CAMELS Modeling and Scoring :Financial Institutional Risk Analysis

Risk Training Session#1- Apr/2010 Dept. of Local Investments

Department of Quantitative Risk Analytics

• CAMELS stands for :C for Capital Adequacy A for Asset Quality M for Management Capacity E for Earnings Base L for Liquidity AvailabilityS for Sensitivity towards Market Risks

• Bank’s Capital Adequacy :

• Total Bank Capital can be divided into two components :

• (Core Capital ) – Tier 1 Capital

• (Supplementary Capital) – Tier 2 Capital

• Tier 1 (Core Capital) Consists of :

Allotted , called up , and fully paid , ordinary Share capital/ common stock net of share held,

Perpetual and preferred shares , disclosed equity reserves in the form of general and other reserves created by appropriation of retained earnings and share premiums less certain deductions as per BASEL 2 Guidelines.

• Tier 2 Supplementary Capital consists of :

Undisclosed reserves , reserves arising from the revaluation of tangible fixed assets and financial fixed assets , hybrid capital instruments.

• Total Eligible Bank Capital :

Total Capital

TIER 1

TIER 2

,

• CAR – CAPITAL ADEQUACY RATIO % :

TIER 1 + TIER 2 /TOTAL RISK WEIGHTED ASSETS

As per Basel II Capital Accord , the minimum CAR of a commercial bank should be at least 8.00%

Similarly the Tier 1 Risk Adjusted Ratio should be at least 4.00% as per the New Capital Accord guidelines.

• What a credit analyst has to remember when assigning scores to key bank capital ratios ?Check Basel II guidelines and minimum threshold

scores recommended by the accordCalculate capital growth rate of the bankCalculate and compare CAR % ratios with local

regulatory requirements Banks with higher CAR % should be assigned higher

score on a scale of 1-5 and vice versa.

• Bank’s Asset Quality :

A credit analyst has to breakdown & scrutinize all asset side transactions/ratios/indicators such as: Goodwill, Investments, Total Sector wise Loan exposures, Non Performing Loans ,provisioning expenses, NPL coverage ratio, net interest income margins, receivables , fee incomes , non –fee incomes, operating incomes, maturity of assets, weighted earnings for each portfolio, cost to operating ratios, contingent asset claims etc.

• What a credit analyst has to remember when assigning scores to key asset ratios/ indicators ?

Certain asset ratios can be analyzed on standalone basis; whereas other require peer group comparative data for analysis and scoring

Bad Loan Coverage Ratio should strictly not be less than 1.00 and ideally at least upto 1.5x.

Overdue loans report should be matched by total provisions set aside to meet losses from defaults.

Cost to operating ratio should in excess of 50% should be assigned a lower score and vice versa

Portfolio of securities should be analyzed as per their accounting classification and proportion of total investments

Operating income should be separately analyzed from total earnings after tax deductions

Provisioning expenses should be analyzed in relation to total loans, assets and expenses , with higher ratios to be assigned lower risk scores and vice versa

• Management Capacity:Qualitative analysis of bank management

capacity is as important as quantitative analysis of financials

Well qualified staff at banks always add values to the latter’s brand equity, service quality and market reputation

Group strength and sponsor reputation matters!

• What a credit analyst has to remember when assigning scores to Management indicators ?

Analyze the External Management Ratings as assigned by external rating agencies like S&P and Moody’s

Group Support Ratings are a sign of Sponsor strength and group management quality; hence brand equity and management quality of the group to which the bank may belong, should also be assigned scores

External and Internal Auditor reports should be analyzed to pick up traces of adverse opinion about the management team (if any)

• Bank’s Earnings Base :

The overall underlying earnings trend of a bank are a key risk driver and determinant of default risk in itself

Bank earnings are derived from asset side of the balance sheet in terms of revenues and from liability side of the balance sheet in terms of cost reductions and controls

Return on Asset - ROA is a key earnings driver. A positive ROA should be assigned a positive score and the higher it is the higher the score that needs to be assigned

ROE - is the Return on Equity and also the opportunity costs of providing funds to different arms of the bank .Higher ROE should be assigned a higher score

ROSF – Return on Shareholder Funds is the ratio of net income after tax to capital employed

Operating income to Net Income attributed to shareholders is key to understanding contributions of revenues from direct business operations

Fee Income to Net Income ratio should be analyzed separately

Income from investments and that from financing should be analyzed separately

• What a credit analyst has to remember when assigning scores to Earnings ratios/ indicators?

