Capital Adequacy and Asset Quality
What you'll learn
- LOS 10.cExplain the CAMELS (capital adequacy, asset quality, management, earnings, liquidity, and sensitivity) approach to analyzing a bank, including key
ratios and its limitations.
The CAMELS approach is a six factor analysis of a bank, including capital adequacy, asset quality, management, earnings, liquidity, and sensitivity.
Capital Adequacy
To prevent financial insolvency, a bank must maintain adequate capital to sustain business losses. Capital adequacy is based on risk weighted assets (RWAs); more risky assets require a higher level of capital. Risk weighting is specified by individual regulators.
Mega Bank is regulated by the Central Bank of Zima. Per the central bank rules, the following risk weightings are applied to the bank’s assets.
An Analysis of Mega Bank’s balance sheet for 20X8 reveals the following.
Calculate Mega Bank’s RWA.
Solution
Basel III defines a bank’s capital in a tiered, hierarchical approach:
1. Tier 1 capital: a. Common Equity Tier 1 capital (the most important component): Common stock, additional paid in capital, retained earnings, and OCI less intangibles and deferred tax assets. b. Other Tier 1 capital: subordinated instruments with no specified maturity and
no contractual dividends (e.g., preferred stock with discretionary dividends).
2. Tier 2 capital: Subordinated instruments with original (i.e., when issued) maturity of more than five years.
Tier 1 capital plus Tier 2 capital makes up the total capital of a bank.
Again, individual jurisdictions specify the minimum capital requirements. Basel III guidelines specify a minimum Common Equity Tier 1 capital of 4.5% of RWA, minimum total Tier 1 capital of 6% of RWA, and minimum total capital of 8% of RWA.
Mega Bank’s RWA for 20X7 and 20X8 were $4,700,000 and $5,175,000, respectively. An analysis of bank’s capital for the two years reveals the following information.
1. Determine the Common Equity Tier 1 capital ratio, Tier 1 capital ratio and total capital ratio for both years.
2. Comment on capital adequacy for Mega Bank.
Solution
1. Mega Bank’s capital ratios as a percentage of its RWA for the two years are shown in the following table.
2. Mega Bank’s Common Equity Tier 1 ratio is less than Basel III guideline of 4.5%. Furthermore, it has worsened from 20X7 to 20X8. Given that this is the most important component of capital, it should be a cause for concern for the bank’s regulators.
The bank’s total Tier 1 ratio was above the Basel III guideline of 6% in 20X7, but it has fallen below the guideline for 20X8. The total capital ratio is above the Basel III guideline of 8% for 20X7 but again has fallen short in 20X8.
Asset Quality
In a broad context, asset quality derives from the processes of generating assets, managing them, and controlling overall risk. Evaluation of asset quality includes analysis of current and potential credit risk associated with the bank’s assets.
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), the accounting treatment for investments in securities differs between U.S. GAAP and IFRS. Under IFRS 9, depending on the business model, debt securities may be carried at amortized cost, fair value through OCI, or fair value through profit or loss.
Equity securities are always carried at fair value (either through OCI or through profit or loss). Under U.S. GAAP, equity investments are carried at fair value through profit or loss, while debt securities can be carried at amortized cost (held to maturity classification), fair value through OCI (available for sale classification) or fair value through profit or loss (trading classification).
It helps to be familiar with a couple of terms used in bank balance sheets (even though terms used can vary quite a bit among banks):
1. Reverse repurchase agreements are bank loans advanced under a repurchase agreement (i.e., against a high quality collateral).
2. Assets held for sale pertain to discontinued operations whose value in the balance sheet assumes disposition (as opposed to long term holding).
Credit Risk Analysis
The nature of a bank’s business entails a large exposure to credit risk. 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 (e.g., unused lines of credit, or letters of credit). Analyzing the credit quality of a bank’s assets can provide an analyst key insights into the bank’s solvency and future profitability.
The following table provides information for loans held by Small Bank at the end of 20X8 and 20X7.
1. It appears that from 20X7 to 20X8, the credit quality of Small Bank’s loan assets has most likely:
A. worsened.
B. improved.
C. remained essentially the same.
2. The proportion of loans at the end of 20X8 that are either past due or impaired is closest to:
A. 12%.
B. 16%.
C. 19%.
Solution
The following table summarizes the percentage of loans in each category for both years.
1. A It appears that proportion of better quality loans (at least satisfactory credit quality) has declined while that of poor credit quality (past due, impaired and seriously impaired) has increased.
2. B The total of loans that were either past due or impaired (including seriously impaired) at the end of 20X8 = 5% + 8% + 3% = 16%. Though not asked for in this question, the total for 20X7 was 4% + 6% + 2% = 12%.
Loan Loss Provisions
For a bank, loans represent a large portion of its total assets. Accordingly, the credit quality of loans and loss provisions are critical in evaluating the bank’s financial position and performance. Allowance for loan losses is a contra asset account to loans and is the result of provision for loan losses, an expense subject to management discretion.
Analysts need to evaluate the bank’s policy of setting aside adequate provisions relative to actual loan performance. Actual losses (net of recoveries) are then written off against these provisions.
Several ratios are useful in this evaluation:
1. Ratio of allowance for loan losses to nonperforming loans.
2. Ratio of allowance for loan losses to net loan charge offs.
3. Ratio of provision for loan losses to net loan charge offs.
Each ratio compares a discretionary metric (i.e., allowance or provision) to a more objective measure.
The following information is collected for Mega Bank.
Calculate the appropriate ratios to evaluate the adequacy of loan loss reserves as well as provisions for loan losses for Mega Bank.
Solution
The allowance for loan losses to nonperforming loans ratio has declined from 1.02 to 0.56, indicating that the bank has not made sufficient provisions for loan losses (i.e., possible aggressive accounting).
This aggressive accounting is also evidenced by the provision for loan losses to net loan charge offs ratio, which is also declining from 0.68 to 0.65. In other words, for 20X8, the expense recorded for loan losses was only 65% of actual losses during that year.
The allowance for loan losses to net loan charge offs ratio has decreased for 20X8, indicating that the rate of increase in allowance for loan losses is significantly below the growth rate of actual write offs.