IDC Financial Publishing’s CAMEL Safety Ratings Explained; The “E” in CAMEL: Earnings Returns

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 explain 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 together the following:

  • One-and-a-half times the 30-year T-Bond yield
  • 20% of the standard deviation of the operating profit margin for the S&P 500

A commensurate increase in the stock price to book value demonstrates a successful ratio of ROE greater than COE.

IDCFP looks at an institution’s ROE in terms of two components, return on operating earning assets (ROEA) and return on financial leverage (ROFL), both of which provide additional insight into management’s style, operating and financial decisions.

  • ROEA measures the profitability of an institution’s operating strategy. It is the percentage of after-tax income from operations before funding costs divided by earning assets. Components of this numerator include income from loans and investments, non-interest income, operating expenses and taxes, and the change in the loan loss reserve. ROEA reflects the operation of an institution, as if equity and the loan loss reserve were total liabilities and capital.
  • ROFL measures the profitability of an institution’s financial strategy and reflects the degree to which an institution uses deposits and debt to finance its operating strategy. IDCFP defines ROFL as the leverage spread (after-tax operating income [ROEA] less the after-tax cost of funding deposits and debt) times the leverage multiplier. The leverage multiplier equals net adjusted debt (earning assets funded by deposits and debt) divided by the total equity capital plus the loan loss reserve.

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. 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, and, as a result, leads to a rank below 125.

A Forecast for the Next Banking Crisis

Out of the 5,589 total commercial banks and savings institutions, IDCFP has identified 1,352 that have outstanding brokered CDs. Using this group of 1,352 institutions, and tracking institutions ranked less than 125 within this group, provides a forecast for the next era of banking problems in 2021.

Table I illustrates this trend when examining these commercial banks and savings institutions ranked less than 125 by IDCFP with our CAMEL analysis.

  • The number of 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 and increased in the second quarter.
  • The “A” component represents institutions lacking Adequacy of capital to cover delinquency with less than 5% risk-adjusted capital. These institutions declined to a low of 5 in the fourth quarter of 2017.
  • The “M” component, which uses Margins as a measure of management continues to decline, reaching 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 represents negative Liquidity, or high levels of loan delinquency with negative balance sheet cash flow. This fell to a floor of 0 in the second quarter of 2018.

When examining institutions with outstanding brokered CDs, there is an increase in the number among these ranked less than 125 by IDCFP. 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, IDCFP’s CAMEL ranks under 125 of all institutions 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% adequacy of 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, 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.

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, President,

Robin Rickmeier, Marketing Director