FRBSF Economic Letter
99-19; June 11, 1999
Using CAMELS Ratings to Monitor Bank Conditions
Bank supervisory agencies are responsible for monitoring the financial
conditions of commercial banks and enforcing related legislation and regulatory
policy. Although much of the information needed to do so can be gathered
from regulatory reports, on-site examinations are needed to verify report
accuracy and to gather further supervisory information. Much research
has explored the value of this private information, both to the bank supervisors
and to the public who monitor banks through the financial markets.
This Economic Letter selectively surveys this literature, focusing
mainly on studies using CAMELS ratings. These supervisory ratings are
assigned at the end of exams and are directly disclosed only to senior
bank management and to the appropriate supervisory personnel. CAMELS ratings
are commonly viewed as summary measures of the private supervisory information
gathered by examiners regarding banks' overall financial conditions, although
they also reflect available public information.
The general consensus in this literature is that the private supervisory
information contained in CAMELS ratings is useful in the supervisory monitoring
of banks. Furthermore, to the extent that this information filters out
into the financial markets, it appears to affect the prices of bank securities.
Thus, private supervisory information in CAMELS ratings also appears to
be useful in the public monitoring of banks.
What are CAMELS ratings?
During an on-site bank exam, supervisors gather private information,
such as details on problem loans, with which to evaluate a bank's financial
condition and to monitor its compliance with laws and regulatory policies.
A key product of such an exam is a supervisory rating of the bank's overall
condition, commonly referred to as a CAMELS rating. This rating system
is used by the three federal banking supervisors (the Federal Reserve,
the FDIC, and the OCC) and other financial supervisory agencies to provide
a convenient summary of bank conditions at the time of an exam.
The acronym "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, a bank's Sensitivity to market risk, was added in
1997; hence the acronym was changed to CAMELS. (Note that the bulk of
the academic literature is based on pre-1997 data and is thus based on
CAMEL ratings.) Ratings are assigned for each component in addition to
the overall rating of a bank's financial condition. The ratings are assigned
on a scale from 1 to 5. Banks with ratings of 1 or 2 are considered to
present few, if any, supervisory concerns, while banks with ratings of
3, 4, or 5 present moderate to extreme degrees of supervisory concern.
All exam materials are highly confidential, including the CAMELS. A bank's
CAMELS rating is directly known only by the bank's senior management and
the appropriate supervisory staff. CAMELS ratings are never released by
supervisory agencies, even on a lagged basis. While exam results are confidential,
the public may infer such supervisory information on bank conditions based
on subsequent bank actions or specific disclosures. Overall, the private
supervisory information gathered during a bank exam is not disclosed to
the public by supervisors, although studies show that it does filter into
the financial markets.
CAMELS ratings in the supervisory monitoring
Several academic studies have examined whether and to what extent private
supervisory information is useful in the supervisory monitoring of banks.
With respect to predicting bank failure, Barker and Holdsworth (1993)
find evidence that CAMEL ratings are useful, even after controlling for
a wide range of publicly available information about the condition and
performance of banks. Cole and Gunther (1998) examine a similar question
and find that although CAMEL ratings contain useful information, it decays
quickly. For the period between 1988 and 1992, they find that a statistical
model using publicly available financial data is a better indicator of
bank failure than CAMEL ratings that are more than two quarters old.
Hirtle and Lopez (1999) examine the usefulness of past CAMEL ratings
in assessing banks' current conditions. They find that, conditional on
current public information, the private supervisory information contained
in past CAMEL ratings provides further insight into bank current conditions,
as summarized by current CAMEL ratings. The authors find that, over the
period from 1989 to 1995, the private supervisory information gathered
during the last on-site exam remains useful with respect to the current
condition of a bank for up to 6 to 12 quarters (or 1.5 to 3 years). The
overall conclusion drawn from academic studies is that private supervisory
information, as summarized by CAMELS ratings, is clearly useful in the
supervisory monitoring of bank conditions.
CAMELS ratings in the public monitoring
Another approach to examining the value of private supervisory information
is to examine its impact on the market prices of bank securities. Market
prices are generally assumed to incorporate all available public information.
Thus, if private supervisory information were found to affect market prices,
it must also be of value to the public monitoring of banks.
Such private information could be especially useful to financial market
participants, given the informational asymmetries in the commercial banking
industry. Since banks fund projects not readily financed in public capital
markets, outside monitors should find it difficult to completely assess
banks' financial conditions. In fact, Morgan (1998) finds that rating
agencies disagree more about banks than about other types of firms. As
a result, supervisors with direct access to private bank information could
generate additional information useful to the financial markets, at least
by certifying that a bank's financial condition is accurately reported.
