Skip to content

CFA Level II Exam · Analysis of Financial Institutions

CAMELS Approach to Analyzing Banks for CFA Level II

Updated 7 October 2026 · Fact-checked

CAMELS is a framework for judging a bank's health. It covers Capital adequacy, Asset quality, Management, Earnings, Liquidity and Sensitivity to market risk. To solve a question, find the vignette ratios for each component, compare them with peers or prior periods, and decide whether the bank is stronger or weaker.

Understand CAMELS Approach to Analyzing Banks

CAMELS is a checklist that analysts and regulators use to rate a bank. A bank borrows short and lends long, uses high leverage, and depends on depositor trust. So you cannot judge it by one ratio. You need to look at six areas together.

The six letters stand for Capital adequacy, Asset quality, Management capabilities, Earnings sufficiency, Liquidity position and Sensitivity to market risk. Each one answers a different question. Does the bank have enough loss-absorbing equity? Are its loans likely to be repaid? Is it well run? Does it earn enough? Can it meet withdrawals? Can rate or currency moves hurt it?

The components are linked. Weak asset quality means more loan losses, which cuts earnings, which erodes capital. Poor management can cause all of these. A bank with thin liquidity can be forced to sell assets at a loss. That is why one strong ratio never settles the answer.

On the exam, the vignette gives you a few figures and some text. Your job is to map each piece of data to a letter, compare it with a benchmark (a peer bank, regulatory minimum or the prior year), and draw a conclusion. Some components, such as management, are mostly qualitative. Look for clues like governance, risk culture, strategy consistency and past regulatory issues.

Note that CAMELS is an analyst framework. It is not a single score formula. Regulators may assign ratings, but in the exam you usually reason about direction: stronger, weaker or unclear.

Key formulas to remember

Capital adequacy (risk-based)
Capital ratio = Regulatory capital ÷ Risk-weighted assets
Compare with the regulatory minimum. Higher means a bigger buffer. Tier 1 and total capital versions both exist.
Leverage ratio
Leverage ratio = Tier 1 capital ÷ Total exposure (or total assets)
Does not use risk weights, so it checks for risk-weight manipulation.
Asset quality: nonperforming loans
NPL ratio = Nonperforming loans ÷ Total loans
Higher is worse. Also watch loan loss reserves ÷ NPLs (coverage).
Reserve coverage
Coverage = Loan loss reserve ÷ Nonperforming loans
Higher means more cushion against expected losses.
Net interest margin
NIM = Net interest income ÷ Average earning assets
Core earnings measure for a lending-based bank.
Return on equity / assets
ROE = Net income ÷ Average equity; ROA = Net income ÷ Average assets
Check quality of earnings: stable, recurring income is better than one-offs.
Efficiency ratio
Efficiency ratio = Noninterest expense ÷ Total revenue
Lower is better. A rising ratio can signal weak cost control.
Liquidity coverage ratio
LCR = High-quality liquid assets ÷ Net cash outflows over 30 days
Regulatory minimum is 100%. Higher means more short-term resilience.
Net stable funding ratio
NSFR = Available stable funding ÷ Required stable funding
Regulatory minimum is 100%. It looks at funding over one year.
Loan-to-deposit ratio
Loans ÷ Deposits
A high value suggests reliance on less stable wholesale funding.

How to solve CAMELS Approach to Analyzing Banks questions

Use the same routine for any CAMELS item. It keeps you organised and stops you from mixing components.

  1. 1Read the question first so you know which component or overall conclusion is asked for.
  2. 2Scan the vignette and exhibits. Label each data point with a letter: C, A, M, E, L or S.
  3. 3Identify the right ratio for the component and compute it if needed. Use average balances when the formula says so.
  4. 4Pick the benchmark: regulatory minimum, peer bank or prior year. A ratio means little alone.
  5. 5Decide the direction. Higher is better for capital, coverage, NIM, ROE and liquidity ratios. Higher is worse for NPL and efficiency ratios.
  6. 6Link the components. Ask if one weakness explains another, such as rising NPLs hurting earnings and capital.
  7. 7Choose the option that matches your conclusion and the vignette facts. Reject options that use data from the wrong component.

Quickest way: Letter-tagging and direction check

When to use it: Use it when a vignette has many numbers and you have limited time per item set.

  1. Write C A M E L S down the side of your scratch space.
  2. Put each number or phrase in the vignette next to its letter as you read.
  3. Mark each one as plus or minus against its benchmark.
  4. Answer the question from the tags. Compute only the ratio you really need.
  5. If two options both look reasonable, pick the one tied to the specific evidence in the vignette.

