How to balance and improve CAMELS ratings
For the average banker, the word “camels” may evoke the image of the beloved, desert-living transportation device, but it could also evoke memories of their institution’s last regulatory exam. The CAMELS rating is a measure of a financial institution’s riskiness based on the bank’s financial statements. Examiners assign ratings, based on a 1 to 5 scale, with 1 indicating low risk and 5 indicating high risk.
As innocent as the desert camel may be, the CAMELS rating can cause stress or challenges for banks as they prepare for Safety and Soundness Exams. The rating is composed of several components of bank operations, and each component must be monitored to prevent a downgrade, a Memorandum of Understanding, or a consent order. And because several of these components are interrelated, it can be difficult for a financial institution to improve its performance in one component without affecting, perhaps negatively, another component. An improvement in one area could lead to higher exposure within another.
“CAMELS” is an acronym for the different components:
Capital Adequacy: The amount of capital that must be held in the financial institution relative to the institution’s asset amount.
Asset Quality: The quality of the assets on a financial institution’s balance sheet.
Management: The planning, organizing, staffing, and directing of employees.
Earnings: The quality, trend, and sustainability of the net profits from a financial institution’s operations.
Liquidity: The ability of the bank to meet the demands of its depositors and other creditors when due.
Sensitivity to Market Risk: The position of the bank relative to inherent market risks.
To illustrate how these components can be difficult to balance, consider real estate values. If a financial institution has seen a drastic decrease in real estate values, the decrease has likely affected the quality of their loan portfolio. In preparing for their next exam, this financial institution would naturally want to resolve these issues and make certain that related asset quality is viewed as “superior” or “above average.” But, in order to address the portfolio issues, bank management might consider:
- Troubled debt restructure
- The sale of certain impaired loans
- Boosting reserves against potential losses
And these solutions might lead to a problem with another component in the CAMELS rating, for example Capital Adequacy. In order to shore up the troubled loan portfolio, it will usually require tremendous capital investment. The financial institution’s capital is already near regulator thresholds so any reduction in capital to shore up the loan portfolio could lead to other problems in the exam. Consequently, the CAMELS rating becomes a bit of a balancing act for bank management.