IDC Financial Publishing, Inc. (IDCFP) utilizes the acronym CAMEL to represent the financial ratios used to evaluate the safety and soundness of commercial banks, savings institutions and credit unions. In this article, we discuss margins as a measure of management, the “M” component of IDCFP’s CAMEL, and why it is important to monitor.
The key “margins” that measure management include the spread between return on equity (ROE) and cost of equity (COE), the operating profit margin, and the standard deviation of the operating profit margin over 3-5 years. For example, a negative spread between ROE and COE, an operating profit margin (OPM) below 20%, and a standard deviation in the OPM of 8 or higher, together indicate an institution is at risk. The level of risk can also vary, depending on the combination of these factors.
Institutions with ROE less than COE, narrow or negative operating margins and/or large standard deviations in OPM are ranked below 125 by IDCFP. Our 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.
“M” Relative to Other CAMEL Components
The total number of banks ranked less than 125 by IDCFP continues to decline, however, certain components of the CAMEL rating are exhibiting warning signs of risk to come. As shown in Table I, column “M”, there was a small increase in institutions yielding narrow profit margins with high standard deviations in Q1 of 2018. In addition, more banks began exhibiting negative returns on financial leverage (ROFL) in 2017 Q4, resulting in negative earnings (column “E”).
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% adequacy of 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).
All 5 categories of rank, Capital, Adequacy of capital, Margins as a measurement of management, Earnings from operations and financial 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, institutions with insufficient capital reached a low of 47 in the 3rd quarter of 2006. Institutions with less than 5% adequacy of capital reached a low count of 29 in the 3rd quarter of 2005. In the 4th quarter of 2005, those with a lack of profitability, or low and unstable margins reached a low of 178, and institutions with severe negative earnings due to financial leverage reached a low of 185. Finally, institutions with high loan delinquency and negative balance sheet cash flow, or negative liquidity, reached a low of 2 in the 1st quarter of 2006.
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.
John E Rickmeier, CFA
IDC Financial Publishing, Inc.
700 Walnut Ridge Drive, Suite 201
PO Box 140
Hartland, WI 53029