How We Asses the Health of Banks? These are Simple Steps to Help You Do That

Regarding their importance, All banks on the Planet should be financially health

Owners of the business require their business to always generate profit. Beyond that, they demand sustainability. There is no point in huge profit if they get it only in one time. However, it can be accomplished only if the business are financially healthy.

Banks are not the exception. As I said in the previous posts, banks are the place where big money comes in and out in a day. In the same time, banks should balance their functions as a channel of fund and also profit making machine. Banks put their legs on both social and commercial side. But, those are nothing if the banks are not in the good condition.

The next big question is how we asses the condition of a bank?

CAMELS are the answer.

I am not kidding. Wikipedia said like this.

Camels rating is a supervisory rating system originally developed in the U.S. to classify a bank’s overall condition. It’s applied to every bank and credit union in the U.S. and is also implemented outside the U.S. by various banking supervisory regulators.

So, CAMELS or C-A-M-E-L-S should stand for something and that is exactly what I will talk about later.

Capital

C in CAMELS stands for bank capital. It refers to capital requirement for bank in order to keep the solvency and do their functions well. There is ratio for that; Capital Adequacy Ratio.

CAR = Tier I capital + Tier II capital / Risk weighted assets

The assets included here is literally all assets, whether it is on-balance sheet or off-balance sheet.

In Indonesia, regulator (in this case Bank Indonesia) require all banks to have 8% minimum CAR. Lower than that number, Bank Indonesia will take any possible actions to fix it.

Asset Quality

A in CAMELS stands for Asset Quality. It asses the quality of all productive asset the bank have.

There is ratio for that; Non-Performing Loan.

NPL ratio = Net non-performing loans/ Total credit given

The regulator require banks to have maximum 5% NPL before Bank Indonesia give warnings. However, if the value is higher than 5%, there is another way to “manipulate” it. Banks can give out more credit or write off the bad credit (assume it as bank loss).

Management

M in CAMELS stands for Management. It refers to how good the decision maker made money for the stockholders.

There is ratio for that; Net Profit Margin.

NPM = Net Income/Operational Revenue

This is the trick. Operational revenue for banks only comes from interest rate and fee. Just that. However, Net Income include interest rate, fee and also miscellaneous income after subtracting with operational expenses.

The lower the value, the better. It is because the operational revenue (deposit&lending, etc.) is higher than net income. It reflects the banks do their job well.

Earning

E in CAMELS stand for Earning. It refers to how profitable the bank is.

There are some ratios for that. Two of them are Return on Asset and Cost Ratio (BOPO — Beban Operational Pengeluaran Operational).

ROA = EBIT (Earning Before Interest and Taxses)/Total Asset

Cost Ratio = Operating Expense/Operating Income

Liquidity

L in CAMELS stand for Liquidity. It measures how good bank meet their short term liability.

There is ratio for that; Loan to Deposit Ratio.

LDR = Total Credit/any Deposit from public

The higher the value, the better in term of banking function (I mean like give loan and keep deposit).

Sensitivity to Market Risk

S in CAMELS stand for Sensitivity to market. It refers to the risk of losses in positions arising from movements in market prices.

There is ratio for that; Interest Expense ratio.

IER = Interest paid/Total deposit

In this case, the lower the ratio, the better the bank performs.

Evaluating The Risk Of Banks

Running a bank is risky. It will be exposed to dozens of risks, internally or externally. They are some of them.

1. Credit risk ~ The risk comes from the borrower’s inability to payback the loan. So, that’s why banks can specialize their credit to certain regions, industries or type of borrowers. Every borrowers usually had credit score (SID — Sistem Informasi Debitur). This is the first identifier for banks before they give out the loans. However, loans are still the most profitable assets, hence they are very risky in the same time. One of the solution of this is to diversify the loans (creating loan credit portfolio) to avoid systematic risks. Other than that, credits are also protected by reserves.
2. Liquidity risk ~ Banks do not allowed to turn all deposits they have into loans. They should have additional money available for depositors to withdraw in any time.
3. Market risk ~ Banks also exposed to fluctuation of asset prices. The risk include interest risks or foreign exchange risks.
4. Operational risk ~ operating expense may very significantly because of many factors such as government regulations.
5. Reputation ~ Negative publication can break people’s trust to not only banks but also other financial institutions.
6. Legal risk

To sum up, analyzing bank’s healthiness is hard. But, there is a much simpler way to that. It is to look at the bank’s stock price because price is commonly an accumulated value of everything that need to be analyzed.