Using Camels To Foresee Bank Failures???

No, not desert camels.  No no no, not cigarettes (but you can smoke while you're reading this). Oh well, I guess I should have capitalized that because it's an acronym. CAMELS
The St. Louis Federal Reserve has a nice publication titled "Central Banker".  In the Spring 2010 edition they have a nice article written by researcher Yadav Gopalan which explains CAMELS, a system which helps measure the risk and soundness of banks.

Banks have data they release on a quarterly basis (every 3 months) called Reports on Condition and Income.  Regulatory agencies give banks ratings based on the CAMELS ratings the regulators give banks after examination. So what does this acronym CAMELS stand for??? 
Capital, Asset quality, Management,  Earnings, Liquidity and Sensitivity to risk.

The St. Louis Federal Reserve examined banks that failed between 1990 and 2009 (19 years).  They did this in order to better understand the features (financial and supervisory) that might have been more particular to (or given foresight to) failed banks.  CAMELS has a 1 to 5 rating system. 1 is best and 5 is the worst. 1 and 2 ratings is healthy, 3 is borderline, 4 and 5 ratings means trouble.

So, which is the first indicator of the six CAMELS indicators to show trouble in the reports??? It's important to remember the ratings are based on what we see on paper in the Reports on Condition and Income.  Capital (as in Capital ratios)??? NO!! Although many (including your earnest blogger) might have guessed that.  The first sign (indicator) from the reports that shows deterioration is Earnings.  The banks will start to add provisions for the chance of loan losses.  So Earnings will be the first sign of danger on paper among the 6 CAMELS indicators.

The next CAMELS indicators to "tip off" early as signs of trouble are Asset quality, and management which both get the 3 CAMELS rating about 9 quarters (27 months) before bank failure.  The management indicator declines in rating very shortly after the earnings indicator.  This is a reflection of "on going" assets quality problems and bank regulators should be communicating these problems to management (by ratings etc...)

The next CAMELS indicator to decline in rating is capital, it arrives at the first warning level (CAMEL rating 3) 7 quarters (or 21 months) before bank failure.  Federal Reserve research strongly suggests that capital ratios do not fall as fast as asset quality does.  Why??  Because banks can find new capital.  The financial institutions can increase capital ratios many ways.  Banks can lower assets by cutting back on lending or selling assets.  It should be noted though, that capital ratios drop off dramatically roughly 1 year before bank failure, as investors foresee the possibility of default.

The last two CAMELS indicators to fall (the "procrastinators" or "laggard indicators") would be Liquidity, which hits the warning rating (rating 3) roughly 6 quarters before failure, and Sensitivity to risk, only two quarters (6 months) out.  You can look at a nice color graph of the CAMELS data at this StLouisFed link (scroll down slightly after the jump).

Another important indicator Yadav Gopalan's report mentions is the core earnings of failed banks.  Bank supervisors have tagged this the "earnings run rate" which is the sum of net interest income and net noninterest income by average assets. This run rate is expressed as a percentage and indicates profit or losses as banks open their doors for customers.  Gopalan shows a chart which shows between 1990 and 2009 failed banks on average had a negative earnings run rate four quarters (1 year) before failure.  There is also a nice chart at the the StLouis Fed on the earnings run rate on a quarterly basis before failure, just scroll down to the brown colored chart after the jump.

Gopalan states (I'm paraphrasing here) that asset quality is the main factor of bank stress, BUT, and it's a big BUT, the first indicator to show up in the banks financial reports is decrease in earnings performance.  Capital ratios, while crucial to banks financial healthiness, usually deteriorate (on the reports) long after the banks get shaky financially.

I can imagine some readers will say this info is a little silly because there are so many ways to mislead with the numbers on the balance sheet.  And of course with "shadow banking", and derivatives/swaps, these numbers are less dependable than in years past.  Although I would totally agree these numbers don't mean what they used to (are not as reliable).  But studied closely and in a meticulous fashion CAMELS could be helpful in foreseeing some disasters in banks coming around the corner.