International Journal of System Modeling and Simulation Vol 1(3) Oct-Dec 2016

Camels Rating Model For Evaluating Financial

Performance of Banking Sector: A Theoretical
Perspective
Parvesh Kumar Aspal Sanjeev Dhawan
Department of Finance and Accounts Post Graduate Department of Economics,
I. K. Gujral Punjab Technical University DAV College,
Jalandhar, India Jalandhar, India.
pk_aspal@yahoo.com dhawan2sanjeev@yahoo.co.in

Abstract— The function and significance of banking sector cannot of financial system [1]. Another study highlighted that financial
be under-estimated in the development of an economy. The sector performs as supply leading role in transferring of
strength of economy of any country basically hinges on the resources from traditional, low growth sector to high growth
strength and efficiency of financial system, which, in turn, depends sector and stimulates an entrepreneurship response in the high
upon a sound banking system. Reserve Bank of India growth sector [2]. From the above discussion it is cleared that
recommended two supervisory rating models named as CAMELS
the role of banking system is vital and crucial for the capital
(Capital Adequacy, Assets Quality, Management, Earning,
Liquidity, Systems and Controls) and CACS (Capital Adequacy, formation in the country and it necessitates that banks must be
Assets Quality, Compliance, Systems and Controls) for rating of more closely watched for their economic efficiency and
Indian commercial, private and foreign banks operating in India. performance.
The present study describes the various financial ratios used in the
above mentioned models to measure the financial performance of
banking sector. The study examined each parameter of CAMELS
S In the recent past the banking regulators and policy makers
have recommended bank supervision by using CAMELS
(capital adequacy, asset quality, management quality, earnings,
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system by review of literature and empirical studies. liquidity and sensitivity) rating model to assess and examine
the performance and financial soundness of the bank.
Index Terms: Capital Adequacy, Assets Quality, Management,
CAMELS rating system as an effective internal supervisory
Earning Quality, Liquidity and Sensitivity etc.
tool for evaluating and identifying financial firms, was adopted
I. INTRODUCTION for the first time in 1979 by the Federal Financial Institution
Industrial development, modernization of agriculture, Examination Council (USA) [3]. Regulators of the banking
expansion of internal trade and foreign trade are the factors sector always monitors the performance of the banks to ensure
which mainly determine the economic development of an efficient financial system based on CAMELS ratio.
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economy. A robust financial system is essential for the growth

of a strong and vibrant economy. In the globalized economic II. REVIEW OF LITERATURE
scenario for economic development of an economy, the role The evaluation of financial performance of banking sector
and importance of prudent banking system cannot be has been assessed by various researchers, academicians and
underestimated. The banking sector, being a fundamental policy makers in different time periods. A simplistic review of
component of financial system is the backbone of the modern some of the important studies is presented here which fulfills
economic system. Banks are one of the oldest financial the need for the present study.
institutions in the financial system, which play a crucial role in Narsimham Committee set up by the Government of India
the mobilization of deposits and disbursement of credit among had recommended various financial and banking sector reforms
the various sectors of the economy. A sound banking system which laid more emphasis on improvement in performance and
acts as fuel injection which stimulates economic efficiency by profitability of banks. In India Padmanabhan Working Group
mobilizing savings and allocating them to high return recommended two supervisory rating models named CAMELS
investment. Various research studies substantiates that (Capital Adequacy, Assets Quality, Management, Earning,
countries with a well developed banking system grow faster in Liquidity, Systems and Controls) and CACS (Capital
contrary to countries having weak banking system. Adequacy, Assets Quality, Compliance, Systems and Controls)
Research studies emphasized the function of financial for rating of Indian commercial banks and foreign banks
sector in economic development and expressed that there is a operating in India [4]. CAMEL system is beneficial, even after
strong correlation between economic growth and development controlling for a wide range of publicly available information

