The Indian financial sector has been applying the CAMEL Model as a supervisory method/tool for well over fifteen years. The purpose is to assess bank's/financial institution's policies (specifically their loan portfolio) and also the Management's effectiveness and efficiency. Various factors pertaining to the model cover the reliability and soundness of the bank while covering their compliance with Federal/Prudential policies. Examples of these principal factors can range from earning capacity-management quality to the solvency of the banking institute. (Suresh & Paul, 2010).
While conducting a complete evaluation of the banking institute, the people in charge (the assessment team) gather information via two different ways; onsite (i.e. conducting interviews with both managers as well as employers) and off the site. Every indicator after the calculation is assigned a range which goes from 1 (Excellent) to 5 (the Worst). In general, banks presenting CAMEL 1 and CAMEL 2 ratings are considered adequate, while the next three are supposedly below satisfaction. The institutes with less satisfied ratings are advised to elevate their ratings. The ratings obtained are not for the public; rather it is limited to the top most management. (Mishkin, 2002). Another interesting fact relating to the disclosure is that in the US, some insuring companies and more specifically some under-writers were requesting banks to provide their CAMEL ratings. But since early 2005, all underwriters etc. are legally bound to take permission from their respective Federal (banking) Agency. (Office of the Comptroller of the Currency Federal Deposit Insurance Corporation Board of Governors of the Federal Reserve System Office of Thrift Supervision, 2005).
The application of CAMEL model for regulating purposes gave encouraging results even in the past. Even by the mid 1990's CAMEL model was considered a very dependable and consistent tool despite been very old and orthodox. In 1995, the Federal Deposit Insurance Corporation used these conventional ratings. The banks having satisfactory results i.e. CAMEL 1 & 2 were given an enormous relief as they had to give only 4 cents per one hundred dollars while other had to bear with the previous established rates (coverage of 31 cents/100 dollars). (Wells, 2004).
Another example is of Premier Bank (which later became part of Bank One Corporation). The FDIC (Federal Deposit Insurance Corporation) by using the CAMEL model gave this bank a rating of "5". The new Chief Executive took the ratings acutely and in a short period of time changed the bank's condition. According to (Burke, Trahant, & Koonce, 2012) the best rating of 1 is like a "Good House-Keepings Seal of Approval" as compare to being deceased and then buried in the ground.
Now coming back to developing nations, let's see its application and effectiveness in India. Reserve Bank of India considers the CAMEL model as an integral tool used for regulating banks present in its jurisdiction. While there are many other monitory policy tools, both onsite and off-site, the CAMELS approach (where S is for Systems) is the single most important. C representing capital sufficiency has two components, the amount or the quantity of capital available which is obviously easy to assess and the quality of the capital. The funds quality is of vital importance as it translates to the loan portfolio. After this is the Asset Capability; this part of the model is strictly related to the credit risk pertaining to the bank. Everything, from advances to investments is covered. After this is a bit complicated part of the CAMEL model, the managing quality of the organization. Now the bank's basic earning is interest related (more specifically the Net Income Spread), and apparently we don't see a direct relationship of this with the class of the management. But it the most critical part of this model and also one of the most difficult ones to calculate. It all comes down to the ability of managers and board to monitor and regulate various activities in the bank while following all the prudential regulations pointed out by the central bank. Various means can be employed, ranging from internal auditing, auditing, MIS, internal guidelines etc. (Sharma, 2008).
E represents the Earning capacity. Two things worth considering, the amount of earning and the risks involved in achieving these higher earnings. In examining earnings, the operating costs as well as the risks involved in different investments are taken into account. Lastly, the liquidity requirements are to be considered for two reasons which eventually converge at the same point. The bank needs liquidity for the depositors, so that any difference between deposits and lending can be met without any difficulties; and to invest in new ventures as well as new loans. (Sharma, 2008).
The development of CAMEL model began in the 80s in the US and the principal function was to scrutinize financial institutions with special emphasis on banks. Eventually, this technique/methodology became the benchmark. It effectiveness was mainly because of its ability to cover a vast array of factor pertaining to banks value. Despite considering many factors, its ease of application makes it even more popular. The model is utilized by almost every assessor and evaluator around the globe. This ranking model covers up to six aspects pertaining to the soundness of the institute. The parts of CAMEL(S) model are believed to be dynamic because they incorporate that specific nation's economy, its regulatory/fiscal policies as well as the government condition. Obviously, while considering these factors it is not easy to determine if the bank is fiscally viable or not. This is where the assessor becomes important; he/she not only has to assess the quantity of assets, of earnings but also their quality while employing the CAMEL(S) model. (Grier, 2007).
While looking at Banking Institutions related specific models, CAMEL is the most prominent one. Its application is of an on site Early-Warning-System. The development (as mentioned earlier) was conducted in Washington by the Currency Comptroller's Agency with assistance from the Federal Reserve. The official title known as UFIRS (uniform-financial-institutions-rating-system) was given in 1979. As its origin suggests, the model was basically a supervisory tool. The application helped the allocation of the regulator's resources; if a bank's CAMEL showed a poor or less than satisfactory performance, the Federal Reserve would allocate more resources to monitor that institute and vice versa. Eventually this model became the yard stick all over the world, and they became part of government fiscal policies. Broadly the regulator is required to cover the five base components of the model, from capital sufficiency to the liquidity requirements. A further enhancement to this is the addition of market risk sensitivity and is represented by S, hence converting the model to CAMELS. Two further variations of this model were also seen, both called CAMELOT. The agency responsible for these advancements is the Office of Superintendent of Financial Institutions Canada. In the first version operations/operating condition and Treasury were also considered with the basic indicators, while in the second variation T represented transparency asking banks to illustrate how risky their investments are. (Yokoi-Arai, 2002).
