The end of the year is a natural time to contemplate performance
reviews. Students receive their A through F grades, bosses complete
year-end assessments and best and worst lists abound. In that spirit,
this article describes the rating system used by supervisors to
assess banks, reviews the grades for Ninth District banks and briefly
discusses some policy issues raised by bank ratings.
In 1979, the bank regulatory agencies created the Uniform Financial
Institutions Rating System (UFIRS). Under the original UFIRS a bank
was assigned ratings based on performance in five areas: the adequacy
of Capital, the quality of Assets, the capability of Management,
the quality and level of Earnings and the adequacy of Liquidity.
Bank supervisors assigned a 1 through 5 rating for each of these
components and a composite rating for the bank. This 1 through 5
composite rating was known primarily by the acronym CAMEL.
A bank that received a CAMEL of 1 was considered sound in every
respect and generally had component ratings of 1 or 2 while a bank
with a CAMEL of 5 exhibited unsafe and unsound practices or conditions,
critically deficient performance and was of the greatest supervisory
concern. While the CAMEL rating normally bore close relation to
the five component ratings, it was not the result of averaging those
five grades. Rather, supervisors consider each institution's specific
situation when weighing component ratings and, more generally, review
all relevant factors when assigning ratings. (A similar process
and component and composite system exists for bank holding companies.)
The UFIRS was revised at year-end 1996 and CAMEL became CAMELS
with the addition of a component grade for the Sensitivity of the
bank to market risk (that is, the degree to which changes in market
prices such as interest rates adversely affect a financial institution).
The end of 1996 also saw a change in the communication policy for
bank ratings. Starting in 1997, the supervisors were to report the
component rating to the bank. Prior to that, supervisors only reported
the numeric composite rating to the bank. Supervisors continue to
forbid the release of a specific bank's component and composite
ratings to the public, raising issues discussed below.
CAMELS ratings in the Ninth District as of the third quarter of
1998 reflect the excellent banking conditions and performance over
the last several years. Comparison between the distribution of ratings
in the most recent quarter and 10 years ago during the height of
the national banking crisis is illustrative (221 banks failed nationally
in 1988 while 3 banks failed in 1998). Nearly 100 percent of Ninth
District banks currently fall into the top two ratings with 40 percent
receiving the top grade. Ten years ago one-third of Ninth District
banks fell into the bottom three ratings and only about one of 10
banks received the highest grade.
Analysts have raised a number of questions about bank ratings,
focusing in particular on their ability to measure bank financial
health relative to alternative systems. For example, Federal Reserve
economists found that CAMELS ratings were better able to forecast
bank distress than statistical monitoring regimes, but only when
the CAMELS rating was "fresh" (assigned within the last six months).
Perhaps more important is the capability of bank ratings compared
to market measures of bank health. If the market measure of bank risk
taking can be shown to be superior to the CAMELS system, this could
bolster arguments for supplementing the supervisory structure with market
processes. One way to make such a comparison is to determine if CAMELS
ratings reflect assessments of bank risks before market measures capture
such risk. In contrast to previous work, recent research has found that
bank ratings capture bank risk taking several months before market pricing
reflects it. (DeYoung, Flannery, Lang and Sorescu, "The
Informational Advantage of Specialized Monitors: The Case of Bank Examiners,"
Working Paper 98-4, Federal Reserve Bank of Chicago.)
The potential that bank ratings have new, valuable information
has led some analysts to call for the release of the ratings to
the public to improve market assessments and disciplining of bank
risk taking. More generally, this bank has suggested that additional
disclosures of financial information by banks could improve market
discipline; this could include the information examiners use to
derive the CAMELS rating, but not necessarily the CAMELS rating
itself. ("Fixing FDICIA,"
1997 Annual Report, The Region, March 1998.)
However, the release of the CAMELS rating is controversial because
of its potential costs. For example, public release could alter
the dynamics under which supervisors produce the ratings. In particular,
release could make bankers more sensitive to their ratings and thus
make the examination process more contentious and less open to forthright
sharing of information.
The potential response to public release from depositors and bankers
could also lead to a change in the behavior in the examiners who
assign the ratings. For example, they could be slower to change
ratings or may use alternative means of communicating their findings
to bankers. As such, the release of the rating could have the perverse
effect of reducing the new information they contain. The existing
difficulty in weighting the often intangible cost and benefit of
public release suggests that any policy change would involve contentious
debate and require additional research.