What is a Rating System?

A system of classifying according to quality or merit or amount

WHY HAVE A RATING SYSTEM FOR BANKS?

We Need To: Characterize or Describe Banks Compare Relative Strength of Banks Distinguish Satisfactory Banks from

others To monitor performance Ensure Consistency Among Regulators Drive Examination Report

An international bank-rating system with which bank supervisory authorities rate institutions according to six factors. The six areas examined are represented by the "CAMELS."

CAMEL Background

The CAMEL methodology was originally adopted by North American bank regulators to evaluate the financial and managerial soundness of U.S. commercial lending institutions and also by by National Credit Union Administration (NCUA) in October 1987

It is used as an internal tool to measure risk and allocate resources for supervision purposes.The last version of the CAMEL Rating System was published in Letter to Credit Unions No. 161, dated December 1994

Revision of CAMEL Rating System

The existing CAMEL rating system produces a composite rating of an institution's overall condition and performance by assessing five components

The updated rating system now will be referred to as the CAMELS rating system, to include Sensitivity to Market Risk

This was effected from January 1, 1997.

The CAMEL rating system is based upon an evaluation of following critical elements: Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market

The purpose of CAMELS ratings is to determine a bank’s overall condition and to identify its strengths and weaknesses:

Financial Operational Managerial

Each bank is assigned a uniform composite rating based on six elements. The system provides a general framework for evaluating the banks.

It is a standardized method which allows the assessment of the quality of banks according to standard criteria providing a meaningful rating.

Each element is assigned a numerical rating based on five key components:

Rating 1 indicates strong performance: BEST rating. Rating 2 reflects satisfactory performance. Rating 3 represents performance that is flawed to

some degree. Rating 4 refers to marginal performance and is

significantly below average and Rating 5 is considered unsatisfactory: WORST

rating. Based on the ratings of each element, a composite

rating of 1 through 5 is assigned to the bank. All the factors reflected in the key components ratings are considered in assigning the composite rating.

Capital is rated based on the following considerations:

Nature and volume of problem assets in relation to total capital and adequacy of LLR and other reserves

Balance sheet structure including off balance sheet items, market and concentration risk

Nature of business activities and risks to the bank Asset and capital growth experience and prospects Earnings performance and distribution of dividends Capital requirements and compliance with

regulatory requirements Access to capital markets and sources of capital Ability of management to deal with above factors

Asset quality is based on the following considerations:

Volume of problem of all assets Volume of overdue or rescheduled loans Ability of management to administer all the assets of

the bank and to collect problem loans Large concentrations of loans and insiders loans,

diversification of investments Loan portfolio management, written policies, procedures

internal control, Management Information System Loan Loss Reserves in relation to problem credits and

other assets Growth of loans volume in relation to the bank’s

capacity

Management includes all key managers and the Board of Directors

Management is the most important element for a successful operation of a bank. Rating is based on the following factors:

Quality of the monitoring and support of the activities by the board and management and their ability to understand and respond to the risks associated with these activities in the present environment and to plan for the future

Development and implementation of written policies, procedures, MIS, risk monitoring system, reporting, safeguarding of documents, contingency plan and compliance with laws and regulations controlled by a compliance officer

Availability of internal and external audit function Concentration or delegation of authority Compensations policies Response to CBI concerns and recommendations Overall performance of the bank and its risk profile

Earnings are rated according to the following factors: Sufficient earnings to cover potential losses, provide

adequate capital and pay reasonable dividends Composition of net income. Volume and stability of the

components Level of expenses in relation to operations Reliance on extraordinary items, securities transactions,

high risk activities Adequacy of budgeting, forecasting Earnings exposure to market risks, such as interest rate

variations, foreign exchange fluctuations and price risk

Liquidity is rated based on the followingfactors: Sources and volume of liquid funds available to meet

short term obligations Volatility of deposits and loan demand Interest rates and maturities of assets and liabilities Access to money market and other sources of funds Diversification of funding sources Reliance on inter-bank market for short term funding Management ability to plan, control and measure

liquidity process. Contingency plan

Market risk is based primarily on the followingevaluation factors: Sensitivity to adverse changes in interest rates, foreign

exchange rates, commodity prices, fixed assets—Nature of the operations of the bank—Trends in the foreign currencies exposure—Changes in the value of the fixed assets of the bank—Importance of real estate assets resulting from loans write off

Ability of management to identify, measure and control the market risks given the bank exposure to these risks

The composite rating assigned is not an arithmetic average of the component ratings, but is based on a qualitative analysis of the factors comprising each component, the interrelationship between components, and the overall level of supervisory concern about the bank.

