Explained: CAMELS approach for the evaluation of financial institutions

0

The CAMELS approach is widely used as a starting point for bank analysis.

An investor’s analysis of a given security depends on a plethora of factors that directly or indirectly affect the investment process or the conclusions that flow from it. Business model, revenue model, cash flow, assets, primary business environment, industry, etc. of a business are just a few of the many factors that are relevant when evaluating a stock. Considering the nuances and types of businesses, different valuation approaches have been developed and followed to assess businesses.

For a financial institution called a bank involved in providing loans (assets) on the backs of deposits received (liabilities), one of the popular valuation and analysis approaches used is the “CAMELS” approach.

It is an acronym for capital adequacy, asset quality, management capabilities, profit sufficiency, liquidity position and sensitivity to market risk.

Let us briefly see the importance of the six elements.

Capital adequacy: For simplicity, suppose you have deposited Rs 100 in a bank for a fixed rate of 6%. The bank lends the same amount for one year at 8%. In an ideal situation, the bank should receive Rs 108 after one year, and give you Rs 106 and make a profit of Rs 2 for itself. But for some reason if the borrower defaults and the bank is only able to recover Rs 100. What do you think the loss would be Rs 8. It will be depositors, which is exactly why it? should be sufficient capital (equity) to absorb these losses so that depositors are protected.

Asset Quality: It refers to the credit risk associated with a bank’s assets. In the example above, we would like to assess the credit risk of the borrower. A high credit risk implies a high probability of default.

Management skills: This is the effective management of the financial institution.

Profits: For an investor who invests in a bank, one would like the benefits to be of high quality, that is, derived from durable elements rather than non-recurring.

Liquidity: Banks are a highly regulated industry due to their economic importance. Various regulations are in place to guide banks as to their liquidity position.

Sensitivity Analysis: The investor should identify the bank’s exposures and sensitivity to those factors which may have a significant impact on its earnings.

Share.

Comments are closed.