FRBSF Economic Letter
99-07; February 26, 1999
 Economic
Letter Index
How Frequently Should Banks Be Examined?
Bank supervisory agencies, such as the Federal Reserve, need timely and
reliable information about banks' financial conditions in order to conduct
effective supervision. On-site examinations of banks are an important
source of such information: they not only permit supervisors to confirm
the accuracy of regulatory reports that the banks themselves file, but
they also allow supervisors to gather additional, confidential information
on banks' financial conditions. However, since these exams absorb considerable
resources on the part of both supervisors and banks, there is clearly
a trade-off between the timeliness of the supervisory information gathered
from bank exams and the costs of obtaining it.
The potential "time decay" of such supervisory information
plays an important role in this trade-off and is a concern for policymakers.
This Economic Letter reports on research by Hirtle and Lopez (1998)
that assesses how the length of time between exams affects the quality
of supervisory information; "quality" here refers to how accurately
supervisory information from a previous exam reflects a bank's current
condition. The analysis suggests that, on average, supervisory information
is of some use for about 6 to 12 quarters (one and a half to three years).
For banks with low supervisory ratings, however, the information seems
to be of use for about 3 to 6 quarters (nine months to one and a half
years).
These results suggest that the yearly on-site examinations required by
the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA)
are quite reasonable. The range of 6 to 12 quarters is an upper bound
beyond which, on average, no useful information about a bank's current
condition remains. Thus, it is appropriate to examine banks more often
than that, especially if they are financially troubled. The results also
indicate that the decay rate of supervisory information is faster during
periods of stress in the banking industry.
Bank examinations and CAMEL ratings
On-site, full-scope exams are the most resource-intensive and generally
provide the greatest amount of confidential supervisory information. The
frequency of such exams has varied over time and across supervisory agencies.
For example, during the early to mid-1980s, some supervisory agencies
reduced the exam frequency from an average of once a year to once every
two years to cut the size of their examination staffs; however, as problems
in the banking industry increased in the late 1980s, exams were, on average,
conducted more frequently and examination staffs were increased.
Since the advent of FDICIA in 1991, supervisors have had less discretion
to lengthen the time period between full-scope exams. However, supervisors
can accelerate exams if there are indications that problems are developing
at a bank. In fact, supervisors employ extensive off-site monitoringCincluding
the use of statistical modelsCto help identify banks where problems might
be emerging.
At the end of the exam, the examiners assign a CAMEL rating that indicates
a bank's overall financial condition. CAMEL refers to the five components
of a bank's condition that are assessed: Capital adequacy, Asset quality,
Management, Earnings, and Liquidity. (A sixth component reflecting a bank's
sensitivity to market risk was added in 1997.) Examiners assign a rating
for each component on a scale from 1 to 5, with 1 representing the highest
rating, as well as a composite rating for the bank's overall condition
and performance. Banks with composite CAMEL ratings of 1 or 2 are considered
to present few supervisory concerns, while banks with ratings of 3 or
more present moderate to extreme degrees of supervisory concern. A bank's
CAMEL rating is highly confidential and known only by its senior management
and the appropriate supervisory staff. While CAMEL ratings are not a comprehensive
indicator of all the supervisory information gathered during a full-scope
exam, they serve as a convenient summary measure for analysis.
The data set and the analytical method
The data used by Hirtle and Lopez (1998) consist of the CAMEL ratings
assigned after full-scope bank exams by the Federal Reserve, the FDIC,
the Office of the Comptroller of the Currency, and state bank supervisory
agencies from 1989 to 1995. For each rating, the as-of date, which is
the date as of which the bank's condition is evaluated, and the identity
of the bank are known. Each rating was matched to the corresponding bank's
income and balance sheet data for the quarter before the as-of date. These
data serve as a proxy for the information available from regulatory reports
and other public information sources about the bank's condition at the
time of the exam. To assess how quickly the supervisory information from
a bank exam decays, each bank's rating also was linked to the CAMEL rating
from its previous exam.
Two econometric models were estimated for each year in the sample. The
"off-site" model, based on the model used by the Federal Reserve
for off-site monitoring purposes, uses banks' balance sheet data to forecast
their CAMEL ratings. The "exam" model includes all the variables
used in the off-site model plus variables that control for the time since
the most recent exam multiplied by the CAMEL rating for that exam. Because
the exam model contains variables that control for information from updated
regulatory reports, any additional explanatory power due to introducing
the lagged CAMEL rating is assumed to arise from the supervisory information
it contains.