Capital Adequacy Ratio - CAR CAR= tier 1 capital + tier 2 capital

risk weighted assets The higher the CRAR, the stronger is considered a bank, as it

ensures high safety against bankruptcy Tier 1 Capital Mean

Tier I capital is core capital, this includes Equity capital Disclosed reserves

Tier 2 Capital MeanTier II capital is secondary bank capital that includes items such as Undisclosed Reserves Revaluation Reserves General Provisions Hybrid Instruments Subordinated Term Debt

Tier I capital is core capital

It is the more important of the two, consists largely of shareholders' equity.

Shareholders equity and retained earnings are now commonly referred to as "Core" Tier 1 capital

Equity capital Invested money that, in contrast to debt capital, is

not repaid to the investors in the normal course of business. It represents the risk capital staked by owners through purchase of the firm's common stock. Its value is computed by estimating the current market value of everything owned by the firm from which the total of all liabilities is subtracted. On the balance sheet of firm, equity capital is listed as stockholders’ equity or owners' equity.

Tier I capital is core capital Disclosed reserves

created or increased by appropriations of retained earnings or other surplus, e.g. share premiums, retained profit, general reserves

Share Premium The share premium account of a company is

the capital that a company raises upon issuing shares that is in excess of the nominal value of the shares.

Retained Profit Profit attributable to ordinary equity shareholders

less dividends paid. Retained profit is the profit/loss for the financial year transferred to/from reserves.

General Reserves The amounts are set aside so that when the future

profits are low, the company can utilize the reserves for distribution of profits

Tier II capital is secondary bank capital

Undisclosed Reserves Undisclosed reserves are not common, but are

accepted by some regulators where a bank has made a profit but this has not appeared in normal retained profits or in general reserves of the bank.

Such reserves consist of that part of the accumulated after-tax surplus of retained profits which banks in some countries may be permitted to maintain as an undisclosed reserve. 

Revaluation Reserves A revaluation reserve is a reserve created when a

company has an asset revalued and an increase in value is brought to account. A simple example may be where a bank owns the land and building of its head-offices and bought them for $100 a century ago. A current revaluation is very likely to show a large increase in value. The increase would be added to a revaluation reserve.

Tier II capital is secondary bank capital

General Provisions A general provision is created when a

company is aware that a loss may have occurred but is not sure of the exact nature of that loss.

Hybrid Instruments It includes a range of instruments which

combine characteristics of equity capital and of debt. An example of this is Cumulative preference shares

Tier II capital is secondary bank capital

Subordinated Term Debt includes conventional unsecured subordinated

debt capital instruments with a minimum original fixed term to maturity of over five years and limited life redeemable preference shares.

Such debt is referred to as subordinate, because the debt providers (the lenders) have subordinate status in relationship to the normal debt. 

Subordinated debt has a lower priority than other bonds of the issuer in case of liquidation during bankruptcy

Subordinated loans typically have a higher rate of return than senior debt due to the increased inherent risk

Risk weighted assets

In terms of the minimum amount of capital that is required within banks and other institutions, based on a percentage of the assets, weighted by risk

For example, loans that are secured by a letter of credit would be weighted riskier than a mortgage loan that is secured with collateral.

NON PERFORMING LOANS Non-performing loans (NPL) / total loans

A non-performing loan is a loan that is in default or close to being in default. Many loans become non-performing after being in default for 3 months, but this can depend on the contract terms

An asset, including a leased asset, becomes nonperforming when it ceases to generate income for the Bank

DELINQUENT LOANS Total of Loans Delinquent / Total Loans A loan that is 30 to 60 days past due with no payments

being made

GROSS NPL Gross NPL / gross advances

NET NPL Net NPL / Net advances

The amount of principal out standing is gross advance n the principal together with outstanding interest is net advance on particular time.

A non-performing loan is a loan that is in default or close to being in default. A loan that is 90 days past due with no payments being made

Key Ratio (Total Income-Total Expenditure)

This should be positive Administrative to total expense Total Advance to Total Deposit Ratio

This ratio measures efficiency and ability of banks management in converting deposits available with banks into high earning advances. Total deposits include demand deposits, saving deposits, term deposit & deposit of other bank. Total advances also include receivables.

Return On Assets – ROA (Net Income + Interest Expense – Interest

Tax Saving) / Average Total Assets

Net Interest margin It is usually expressed as a percentage of what

the financial institution earns on loans in a time period and other assets minus the interest paid on borrowed funds divided by the average amount of the assets on which it earned income in that time period

NET LIQUID ASSETS / TOTAL ASSETS A measure that examines a company's net

liquid financial assets. The net liquid assets show how much of a company's liquid assets would be left if all current liabilities were paid off.Calculated as:

The sum of current and long-term assets owned by a company is known as total assets

TOTAL LOANS / TOTAL DEPOSITS The amount of a bank's loans divided by

the amount of its deposits at any given time. The higher the ratio, the more the bank is relying on borrowed funds, which are generally more costly than most types of deposits.

