Definition:

CAMELS is a recognized international rating system that bank supervisory authorities use in order to rate financial institutions according to six factors represented by its acronym. Supervisory authorities assign each bank a score on a scale. A rating of one is considered the best, and a rating of five is considered the worst for each factor.


Components:

What is CAMELS Rating System ? Definations, Components, Ranking Indicators
The six parameters on the basis of which the ratings are done are represented by an acronym “CAMELS”. Which are :
  1.     Capital adequacy
  2.     Asset quality
  3.     Management
  4.     Earnings
  5.     Liquidity
  6.     Sensitivity to market risk
1. 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.

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

Ranking :

Banks are rated on each component, and a composite rating is also computed. Ratings range from one to five:

    1 is “strong.”
    2 is “satisfactory.”
    3 is “less than satisfactory.”
    4 is “deficient.”
    5 is “critically deficient.”

To earn a 1 on any component, a bank must show the strongest performance and risk management practices in that area. Alternatively, a rating of 5 indicates weak performance, inadequate risk management practices and the highest degree of supervisory concern.

The overall, or composite, rating for each bank is based on the six components. However, it is not an arithmetic average of the individual component ratings. Rather, some components are weighed more heavily than others based on examiner judgment of risk. The weights of different six components are as follows:

    Capital adequacy     = 20 %
    Asset quality            = 20%
    Management             = 25%
    Earnings                   = 15%
    Liquidity                  = 10%
    Sensitivity               = 10%


Thus, through CAMELS rating, the overall financial position of the bank is evaluated and the corrective actions, if any, are taken accordingly.