IDC Financial Publishing’s CAMEL Safety Ratings Explained; The “M” in CAMEL: Margins as a Measure of Management

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 (OPM), and the standard deviation of the OPM over 3-5 years. For example, a negative spread between ROE and COE, an 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.

Our 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. Institutions with ROE less than COE, narrow or negative operating margins and/or large standard deviations in OPM are ranked below 125 by IDCFP.

A Forecast for the Next Banking Crisis

Out of the 5,525 total commercial banks and savings institutions, we have identified 1,434 that have outstanding brokered CDs. Using this group of 1,434 institutions, and tracking institutions ranked less than 125 within this group, we have put together a forecast indicating the next era of banking problems is due in 2021.

Table I illustrates the trend of most CAMEL components reaching lows when examining commercial banks and savings institutions ranked less than 125 by IDCFP:

  • The number of risky institutions reached a low of 55 in the second quarter of 2017.
  • The “C” component, or institutions with insufficient Capital, fell to a low of 2 in the first quarter of 2018.
  • The “A” component represents institutions lacking Adequacy of capital to cover delinquency with less than 5% risk-adjusted capital. These institutions declined to a new low of 3 in the third quarter of 2018.
  • The “M” component, which uses Margins as a measure of management reached a low level of 14 in the second quarter of 2018.
  • The “E” component represents institutions exhibiting negative Earnings or returns on financial leverage (ROFL). These institutions fell to a low of 17 as early as the third quarter of 2016.
  • Finally, the “L” component, which represents Liquidity, or negative balance sheet cash flow, fell to 0 in the second quarter of 2018.

When examining institutions with outstanding brokered CDs, there is an increase in the number among these that we ranked less than 125. The current trend shows the number of these institutions in most components of CAMEL have hit a low and are rising (see Table I). This group of institutions ranked less than 125, and having brokered CDs, points to another potential banking problem in 2021. Similarly, in 2005 and 2006, the IDCFP CAMEL ranks that fell under 125 forecast the 2008 and 2009 banking crisis. (See Table II).

Table I

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 financial 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.

All 5 categories of rank: Capital, Adequate Tier 1 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.

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

Robin Rickmeier
Marketing Director