The direct public beneficiaries of private supervisory information, such
as that contained in CAMELS ratings, would be depositors and holders of
banks' securities. Small depositors are protected from possible bank default
by FDIC insurance, which probably explains the finding by Gilbert and
Vaughn (1998) that the public announcement of supervisory enforcement
actions, such as prohibitions on paying dividends, did not cause deposit
runoffs or dramatic increases in the rates paid on deposits at the affected
banks. However, uninsured depositors could be expected to respond more
strongly to such information. Jordan, et al., (1999) find that uninsured
deposits at banks that are subjects of publicly-announced enforcement
actions, such as cease-and-desist orders, decline during the quarter after
The holders of commercial bank debt, especially subordinated debt, should
have the most in common with supervisors, since both are more concerned
with banks' default probabilities (i.e., downside risk). As of year-end
1998, bank holding companies (BHCs) had roughly $120 billion in outstanding
subordinated debt. DeYoung, et al., (1998) examine whether private supervisory
information would be useful in pricing the subordinated debt of large
BHCs. The authors use an econometric technique that estimates the private
information component of the CAMEL ratings for the BHCs' lead banks and
regresses it onto subordinated bond prices. They conclude that this aspect
of CAMEL ratings adds significant explanatory power to the regression
after controlling for publicly available financial information and that
it appears to be incorporated into bond prices about six months after
an exam. Furthermore, they find that supervisors are more likely to uncover
unfavorable private information, which is consistent with managers' incentives
to publicize positive information while de-emphasizing negative information.
These results indicate that supervisors can generate useful information
about banks, even if those banks already are monitored by private investors
and rating agencies.
The market for bank equity, which is about eight times larger than that
for bank subordinated debt, was valued at more than $910 billion at year-end
1998. Thus, the academic literature on the extent to which private supervisory
information affects stock prices is more extensive. For example, Jordan,
et al., (1999) find that the stock market views the announcement of formal
enforcement actions as informative. That is, such announcements are associated
with large negative stock returns for the affected banks. This result
holds especially for banks that had not previously manifested serious
Focusing specifically on CAMEL ratings, Berger and Davies (1998) use
event study methodology to examine the behavior of BHC stock prices in
the eight-week period following an exam of its lead bank. They conclude
that CAMEL downgrades reveal unfavorable private information about bank
conditions to the stock market. This information may reach the public
in several ways, such as through bank financial statements made after
a downgrade. These results suggest that bank management may reveal favorable
private information in advance, while supervisors in effect force the
release of unfavorable information.
Berger, Davies, and Flannery (1998) extend this analysis by examining
whether the information about BHC conditions gathered by supervisors is
different from that used by the financial markets. They find that assessments
by supervisors and rating agencies are complementary but different from
those by the stock market. The authors attribute this difference to the
fact that supervisors and rating agencies, as representatives of debtholders,
are more interested in default probabilities than the stock market, which
focuses on future revenues and profitability. This rationale also could
explain the authors' finding that supervisory assessments are much less
accurate than market assessments of banks' future performances.
In summary, on-site bank exams seem to generate additional useful information
beyond what is publicly available. However, according to Flannery (1998),
the limited available evidence does not support the view that supervisory
assessments of bank conditions are uniformly better and more timely than
The academic literature effectively shows that CAMELS ratings, as summary
measures of the private supervisory information gathered during on-site
bank exams, do contain information useful to both the supervisory and
public monitoring of commercial banks. A relevant policy question is whether
supervisors might benefit by disclosing CAMELS ratings to the public.
Such disclosure could benefit supervisors by improving the pricing of
bank securities and increasing the efficiency of the market discipline
brought to bear on banks. As argued by Flannery (1998), market assessments
of bank conditions compare favorably with supervisory assessments and
could improve with access to supervisory information. However, although
supervisors could benefit from such improved public monitoring of banks,
the costs to the current form of supervisory monitoring must also be considered.
For example, if CAMELS ratings were made public, the current information-sharing
relationship between examiners and bankers could change in a way that
adversely affects supervisory monitoring. Further research and debate
on this question is currently needed.
Jose A. Lopez
Barker, D., and D. Holdsworth. 1993. "The Causes of Bank Failures in
the 1980s." Research Paper No. 9325, Federal Reserve Bank of New York.
Berger, A.N., and S.M. Davies. 1994. "The Information Content of Bank
Examinations." Journal of Financial Services Research 14, pp.
___, ___, and M.J. Flannery. 1998. "Comparing
Market and Supervisory Assessment of Bank Performance: Who Knows What
When?" Finance and Economics Discussion Series 1998-32, Federal Reserve
Board of Governors.
Cole, R.A., and J.W. Gunther. 1998. "Predicting Bank Failures: A Comparison
of On- and Off-Site Monitoring Systems." Journal of Financial Services
Research 13, pp. 103-117.
DeYoung, R., M.J. Flannery, W.W. Lang, and S.M. Sorescu. 1998. "The
Informational Advantage of Specialized Monitors: The Case of Bank Examiners."
Working Paper No. 98-4, Federal Reserve Bank of Chicago.
Flannery, M.J. 1998. "Using Market Information in Prudential Bank Supervision:
A Review of the U.S. Empirical Evidence." Journal of Money, Credit
and Banking 30, pp. 273-305.
Gilbert, R.A., and M.D. Vaughn. 1998. "Does the Publication of Enforcement
Actions Enhance Market Discipline?" Manuscript, Research Department, Federal
Reserve Bank of St. Louis.
Hirtle, B.J., and J.A. Lopez. 1999. "Supervisory
Information and the Frequency of Bank Examinations." Federal Reserve
Bank of New York Economic Policy Review 5, pp. 1-20.
Jordan, J.S., J. Peek, and E.S. Rosengren. 1998. "The
Impact of Greater Bank Disclosure Amidst a Banking Crisis." Working
Paper No. 99-1, Federal Reserve Bank of Boston.
Morgan, D.P. 1998. "Judging
the Risk of Banks: What Makes Banks Opaque?" Working Paper No. 98-05,
Federal Reserve Bank of New York.
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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