Page 77 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

LOS 17.c: Explain the CAMELS (capital adequacy, asset quality, READING 17: ANALYSIS OF FINANCIAL INSTITUTIONS
management, earnings, liquidity, and sensitivity) approach to
analyzing a bank, including key ratios and its limitations.

MODULE 17.2: CAPITAL ADEQUACY AND ASSET QUALITY
The CAMELS approach is a 6-factor analysis of a bank:
• Capital adequacy,
• Asset quality,
• Management, Capital Adequacy
• Earnings, To prevent financial insolvency, a bank must maintain adequate capital to sustain business losses. Capital adequacy is based on risk-
• Liquidity, and weighted assets (RWA); more risky assets require a higher level of capital. Risk-weighting is specified by individual regulators.
• Sensitivity.

Basel III defines a bank’s capital in a tiered, hierarchical approach:

Tier 1 capital:
• 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.

• Other Tier 1 capital: subordinated instruments with no specified maturity and no
contractual dividends (e.g., preferred stock with discretionary dividends).

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.