The document discusses how IDCFP uses margins as part of its CAMEL ranking system to evaluate the safety and soundness of banks. Key margins include return on equity vs. cost of equity, operating profit margin, and the standard deviation of operating profit margin over 3-5 years. Banks with negative spreads between these margins and high standard deviations are at higher risk. The document shows that most components of CAMEL, including margins, reached low points in 2005-2006, up to three quarters before the total number of banks ranked below 125 reached its low in 2006, correctly indicating an impending banking crisis.

1. Margins as a Measurement of
Management - - The “M” in
CAMEL
IDC Financial Publishing, Inc. (IDCFP) uses the acronym
CAMEL and its component financial ratios to evaluate the safety
and soundness of commercial banks and savings institutions.
This article explains how IDCFP uses margins as a component
of its CAMEL ranking system and why it is valuable and
important to monitor.

2. The key Margins that Measure Management include Return on Equity
(ROE) vs. Cost of Equity (COE), Operating Profit Margin (Inverse of
Efficiency Ratio) and Standard Deviation of the Operating Profit
Margin over 3 to 5 years. Components of the operating profit margin
are also analyzed separately and rated. As an example, margins with
a negative spread between ROE and COE, an operating profit as a
percent of net interest and noninterest income (OPM) below 20% and
a standard deviation in the operating profit margin of 8 or higher,
together, indicate a bank or savings institution at risk. Many
combinations of ROE less than COE and the level and standard
deviation of the operating profit margin determine varying levels of
risk to the bank or savings institution.
Commercial banks and savings institutions with ROE less than
COE, narrow or negative operating margins and/or large
standard deviations in the operating profit margin are ranked by
IDCFP below the rank industry standard for safety and
soundness of “125” (300 the Highest and 1 the Lowest).

3. ALERT
The “E” Component of CAMEL, as Well as, the Total of Banks
Ranked Less Than “125”, Indicates Risk from our Early
Warning System of a Future Financial Crisis in 2020 or 2021.
The low risk level in the number of banks and savings institutions of
146 ranked less than “125” in “E” in the 3rd quarter 2017, caused a
low for all institutions ranked less than “125” of 447 in the 3rd
quarter of 2017 (see Table I).

4. The risk in a bank or savings institution is a negative ROE, which
destroys equity capital. The risk is amplified, however, to the
institution’s safety and soundness, when ROFL is negative. The
operating earnings ratio (ROEA) is low or negative and the cost of
adjusted deposits and debt exceeds ROEA, causing a negative
leverage spread, and then, times financial leverage, creates an
even greater loss, as reflected in ROFL. Currently, a negative ROFL
has been exhibited in smaller banks. As the Federal Reserve raises
the fed funds rate by 1% to 1.5% in the next two years, the low
levels of operating returns (if not corrected) accompanied with rising
costs of funding, create continuous future losses in net income for
these 173 firms and, potentially, more financial institutions. Given
Reported and Continuing Future Losses, Recent Tax
Reductions Fail to Assist These Institutions.

5. Table I

6. All 5 categories of rank, C-Capital, A-Adequacy of Capital, M-Margins
as a Measurement of Management, E-Earnings from Operations and,
separately, Earnings from Financial Leverage, and finally, L-Liquidity
all together provide a timely indication of risk and potential failure.
Additional components of CAMEL, however, are required to increase
in the count of banks under “125” in other CAMEL components to
confidently forecast the severity of the coming banking crisis.
Early Warning Indicators in 2005 and 2006
(see Table II)
The low in the number of commercial banks and savings institutions
ranked below the industry standard as investment grade “125”
occurred in the 2nd quarter of 2006, two years before the banking
crisis in 2008. Most important, however, is that all but 1 of the 5
components of CAMEL reached a low in their number of institutions
from the 3rd quarter of 2005 through the 1st quarter of 2006 – prior to
the low count for all institutions ranked less than “125” in the 2nd
quarter of 2006.

7. As seen in Table II below, commercial banks and savings
institutions not well capitalized (“C” in CAMEL) reached a low of 47
in the 3rd quarter of 2006. Financial institutions measuring
adequacy of capital with adjusted Tier 1 capital below 5% (Tier 1
capital adjusted for bad and delinquent loans net of the loan loss
reserve), the “A” in CAMEL, 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, the “M” in CAMEL,
reached a low of 178 in the 4th quarter of 2005. The commercial
banks and savings institutions with severe negative “Earnings
due to Leverage” (the “E” in CAMEL) reached their low of 185
in the 4th quarter of 2005, two quarters before the total number
of institutions ranked below “125” reached its low in the 2nd
quarter of 2006. Finally, institutions with high loan delinquency and
negative balance sheet cash flow – the “L” in CAMEL – reached
their low of 2 in the 1st quarter of 2006.

8. Table II
Components of CAMEL Forecast Banking Crisis in 2005, up to Three
Quarters Before the Total Ranked Below “125” in June of 2006

9. IDCFP has been helping CD brokers and investors, insurance
companies, federal agencies and a host of other institutions make better
decisions using its unique and proprietary CAMEL rating methodology
since 1985. For more information on CAMEL go to www.idcfp.com or
call 1-800-525-5475.