IDC Financial Publishing (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 the “E” component of our CAMEL ranking, and why it is 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.
Forecasting the Next Banking Crisis - Updated with 2018Q4 ranks
Out of the 5,453 total commercial banks and savings institutions, we have identified 307 ranked less than 125 in the fourth quarter of 2018. When we see the number of these poorly rated banks reach a low and begin to rise, either in the total institutions ranked or by CAMEL component, this indicates the potential for a future crisis.
Table I illustrates the trend of one CAMEL component reaching its low when examining commercial banks and savings institutions ranked less than 125 by IDCFP (see Table I). Most of these components, however, are still declining as of the fourth quarter of 2018.
- The number of risky institutions reached a new low of 307 in the fourth quarter of 2018.
- The “C” component, or institutions with insufficient capital, fell to a new low of 31 in the fourth 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 41 in the fourth quarter of 2018.
- The “M” component, which uses margins as a measure of management reached a new low level of 74 banks in the fourth quarter of 2018.
- The “E” component represents institutions exhibiting negative earnings or returns on financial leverage (ROFL). These banks fell to a new low of 88 in the fourth quarter of 2018.
- Finally, the “L” component represents negative liquidity. The number of banks ranked below 125 with negative balance sheet cash flow and high loan delinquency remained at a low of 5 in the third quarter of 2018 and increased to 9 in the fourth quarter of 2018, which is an indication of risk.
To forecast a banking crisis, the number of all banks ranked less than 125, as well as those in each component of CAMEL, must reach a low and begin to increase. With only the “L” component currently showing this trend, the next few years are forecast to be free of major problems with no crisis on the horizon.
Early Warning Indicators in History
In history, we have seen banks in total and the components of CAMEL hit lows and begin to rise, which forecasted the banking crisis of 2008. The number of commercial banks and savings institutions ranked below 125 reached a low in the second quarter of 2006, two years before the crisis. More importantly, leading up to that point, the number of banks in 4 out of the 5 components of CAMEL also reached lows from the third quarter of 2005 through the first quarter of 2006, and then began to rise.
As seen in Table II below,
- The number of high-risk institutions reached a new low of 885 in the second quarter of 2006 and steadily rose in subsequent quarters.
- Commercial banks and savings institutions with insufficient capital reached a low number of 47 institutions in the third quarter of 2006 and began to increase in subsequent quarters.
- The number of financial institutions with less than 5% adequacy of capital reached a low count of 29 in the third quarter of 2005, and then increased.
- The number of banks and savings institutions with a lack of profitability, or low and unstable margins, reached a low of 178 in the fourth quarter of 2005, and subsequently rose.
- The number of banks and savings institutions with severe negative earnings due to financial leverage reached a low number of 185 in the fourth quarter of 2005, and then increased.
- Finally, the number of institutions with high loan delinquency and negative balance sheet cash flow, or negative liquidity, reached a low of 2 in the first quarter of 2006, and then increased.
In addition to the total number of banks ranked less than 125, all 5 categories of rank provided a timely indication of risk and potential failure. All these elements combined displayed a trend where the number of institutions reached a low and subsequently increased and forecasted the banking crisis of 2008.
As seen in history, the increase in the number of financial institutions with an IDCFP CAMEL rating below 125, or below investment grade, forecast the bank financial crisis a few years later. Our ranks are critical for investors to monitor financial institutions and prepare for potential risk.
To view our products and services please visit our website at www.idcfp.com . For further information about our CAMEL ranks, or for a copy of this article, please contact us at 800-525-5457 or email@example.com.
John E Rickmeier, CFA, President, firstname.lastname@example.org
Robin Rickmeier, Marketing Director