By comparing the ability of the two models to forecast CAMEL ratings,
the authors assess how long supervisory information provides additional
useful information on banks' current conditions. The two models were estimated
using data from one year, say, 1989, and then were used to forecast the
CAMEL ratings for the following year, say, 1990. Each model generates
a probability for the rating that occurred. The higher the probability
that a model places on the actual rating, the greater its accuracy. For
example, a model forecasting an 80% probability of the actual rating is
more accurate than the model forecasting just a 40% probability. Statistical
tests were used to determine the statistical significance of the differences
in the accuracy between the two models.
Empirical results
For 1990 and 1991, the results suggest that the exam model is more accurate
than the off-site model for exam ratings up to 6 to 7 quarters old; in
other words, the exam model produces more accurate forecasts than the
off-site model, and the supervisory information is still of some use up
to that point. After 1991, this cut-off point increases to between 10
and 12 quarters. Thus, the results suggest that supervisory information
contained in lagged CAMEL ratings provides useful information regarding
banks' current conditions for 6 to 12 quarters after the previous exam.
Beyond this upper bound, there appears to be little or no value in the
information contained in the prior CAMEL rating.
The empirical results further suggest that there is important variation
over the time period in the useful life of supervisory information from
prior exams. This variation may reflect changes in the condition of the
U.S. banking industry over the sample period. In particular, supervisory
information contained in CAMEL ratings decays more rapidly during the
early years of the sample period, when the U.S. banking industry was experiencing
financial stress, than during the later part of the sample period, when
the industry experienced more robust performance. Since the condition
of banks is more likely to change rapidly during periods of financial
stress, a faster rate of information decay seems reasonable during these
periods.
To explore the results further, the authors divided the data into subsets
according to the initial financial condition of each bank. Specifically,
for each year, the data sample was divided into observations with lagged
CAMEL ratings of 1 or 2 and with lagged CAMEL ratings of 3, 4, or 5. The
results for both CAMEL forecasting models for each subset were then compared.
The empirical results for the subsample with lagged CAMEL ratings of
1 or 2 are similar to those for the overall sample. They indicate that
the lagged CAMEL ratings cease to provide useful information about the
current condition of a bank after 6 to 12 quarters and that this information
decays faster in the early part of the sample. The similarity between
these subsample results and the overall results is not surprising, since
most observations have lagged CAMEL ratings of 1 or 2.
The results for observations with lagged CAMEL ratings of 3 or more are
considerably different. This subsample consists of between 10% and 30%
of the yearly samples. The point at which lagged CAMEL ratings cease to
provide useful information about current CAMEL ratings is significantly
earlier than for the overall sample: the information in these prior CAMEL
ratings is no longer useful after just 3 to 6 quarters. Furthermore, the
cyclical pattern evident in both the overall sample and in the subsample
with lagged CAMEL ratings of 1 or 2 does not emerge in these results.
Taken together, these findings suggest that the rate of decay in supervisory
information is considerably faster for banks experiencing some degree
of financial difficulty, regardless of the overall condition of the banking
industry.
Conclusions
What do these results imply for the basic question of how frequently
banks should be examined? To answer this question, it is important to
understand that the tests described above provide an upper bound for the
length of time that prior CAMEL ratings provide useful information about
current conditions. That is, beyond 6 to 12 quarters the lagged CAMEL
rating contains little or no useful information about the current condition
of a bank. In practice, supervisors should probably examine a bank before
this point, when the supervisory information gathered during the prior
exam continues to have some--though diminished--value.
Finally, in thinking about the optimal time between exams, the results
suggest that this horizon may vary. When the banking industry is facing
financial stress, the quality of supervisory information appears to decay
faster than when conditions are more stable, suggesting that the optimal
time between exams may be shorter in these periods. Further, the rate
of information decay is markedly greater for banks that are themselves
financially troubled, regardless of the state of the overall industry.
This finding implies, rather sensibly, that it is desirable to examine
troubled institutions more often than healthy ones, although the optimal
exam interval for any particular bank will vary from the averages discussed
here.
In light of these results, FDICIA's requirement for annual, full-scope
exams seems reasonable, particularly for banks whose initial financial
condition is troubled or when the banking system as a whole is experiencing
financial stress.
Jose A. Lopez
Economist
References
Hirtle, B.J., and J.A. Lopez. 1998. "Supervisory Information and
the Frequency of Bank Examinations." Manuscript. Federal Reserve
Bank of San Francisco.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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Research Department
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