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Use the CAMEL system, built around earnings, liquidity, management, asset quality and capital adequacy, to appraise how sound a bank is financially.

FRM® Part II · Credit Risk Measurement and Management · Introduction to Credit Risk Modeling and Assessment · FRM2.CR.5.a

The idea

The CAMEL system is a supervisory framework that rates a bank on five dimensions: capital adequacy, asset quality, management, earnings and liquidity. Capital adequacy asks whether capital relative to risk-weighted assets can absorb losses, using Tier 1 and total capital ratios. Asset quality looks at the loan book: non-performing loans to gross loans, reserves to non-performing loans and concentrations. Management is the most judgmental element, covering governance, risk controls and strategy. Earnings are judged through return on assets, net interest margin and cost-to-income. The sustainability of income matters as much as its level, so one-off gains should be stripped out. Liquidity covers funding stability, loans to deposits and maturity gaps. A bank can look strong on four letters and still fail on the fifth, and exam items usually ask which letter a given indicator belongs to.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which CAMEL component is most directly assessed by the ratio of non-performing loans to gross loans and by the level of loan loss reserves?

  1. Capital adequacyWhy not: Capital adequacy looks at capital relative to risk-weighted assets; it uses reserves only indirectly and is not measured by NPL ratios.
  2. EarningsWhy not: Earnings is judged through return on assets, net interest margin and cost-to-income, not through the credit quality of the loan book.
  3. LiquidityWhy not: Liquidity concerns funding stability and maturity gaps, such as loans to deposits, not borrower performance.
  4. Asset quality - correct

The NPL ratio and reserve coverage describe how well the loan book is performing, which is the asset quality letter (A) of CAMEL.

A harder one

A bank reports a return on assets of 1.3 percent, an NPL ratio of 1.1 percent and a Tier 1 ratio of 14 percent. However, its loans are 130 percent of deposits and 60 percent of funding is wholesale money maturing within three months. Which CAMEL component raises the greatest concern?

  1. EarningsWhy not: A 1.3 percent return on assets is healthy, so earnings is not the weak point.
  2. Asset qualityWhy not: An NPL ratio of 1.1 percent is low, so the loan book is not the problem.
  3. Liquidity - correct
  4. Capital adequacyWhy not: A Tier 1 ratio of 14 percent is comfortable, so capital is not the weak point.

The loans-to-deposits ratio above 100 percent and heavy short-term wholesale funding point to a funding and maturity mismatch, which is the liquidity component. The other three indicators are strong.

The hardest tier

A bank has gross loans of USD 5,000 million, an NPL ratio of 4 percent, loan loss reserves of USD 90 million and equity capital of USD 400 million. Assuming each NPL could be lost in full, unreserved NPLs as a percentage of capital are closest to:

  1. 50.0%Why not: Ignores the reserves already held against NPLs: 200 / 400.
  2. 27.5% - correct
  3. 2.2%Why not: Divides unreserved NPLs by gross loans instead of by capital: 110 / 5,000.
  4. 45.0%Why not: This is the reserve coverage ratio, 90 / 200, not unreserved NPLs relative to capital.

NPLs = 4% x 5,000 = 200. Unreserved NPLs = 200 - 90 = 110. Relative to capital: 110 / 400 = 27.5%. This links asset quality to capital adequacy, the loss-absorbing buffer.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

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