CAMELS Ratings: Asset Quality
By: Julie Stackhouse
In the last post, we addressed the examiner's process for reviewing and rating bank management. This month, we examine the fourth component of the safety and soundness ratings system for banks (called CAMELS): earnings.¹ Banks, like other firms, are in the business of making money and won’t stay in business if they lose money over any significant period of time.
Earnings Components
Banks derive income from:
- Assets that earn interest, such as loans
- Products and services that don’t earn interest, such as fees for services
Interest income from loans and investments generally makes up the majority of earnings for community banks. While loans typically comprise the bulk of assets that earn interest, banks also hold investments to bolster interest income when quality loan demand is lacking. Noninterest income from fees and other sources are usually supplemental in nature, comprising a much smaller portion of total bank income.
Bank expenses are also divided into interest and noninterest components. Interest expenses for a typical community bank are driven by the interest rates paid on deposits, although there may be interest expenses from borrowed money. Noninterest expenses are the expenses related to bank operations, such as salary and overhead.
The third main component affecting earnings is an expense called the provisions for loan losses. Provisions for loan losses are used to build a fund (called the loan loss reserve) to cover loans that are not paid off.
Adding It Up
When evaluating earnings, bank examiners complete a number of assessments that adjust for a bank’s size. They can then compare those assessments to the past performance of the bank and to that of similar institutions. These appraisals give examiners a good sense of the quantity of bank earnings and how they might be changing.
Just as important, though, is the sustainability of good-quality earnings. Poor asset quality may portend a large loan loss provision that will depress future earnings. Depending on how the bank’s balance sheet is structured, volatility in interest rates may also jeopardize future earnings.
Importance of Earnings
While earnings are important for maintaining operations, they serve other important purposes. Building capital is important for banks that want to grow since all banks are subject to minimum capital requirements. Healthy earnings also allow banks to pay dividends to their shareholders, providing them with a reason to keep and perhaps augment their investment.
As with the other components of CAMELS, the earnings component is rated on a scale of 1 to 5, with 1 indicating strong earnings that are consistent with operations support and capital maintenance. Banks assigned ratings of 4 or 5 on the earnings component have deficient earnings that threaten their ongoing viability. When this occurs, regulators will typically require these banks to stop paying dividends.
Notes and References
¹ The first component that we addressed was
capital adequacy, the second component was
asset quality, and the remaining components are liquidity and sensitivity to market risk. See Stackhouse, Julie. “
The ABCs of CAMELS.” St. Louis Fed
On the Economy, July 24, 2018.