IX. Write a memorandum

Introduction to the Camel Rating System

A prime task of bank supervisors is to judge evaluate the financial condition of the banks for which they are responsible.

In evaluating or "rating" a bank, it is important that a standard system be used all bank supervisors can look at it in the same way.

With a clear rating system, everyone from the Governor to the newest staff member in bank supervision can quickly understand the financial condition of a bank by learning its rating.

However, such a system needs to take into account all the financial aspects that are important to a bank's soundness.

In the United States, the three bank supervision agencies, the Federal Reserve, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation, all previously used their own rating systems.

In 1978, these three agencies all agreed to standardize their rating system. This agreed upon system has been in place since then.

This rating system takes into account all the major components of bank soundness. Thus, learning the system in detail serves as a method of teaching financial analysis of banks.

Because this system is clear and most of its concepts are easily understood, even by those not highly trained in bank supervision, many supervisory authorities in developing countries are now using this system for rating their banks.

The American bank rating system is called “CAMEL” as the first letter of each component that is analyzed spells out that word:

" C " is for capital adequacy. The system measures how much capital a bank has to protect its depositors and if this amount is sufficient.

" A " is for asset quality. The system determines the collectibility of assets and off-balance sheet items, as well as the financial impact of problem advances.

" M " is for management. The system evaluates a bank's management based on performance, policies established, controls, depth, and adherence to law and regulation.

" E " is for earnings, or profitability. The system measures bank profitability to see if it is sufficient to support future growth.

" L " is for liquidity. The system determines if a bank is liquid enough to meet regular and most unexpected obligations.

You work for a bank which performance is being supervised. Your Financial Manager, Charlotte Ameasbury, has asked you to represent her at a meeting and let her know what you said. The meeting was between you, Karl Brewer, working for the Financial Department and Mr. John Cannon, your bank’s supervisor. The main discussion went as follows.

Mr. Cannon:	We look at capital as the main source of protection for depositors. A well-capitalized bank can absorb large losses without the depositors losing their money. To evaluate your bank’s capital adequacy, we primarily rely on ratios. But before a ratio can be calculated, we must define capital, meaning what types of accounts can be used as capital.
Karl:	We recognize as capital paid-up capital by shareholders, share premiums on capital, retained profits, and general or legal reserves. We sometimes call it core capital.
Mr. Cannon:	I’d like to clear out the issue of supplementary capital. Judging from the documentary data it includes revaluation reserves on fixed assets, unencumbered general provisions for future loan losses, and various types of debt instruments which can be subordinated to the interests of the depositors.
Karl:	So, once capital is defined, a choice is to be made as to what it is compared to. Traditionally it has been deposits or more recently total assets.
Mr. Cannon:	Let us agree on capital measured against the risks your bank assumes, both on and off its balance sheet. As a result, a simple gearing or leveraging ratio of capital to total deposits or total assets has been replaced by a risk-based method.
Karl:	But let us leave this question and turn to it when Mrs. Ameasbury joins us.

Your task is:

1) Write a suitable memo to the Finance Manager in accordance with her instructions.

2) Prepare some theoretical material on asset quality to be ready to the supervision of your bank and discuss it with Charlotte.

A major part of bank supervision is determining asset quality, which includes which assets are uncollectible or whose true value is less than shown on the bank’s books.

· To rate asset quality, it is usually necessary for an on-site examination to be done.

· Examiners who are well trained in evaluation of advances and other credit facilities will assign a classification to the problem loans based on analysis of collectibility.

· The classification system of substandard, doubtful, and loss enables the supervisor to quantitatively determine a bank's overall asset quality rating in the CAMEL system, and to judge the adequacy of the provisions for loan losses.

· It is essential to remember that while submitted returns can give some indicators of asset quality, a true and thorough evaluation of it comes from on-site examinations done by examiners trained in credit analysis.

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