2.1 Theoretical Literature
The banking sector in Africa is at a stimulating level of development where opportunities are increasing. Their digitization enhances customers' consciousness, invites foreign investments, contributes to financial presence, and better means of easy access to financial services. Banks have taken off in the southern and northern regions of Africa. However, the East Africa banking sector is more innovative, where people are being charmed by mobile banking usage than other technological methods that require repetitive maintenance and costs of security. East African societies favor transacting money over the telephone network. The recent global financial crisis absorbed financial institutions where banks' loans and financial assets get worse. During this period, customers took their deposits away from banks; interest rate degraded the value of securities controlled by commercial banks, which resulted in a peak of liabilities (Jean et.al 2020). The banking system is crucial to the economic development of the world. It is unbearable to visualize the commercial, industrial and agricultural development of a country with absence of a well-organized banking system. The banking area is a more complex and fastest-growing sector. Its financial success and performance are vital to depositors, employees, shareholders as well as the whole economy. Thus evaluating financial soundness and performance in the banking sector is an interesting issue (Thisaranga and Ariyasena, 2021).
Bank performance is demarcated as the key driver of profitability generated from their operations. In addition, it is the pillar and the purpose of any banking activity (Ferrouhi, 2018). A Performance measure is the specific quantitative representation of a capacity, process, or result believed relevant to the valuation of performance. Currently, the most commonly used method of evaluating the overall performance of financial institutions as proven in different literatures is CAMEL rating system (Ashenafi, 2020).
Return on assets (ROA) and return on equity (ROE) are used as performance indicators. The indicators can be briefly explained as follows: ROA is the ratio between the profit after tax to total/average assets and ROE is expressed as the ratio of profit after tax to total/average equity (Ramazan and Gulden, 2019).
In the 1940s, the number of failed U.S. banks had increased and created a sensitive insight of banks’ supervisors, regulators, and stakeholders. Additionally, the 2007–2008 global financial crises have triggered both national and international economies’ realization of the importance of banking performance from its activities that need supervised mechanisms. The existence of the CAMELS rating system clarifies and categorizes financial conditions of the entire banks’ activities and measures the banking sector’s financial performance and market discipline (Nguyen, 2021).
The camel components are described as following:
Capital adequacy is the capital predictable to sustain balance with the risks exposure of the financial institution such as market risk, credit risk and operational risk, in order protect the financial institution's debt holder and to engross the potential losses. Capital adequacy ratio consists of the types of financial capital considered as the most reliable and liquid, primarily shareholders’ equity (Bishnu, 2019).
Asset Quality reflects the magnitude of credit risk prevalent in the bank due to its composition and quality of loans, advances, investments, and off-balance sheet activities. Following ratios are considered for the purpose of analysis (a) Net NPAs to Net Advances (b) Net NPAs to Total Assets (c) Total Investments to Total Assets (Fentahun and Venkateswarlu, 2019).
Management Efficiency is a basic component of the Camel model that ensures the growth of a bank. The competition in the banking sector reinforces the need to improve productivity of banks through measures which aim to reduce the operating cost and improve the profitability of the banks. The operating cost to total asset is used to evaluate the management efficiency (Kumar&Malhotra, 2017). And also it can be measured as Deposits Interest Expenses to Total Deposits (Thisaranga & Ariyasena., 2021).
Earnings: is one of the most important ratios that measure the performance of the bank. The profitability is the main objective of the banks and the prime source of increase in capital of a bank. The ratio that is used to evaluate the earnings is interest margin to gross income (Isanzu, 2016).
Liquidity ratio measures the bank’s capability to meet their current obligation. Banks make money by providing fund and mobilizing deposit for creditors, thus the bank desires to be sensible to make the payment when depositors demands for. The incapability of the bank to meet the demand of depositor results the liquidity risk. So, the fund management practice should certify an institution is capable to conserve a level of liquidity adequate to meet its financial obligations in a timely and capable of quickly liquidating assets with insignificant loss (Mulalem, 2015).
2.2 Empirical Literature
Many studies were nationally and internationally conducted on effect of CAMEL on financial performance of banking sectors. Some of they were concluded as following;
Ashenafi N. (2020) examined the determinants of financial performance of private commercial banks in the Ethiopia. In this study all 16 operational private commercial banks in Ethiopia are included and EPS, ROA and ROE are taken as indicator of financial performance of private commercial banks in Ethiopia. The study conducted bank specific CAMEL factors for period from 2016 to 2020 and investigate them with fixed effect balanced regression model using SPSS 20. The finding of the study reveals that financial performance is significantly affected by capital adequacy, management efficiency and liquidity position of private commercial bank. In other way the effect of asset quality and earning is weak and irrelevant. For the improvement the financial performance of private commercial banks in Ethiopia, the researcher recommends banks to have better capital adequacy, management efficiency and liquidity position.
According to Mohammed A. and Mohammed M. (2020) investigates the relationship between the financial performance of Islamic finance and economic growth in all of Malaysia, Indonesia, Brunei, Turkey and Saudi Arabia within the endogenous growth model framework. The Applied dynamic panel system GMM is used to estimate the impact of the financial performance of Islamic finance on economic growth using quarterly data. CAMEL’s system parameters were employed as variables of the financial performance of Islamic finance and gross domestic product (GDP) as a proxy of economic growth. The sample includes all Islamic banks operating in the five countries. They found that the only significant factor of the financial performance of Islamic finance, which affects the endogenous economic growth, is profitability through return on equity (ROE). And also indicates the necessity of stimulating other financial performance factors of Islamic finance to achieve a significant contribution to economic growth.
