Explained: CAMELS approach for valuation of financial institutions

CAMELS approach is widely used as a starting point for the analysis of banks.

An investor’s analysis of any given security depends on a plethora of factors that directly or indirectly affect the investment process or deriving conclusions. A company’s business model, revenue model, cash flows, assets, primary business environment, industry, etc are some of the many factors that are pertinent while valuing a stock. Considering the nuances and types of various businesses, different valuation approaches have been developed and followed to value companies. 

For a financial institution called a bank that is involved in giving loans (assets) on the back of deposits received (liabilities), one of the popular approaches for valuation and analysis used is ‘CAMELS’ approach. 

It is an acronym for Capital adequacy, Asset quality, Management capabilities, Earnings sufficiency, Liquidity position, and Sensitivity to market risk. 

Let us have a look at the importance of all six components in brief. 

Capital adequacy: Suppose for simplicity, you have deposited Rs 100 in a bank for a fixed rate of 6%. Bank lends the same amount for one year at 8%. In an ideal situation, the bank should receive Rs 108 after a year, and give you Rs 106 and earn a profit of Rs 2 for itself. But for some reason, if the borrower defaults, and the bank is able to recover only Rs 100. What do you think whose loss would it be of Rs 8. It will be of depositors, which is exactly why there should be sufficient capital (equity) to absorb those losses so that depositors are protected. 

Asset quality: It refers to the credit risk associated with a bank’s assets. In the above example, we would want to evaluate the credit risk of the borrower. High credit risk implies a high probability of default. 

Management capabilities: This refers to the efficient management of the financial institution. 

Earnings: For an investor in investing in a bank, one would want the earnings to be high quality i.e. derived from sustainable rather than non-recurring items. 

Liquidity: Banks are a highly regulated sector due to their economic importance. Various regulations are in place to guide banks regarding their liquidity position. 

Sensitivity analysis: The investor needs to identify exposures of the bank and the sensitivity towards such factors that may have a significant impact on its earnings.