Examiners Will Dial Back on Management in Ratings Revamp

Federal banking regulators have proposed changes to the Uniform Financial Institutions Rating System, better known as CAMELS, to emphasize quantifiable financial metrics over subjective risks. The proposal is likely to be welcomed by much of the industry, but some worry the revamp could hinder institutions’ ability to respond to unforeseen events, like an IT event or the unexpected departure of a CEO.

Under the CAMELS system, banks are evaluated for capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk as part of their regular exam. Recently, the Federal Financial Institutions Examination Council proposed revising CAMELS to give less weight to the management rating and more weight to quantitative financial metrics. The management component has historically encompassed factors such as board and management oversight, compensation policies and the adequacy of audit and internal controls.

In a May 19 proposal, the members of the FFIEC — which include the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. — suggested that the framework remove special consideration given to the management component within the overall composite rating. The interagency body also wants to remove related factors concerning management succession, responsiveness to auditors and willingness to serve the community’s legitimate banking needs. The proposed change would result in a “more balanced approach” and composite ratings that more accurately reflect banks’ financial performance and risk profile, regulators said.

The quantifiable components of CAMELS tend to be lagging indicators of problems, says Josh White, a shareholder at Elliott Davis. “Examiners are going to be looking at some of those lagging indicators more for the financial risk, but [management teams] do not need to get complacent at all,” he says. Many banks understand the importance of cybersecurity, operational resilience and succession planning, he adds. “The best operators will not take their eye off the ball.”

Currently, banks are graded on a 1 to 5 scale on each of the CAMELS components, with 1 being the strongest grade and 5 being the weakest. A composite rating of 1 or 2 is considered strong or satisfactory, with minimal or minor weaknesses, while a rating of 3 or lower indicates less than satisfactory performance or more serious noncompliance. The six component ratings factor into an overall CAMELS rating, but the composite number isn’t an average — regulators might weight certain components differently depending on the environment. Though CAMELS ratings are confidential, a poor score can result in regulatory enforcement actions or fines and may negatively affect a bank’s ability to pursue growth initiatives such as M&A.

Brendan Clegg, a partner with Luse Gorman, says he has seen cases where the management rating was given undue weight in a bank’s overall composite rating. “It would be difficult for [a bank] to have a management rating that was lower than the composite rating,” says Clegg, who previously worked at the OCC.

According to the proposal, the management component “has been the most influential factor in determining composite ratings, particularly in recent years.” Further, bankers have long complained that certain issues have been historically double-counted under the management component of CAMELS. For example, if a regulator flagged weaknesses in the liquidity component, that could also be reflected in the management rating as a weakness in management oversight. Comptroller of the Currency Jonathan Gould said in a statement that he felt the latest proposal did not go far enough in addressing the double-counting issue.

However, some see the proposal as discouraging senior bank examiners from exercising judgment that’s been honed through various crises. The management rating can capture leadership’s ability to oversee and respond to operational risks, like a cybersecurity event or IT outage, says Mayra Rodríguez Valladares, managing principal of the consulting firm MRV Associates. “You want the human element. It is a big mistake to de-emphasize management,” she says. She worries the change could introduce more risk to the financial system if it leads examiners to place less emphasis on items like vendor risk management or succession planning. “It is a real problem” for examiners to not have the ability to raise potential flags around a lack of succession planning at community banks, she says.

The CAMELS revamp follows a broader trend among federal regulatory agencies to peel back some of the more prescriptive elements of certain rules and regulations.

“The general sense from some of [the regulatory agencies’] public statements and the regulatory proposals is that management and the board should be able to exercise their judgment on some of these decisions and whether it’s within their risk tolerance,” Clegg says. Regulators are “going to let management and the board do that more freely rather than prescribe how they should do certain things.”

That means boards should understand how the bank will assess subjective risks such as vendor risk management, succession planning or operational resilience — especially if the regulatory goalposts move again. “How are you assessing the risk?” says Clegg. “And can you explain it?”