Thisaranga, K. and Ariyasena, D. (2021) studied the effect of camel model on bank performance with special reference to listed commercial banks in Sri Lanka. Secondary data was obtained and used from audited annual financial statements of the listed commercial banks. Capital Adequacy, Assets Quality, Management Efficiency, Earning ability, and Liquidity status were used to evaluate the bank performance and Return on Equity (ROE) is used as an accounting-based performance indicator as well as Tobin's Q ratio is used as a market-based performance indicator. The finding of the research indicates that Capital adequacy, Assets quality, and Liquidity status have a positive significant impact on market-based performance whereas other CAMEL indicators have an insignificant impact on market-based performance. Moreover, Management efficiency is negatively related to accounting-based performance, and earning ability is positively related to accounting-based performance at a significant level however other CAMEL indicators have an insignificant impact on the accounting-based performance of Sri Lanka commercial banks.
Jean P, et. al (2020) investigated the Camel Rating System and Financial Performance of Rwandan Commercial Banks. This study was covered11 commercial banks operating in Rwanda and adopted secondary data published by the Central Bank of Rwanda. Descriptive research design and panel regression were used to evaluate the correlation between the predictor and outcome variables. The findings of this study concluded that capital adequacy and asset quality are positively correlated to determine the value of financial performance. Management efficiency, earnings management and liquidity management have a negative correlation. However, capital adequacy, asset quality, management efficiency are statistically significant to predict the ROA at a 5% level. The researchers recommends that both the banks’ management and financial regulatory body should work together to formulate policies that would help improving banking sector efficiency without violating the right of their clients.
Anh Huu Nguyen, Hang Thu Nguyen and Huong Thanh Pham (2020) conducted Applying the CAMEL model to assess performance of commercial banks: empirical evidence from Vietnam. In this study three econometric models were built using four CAMEL’s crucial indicators as independent variables (capital adequacy, asset quality, management effectiveness, bank liquidity) and return on assets (ROA), return on equity (ROE), and net interest margin (NIM) as proxies for commercial banks’ financial performance as dependent variables. They found that capital adequacy, asset quality, liquidity and management efficiency affect the performance of Vietnamese commercial banks.
Abedalfattah Zuhair Al-abedallat (2019) studied the factors affecting the performance of the Jordanian banks using camel’s model. Bank performance was measured by returns on the assets, returns on equity, and net income the components of Camels model were used as independent variables. The finding of the study indicates that the Jordanian banks have Capital Adequacy Ratio above 12%, and that the Jordanian banks generally have low ratios of the return on equity and the return on the assets because of the high level of liquidity, the increased income tax in Jordan, severe reservation in fund investment, and that the commercial banks have an advantage over Islamic banks in the components of Camels model and the performance measures. The study recommended applying Camels model completely by the Central Bank to assess the performance of banks in Jordan, and to increase its attention on the performance of the Islamic banks.
Melaku Alemu and Melaku Aweke (2017) conducted their study on financial performance analysis of private commercial banks of Ethiopia: camel ratings. The study was measured the financial performance of six sampled private banks using the audited financial reports of 10 years period from 2007 to 2016. As per the merged rating of CAMEL, the finding of the study discovered that NIB bank stood on the first followed by United bank, whereas Awash bank and Bank of Abyssinia stood the least. On both panel model estimations, NIEGE, LEVRAGE,NPEP, TLBRA, TDBRA, NIITA, and LATD explanatory variables were significant in determining the profitability indicators- ROE and ROA. Asset quality indicators were insignificant in determining the profitability ratios.
Fentahun Alebachew and P. Venkateswarlu(2019) examined financial performance analysis of commercial banks in Ethiopia using camel rating. A total of 15 commercial banks whose operating year is at least five years have been selected as a sample. The study showed that the majority of banks are performing well. Specifically private commercial banks are the top five performers of which NIB ranked at the top.
Bekana Dembel (2020) evaluated causes affecting the efficiency and performance of Ethiopian commercial banks. 9 years audited financial data from 2010 to 2018 was used to analyze the effect of explanatory variables on the explained variables using explanatory research design with quantitative research approach. In this study performance of the banks was measured by ROA and efficiency ratio. Capital adequacy, management capacity, earning quality, assets quality, liquidity position, GDP and age of banks were used using different measurement techniques. Random effect GLS regression result revealed that assets quality, management capability and earning quality significantly affect the performance of the banks measured by ROA. Capital adequacy, GDP and age of the banks have no impact on the ROA. Earning quality and Management capability have positive effect on the performance of the banks.
Kwadwo Boateng (2019) investigated Credit Risk Management and Performance of Banks in Ghana using ‘Camels’ Rating Model Approach. A total of ten banks were selected for a seven-year period. A standard multiple regressions were employed in the study to analyses the effect the various components of the CAMELS model have on the performance of banks in Ghana. The findings of the study indicated that Earning stood out as the highly significant factor that affects the performance of banks in Ghana. Management efficiency, assets quality, capital adequacy and liquidity were equally found to be significantly affecting the performance of Ghanaian banks.