C.A.M.E.L.S Flashcards
Capital Adequacy
To prevent financial insolvency, a bank must maintain adequate capital to sustain business losses.
Capital adequacy is based on Risk-Weighted Assets (RWA). Lower the risk weighting, lower the risk and higher the risk weighting, higher the risk.
Basel III defines a bank’s capital in a hierarchical approach.
Total Tier 1 Capital:
a. Common Equity Tier 1 Capital: This is the most important component. It is widely recognized as the most loss-absorbing form of capital. E.g. Common Stock, Additional Paid-in-Capital, Retained Earnings and OCI - Intangible Assets and Deferred Tax Assets.
b. Other Tier 1 Capital: Subordinated instruments with no specified maturity and no contractualdividends. E.g. Preferred Stock with discretionary dividends.
Tier 2 Capital: Subordinated instruments with original (i.e. when issued) maturity of more than 5 years.
Asset Quality
In broad context, asset quality derives from the processes of generating assets, managing them and controlling overall risk.
Bank assets include loans (the largest component) and investments in securities; while loans are generally carried on the balance sheet at amortized cost, net of allowances.
- Loans and Advances to Banks
- Loans and Advances to Customers
- Reverse Repurchase Agreement (REPO) is a form of Collateralized Loan made by a Bank to Client.
Assets Held for Sale is related to discontinued operations and specifically refers to long-term assets whose value is driven mainly by their intended disposition rather than their continued use.
Credit risk is present in debt securities that the bank invests in, loans the bank makes as well as in the bank’s off-balance sheet liabilities i.e. guarantees, used committed credit lines and letters of credit
represent potential assets (as well as potential liabilities) to the bank.
Management Capabilities
A strong governance structure with an independent board that avoids excessive compensation or self-dealing is also critically important.
Sound internal controls, transparent management communication and financial reporting quality are indicators of management effectiveness.
Earnings
A major source of earnings of a bank is from investment in securities. Estimates used in the valuation of these securities may lead to biased earnings.
Both IFRS and US GAAP use the concept of ‘Fair Value
Hierarchy’ based on types of inputs used in determining the fair value of financial assets and liabilities.
Level 1 inputs are quoted market prices of identical assets or liabilities in active markets.
Level 2 inputs include quoted prices of similar assets, quoted prices of identical assets in non-active markets, observable interest rates, credit spreads and implied volatility.
Level 3 inputs are non-observable and hence subjective.
For example, fair value may be derived from models or based on estimated future cashflows discounted at an estimated discount rate.
Similar to other companies, other subjective estimates (e.g. goodwill
impairment, recognition of deferred tax assets and recognition of contingent liabilities) affects the quality of a bank’s earnings.
For a typical bank, major sources of earnings are
(i) net interest income (the difference between interest earned in loans minus interest paid on the deposits supporting those loans),
(ii) service income and (iii) trading income; of these trading income is the most volatile year to year and hence on a relative basis banks with proportionally higher net interest income and service income would have more sustainable earnings.
Luqidity Position
The impact of a bank’s failure to honor a current liability could affect an entire economy.
Deposits in most banks are insured upto some specified amount by government insurers.
Sensitivity to Market Risk
Bank earnings are affected by various market risks e.g. volatility of security prices, currency values and interest rates.
The most critical of these is interest rate risk. A bank’s interest rate risk is the result of differences in maturity, rates and repricing frequency between the bank’s assets and its liabilities.
For example, in a rising interest rate scenario, if the assets are repriced more frequently than liabilities, the bank’s net interest income would increase.
The impact of market risk can be captured by Value at Risk (VaR).
In the MD&A section, banks disclose information about the sensitivity of earnings to different market conditions, namely, the earnings impact of a shift up or down in some market.
