Could a CAMELS Downgrade Model Improve Off-Site Surveillance?

The cornerstone of bank supervision is a regular schedule of thorough, on-site examinations. Under rules set forth in the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), most U.S. banks must submit to a full-scope federal or state examination every 12 months; small, well-capitalized banks must be examined every 18 months. These examinations focus on six components of bank safety and soundness: capital protection (C), asset quality (A), management competence (M), earnings strength (E), liquidity risk exposure (L), and market risk sensitivity (S). At the close of each exam, examiners award a grade of one (best) through five (worst) to each component. Supervisors then draw on these six component ratings to assign a composite CAMELS rating, which is also expressed on a scale of one through five. (See the insert for a detailed description of the composite ratings.) In general, banks with composite ratings of one or two are considered safe and sound, whereas banks with ratings of three, four, or five are considered unsatisfactory. As of March 31, 2000, nearly 94 percent of U.S. banks posted composite CAMELS ratings of one or two. Bank supervisors support on-site examinations with off-site surveillance. Off-site surveillance uses quarterly financial data and anecdotal evidence to schedule and plan on-site exams. Although on-site examination is the most effective tool for spotting safety-and-soundness problems, it is costly and burdensome. On-site examination is costly to supervisors because of the examiner resources required and burdensome to bankers because of the intrusion into daily operations. Off-site surveillance reduces the need for unscheduled exams. Off-site surveillance also helps supervisors plan exams by highlighting risk exposures at specific institutions.1 For example, if pre-exam surveillance reports indicate that a bank has significant exposure to interest rate fluctuations, then supervisors will add interest-raterisk specialists to the exam team. The two most common surveillance tools are supervisory screens and econometric models. Supervisory screens are combinations of financial ratios, derived from quarterly bank balance sheets and income statements, that have given warning in the past about the development of safety-and-soundness problems. Supervisors draw on their experience to weigh the information content of these ratios. Econometric models also combine information from bank financial ratios. These models rely on statistical tests rather than human judgment to combine ratios, boiling the information from financial statements down to an index number that summarizes bank condition. In past comparisons, econometric models have outperformed supervisory screens as early warning tools (Gilbert, Meyer, and Vaughan, 1999; Cole, Cornyn, and Gunther 1995). Nonetheless, screens still play an important role in off-site surveillance. Supervisors can add screens quickly to monitor emerging sources of risk; econometric models can be modified only after new risks have produced a sufficient number of safety-and-soundness problems to allow re-specification and out-of-sample testing. At the Federal Reserve, the off-site surveillance toolbox includes two distinct econometric models that are collectively known as SEER—the System for Estimating Examination Ratings. One model, the SEER risk rank model, uses the latest quarterly financial data to estimate the probability that each Fed-supervised bank will fail within the next two years. The other model, the SEER rating model, uses the latest financial data to produce a “shadow” CAMELS rating for each supervised institution. That is, the model estimates the CAMELS rating that examiners would have assigned had the bank been examined using the most recent set of financial R. Alton Gilbert is a vice president and banking advisor, Andrew P. Meyer is an economist, and Mark D. Vaughan is a supervisory policy officer and economist at the Federal Reserve Bank of St. Louis. The authors thank economists Robert Avery, Jeffrey Gunther, James Harvey, Tom King, Jose Lopez, Don Morgan, Chris Neely, and David Wheelock; bank supervisors Carl Anderson, Kevin Bertsch, and Kim Nelson; and seminar participants at the meetings of the SEER Technical Working Group and the Western Economics Association for their comments. Judith Hazen provided research assistance.