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 liquidity as a component of its CAMEL ranking system and why it is valuable and important to monitor.

1. IDCFP’s CAMEL Ranks Explained
The “L” in CAMEL: Liquidity
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 liquidity as a component
of its CAMEL ranking system and why it is valuable and important to
monitor.

2. Liquidity risk occurs when an institution’s loan delinquency exceeds 4% of
its total loans and its balance sheet cash flow is substantially negative.
Balance sheet cash flow is operating cash flow minus financial cash flow.
Operating cash flow equals the annual change in retained earnings less
the annual change in growth-producing assets. The purpose of measuring
operating cash flow is to determine an institution’s ability to internally
finance the growth of these assets. Financial cash flow equals the annual
change in liabilities (excluding retained earnings), less the annual change
in loans, investments, and other non-cash or equivalent assets. Financial
cash flow isolates the annual change in sources, and uses, of funds.

3. Considerably negative balance sheet cash flow occurs if annual
changes in retained earnings are negative and/or the annual
change in all other liabilities substantially exceeds the annual
change in loans and investments. An institution with poor loan
quality or risky investments will experience asset write-offs or
write-downs. At the same time, an at-risk institution will finance its
asset base by relying on deposit increases and new borrowing.
The resulting negative balance sheet cash flow threatens the
safety and soundness of the financial institution.
Institutions with significant negative balance sheet cash flow as a
percent of equity capital, and loan delinquency in excess of 4% of
all loans are ranked by IDCFP below 125. 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. “L” 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.

7. Table II

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