Dive Brief:

• Comments received on the Federal Financial Institutions Examination Council’s proposal to overhaul the CAMELS rating system overwhelmingly called for more detail on what constitutes “material financial risk.” 
• “The strong focus on the undefined phrase ‘material financial risk,’ depending on how it is interpreted by examiners today and in the future, may produce uneven supervisory results across institutions of different sizes,” wrote Amy Ledig and Joseph Chaves, safety and soundness regulatory officials at the Independent Community Bankers of America. 
• Additionally, state bank regulators and Senate Democrats expressed concern with proposed changes intended to de-emphasize the management rating, and warned the overhaul could risk CAMELS becoming a backward-looking, rather than forward-looking, tool that doesn’t appropriately identify emerging issues. Sens. Elizabeth Warren, D-MA, and John Hickenlooper, D-CO, said the proposed changes “would hamstring bank supervisors and invite more bank failures.”

Dive Insight:

A pledge to focus on material financial risk has been a common refrain for Trump-appointed bank regulators, a shift largely cheered by bankers. But many commenters called for a clear definition of that term in the CAMELS overhaul.

FFIEC rolled out the proposed changes to CAMELS, the commonly used name for the Unified Financial Institutions Ratings System, in May, to align with regulators’ emphasis on material financial risk and bolster ratings transparency.

CAMELS, which hasn’t been updated since 1996, stands for capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk. Scores of 1 through 5 for each component are used to assess a bank or credit union’s safety and soundness and flag those requiring more supervisory scrutiny.  

Monday was the deadline to submit comments on the proposed changes, which drew about 80 comments. 

Under the proposal, the ratings system’s basic framework would remain, but alterations would be made to the composite and component rating definitions and factors for evaluation, including removing the “special consideration” the M rating gets in the composite rating. 

The overhaul would cut M evaluation factors including “Management depth and succession,” “Responsiveness to recommendations from auditors and supervisory authorities,” and “Demonstrated willingness to serve the legitimate banking needs of the community,” to keep the focus on “the most material aspects of risk management,” according to the proposal.

In a comment letter, the North Carolina Bankers Association said a clear definition of “material financial risk” would be “the most important improvement to the proposal.”

“The absence of an explicit definition could lead to inconsistent supervisory application across examination teams,” NCBA CEO Peter Gwaltney and Nathan Batts, counsel and director of government relations, wrote.

The California Department of Financial Protection and Innovation went further, with Commissioner KC Mohseni calling the lack of definition of material financial risk “a glaring omission given the significant supervisory and market consequences that attach to CAMELS ratings.”

That agency and its Illinois counterpart expressed concern over the weakening of the management factor.

“The proposed changes ignore the strong causal connection between the competency of a bank’s management and the results of and risk presented by the bank’s operations,” Susana Soriano, banking division director at the Illinois Department of Financial and Professional Regulation, wrote. “Quality management is a key determinative factor for each of the CAMELS components. Effective bank supervision relies on recognizing and assessing this connection.”

David Herndon, bank commissioner for the state of Kansas, called the management rating “the most important factor of the CAMELS rating to ensure the safety and soundness of a bank and should continue to be heavily emphasized in safety and soundness examinations.”

The Bank Policy Institute, however, recommended FFIEC eliminate the M altogether, or replace it with a material operational risks and internal controls component, since the M is “too often treated as a catch-all” for subjective examiner criticisms or findings already factored into other components. 

“The FFIEC proposal would improve the Management component in some respects, but it would continue to include subjective, process-oriented considerations that are not tied to material financial risk,” Tabitha Edgens, BPI’s co-head of regulatory affairs, wrote.  

The American Bankers Association called for additional changes to make ratings more objective, recommending the addition of a definition of “significant non-compliance” with law or regulation and focusing the management component on institution-wide risk management practices.  

Smaller bank trade groups emphasized that the material financial risk standard for a community lender is far different than for a regional or large bank. ICBA officials proposed replacing “material financial risk” with “the more durable and appropriately tailored ‘material safety and soundness concern.’” 

ICBA also urged FFIEC to preserve supervisors’ ability to identify emerging risks, particularly for big banks. “Any revised standard must not become a vehicle for reduced supervisory scrutiny of institutions whose failure or mismanagement could threaten financial stability,” Ledig and Chaves wrote.

“A supervisory framework that places too great an emphasis on material financial risk may naturally focus supervisory discussion on the financial consequences of the action rather than on the failures that produced it,” they wrote.

Sean Vanatta, a senior lecturer in financial history and policy at the University of Glasgow and co-author of “Private Finance, Public Power: A History of Bank Supervision in America,” said proposed changes deserve “careful scrutiny” as they would “shift supervision toward a model in which financial materiality plays a more central role in determining when supervisory judgments become consequential.”

“Supervision has historically been most valuable not when it confirms what markets already know, but when it acts on emerging, ambiguous, and not-yet-material risks — particularly through the evaluation of management and other qualitative channels,” Vanatta wrote.