Why CAMEL failed to recognize the weakness of banks?

Many analysts or bank inspectors use the CAMEL for analyzing banks and not knowing the disadvantages of the model. Here is an expose of the potential loopholes and where the EAGLES benchmark may excel.

Demise of CAMEL?

In the CAMEL, analysts assess five key aspects of the operations of a financial institution – Capital, Assets, Management, Earnings and Liquidity – rating them on a scale of 1 to 5. An overall rating of 1 is best while a rating of 5 implies a bank being laden with existing or potential problems.

However, the CAMEL approach suffers from indeterminacy, subjectivity and even inconsistency. As most bank analysts and examiners will acknowledge, there are instances when an examination of the accounting records cannot decide whether to give an average or below average score. The ‘good’ and ‘bad’ indicators are easy to spot, but not so the ‘in-betweens’. This is a problem of indeterminacy. But when bank inspectors are forced to make a judgement, then it leads to the second problem of subjectivity. And where human minds are at work, they come with differing levels of expectations and perspectives.

So in is of little wonder why CAMEL has failed to recognize weaknesses in banks before the crisis.

Enter the EAGLES

The EAGLES is able to measure and compare banks performance in a more determinate, objective and consistent manner. The name is derived from the key success factors confronting banks today, i.e. Earning ability, Asset quality, Growth, Liquidity, Equity and Strategy. This approach has been pioneered by the writer and has gained creditability among the banking community and fund management industry in Asia, for competitor analysis and investment planning respectively. It also predicted the Asian financial crisis in the 1980s when the writer was “banned” from data collection in many countries.

Earning ability is shown by three noteworthy indicators – Return on Assets (ROA), Return on Shareholders’ Fund (ROSF) and Income/Overheads ratio (IOR). The importance of the IOR is usually not well understood. The main point lies in that Income depends on external market forces, while Overheads is highly influenced by internal staffing. So the bank must know how to adjust the staffing according to market demand for its products and services.

Asset quality is best assessed by on-site inspection of the bank’s loan portfolio.If this is not possible, the asset quality can be measured by the level of bad debt provisions, that is, bad and doubtful debts (BDD) as a percentage of total loans. A conservative approach will dictate that the quantum of provision to err on the high side rather low.

Growth rates of loans and core deposits are the most important indicators of a how a bank wants to position itself in the marketplace. A high growth loan book without a corresponding growth in deposit base signifies an intention to increase interest margins. A higher deposit growth without a corresponding growth in loans means that the bank suffers from low interest margins. For some banks lower interest margins could hamper overall profitability.

Liquidity can be described as the ability of a bank to have sufficient funds to meet cash demands for loans deposit withdrawals and operating expenses. For this reason, a balance should be found between the amount of deposits garnered and the quantum of loans extended. The indicator is the deposit-to-loan ratio.

Equity level and capital adequacy have profound impact upon the bank. Not only is there an international guideline (Basle II) that stipulates a bank must have a minimum capital equivalent to 8% of risk adjusted asset. Many banks are restricted to open additional branches unless they meet minimum capital requirements.

The effective management of a bank strategy is indicated by the strategic response quotient (SRQ). It is an intriguing ratio because it assesses management’s ability to lend, to garner deposits, obtain fee-based income and to manage the operating cost. As to what is an appropriate balance of the three core banking activities will depend on the bank’s strategy. The SRQ is obtained by dividing the interest margin by net operating cost (that is, total operating cost less fee income). The higher figure the better combined with excellent risk controls.

(Excerpt from “Soar on wings of Eagles” Bankers Journal Malaysia, Oct/Nov