CAMELS is a recognized international rating system that bank supervisory authorities use in order to rate financial institutions according to six factors represented by its acronym.

Supervisory authorities assign each bank a score on a scale. A rating of one is considered the best, and a rating of five is considered the worst for each factor.

Capital Adequacy

It is the proportion of a bank's assets that is funded with capital.

There are two types of capital:

Tier-1 capital can absorb losses without a bank being required to cease trading. It includes common stock, retained earnings and comprehensive income.
Tier-2 capital provides a lesser degree of protection to depositors. It cushions losses in case the bank is winding up. It is used to absorb losses if a bank loses all its Tier-1 capital.

Risk-weighted assets are used to determine the minimum amount of capital that must be held by banks to reduce the risk of insolvency. The capital requirement is based on a risk assessment for each type of bank asset. All of the loans the bank has issued are weighted based on their degree of credit risk. For example, loans issued to the government are weighted at 0.0%, while those given to individuals are assigned a weighted score of 100.0%. A loan that is secured by a letter of credit is considered to be riskier and requires more capital than a mortgage loan that is secured with collateral.

The capital adequacy ratio (CAR) is a measurement of a bank's available capital expressed as a percentage of a bank's risk-weighted credit exposures. It is used to protect depositors and promote the stability and efficiency of financial systems around the world.

capital adequacy ratio = (Tier-1 Capital + Tier-2 Capital) / Risk-weighted assets

Generally, a bank with a high capital adequacy ratio is considered safe and likely to meet its financial obligations.

Currently, the minimum ratio of capital to risk-weighted assets is 8% under Basel II and 10.5% under Basel III. Note this is different from the reading.

Asset Quality

It tries to answer the following questions:

- What is the overall asset composition?
- How much credit risk does a bank's assets have? How diversified are they in terms of credit risk?
- How well are these assets generated and managed? What are the bank's investment policies and practices?

Management

To assess a bank's management quality, it requires professional judgment of a bank's compliance to policies and procedures, aptitude for risk-taking, development of strategic plans.

- The performance of the other five CAMELS components will depend on the management quality.
- The ratio of non-interest expenditures to total asset (MGNT) can be one of the measures to assess the working of the management. This variable, which includes a variety of expenses, such as payroll, workers compensation and training investment, reflects the management policy stance.
- Another ratio helpful is Cost per unit of money lent which is operating cost upon total money disbursed.

Earnings

A bank's ability to create appropriate returns to be able to expand, retain competitiveness, and add capital is a key factor in rating its continued viability. Examiners determine this by assessing the company's growth, stability, valuation allowances, net interest margin, net worth level and the quality of the company's existing assets.

This also includes the concept of earnings quality: what are the compositions of earnings? are they sustainable?

Judgment is required whenever fair values cannot be based on observable market prices. A fair value hierarchy can be used to establish the fair value of financial assets and liabilities.

Liquidity

How easy can a bank convert its assets to cash?

Basel III introduced two minimum liquidity standards:

1. The Liquidity Coverage Ratio (LCR) = highly liquid assets / one-month liquidity needs
2. The Net Stable Funding Ratio (NSFR) = available stable funding / required stable funding
available stable funding: a function of the composition and maturity of a bank's funding sources.
required stable funding: a function of the composition and maturity of a bank's asset base.

For both ratios, the standards set a target minimum to be 100%.

Concentration of funding and contractual maturity mismatch are two metrics for liquidity-monitoring purposes.

Sensitivity to Market Risk

The main concern for financial institutions is risk management. Reflects the degree to which changes in interest rates, foreign exchange rates, commodity prices, or equity prices can adversely affect a financial institution's earnings.