Common mistakes in CAMELS Approach to Analyzing Banks

  • Treating a high capital ratio as proof the bank is healthy.

    Capital is the first letter, so students overweight it.

    Fix: Check asset quality and earnings. Capital can fall fast if NPLs are rising and reserves are low.

  • Reading a higher NPL ratio as good or neutral.

    Students mix up ratios where higher is better, like coverage, with those where higher is worse.

    Fix: Note the direction for each ratio before comparing. NPL up is worse. Reserve coverage up is better.

  • Judging earnings by ROE alone.

    ROE is familiar from DuPont work.

    Fix: A high ROE can come from high leverage or one-off gains. Check NIM, efficiency, income stability and capital together.

  • Ignoring qualitative evidence for management.

    There is no formula, so students skip it.

    Fix: Look for governance, risk controls, strategy changes, aggressive growth and regulatory findings in the text. These support or contradict the numbers.

  • Using the loan-to-deposit ratio as the only liquidity test.

    It is simple and quick to compute.

    Fix: Also use LCR and NSFR where given. Consider funding stability and quality of liquid assets.

  • Forgetting that sensitivity to market risk covers interest rate, currency and price risks.

    Students think only of interest rates.

    Fix: Check the vignette for rate gaps, trading book size, foreign currency exposure and securities holdings.

Worked examples

Example 1

Vignette: Bank X and Bank Y are compared. Bank X: nonperforming loans ₹40 crore, total loans ₹1,000 crore, loan loss reserve ₹30 crore, net interest income ₹60 crore, average earning assets ₹1,500 crore. Bank Y: nonperforming loans ₹20 crore, total loans ₹800 crore, loan loss reserve ₹30 crore. Q1: Which bank has the higher NPL ratio? Q2: Which bank has better reserve coverage? Q3: What is Bank X's net interest margin?

Show the solution
  1. Q1: Bank X NPL ratio = 40 ÷ 1,000 = 4.0%. Bank Y = 20 ÷ 800 = 2.5%. Bank X is higher, which is worse for asset quality.
  2. Q2: Bank X coverage = 30 ÷ 40 = 75%. Bank Y = 30 ÷ 20 = 150%. Bank Y has better coverage.
  3. Q3: NIM = 60 ÷ 1,500 = 4.0%.

Answer: Q1: Bank X (4.0% vs 2.5%). Q2: Bank Y (150% vs 75%). Q3: 4.0%. Bank Y looks stronger on asset quality.

Example 2

Vignette: A bank reports Tier 1 capital of $9 billion and risk-weighted assets of $100 billion. Total exposure is $180 billion. Its high-quality liquid assets are $30 billion and projected 30-day net cash outflows are $40 billion. Q1: What is the Tier 1 risk-based ratio? Q2: What is the leverage ratio? Q3: What is the LCR and does it meet a 100% minimum?

Show the solution
  1. Q1: 9 ÷ 100 = 9.0%.
  2. Q2: Leverage ratio = 9 ÷ 180 = 5.0%.
  3. Q3: LCR = 30 ÷ 40 = 75%. This is below 100%, so it fails the minimum.

Answer: Q1: 9.0%. Q2: 5.0%. Q3: 75%, which does not meet the 100% minimum, so liquidity is the weak component.

Exam tips

  • Tag every number in the vignette with a CAMELS letter before you read the questions in detail.
  • Memorise the direction of each ratio. Many wrong options flip higher-is-better with higher-is-worse.
  • Expect questions that link components, such as how rising NPLs affect earnings and capital.
  • For management, use only evidence stated in the vignette. Do not assume facts.
  • You get no penalty for wrong answers, so answer every question even if you have to eliminate options and guess.

CAMELS Approach to Analyzing Banks in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CAMELS Approach to Analyzing Banks: frequently asked questions

What does CAMELS stand for?

It stands for Capital adequacy, Asset quality, Management, Earnings, Liquidity and Sensitivity to market risk. The S was added to the original CAMEL framework. Together they give a broad view of bank health.

How do I analyze a bank using CAMELS in the exam?

Match each fact in the vignette to a component. Compute the relevant ratio and compare it with a benchmark such as a peer, prior year or regulatory minimum. Then state the direction and link the components.

Is there a CAMELS formula or total score I must calculate?

No. CAMELS is a framework, not a single formula. You calculate ratios inside each component, then judge the overall picture.

How is management assessed if there are no ratios?

Use qualitative clues in the vignette, such as governance, risk controls, strategy and compliance history. The efficiency ratio can give some quantitative support for cost control.