Component “E” of IDCFP’s CAMEL, Which Forecast the 2008 Economic Crisis in Banking as Early as 2005, Indicates a Potential Banking Crisis in 2020 or 2021
This article on “The Early Warning Signal of a Potential Banking Crisis” summarizes the components of CAMEL as a forecast of the next banking crisis.
First Early Warning Signal Forecasts a Potential Banking Crisis
1. First Early Warning Signal Forecasts
A Potential Banking Crisis in 2020 or 2021
Component “E” of IDCFP’s CAMEL, Which Forecast the 2008 Economic
Crisis in Banking as Early as 2005, Indicates a Potential Banking Crisis
in 2020 or 2021
This article on “The Early Warning Signal of a Potential Banking Crisis”
summarizes the components of CAMEL as a forecast of the next
banking crisis.
2. At the low risk point in the banking cycle, the number of banks
and savings institutions ranked less than “125” or investment
grade reached its lowest level of 447 in the 3rd quarter data of
2017, driven by the low count of 146 banks in the component
“E”, or earnings from financial leverage in September 2017 (see
Table I).
Brokers of CDs and investors in CDs, as well as insurance
companies, federal agencies, state governments, interbank
lending, and a host of other institutions rely on IDCFP ratings of
commercial banks and savings institutions to make better
decisions using its unique and proprietary CAMEL methodology.
3. Earnings Returns - - The “E” in CAMEL Forecasts
A Potential Banking Crisis in 2020 or 2021
(see Table I)
The separation of Earnings in ROE between Earnings from
ROEA and ROFL provides insight into management’s
operating and financial success or lack thereof.
ROEA is defined income from operations before funding costs
(income from loans, investments and non-interest income,
less operating expenses and applicable taxes and the change
in the loan loss reserve, as a percent of earning assets) to
reflect operation of a bank or savings institution, as if equity
and loan loss reserves were total liabilities and capital.
4. ROFL is defined as income from financial operations. It
reflects the degree to which a bank or savings institution uses
deposits and debt to finance its earning assets or operating
strategy based on the after-tax cost of these deposit and debt
funds. ROFL consists of leverage spread (return on earning
assets less cost of adjusted deposits and debt, both after-tax)
times the leverage multiplier (the ratio of adjusted debt to
equity plus the loan loss reserve). Adjusted debt equals
earning assets (before the loan loss reserve) less equity capital
and loan loss reserves.
5. 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 small 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) 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.
6. IDC Financial Publishing, Inc. is Your Early Warning
System of a Future Financial Crisis.
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 146 banks and savings institutions,
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).
8. Commercial Banks and Savings Institutions with ROE less than
COE and Negative Return on Financial Leverage (ROFL) are so
Deficient in Profitability to Receive an IDCFP Rank Below “125”
(300 the Highest and 1 the Lowest). 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 Potential Banking Crisis.
9. 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.
10. 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.
11. Table II
Components of CAMEL Forecast Banking Crisis in 2005,
up to Three Quarters Before the Total Ranked Below
“125” in June of 2006
12. IDCFP has been helping CD brokers and investors, insurance
companies, federal agencies, numerous state governments 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.