Financial Ratio and Ranking for the Banking Sector (Part I)

One distinctive characteristic of banks is their asset composition.  Generally, non-financial companies’ assets are predominantly tangible assets, such as plants, properties and equipment.  While bank assets are predominantly financial assets such as loans and securities and their liabilities are primarily deposits.

Banks are also heavily regulated by authorities as such, capital, minimum liquidity, and the riskiness of assets must meet authorities’ requirements.

Hence, certain conventional financial ratios such as Gross Profit Margin, Inventory Turnover, Current Ratio and D/E etc are not relevant.

The most common rating approach for banks is “CAMELS”, an acronym of six components as follows:

Capital adequacy

Capital adequacy for banks is described in terms of the proportion of the bank’s assets funded with capital. For purposes of determining capital adequacy, a bank’s assets are adjusted based on their risk, with riskier assets requiring a higher weightage.

Asset quality

Asset quality pertains to the amount of existing and potential credit risk associated with a bank’s assets and focuses primarily on financial assets.

Management capabilities

Management capability is the ability to identify and control risk, including credit risk, market risk, operating risk, legal risk, and other risks.

Earnings sufficiency

Earning sufficiency means banks should ideally generate an amount of earnings to provide an adequate return on capital to their capital providers and specifically to reward their stockholders through capital appreciation and/or distribution of earnings.

Liquidity position

Adequate liquidity is essential for any type of entity. Banks’ systemic importance increases the importance of adequate liquidity. If a non-bank entity’s insufficient liquidity prevents it from paying a current liability, the impact would primarily affect the entity’s own supply chain.

Sensitivity to market risk

Banks’ operational sensitivity to interest rates, exchange rates, equity prices, or commodity prices are key to its financial strength.

(The quantitative part of CAMELS will be covered in Part II of this series of article, stay online!)

Reference:

Analysis of Financial Institutions by Jack T. Ciesielski, CPA, CFA, and Elaine Henry, PhD, CFA