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. This article explains how IDCFP uses earnings returns as a key component of its CAMEL ranking system, and why it is valuable and important to monitor.
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IDCFP’s CAMEL Ranks Explained - The “E” in CAMEL: Earnings Returns
1. IDCFP’s CAMEL Ranks 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. This article explains 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 one-
half of the 30-year T-Bond yield, plus 20% of the standard deviation of
the operating profit margin for the S&P 500, to the 30-year T-Bond
yield. A successful ratio of ROE to COE is demonstrated by the
commensurate increase in price-to-book value.
2. Looking at an institution’s ROE in terms of return on operating
earning assets (ROEA) and return on financial leverage (ROFL)
provides additional insight into management’s style, financial and
operating decisions.
ROEA is defined as after-tax income from operations before
funding costs (income from loans, investments and non-interest
income, minus operating expenses, applicable taxes and the
change in the loan loss reserve, as a percent of earning assets).
This income reflects the operation of an institution, as if equity
and loan loss reserves were total liabilities and capital.
ROFL is defined as after-tax income from financial operations. It
reflects the degree to which an institution uses deposits and debt
to finance its operating strategy. ROFL consists of the leverage
spread, which is return on earning assets (ROEA) minus cost of
adjusted after-tax deposits and debt, times the leverage
multiplier, which is the ratio of adjusted deposits and debt to
equity and the loan loss reserve.
3. As the Federal Reserve raises the federal funds rate toward 3%
over the next year, rising costs of funding, combined with low
levels of operating returns, could create continued losses in net
income for firms with negative earnings (“E”), and potentially
affect more financial institutions. Banks with low after-tax
operating profit returns (ROEA), due to inefficiencies in
operations, experience the same increase in funding costs as
other banks. 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, leading to more banks ranked below 125 due to the “E”
component in CAMEL.
Our 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.
4. “E” Relative to Other CAMEL Components
The total number of banks ranked less than 125 by IDCFP
continues to decline, however, certain components of the
CAMEL rating are exhibiting warning signs of risk to come. As
shown in Table I, column “M”, there was a small increase in
institutions yielding narrow profit margins with high standard
deviations in Q1 of 2018. In addition, more banks began
exhibiting negative returns on financial leverage (ROFL) in 2017
Q4, resulting in negative earnings (column “E”).
The other 3 components of IDCFP’s CAMEL are still declining or
holding, indicating some time before a reversal and potential
financial crisis. “C,” or institutions with capital that is deemed
insufficient, is still declining, currently at 45. “A,” or institutions
with less than 5% adequacy of capital, did not change from the
previous quarter, holding at 63. Finally, “L,” or institutions with
negative liquidity in balance sheet cash flow and substantial
loan delinquency, is also still declining, currently at a level of 8
institutions (see Table I).
5. Table I
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.
6. 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, institutions with insufficient capital
reached a low of 47 in the 3rd quarter of 2006. Institutions with less
than 5% adequacy of capital reached a low count of 29 in the 3rd
quarter of 2005. In the 4th quarter of 2005, those with a lack of
profitability, or low and unstable margins reached a low of 178,
and institutions with severe negative earnings due to financial
leverage reached a low of 185. Finally, institutions with high loan
delinquency and negative balance sheet cash flow, or negative
liquidity, reached a low of 2 in the 1st quarter of 2006.
8. 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.
For further information or to view our products and services please
visit our website at www.idcfp.com or contact us at 800-525-5457 or
info@idcfp.com.
John E Rickmeier, CFA
President
jer@idcfp.com
Robin Rickmeier
Marketing Director
IDC Financial Publishing, Inc.
700 Walnut Ridge Drive, Suite 201
PO Box 140
Hartland, WI 53029
P 800-525-5457
P 262-367-7231
F 262-367-6497