The collapse of three major regional banks in the first half of 2023 has sparked significant concern and debate in Congress and the public. The root cause of these failures lies in the unsafe and unsound banking practices undertaken by the management and directors of these institutions.
Despite having all the necessary tools at their disposal, state and federal bank regulators failed to supervise these banks adequately, neglecting to promptly order them to cease their risky activities.
A controversial suggestion has emerged in response to this crisis, proposing the public disclosure of the currently confidential CAMELS (capital adequacy, asset quality, management, earnings, liquidity, and interest-rate sensitivity) ratings issued by bank regulators as a solution to the problem.
The CAMEL rating system, which predates the current CAMELS system, was developed by the Federal Deposit Insurance Corporation, the Comptroller of the Currency, and the Federal Reserve during the tenure of the author, William M. Isaac, as chairman of the Federal Deposit Insurance Corporation.
The purpose of the CAMEL system was to establish a standardized way for regulatory agencies to express their assessment of each bank’s condition based on regulatory examinations. Each factor in the rating system was assigned a rating from 1 to 5, with 5 indicating the worst condition.
The bank also received a composite rating on the same scale. A 1-rated bank had no significant concerns, a 2-rated bank was considered good, a 3-rated bank had problems requiring attention, a 4-rated bank had significant problems needing immediate attention, and a 5-rated bank had a roughly 50-50 chance of failing and required immediate remediation.
The regulators communicated the CAMELS rating to the bank and its directors, answered any inquiries, and discussed the expected remediation efforts. Public disclosure of these ratings was vehemently rejected due to concerns about its impact.
Making the ratings public could exert undue pressure on examiners, potentially leading them to rate banks more favorably than their instincts dictated. Furthermore, disclosing all ratings could result in a loss of confidence and widespread public panic.
The preferred solution, as determined during the development of the system, was to publicly disclose the facts that led to the examiners’ ratings, including the existence of any enforcement actions, without revealing the ratings themselves.
This approach aimed to protect the privacy of bank customers while providing transparency about the issues requiring corrective actions.
Regulators believe they can assist troubled banks in turning around if given sufficient time. Publicly announcing CAMELS ratings would expedite the implementation of corrective actions and increase the failure rate of poorly rated banks.
However, a significant number of banks remediate their issues after discussing their rating and do not fail. Approximately half of the 5-rated banks ultimately recover.
In summary, the CAMELS rating system has significantly enhanced bank supervision, introducing greater uniformity and objectivity to the process.
Advocates for public disclosure of ratings are deemed incorrect, as it would likely result in heightened depositor stress, avoidable panics, increased bank failures, higher costs to the FDIC and the banking industry, and a less competitive banking system.
The author asserts that the system, developed during his tenure, remains effective, and changing course now would be unwise. William M. Isaac, former chairman of the FDIC & Fifth Third Bancorp, expresses these views independently, not necessarily reflecting the views of any associated firm.