Weighted yield on funded facilities should not be below ROE –Return on Equity

ROE – Return on Equity should be analyzed in light of WACC – Weighted Average Cost of Capital.

Banks with higher ROE should not always be assigned a higher score without properly studying the risk driven earnings structure of the bank

Benchmark return driven ratios with industry figures All return ratios should be assigned scores PIT – (Point in

Time) and credit risk view should not ignore TTC – (Through the Cycle) performances

Return ratios and indicators should be assigned scores in light of other balance sheet ratio trends to check linearity and correlation with other risk drivers .

It may be possible that a bank with a higher risk appetite and higher rate of asset booking transactions may end up with a higher return on equity but in the long run may experience downturn in performance over business cycles

• Bank’s Liquidity Position :Banks liquidity risk drivers are the most potent

downside risk factorMajority of the failed banks in our times, had

defaulted on fixed rate commitments due to liquidity mismanagement

Recent global credit crisis has shown that liquidity risk was a major factor behind failure of big banks and Asset Management Companies

CAR – Capital Adequacy Ratio is a major indicator of liquidity availability

Banks with higher CAR have higher liquidity resources and vice versa

Cash Flow Statement in another important analytical tool . A negative cash flow from either operating , financing and investing activities could result in overall liquidity crunch and expensive borrowing from markets

Liquid assets proportion to total assets determines availability of readily available funding

Liquid assets proportion to liquid liabilities ascertains short term funding position

Overall Asset –Liability Liquidity and Maturity Gaps over various time intervals are key risk drivers. Huge On the Book mismatches can bring about serious cash flow problems

• What a credit analyst has to remember when assigning scores to Liquidity ratios/ indicators?

On –Balance sheet and Off- Balance Sheet exposures should be analyzed separately

Higher availability of liquid assets in relation to total assets should be assigned a higher score

Operating income to total liabilities ratio should be analyzed , with a higher multiple getting a higher score and vice versa

ADR- Advance to Deposit Ratio or Net Lending to Deposit Ratio should be analyzed and a higher ratio should be assigned a lower score and vice versa

Maturity Gaps/ mismatches should be analyzed in context of cumulative liquidity gaps for each bucket . Higher gaps should get lower scores and vice versa

• Bank’s Sensitivity to Market Risks:Credit and market risks factors are integrated Banks have witnessed an increase in loan

defaults due to interest rate hikes Overall increase in market risks may reduce CAR

– Capital Adequacy Ratio and default probability

Price Duration Gaps should be actively managed

• What a credit analyst has to remember when assigning scores to Market Risk Indicators?

Duration of Assets should be subtracted from Duration of Liabilities to do overall gap analysis

If Weighted Duration of Assets exceeds Weighted Duration of Liabilities , than the bank has a Duration surplus and vice versa

Hence banks reduce the duration of their assets when interest rates rise to reduce adverse economic impact on market value of equity and vice versa

A fall in Market Value of Equity will reduce CAR and a rise will do the opposite

A higher score should be assigned to duration surpluses (WDA>WDL) in a falling↓ interest rate environment

A lower score should be assigned to duration deficits (WDA<WDL) in rising↑ interest rate environment

• Country PEST – (Political , Economic, Social and Technological) Risks :

Sovereign Risk Analysis should be carried out if counterparty (bank) is based overseas

Country Risk can be quantified using External Ratings

However internal risk scoring should be done to develop proactive risk monitoring systems

Macroeconomic indicators should be compared at least over the last five years

Social issues should be analyzed with its impact on banking industry

Political situation should be analyzed by studying the economic policy stance of governments towards the financial sector

• What a credit analyst has to remember when assigning scores to Country Risk Ratios/ Indicators?

All sources of foreign exchange inflows and outflows should be studied

All factors that contribute to FX price changes and impact translation losses should also be studied

Historical Macroeconomic trends should be regressed

External Country ratings should be analyzed in context of both local and foreign currency

Merchandise Trade Ratio and Import to Foreign Exchange Coverage Ratios should be positive and always on the higher side

External Debt to GDP ratio should be on the lower side. The lower the ratio the higher the score to be assigned and vice versa

Current Account to GDP overall Balance of Payments to GDP ratio should be analyzed with breakup details . Higher the surplus the higher should be the assigned score and vice versa

• Conclusion :Going forward at TIIB , we shall incorporate

CAMELS modeling at all levels , where FI Risk is analyzed either in context of funded and non - funded correspondent banking transactions or Treasury transactions