housing etc. Beside these day to day expenses they also need money for meeting future requirements like marriage expenses, higher education of children, house building etc. These are those expenses which can be met if we set aside a part of our present income for this purpose.Saving of money is not only used for meeting these expenses but also it acts as a helping hand at our old age and also during ill health. Even in the olden days the importance of saving money was felt by people. They used to hoard money in their homes. By doing this, savings were used whenever they need it but at the same time there was danger of theft, robbery and other accidents. Thus people required a place where their money could be safely stored as well as they could get it at the required time. Banks are such places where people could store their money as well as withdraw the amounts required from their deposits at times of emergency.Apart from this, people could also get loans at reasonable interest for business purposes. Bank is referring to as a lawful organization, which accepts deposits and withdraw able on demand. It also lends money to the needy individuals and business organizations.Beside this, banks also performs variety of other functions like collection of bills, payment of foreign bills, safe keeping of jewels and other valuable items and so on. The term Bank has been derived from the Italian word banc which means a bench the Jews in Lombardy having benches in the market places for the exchange of money and bills. But some argues that the term has been derived from the German word back which means heap or joint stock bond. In the general sense, a bank is a financial institution which deals with money and credit banking involves holding the depositors money and disbursing. It also provides credit when the customers want additional funds. According to Banking Regulations Act 1949, banking means “accepting for the purpose of lending or investments of deposits of money from the public, repayable on demand or otherwise and withdraw able by cheque, draft and order or other.Banks are very old institutions which contribute towards the development of an economy and it’s treated as an important service industry in this modern world. Nowadays the function of bank is not limited to within the same geographical limit of any country. It is an important source of financing for the business organization (Nimalathasan, 2008). Also, bank is a financial institution that require fund to carry out business. Fund may come from deposit and non -deposits such as capital (Al Mamun, 2013). Bank need to find best way to manage resources and assess its activities and decisions of consumption of resources. Simply stated much of the current bank performance literature describes the objective of financial organizations as that of earning acceptable returns and minimizing the risks taken to earn this return (Hempel et al., 1996). Generally financial performance of banks and other financial institution measured by using combination of financial ratio analysis., benchmarking, measuring performance against budget or mix of these methodologies (Avkiran, 1995). In simple accounting terms, performance to banks refers to the capacity in generating sustainable profitability (Rozanni & A. Rahman, 2013). Banks need a way to evaluate performance and consider some important financial ratios and find the strengths and weaknesses. Traditional method of applying financial ratios to evaluate bank’s state of performance has been long practiced, with practitioners using CAMELS rating to measure their banks’ performance. CAMELS bank rating is used by bank’s management to evaluate financial health and performance (Rozanni & A. Rahman, 2013). Banking sector is considered as the backbone of the financial service sector. The growth of banking sector may be seen as the replica of economic activities of a nation because it acts as the indicator of social economic and industrial growth.The evolution of Indian banking industry has been shaped by good government policies and socio economic objectives. Today many changes are occurring in the banking and financial services of the country. Banking is considered as one of the most regulated industries globally and the rules governing bank capital are also one of the most important aspects of such regulation. The study is purely a conceptual study to get insight knowledge on the CAMELS model of rating system.HISTORYCAMEL rating was firstly introduced in US in 1970’s by three federal banking supervisors. For the purpose of rating commercial banks and foreign banks in India, Padmanabhan Working Group(1995) suggested the two supervisory rating models named CAMEL(Capital adequacy, Asset Quality, Management capability, Earning, Liquidity and CACS(capital adequacy, asset quality, compliance, systems and controls) respectively. Narasimham Committee (1998) has also made many recommendations and evaluation of operations and banks performance has been provided by the Reserve Bank’s measuring rod of CAMEL. Every banks financial condition have to be periodically assessed by the regulators, analysts and investors. Banks are rated on several parameters based on financial and non-financial performance. One such popularly used assessment is CAMEL-where each letter refers to a particular category of performance. These ratings are used for determining the supervision policies for individual banks by regulators both internationally and in India.CONTENT The CAMEL refers to the five components of banks conditions; they are capital adequacy, asset quality, management earnings and liquidity. The last component is sensitivity which was added in 1997. By this the term was changed to CAMELS. To find out the firms overall financial condition, ratings are assigned to each component. 1-5 scaling is used for assigning the rates. Banks with in the rating 1 or 2 are considered to require supervisory concern. When the banks are within the rating 3, 4 or 5 require moderate or extreme degree of supervisory concern.In 1994, RBI establishes board of financial supervision [BFS]. To control the changing needs of a strong and stable financial system, the entire supervisory mechanism was realigned. BFS has a supervisory jurisdiction; it was slowly extended to the entire financial system including the capital market institutions and the insurance sector. Its major aim is to strengthen the supervision of the financial system by the integration of the financial service firm. BFS also established a subcommittee for the purpose of routing exam auditing practices, quality and coverage. Banks CAMELS rating is directly known only by the senior management of the banks and the appropriate supervisory staffs. The CAMELS rating are never released by supervisory agencies. The information are confidential and the public may inter such type of supervisory information on bank conditions based on subsequent bank actions or for special disclosures, private information gathered during the time of evaluation is not disclosure by the supervisor to the public. The studies proven that it does filter into the financial market.CAMELS rating in the supervisory monitoring of banks Many studies had shown that, how and to which the private supervisory information extend is useful in the supervisory monitoring of banks. CAMELS rating are useful, even after the controlling