CAMELS Ratings: Capital Adequacy

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This post is part of a series titled “Supervising Our Nation’s Financial Institutions.” The series, written by Julie Stackhouse, executive vice president and officer-in-charge of supervision at the St. Louis Federal Reserve, appears at least once each month.

Last month, we provided an overview of the CAMELS rating system used by bank examiners to classify a bank’s health across a variety of important measures:

• Capital adequacy
• Asset quality
• Management
• Earnings
• Liquidity
• Sensitivity to market riskSee Stackhouse, Julie. “The ABCs of CAMELS.” St. Louis Fed On the Economy, July 24, 2018.

This month, we are taking a closer look at the first component of CAMELS: capital adequacy.

The Importance of Capital

For any business, capital is an important line of defense in the event of heavy losses. This is especially true for banks, which operate with relatively low levels of capital relative to the size of their balance sheets.

With that in mind, examiners assess capital adequacy based on a bank’s business strategy, asset quality, concentration risks and growth targets. Federal law establishes minimum ratios of capital to assets, and mandates restrictions or penalties—called Prompt Corrective Action—when the capital ratios of banks deteriorate to unsafe levels.See Stackhouse, Julie. “Views: Prompt Corrective Action: What Does It Mean for a Bank’s Liquidity?” Central Banker, Fall 2008.

Quantitative Factors

Examiners consider a number of capital ratios when assessing capital adequacy. The ratios are calculated by dividing the quantity of capital by the bank’s total assets or, depending on the ratio, by assets that are weighted for risk. The risk-weighting of assets recognizes the loss potential of different balance sheet strategies as well as the risk of off-balance sheet commitments such as unused lines of credit and derivative contracts.

In addition to making sure capital ratios meet regulatory minimums, examiners also compare a bank’s capital ratios with those of similar banks. This “peer group” analysis is important in understanding the relative strength of capital.

Qualitative Factors

Examiners also consider a variety of qualitative factors when assessing the capital adequacy of a bank. These factors include the bank’s liquidity position, managerial strength, asset quality, earnings capacity and sensitivity to market risk. Concentrations in the bank’s loan book, for example, may warrant capital in excess of regulatory minimums.An asset concentration exists when extensions of credit possess similar risk characteristics and, when aggregated, exceed 25 percent of the bank’s capital structure. Credit concentrations can significantly impair capital should the credit deteriorate in quality.

Those not familiar with the examination process may wonder why managerial capability is considered in the assessment of capital adequacy. Examiners have long found that the quality, experience and depth of bank management are critical factors in the long-term financial health of a bank. Strong management teams proactively implement policies, procedures and risk limits that promote capital protection.

Capital Planning

Besides maintaining minimum capital ratios, bank leadership is expected to implement adequate capital planning practice. Strong capital planning considers strategic growth opportunities, acquisition plans, changes in balance sheet composition and dividend/capital repurchase plans.

Many banks “stress” capital ratios to reflect the potential impact of negative economic or financial events. These exercises allow bank management to identify actions that can be taken during such events, including expense reductions, new capital issuance and dividend reductions.

The capital of large banking organizations is routinely stressed by regulatory capital planning exercises, including the Comprehensive Capital Analysis and Review process and the Dodd-Frank Act Stress Test.See “Stress Tests and Capital Planning.” Board of Governors of the Federal Reserve System, June 28, 2018.

The Capital Adequacy Rating

After carefully considering the factors noted above, the examiner will assign a rating to capital adequacy ranging from 1 (strong) to 5 (critically deficient). The capital component rating is an important factor in the bank’s overall CAMELS rating. Examiners work closely with banks assessed a capital adequacy rating of 3, 4 or 5 to identify ways to strengthen capital protection.

Notes and References

¹ See Stackhouse, Julie. “The ABCs of CAMELS.” St. Louis Fed On the Economy, July 24, 2018.

² See Stackhouse, Julie. “Views: Prompt Corrective Action: What Does It Mean for a Bank’s Liquidity?” Central Banker, Fall 2008.

³ An asset concentration exists when extensions of credit possess similar risk characteristics and, when aggregated, exceed 25 percent of the bank’s capital structure.

⁴ See “Stress Tests and Capital Planning.” Board of Governors of the Federal Reserve System, June 28, 2018.

Additional Resources

• On the Economy: Why Are Banks Regulated?
• On the Economy: Why Does the Fed Supervise Small Banks?
• On the Economy: The ABCs of CAMELS