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 International Journal of System Modeling and Simulation Vol 1(3) Oct-Dec 2016

about the condition and performance of banks. CAMEL system present study has been done mainly on the basis of literature
further acts as a bank’s failure predicting model. The rating is review and secondary information available from various
designated based on both quantitative and qualitative journals, conference proceedings and reports of professional
information about the bank [5]. In a study based on CAMEL to bodies.
assess the performance of all nationalized banks for the year
1998, it was found that Corporation Bank has the best rating IV. OBJECTIVE OF THE STUDY
followed by Oriental Bank of Commerce, Bank of Baroda, The prime objective of the study is to analyze and discuss
Dena Bank, Punjab National Bank, etc. And the worst rating the various theoretical aspects ratios used in CAMELS rating
was found to be of Indian Bank preceded by UCO Bank, model for the assessment of financial performance of banking
United Bank of India, Syndicate Bank and Vijaya Bank [6]. In sector
India a study analyzed the performance of Indian banks by
adopting the CAMEL Model. The study concluded that the V. DISCUSSION AND THERETICAL ANALYSIS OF
competition was tough and consumers benefited from better VARIOUS FINANCIAL RATIOS
services quality, innovative products and better bargains [7]. Since the inception of CAMELS model various researchers
In an analysis, it was suggested that such types of rating and policy makers have used this model in different
would help the Reserve Bank of India to identify the banks perspectives for the assessment of performance of banking and
whose performance needs special supervisory attention. The financial sector in different time periods in different countries.
main attempt of CAMEL system is to find out problems which The CAMELS rating model is based on the evaluation of
are faced by the banks themselves and catch up the performance of the banks and financial institutions by
comparative analysis of the performance of various banks [8]. scrutinizing its balance sheet, as well as, profit and loss
A framework was suggested to assess the performance of statement on the basis of each component [15]. CAMEL rating
Jordanian brokerage firms by developing a CAMELS’ based is a concise and indispensable tool for researchers, policy
banking rating system. This framework would also be helpful makers and regulators. This rating ensures a bank’s healthy
to supervisory bodies, investors, clients, stakeholders and conditions by analyzing various aspects of a bank such as
researchers [9]. Many banks are not aware of how to assess
their ratings but there is a great need to understand, the work of
the banks and what to do when something goes wrong. It is
S financial statement, funding sources, macroeconomic data,
budget and cash flow [16]. CAMELS methodology was
adopted by North America Bank regulators to know the
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very crucial to assess the soundness of banks and financial financial and managerial reliability of commercial lending
institutions through rating system which is used by federal and institutions. To examine a bank’s performance using CAMELS
state regulators, usually known as CAMELS rating system rating model, information is obtained from different sources
[10]. Bank’s CAMEL rating is highly confidential, and only like financial statements, funding sources, macroeconomic
exposed to the bank’s senior management for the purpose of information, budget and cash flow projection, and business
projecting the business strategies, and to appropriate operations. This model assesses the overall financial position
supervisory staff. CAMEL is an acronym for five components and performance of the bank [17].
of bank safety and soundness: capital adequacy, asset quality, The various components of the CAMELS rating model in
management quality, earning ability and liquidity [11]. the form of financial ratios are described as below:
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The CAMELS model is very much popular among

regulators due to its effectiveness. This model is highly 1. Capital Adequacy
compatible for the assessment of the performance of the bank Capital adequacy is assumed to be a crucial reflector of the
[12]. The importance of banks is more prominent in developing financial soundness of a bank. In order to survive, it is
countries because financial markets are usually indispensable to protect the stakeholder confidence and
underdeveloped, and banks are typically the only major source preventing its bankruptcy. Capital is assumed to be a cushion
of finance and are act as custodian of economic savings [13]. that offers protection to stakeholder’ and it enhances the
The strength of CAMEL’s factors would determine the overall stability and efficiency of bank. Capital adequacy represents
strength of the bank. The quality of each component further the overall financial position of a bank. It reflects whether the
underlines the inner strength and how far it can take care of bank has sufficient capital to bear unexpected losses in the
itself against the market risks [14]. Sound financial health of a future and bank leverage. The capital adequacy of a bank is
bank also provides the assurance to its stakeholders and assessed through following ratios:
economy as a whole.
a) Capital to Risk-weighted Assets Ratio
III. RESEARCH METHODOLOGY This ratio is advocated to ensure that banks can bear a
The nature of present study is mainly qualitative and does reasonable amount of losses occurring during the operations
not make use of any statistical technique for analysis. The and to ascertain bank’s loss bearing capacity. Higher the ratio

