IDCFP’s CAMEL Ranks Explained - The “C” in CAMEL: Capital Requirements in Banks

IDC Financial Publishing, Inc. (IDCFP) uses the acronym CAMEL to represent the financial ratios used to evaluate the safety and soundness of commercial banks and savings institutions. This article explains how IDCFP uses the capital requirements ratios in banks as a component of its CAMEL ranking system, and why it is valuable and important to monitor.

Capital ratio requirements used by the FDIC to determine if an institution is well-capitalized are:

  1. Tier 1 Leverage Capital Ratio (Tier 1 capital divided by Tier 1 assets) of 5% or higher.
  2. Total Risk Based Capital Ratio (Tier 1 + Tier 2 capital divided by risk-based assets) of 10% or higher
  3. Tier 1 Risk Based Capital Ratio (Tier 1 capital divided by risk-based assets) of 6% or higher

IDCFP also reviews enforcement actions by the FDIC to determine if an institution is required to file a written “Capital Plan” to increase capital above the threshold of ratios indicated above. As an example, a letter of consent for an institution might require a Tier 1 leverage ratio of 9% vs. the standard 5%. IDCFP then uses the 9% threshold as the Tier 1 requirement until the enforcement action is terminated.

IDCFP’s CAMEL ratings of banks, savings institutions, and credit unions range from 300 (the top grade attainable) to 1 (the lowest). From the early 1990’s, through today, institutions using our ranks determined that ratings lower than 125 were deemed below investment grade. Commercial banks and savings institutions with capital ratios below the requirements outlined above have “insufficient capital” and, therefore, receive an IDCFP rank below 125.

“C” Relative to Other CAMEL Components

One type of risk in a bank or savings institution occurs when return on equity (ROE) is negative, destroying equity capital. The risk is amplified when elements of ROE are negative, such as the return on financial leverage (ROFL). When the after-tax returns on operating earnings assets (ROEA) is exceeded by the after-tax cost of adjusted deposits and debt, the result is a negative leverage spread. Multiplying a negative spread by an institution’s financial leverage creates an even greater loss, or a negative ROFL. Currently, a negative ROFL has been exhibited in an increasing number of banks. As the Federal Reserve raises the federal funds rate to 3% or above over the next two years, rising costs of funding, combined with low levels of operating returns, could create continued losses in net income for firms with negative earnings (“E”), and potentially affect more financial institutions.

Although the total number of banks ranked less than 125 by IDCFP continues to decline, certain components of the CAMEL rating are exhibiting warning signs of risk to come. As shown in Table I, column “E,” more banks began exhibiting negative ROFL in 2017 Q4, resulting in negative earnings. In addition, there was a small increase in institutions yielding narrow profit margins with high standard deviations in this margin over time, shown in column “M.”

The other 3 components of IDCFP’s CAMEL are still declining or holding, indicating some time before a reversal and potential financial crisis. “C,” or institutions with capital that is deemed insufficient, is still declining, currently at 45. “A,” or institutions with less than 5% adequate capital*, did not change from the previous quarter, holding at 63. Finally, “L,” or institutions with negative liquidity in balance sheet cash flow and substantial loan delinquency, is also still declining, currently at a level of 8 institutions (see Table I).

*Tier I capital adjusted for loan delinquency minus loan loss reserve.

Table I

All 5 categories of rank, Capital, Adequacy of capital, Margins as a measurement of management, Earnings from operations and leverage, and, finally, Liquidity, together provide a timely indication of risk and potential failure. An increase in the number of banks ranked under 125 in all components of CAMEL is required to confidently forecast a future banking crisis.

Early Warning Indicators in History

The number of commercial banks and savings institutions ranked below 125 reached a low in the 2nd quarter of 2006, two years before the banking crisis in 2008. More importantly, leading up to this point, 4 out of the 5 components of CAMEL also reached lows from the 3rd quarter of 2005 through the 1st quarter of 2006, and then began to rise.

As seen in Table II below, commercial banks and savings institutions with insufficient capital reached a low of 47 institutions in the 3rd quarter of 2006. Financial institutions with less than 5% adequate capital* reached a low count of 29 in the 3rd quarter of 2005. Banks and savings institutions with a lack of profitability, or low and unstable margins, reached a low of 178 in the 4th quarter of 2005. The commercial banks and savings institutions with severe negative earnings due to leverage reached their low of 185 in the 4th quarter of 2005. Finally, institutions with high loan delinquency and negative balance sheet cash flow, or negative liquidity, reached their low of 2 in the 1st quarter of 2006.

*Tier I capital adjusted for loan delinquency minus loan loss reserve.

Table II

As seen in history, the increase in the number of financial institutions with IDCFP’s CAMEL ranks below 125, or below investment grade, forecast the bank financial crisis a few years later. IDCFP’s ranks are critical for investors to monitor financial institutions.

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John E Rickmeier, CFA


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IDC Financial Publishing, Inc.

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