The application of the CAMEL system is very supportive for the regulators in developed and developing countries alike. Still, one thing should be considered; the model doesn't helps in evaluating any explicit risks and definitely cannot be used as a risk-reduction or risk-controlling instrument. The application is limited to its supervisory role, hence its vital importance in prudential regulations. Out of all the factors in CAMEL, the management capability is amongst essentials. And despite its importance regulating bodies often overlook the management aspect. (Ledgerwood & White, 2006).
Another application of the CAMEL model pertaining to government regulators around the world is of Mergers. While supervising merger proceedings the main point comes to the wellbeing and reliability of both banking institutes. The CAMEL features help by providing the safety-aspects and thus facilitating the whole process. (Rezaee, 2001).
CAMEL models development is the result of a joint effort of the three American regulators, the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. The ratings of banks in question informed the overall financial condition by covering all five areas. The model helped in forecasting banks failing tendencies. After its developments, the standardization process was conducted by the UFIRS (Uniform-Financial-Institutions-Ratings-System). While the capital sufficiency section of the model is considered the most important by regulating bodies, its importance is still not officially recognized. The evaluation of the banking institutes is executed by comparing them with the standardized values developed by the regulators. Any deviations recorded in this regard result in categorization of that particular bank as dissatisfactory. The number of the agreed upon ratios is eighteen. The selection of these ratios was conducted by the three regulating mentioned before and the results found by using these ratios have been recognized as excellent indicators. (Ghosh, 1995).
A CAMEL model similar to Federal Regulators in industrialized nations is also utilized by Credit-Rating organizations. The application is obviously specified to credit ratings of different banks, but its effectiveness is still present. Instead of applying all functions of the model, a more compacted version of the model is used and different organization specified names are used (e.g. model is called Financial-Fundamentals by Moody's Investor Service). The model still comprises of the original five functions; capital sufficiency, asset quality assessment, management, earnings of the bank and its liquidity status. Out of these, the three functions namely liquidity position, asset quality and capital sufficiency are more significant. The Federal Reserve has also pointed out that this model has been very supportive in the past. Out of the many ratios, Capital-Adequacy is still considered the central one and like the regulating bodies the Credit Rating agencies also give this the highest value. While considering different parameters, the Credit rating firms should try to shape the model in such a way that it acts as an early forewarning. This is important because of the general perception of CAMEL that it is a parameter that shows the deterioration of the bank instead of showing improvement. (Levich, Majnoni, & Reinhart, 2002).
Out of many Ratio-Analyzing procedures CAMEL is the one considered most favorable. The system pertains to American banks but due to its universal nature, the CAMEL Ratings can also be applied in other banking systems. Of course the rating system in USA is standardized and implemented by the UFIRS and same should be done when applied in any other country. The general categorization of the model consists of five functions/factors. While applying the model, an overall value (which takes into account all the five factors) of 1 or 2 also called Composite 1 & 2 are considered satisfactory. While banks showing ratings of 3, 4 and 5 require further scrutiny as they are the predictors of a near future setback. (Huang, 2007).
Being a part of most famous Multivariate systems; where analyzing of two or more resulting variables is performed, five different functions help evaluate financial conditions of different banking institutes. The CAMEL model, exercised by regulatory bodies uses different financial ratios in each function of the model to achieve an aggregate result. Various weight-age is given to each set of ratios and at the end an outcome ranging from 1-5 (where 1 is most excellent and 5 is bad) is achieved. Despite being used by Federal regulators the findings are not made public and also the approach towards this model also varies in every agency. Still the Officer of the Comptroller of Currency and the Feds both use CAMEL Composite 1 to 5. (Caouette, Altman, Narayanan, & Nimmo, 2011).
While covering different aspects pertaining to the 2008 financial crisis, one of the reasons of the failure by supervisory bodies was the lack of CAMELS ratings proper implementation as a EWS (Early Warning System). The evaluation was done on six aspects; Capital sufficiency, Asset managing quality, Earning capability, Management, covering Liquidity requirements and sensitivity for market risk. The measurements were conducted on a reference scale ranging from 1 to 5 where 1 and 2 showed best conditions in terms of supervisory needs. Although 3 seem like a middle value but it is linked with 4 and 5 i.e. worsened form. The evaluation that was given to relevant institutions comprised of an overall rating as mentioned before as well as on each of the six functions. One variation to this model (with specific needs) was implemented by the Federal Deposit Insurance Fund; all banks/financial firms with asset-valuation of ten billion dollars or more were scrutinized to assess any threats. Instead of giving the range numerical values, a rating starting from A to E was given. The risk assessment of A showed excellent financial conditions and vice versa. (Senate Subcommittee on Investigations, 2011).
The term Micro-Prudent Parameters definitely matches the CAMELS model; by exhibiting the financial strength of an individual institute. The six groups while covering almost all aspects related to the financial indicators give a very comprehensive analysis of the financial organization. The results found by this model are also in alignment with the market sentiment of that particular organization and is mostly evident from that institution's market value. (Evans & IMF, 2000).
