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. This article explains how IDCFP uses earnings returns as a key component of its CAMEL ranking system, and why it is valuable and important to monitor.
Good management strives to increase return on equity (ROE) above cost of equity (COE). IDCFP calculates nominal COE by adding one-half of the 30-year T-Bond yield, plus 20% of the standard deviation of the operating profit margin for the S&P 500, to the 30-year T-Bond yield. A successful ratio of ROE to COE is demonstrated by the commensurate increase in price-to-book value.
Looking at an institution’s ROE in terms of return on operating earning assets (ROEA) and return on financial leverage (ROFL) provides additional insight into management’s style, financial and operating decisions.
- ROEA is defined as after-tax income from operations before funding costs (income from loans, investments and non-interest income, minus operating expenses, applicable taxes and the change in the loan loss reserve, as a percent of earning assets). This income reflects the operation of an institution, as if equity and loan loss reserves were total liabilities and capital.
- ROFL is defined as after-tax income from financial operations. It reflects the degree to which an institution uses deposits and debt to finance its operating strategy. ROFL consists of the leverage spread, which is return on earning assets (ROEA) minus cost of adjusted after-tax deposits and debt, times the leverage multiplier, which is the ratio of adjusted deposits and debt to equity and the loan loss reserve.
As the Federal Reserve raises the federal funds rate toward 3% over the next year, 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. Banks with low after-tax operating profit returns (ROEA), due to inefficiencies in operations, experience the same increase in funding costs as other banks. A low return from operations, combined with rising funding costs, creates a negative leverage spread. This negative spread multiplied by a bank’s leverage provides a highly negative ROFL, leading to more banks ranked below 125 due to the “E” component in CAMEL.
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.
“E” 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