for the wide range of publicity available information about the performance and conditions of the banks. Hire and Lopez (1999) is examine that the banks present conditions can assumed by the part CAMELS rating. They find that the current private and public supervisory and which provide further insight is to the banks current conditions.CAPITAL ADEQUACYExaminers assess institutions’ capital adequacy through capital trend analysis. To get a high capital adequacy rating, institutions must comply with interest and dividend rules and practices. Other factors involved in rating and assessing an institution’s capital adequacy are its growth plans, economic environment, ability to control risk, and loan and investment concentrations. In India banks have to maintain CRAR of 9″….It is computed by dividing Tier I and Tier II capital with risk weighted assets. Tier I includes shareholders equity, perpetual non-cumulative preference shares, disclosed reserves and innovative capital instruments. Tier Ii includes undisclosed reserves revaluation reserves of fixed assets and long term hidings of equity securities hybrid debt capital instruments and subordinated debt.Capital adequacy ratio is a measure of the amount of a bank’s core capital expressed as a percentage of its risk-weighted asset.Capital adequacy ratio = (Tier I Capital + Tier II Capital)/Risk Weighted Assets The following ratios measure capital adequacy:Capital risk adequacy ratio (CRAR): It is the ratio of capital fund to risk weighted assets. Higher the CRAR rate depicts high safety against bankruptcy.CRAR = Capital Fund /Total Risk Weighted Credit ExposureDebt equity ratio: it is the ratio which measures the degree of leverage of a bank. It shows the debt equity mix of the bank. Higher the ratio indicates less protection for the creditors and depositors. Debt Equity = Total Borrowings / Total Capital Total advances to total assets ratio: it measures the aggressiveness in lending which results in creating profitability. The ratio is derived by diving total advances to total assets.Government Securities to Total Investments: Government securities are a safe debt instrument which earns a low return and are risk free. More the government securities the lesser is the risk in the investment in banks. The ratio is derived by dividing government securities to total investments.ASSET QUALITYAsset quality covers an institutional loan’s quality, which reflects the earnings of the institution. Assessing asset quality involves rating investment risk factors that the company may face and comparing them with the company’s capital earnings. This shows the stability of the company when faced with particular risks. Examiners also check how companies are affected by the fair market value of investments when mirrored with the company’s book value of investments. Lastly, asset quality is reflected by the efficiency of an institution’s investment policies and practices. The main indicators for assessing the asset quality are the ratio of non-performing assets to total loans. High ratio of NPA suggests high number of credit defaults which affects in achieving profit and the net worth may also falls. The following are the ratios which assess the asset qualityNet NPA to Total Assets= Net NPA/Total AssetsNet NPA to Net Advances=Net NPA/Net AdvancesTotal Investment to Total Asset= Total Investment/Total AssetMANAGEMENTManagement assessment determines whether an institution is able to properly react to financial stress. This component rating is reflected by the management’s capability to point out, measure, look after and control risks of the institution’s daily activities. It covers management’s ability to ensure the safe operation of the institution as they comply with the necessary and applicable internal and external regulations. The soundness of the management should be measured for analysing the performance of the banking institutions. Following are the ratios which assess the efficiency of management.Total Advance To Total Deposit Ratio= Total Advances/Total DepositsBusiness Per Employees Ratio= Net Income/ No. of EmployeesProfit Earned Per Employee= PAT/ No. of EmployeesEARNINGSAn institution’s ability to create appropriate returns to be able to expand, retain competitiveness, and add capital is a key factor in rating its continued viability. Examiners determine this by assessing the company’s growth, stability, valuation allowances, net interest margin, net worth level and the quality of the company’s existing assets. The indicator to assess the earnings is return on assets (ROA). The following ratios tests the income earned. They are:Dividend Payout Ratio= Dividend / Net ProfitROA=Net Profit/Total AssetsLIQUIDITYTo evaluate and examine a company’s liquidity, examiners look at interest rate risk sensitivity, availability of assets that can easily be converted to cash, dependence on short-term volatile financial resources and ALM technical competence. Liquidity refers to the banks efficiency in meeting up the financial obligations which are due. It can be assessed by taking the proportion of liquid asset to total asset. Various ratios which ascertains the liquidity of the bank are as followsLiquid Assets to Total Assets= Liquid Assets/Total AssetsLiquid Assets to Total Deposits= Liquid Assets/ Total DepositsLiquid Asset to Demand Deposits= Liquid Assets/ Demand DepositsGovt Securities to Total Assets= Govt Securities/Total AssetsSENSITIVITYSensitivity refers to the risk element involved. It is the risk which can inversely affect the earnings. The ratio used to measure the sensitivity of market risk. It measures how much is bank exposed to interest rate risk. Sensitivity analysis is an extension of liquidity analysis. The S factor which forms in camels rating system depicts the ability of the bank to understand about the market risk and take the control measures to minimise the risk factor. Thus it becomes an aid to management in proper decision making.Sensitivity Ratio= Total Securities/Total Assets CONCLUSIONThe study intends to speak about the rating system of commercial banks and foreign banks in India. The investigators try to spread out the knowledge on CAMELS rating system. CAMELS model is important tool to evaluate the relative financial strength of a banking system and to suggest remedial measures to improve the deficiencies. CAMELS model is a ratio-based model to appraise the performance of banks. The above study is a humble effort to describe the various ratios which are helpful for the assessment of financial performanceof banking sector. The ratios described in the present study are used by various researchers for the evaluation of banks performance in their respective studies. Under this bank is required to enhance capital adequacy, strengthen asset quality, improve management, increase earnings, maintain liquidity, and reduce sensitivity to various financial risks. From the study we observed that the CAMELS framework is not a comprehensive framework; for example, it does not take into consideration other forms of risk (such as credit risk).REFERENCEThe Bank Credit Analysis Handbook: A Guide for Analysts, Bankers and Investors By Jonathan Golin, Philippe Delhaise Performance Evaluation of Commercial Banks Through Camel Approach “A Comparative study of selected Public, Private and Foreign banks working in India” – kaushal Bhatt 2012