By Julie Stackhouse, Executive Vice President
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 outlined what bank examiners look for when assigning the rating for capital adequacy in a bank’s overall safety and soundness rating, called CAMELS. This month, we examine the second component of the CAMELS rating: asset quality.The remaining components are management, earnings, liquidity and sensitivity to market risk. See Stackhouse, Julie. “The ABCs of CAMELS.” St. Louis Fed On the Economy, July 24, 2018.
A bank’s assets—including loans, leases, securities and derivative contracts—drive its earnings performance and, therefore, its long-term viability. In short, banks make money by making loans and investments that generate income and can be repaid.
Lending is a risky business for banks because of the uncertainty of loans. To make loans, bankers use personal and corporate deposits placed at the bank, as well as other funding sources. If loans are not repaid, the bank will lose money. Inevitably, some loans will default despite the best intentions of bankers and their customers.
Because of the importance of asset quality to a bank’s viability—especially a community bank’s—examiners pay close attention to the level, distribution, severity and trend of poor-performing assets. In practice, examiners use a number of labels or categories (some of them overlapping) to assess asset quality, including problem, classified, delinquent, nonaccrual, nonperforming and restructured. In reviewing asset quality, examiners first consider the risk management practices of the bank, including:
Examiners then test the bank’s process by reviewing a statistical sample of assets. Sampling allows the examiners to determine management’s effectiveness in implementing the policies, procedures and risk limits set out by the board of directors.
While review of policies and a statistical sample of the assets themselves are keys to a bank examination, the asset quality rating also depends on the level of funds redirected from earnings to cover potential and known losses on assets. This reserve is called the allowance for loan and lease losses (ALLL).
Examiners look at both the level of the ALLL—making sure it is proportionate to the level of credit risk in the portfolio—and the methodology used to determine it. When loans go bad, the bank forecloses on the loan, and any losses are offset by the reserve.
Examiners also consider any concentration of assets, such as unusually high volumes of lending to real estate developers. Losses from unexpected changes in economic, industry or geographic conditions are magnified when concentrations exist.
After completing this comprehensive review, examiners assign an asset quality rating of 1 to 5 using the following definitions:
A bank’s asset quality rating is an important input into other CAMELS components. Should asset quality deteriorate, more funds must be set aside to fund the ALLL, depressing earnings. Operating losses can deplete capital and threaten the bank’s solvency.
For community banks—where loans are the primary component of the asset side of the balance sheet—good lending practices are essential. For this reason, bankers and examiners alike pay close attention to asset quality.
1 The remaining components are management, earnings, liquidity and sensitivity to market risk. See Stackhouse, Julie. “The ABCs of CAMELS.” St. Louis Fed On the Economy, July 24, 2018.
2 In practice, examiners use a number of labels or categories (some of them overlapping) to assess asset quality, including problem, classified, delinquent, nonaccrual, nonperforming and restructured.