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 International Journal of System Modeling and Simulation Vol 1(3) Oct-Dec 2016

reflects that banks are stronger and the investors are more such security should always be equal to or greater than the
protected. In India, the banks have to maintain a CRAR of 9%. amount of such advance. With a view to reduce risk, banks
Capital to Risk-weighted Assets Ratio (CRAR) is calculated by always sanction secured advances. The greater the security
dividing Tier-I and Tier-II capital with Risk Weighted Assets. against loans lesser will be the risk and vice versa.
Tier 1 capital includes shareholders’ equity; perpetual non-
cumulative preference shares, disclosed reserves and innovative c) Priority Sector Advances to Total Advances
capital instruments. Tier 2 capitals include undisclosed To secure better adaptation of the banking system to the
reserves, revaluation reserves of fixed assets and long-term needs of economic planning, priority sector lending plays more
holdings of equity securities, general provisions/general loan- active role [19]. Issuance of advances to the priority sector is
loss reserves; hybrid debt capital instruments and subordinated the prime objective of banks as recommended by Government
debt. of India. Such advances include agricultural loans, Small scale
industry advances, micro industry advances, export credit and
b) Debt-Equity Ratio advances to weaker sections of the society. It is expressed as
The debt-equity ratio reflects the degree of leverage of a total Priority sector advances divided with total advances.
bank. It expresses the proportion of debt and equity in the total
fund structure of the bank. It is computed by dividing total 3. Management Efficiency
borrowings of the bank with shareholders’ net worth. Net worth Management efficiency is another indispensable
encompasses equity share capital, and reserves and surpluses. constituent of the CAMELS model that guarantees the growth
Higher ratio reflects less protection for the depositors and and endurance of a bank. Management efficiency signifies
creditors and vice-versa. adherence with prescribed norms, capability to counter to
changing environment, leadership and administrative capability
c) Government Securities to Total Investments Ratio of the bank. The following ratios are required to assess
The risk engrossed in the investments of banks is reflected management efficiency:
by this ratio. It is computed by dividing the investment in
government securities by total investment of banks. It is
assumed that Government securities are most secured and risk-
free debt instruments .It means higher the investment in
S a) Total Advances to Total Deposits
This ratio expresses the efficiency of the bank’s
management in utilization of the deposits (including
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government securities will result in lower risk and vice versa. receivables) available into advances with maximum returns.
Total deposits include savings deposits, demand deposits, term
2. Assets Quality deposits and deposits of other banks are included in total
The quality of assets is significant aspect to assess the deposits. Higher the ratio better it is and vice versa.
degree of financial strength of a bank. The principal purpose to
measure the assets quality is to determine the composition of b) Business per Employee
non-performing assets (NPAs) as a percentage of the total Business per employee reveals the overall business
assets. The quality of credit portfolio expresses the profitability contributed by each employee of a bank [20]. Business per
of banks. employee highlights the productivity and efficiency of human
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The major concern of all commercial banks is to keep the resources of bank. It is computed by dividing the total business
amount of non-performing loans to low level. This is so with total number of employees. Higher the ratio, the better it is
because high non-performing loan affects the profitability of for the bank and vice versa.
the bank [18]. The following ratios are required to assess assets
quality: c) Return on Advances
This ratio reveals the relationship between net profit after
a) Net NPAs to Net Advances tax (or interest income) and total advances issued by the bank.
This ratio is the most standard measure to evaluate the Higher return on advances results in more returns earned on
assets quality. It is expressed as the net non-performing assets advances. Higher the ratio of return on advances, higher will be
as a percentage of net advances. Net NPAs is calculated by the productivity and profitability of funds and vice versa.
subtracting Net of provisions on NPAs and interest in suspense
account from Gross NPAs. Growing NPAs is a challenge to 4. Earning Quality
banks, which will adversely affect the performance of banks. High earnings quality should reflect the firm’s current
operating performance and a good indicator of future operating
b) Secured Advances to Total Advances performance [21]. The quality of earnings is an extremely
As per Banking Regulation Act, 1949 an advance should significant parameter which expresses the quality of
be granted against the security of an asset, the market value of profitability and capability of a bank to sustain quality and

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 International Journal of System Modeling and Simulation Vol 1(3) Oct-Dec 2016