Gap Rate Sensitive Assets / Rate Sensitive Liabilities 

RSA - RSL Rate Sensitive Assets (RSA) 

The dollar amount of interest earning assets that will have a rate change due to maturity, re pricing or principal pay down within a predefined time period.

Rate Sensitive Liabilities (RSL) The dollar amount of interest paying liabilities that will have a rate change due to maturity, re pricing, principal decay, or early withdrawals within a predefined time period.

Rate Sensitive Assets / Rate Sensitive Liabilities Reveals the mismatch between earning assets and paying liabilities within a particular time frame. An equilibrium will be achieved when the ratio equals 100, which implies that rate sensitive assets are equal to rate sensitive liabilities.

Who Impliments CAMEL Rating system in Pakistan?

Banking Inspection Department of SBP (BID) is one of the core departments at SBP.

Its mission is to strive for soundness & stability of the financial system and safeguard interest of stakeholders through proactive inspection, compatible with best international practices

BID plays a pivotal role in meeting SBP’s main responsibility of supervising the financial institutions to maintain soundness of the system and protection of the interest of depositors, thereby ensuring public confidence in the system.

Banking Inspection Department of SBP During the decade of 1990s, the Bank undertook a

number of measures to strengthen its supervisory and regulatory capabilities. In 1997, services of an international consultant were acquired by the Bank6 to undertake an in-depth review of the banking supervisory system and monitoring techniques. The consultants recommended risk-based inspection of financial institutions and CAMELS (Capital, Asset quality, Management soundness, Earnings, Liquidity & Sensitivity to other risks) system of off-site surveillance. The training of Bank officials (both in the country and abroad) and up-gradation of information technology system is a continuing process for effective implementation of the consultant's recommendations.

The present supervisory structure at the department is institution focused whereby concerned Desk In-charges have been assigned specific institutions for effective monitoring through on-site examination, off-site reports from Banking Supervision Department and various market reports

The regular on-site inspection is conducted on the basis of CAMELS Framework. (Capital, Asset Quality, Management, Earnings, Liquidity, Sensitivity and System & Controls). CAMELS is an effective rating system for evaluating the soundness of financial institutions on a uniform basis and for identifying these institutions requiring special attention or concern.

Banking Inspection Department of SBP

Here the focus of inspection is generally on risk assessment policies & procedures of the banks and control environment to keep attached risks within acceptable limits and compliance with laws, regulations and supervisory directives

BID conducts the regular full scope examination of banks pursuant to an inspection schedule; however, flexibility exists in policy for frequency of inspections depending upon the need to maintain safety & soundness.

CAMELS rating is a criteria to determine the frequency of inspection of banks as weak institutions are given greater attention.

Banking Inspection Department of SBP

Other Rating Systems PEARLS rating system. This is a rating system developed for credit

unions by the World Council of Credit Unions (WOCCU). The rating system includes a certification process called Finance Organization Achieving Certified Credit Union Standards (FOCCUS).

Girafe rating system. Developed by PlaNetFinance. ORAP Rating system The French Banking Commission

introduced the annual Organization and Reinforcement of Preventive Action (ORAP) Rating System in 1997 as a multi-factor analysis system for individual institutions.

PATROL Rating System. The Bank of Italy has introduced the annual PATROL rating system in 1993 as an off-site supervision tool to give a systematic representation of the financial health of individual banks and provide support in prioritization of the use of supervisory resources in scheduling on-site examinations.

MicroRate. Developed by Damian von Stauffenberg of MicroRate. The Philippine Coalition for Micro-finance Standards. Developed a

set of performance standards to serve as guidelines or benchmarks to assess the operations of Philippine NGOs involved in Micro-finance.

Institutional Performance Standards and Plans Developed by the Committee of Donor Agencies for Small Enterprise Development and Donor's Working Group on Financial Sector Development, United Nations Capital Development Fund.

Reference http://www.ncua.gov/letters/Prior1996/E-LET161.html http://www.sbp.org.pk/about/banks_nbfis/capitalbanks/

creq1.htm

http://www.federalreserve.gov/boarddocs/press/general/1996/19961224/default.htm

http://www.ibtra.com/pdf/Camel%20Rating_IBTRA%20Journal.pdf

http://www.ncua.gov/letters/2000/00-CU-08.pdf http://www.bank-ratings.net/camels/ http://www.sbp.org.pk/departments/bid.htm http://www.sbp.org.pk/reports/annual/arFY01/chap6.pdf http://www.sbp.org.pk/ecodata/NPL.pdf http://webcache.googleusercontent.com/search?

q=cache:qYWJ5Loy9k0J:riskinstitute.ch/00007080.htm+difference+between+undisclosed+reserves+and+disclosed+reserves&cd=1&hl=en&ct=clnk&gl=pk