In the USA, however, federal and state regulators regularly assess the financial condition of each bank and specific risks faced via on-site examinations and periodic reports. A thorough review includes an evaluation of the bank’s asset quality- particularly the probability of default of interest and principal payments in the loan portfolio- loan review policies, interest rate risk profile, liquidity profile, cash management and internal audit procedures and management quality. Federal regulators rate banks according to the uniform financial institutions rating system, which now encompass six general categories of performance under the label CAMELS. Each refers to a specific category as follows:Professor Rafiqul Islam
C= Capital adequacy
A= Asset quality
M= management quality
S= Sensitivity to market risk.
The sixth category, sensitivity to market risk, has only been used since January 1, 1997. The capital component (C) signals the institution’s ability to maintain capital commensurate to identify, measure, monitor and control these risks. Asset quality (A) reflects the amount of existing credit risk associated with the loan and investment portfolio as well as off balance sheet activities. The management category (M) reflects the adequacy of the broad of directors and senior management systems and procedures to identify, measure, monitor and control risks. Regulations emphasize the existence and use of polices and process to manage risks within targets. Earnings (E) reflect not only the quality and trend in earnings, but also the factors that may affect the sustainability or quality of earnings. Liquidity (L) reflects the adequacy of institution’s current and perspective sources of liquidity and funds management practices. Finally, the last category, sensitivity to market risk (S), reflects the degree to which changes in interest rate, exchange rate, commodity prices and quality prices can adversely affect earrings or economic capital.
Regulators numerically rate each bank in each category, ranging from the higher or best rating (1) to the worst or lowest (5) rating. It also assigns a composite rating for the bank’s overall operation. A composite rating 1 or 2 indicates a fundamentally sound bank. A rating of 3 indicates that the bank shows some underlying weakness that should be corrected. A rating of 4 or 5 indicates a problem bank with some near-term potential for failure.
The public opinion of how much capital is adequate is equally an important factor. If the depositors think the amount of capital is too small for a bank, they could withdraw deposits and force liquidation of assets. Thus a solvent bank should suffer loss and liquidation when capital is inadequate for the maintenance of confidence. Bank capital supports confidence in very real sense.
To monitor the capital adequacy requirement of banking institutions effectively, a strong financial regulator like a powerful central bank or an efficient financial services authority is essential. The financial regulator needs three things: a sound operating structure’ sensible procedures and competent staff’ and credibility so that wrong doers are properly punished and others deterred.
Furthermore, the bank supervisor is concerned not only with what may be adequate at the moment but with what may be a needed in the future. Bank capital is a cushion not only against the facts of today, but also, or even more so, against the contingencies of tomorrow. Determining the size of bank capital is not easy, but it is important. And if a bank is to grow, with increased deposits and earrings assets, it must expand its capital base but at the same time keep the risk level constant.
Faculty of Business & Economics (FBE)Next topic will be on Basel Accords