earning consistently. It primarily reflects the profitability of The liquid assets include cash in hand, money at call and
bank and enlightens consistency of future earnings. The short notice, balance with Reserve Bank of India and balance
following ratios are required to assess earning quality: with other financial institutions and banks. Liquidity
management is one of the most imperative aspects of a bank. If
a) Operating Profit to Total Assets available funds are not properly utilized, the bank may suffer
Operating profit ratio as the operating profit (or net loss because idle cash has no return.
operating income) of the bank divided by average total assets.
It measures the ability of the management to keep revenue b) Liquid Assets to Demand Deposits
growth ahead of rising costs. Operating profit includes the Under CAMELS approach, bank liquidity is measured by
amount earmarked for provisions and contingencies [22]. This liquidity ratios based on accounting data such as liquid assets to
ratio reveals how much profit a bank can earn from its total assets or total loans to total deposits [19]. This ratio
operations for every rupee invested in its total asset. The reveals the capability of bank to fulfill the demand from
optimal utilization of assets will increase the operating profit of depositors during a particular year. In order to maintain higher
the bank. The higher the ratio the better will be the earning of liquidity for depositors, bank has to invest these funds in highly
the bank. liquid form so that the needs of the depositors can be honoured
in time.
b) Net Interest Margin to Total Assets
Net interest margin is a measure of the difference between c) Credit Deposit Ratio
the interest income generated by banks and the amount of Credit-Deposit ratio is expressed as percentage of loan
interest paid out to their lenders, relative to the amount of their issued by banks from the deposits received from customers. It
assets [23]. Net Interest Margin is computed as the difference reflects the capacity of banks to lend. Higher the ratio, more
between the interest earned by a bank and the interest expended credit the bank generates from its deposits. Credit Deposit ratio
by a bank. It is expressed as a percentage of total assets. Higher is influenced by certain factors like credit-deposit growth, cash
ratio indicates the better earnings given the total assets. reserves and investments of the banks. Banks sanction credit

c) Interest Income to Total Income

This ratio estimates the income gained from lending
S after fulfilling the requirements of cash reserves and statutory
liquidity out of its deposits. A higher ratio reveals more
reliance on deposits for lending and vice-versa.
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operations as a percentage of the total income earned by the
bank during a financial year. Interest income is consists of 6. Sensitivity Ratios
interest/discount on advances/bills, income on investments, Sensitivity is expressed as the risk which occurs due to
interest on balances with central bank and other inter-bank alteration in market conditions, such changes could adversely
funds. Total income consists of interest income and other impact earnings and/or capital. Market risk includes exposures
income like commission, net profit (loss) on sale of investment, associated with changes in interest rates, foreign exchange
land and other assets, revaluation of investment and rates, commodity prices, equity prices, etc. While all of these
miscellaneous income. items are important, the primary risk in most banks is interest
rate risk [25]. The sensitivity of the market risk is assessed by
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5. Liquidity banks through changes in interest rate, foreign exchange rates

The adverse effect of increased liquidity for financial and equity prices. The changes in these variables effects
Institutions stated that although more liquid assets enhances the earning ability of the bank. So, sensitivity to market risk
ability to raise cash on short-notice, but also reduce expresses how adversely the bank is affected due to such
management’s ability to commit credibly to an investment changes. Market risk is the effect of trading activities, non-
strategy that protects investors [24]. Liquidity is another trading activities and foreign exchange operation. The
noteworthy aspect which expresses the financial performance following ratios are required to assess sensitivity:
of banks. Liquidity means the ability of the bank to honour its
obligations toward depositors. Bank can preserve adequate a) Price Earnings Ratio
liquidity position either by increasing current liabilities or by High level of price earnings ratio is a signal of overheating
converting its assets in to cash quickly. It also denotes the fund of stock markets. Price earnings ratio have more predictability
available with bank to meet its credit demand and cash flow in emerging markets and can be utilized to forecast future
requirements. The following ratios are required to assess the returns and particularly to choose the entry/exit timings and
liquidity: stock selections [26]. The Price Earnings ratio reflects an idea
of what the market is willing to pay for the company’s
a) Liquid Assets to Total Assets earnings. Higher the Price Earnings ratio more the market is
This ratio expresses the overall liquidity position of a bank. eager to pay for the earnings of the company. Conversely, a

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 International Journal of System Modeling and Simulation Vol 1(3) Oct-Dec 2016

low Price Earnings ratio may designate a “vote of no used by various researchers for the evaluation of banks
confidence” by the market. In general, a high price earnings performance in their respective studies. Under this bank is
ratio recommends that investors are expecting higher earnings required to enhance capital adequacy, strengthen asset quality,
growth in the future. A valuation ratio of current share price improve management, increase earnings, maintain liquidity,
compared to its per-share earnings. Price Earnings Ratio is and reduce sensitivity to various financial risks. From the study
calculated by dividing the Market Value per Share with we observed that the CAMELS framework is not a
Earnings per Share. comprehensive framework; for example, it does not take into
consideration other forms of risk (such as credit risk).
b) Total Securities to Total Assets Ratio
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