Regulators examine banks’ financial health and assign them ratings. A key framework for bank ratings, known as CAMELS, assesses banks on six metrics:
- Capital: Adequacy of a bank’s capital to absorb potential losses. Capital adequacy is evaluated based on quantitative factors, such as regulatory minimums, and qualitative factors such as bank management’s capital planning practices.
- Asset Quality: The quality of a bank’s portfolio of loans, securities and other assets and the management of risk associated with those assets.
- Management: The capability of a bank’s leadership to manage risk, operate the bank in a safe and sound manner and comply with all applicable rules and regulations.
- Earnings: The strength of a bank’s income, including from interest and noninterest sources.
- Liquidity: The strength of a bank’s liquidity position, its liquidity policies, procedures and management.
- Sensitivity to Market Risk: An institution’s vulnerability to market changes, such as shifting interest rates or market volatility.
Banks are rated on each component from 1 (“strong”) to 5 (“critically deficient”), then the bank is assigned an overall composite rating.[1]
The Problem: In theory, CAMELS ratings should reflect an accurate picture of banks’ financial condition. In reality, under the current framework, subjective factors like the Management rating skew CAMELS ratings and can provide a misleading impression of banks’ condition.
- Severe Consequences. CAMELS ratings have evolved from an internal supervisory tool to a lever that carries binding legal and financial consequences, such as higher insurance premiums or bans on mergers and acquisitions.
- The Runaway “M.” Examiners use the uniquely subjective “M” or “Management” rating to dictate bank behavior: a bank that does not obey examiner mandates on how to manage its operations or conduct its business may receive an unsatisfactory Management rating, regardless of its financial strength. The M is given outsize weight in a bank’s overall rating, despite all other component ratings already assessing management quality. Although a bank with strong financial performance would be expected to be well-managed, the M has become divorced from the other components.
Change on the Horizon: The Federal Financial Institutions Examination Council recently proposed changes to the CAMELS framework that would tie ratings more closely to banks’ financial condition – part of a broader effort to refocus supervision on material risk. The proposed revisions would:
- Focus component and composite ratings on factors that materially affect an institution’s financial condition and risk profile.
- Make changes to the Management rating, including removing certain subjective evaluation factors and removing a directive that it be given “special consideration” when assigning a composite rating.
- Provide that an institution receive a Management rating of “3” or worse only when risk management practices result in material financial risk to the institution.
- Revise the composite rating definitions to emphasize material financial risk.
BPI supports these changes and recommends further reforms to bolster the objectivity and transparency of the framework, including:
- Eliminate the Management component or replace it with a Material Operational Risks and Internal Controls component that would assess the extent to which certain operational risks or deficiencies in internal controls may adversely affect a bank’s financial condition.
- Tie each of the financial components to objective evaluation factors and remove overlapping evaluation factors among the components.
- Establish clearer standards for the composite rating and ensure that the CAMELS rating framework is applied consistently with the federal banking agencies’ standards governing Matters Requiring Attention.
Learn More. To understand the implications of the CAMELS framework, access BPI resources below:
- How Do Bank Examination Ratings Work?
- A Better M for CAMELS
- CAMELS Proposal Makes Meaningful Progress, But More Reform is Necessary
- BPI Statement on CAMELS Proposal
- Myth vs. Reality: Bank Supervision
[1] In addition to CAMELS, the Federal Reserve uses the Large Financial Institution rating system to assess large bank holding companies.The Fed recently finalized updates to the LFI rating system to align ratings more closely with material risk. Read more here.
