Dive Brief:

• Federal regulators have proposed changes to the financial institution ratings system commonly known as CAMELS that are intended to focus on material financial risk and bolster ratings transparency, the Federal Financial Institutions Examination Council said Tuesday.
• Revisions to the ratings system have been a priority for Michelle Bowman, the Federal Reserve’s vice chair for supervision and FFIEC chair, the interagency body said. “The revised CAMELS framework marks a decisive shift toward transparency, quantitative factors, and predictability of supervisory oversight,” Bowman said in a news release.
• The CAMELS framework, first developed in 1979, hasn’t been updated since 1996, so changes are long overdue, said Kevin Stein, managing director of Klaros Capital and a former associate director at the Federal Deposit Insurance Corp. 

Dive Insight:

CAMELS stands for capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk. The CAMELS ratings system, with scores of 1 through 5 for each component, is used to assess a bank or credit union’s safety and soundness and flag financial institutions requiring more supervisory scrutiny. 

FFIEC called CAMELS “a critical tool for supervisors to assess, identify, and communicate threats to the safety and soundness of financial institutions.” 

The M for management has been “the most influential factor in determining composite ratings, particularly in recent years — yet it is the least grounded in objective financial data,” Stein said.

“There’s just too much subjective examiner opinion in there,” he said. “The industry wants a certainty, they want to know where the goalposts are.”

CAMELS ratings govern merger and acquisition approvals, insurance premiums and enforcement actions, Stein noted. “When decisions of that magnitude rest on opaque, subjective assessments rather than measurable financial risk, the credibility of the entire supervisory system is questionable,” he said. 

Bank trade groups welcomed the overhaul effort, also calling out the M issue. “As the proposal acknowledges, the Management component has had undue weight in determining bank ratings. Improving supervision requires reforming the ‘M,’” Greg Baer, the Bank Policy Institute’s CEO, said in a statement. 

Under the proposal, the ratings system’s basic framework would remain, but changes 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. 

The “but not limited to” language would be scrapped from CAMELS component descriptions and replaced with a general paragraph allowing for more evaluation factors to be considered “only if warranted by exceptional circumstances or evolving business practices,” the proposal said.  

Proposed changes would also restrict the impact of specialty review findings to those posing material financial risk; and focus the ratings definitions and evaluation factors on the areas most impactful to an institution’s financial condition, FDIC Chair Travis Hill said Tuesday. 

Hill called the proposal an “important step” in the agency’s efforts to reshape bank supervision around material financial risk.    

Comptroller of the Currency Jonathan Gould said he supports the direction of the proposal but remains concerned revisions don’t sufficiently address “double counting” within the M.

“For the CAMELS framework to function effectively, each component must provide distinct, incremental value,” Gould said Tuesday in a statement. “Historically, the Management rating has reflected deficiencies already captured in other components. To maintain the integrity and transparency of the CAMELS system, it is vital that the Management rating serve as a standalone assessment rather than a secondary reflection of other components.”

No single component rating should disproportionately drive the composite rating, Gould added.

Charles Cooper, FFIEC’s state liaison committee chair, said it’s essential that a balanced approach is maintained in the updated CAMELS framework. 

“While identification and mitigation of material financial risks remain a core focus of supervision, the proposed rating system must also factor in an institution’s effective management of cyber, information technology, legal and regulatory compliance and operational risks,” Cooper said in a statement. 

Last year, the Fed adjusted its large financial institutions ratings framework, making it easier for those lenders to be deemed “well managed.” Changes were intended, in part, to better align the supervisory rating framework with others such as CAMELS.  

Regulators encouraged robust feedback on the proposed changes. Comments on the proposal will be accepted through Aug. 17. 

“There'll be some back and forth before it gets finalized, but this feels to me like we're addressing something that has needed to be addressed for quite some time,” Stein said.