VI. Study the following notes and prepare an oral presentation

Mrs. Charlotte Ameasbury summons Karl Brewer to her office and asks him to prepare the final part of the CAMEL rating system liquidity, which indicates the ability of the bank to quickly meet its obligations. So, Karl has brought some notes on liquidity he prepared the other day. He also reminds Charlotte of CAMEL ratings: 1= strong; 2 = satisfactory; 3 = fair; 4 = marginal; 5 = unsatisfactory.

 

The final part of the camel rating system is liquidity, which indicates the ability of a bank to quickly meet its obligations.

· It is important to remember that for a bank to properly manage its liquidity, it must be able to meet its obligations without a loss.

- Banks must have available liquid assets which can quickly be turned into cash, or they must be able to raise funds on very short notice to meet an obligation;

- Managing liquidity involves both sides of the balance sheet, meaning having available back-up sources to raise liquidity quickly.

· Since liquidity involves many factors, no single ratio measures all a supervisor needs to know about liquidity. Several ratios can be indicators as will be discussed.

· As part of an on-site examination, the examiners review how liquidity is managed which includes:

- Are specific policies in place to set liquidity targets and limits to meet statutory requirements and to manage liquidity as set by directors and senior management?

- Are reporting systems and data bases sufficient to give quick and accurate information on a bank's position?

- How much reliance has the bank placed on deposits or other funding which might be withdrawn on very short notice?

· The on-site review is combined with an analysis of various liquidity ratios to determine the trend of liquidity and how it compares to other banks.

Using their judgment in both the on-site examination of how a bank manages its liquidity and from liquidity ratios, liquidity is then rated as sound, satisfactory, fair, marginal, or unsatisfactory.

 

Karl also presents component ratings. They are:

 

Component ratings

Rating 1

- strong performance

- significantly higher than average performance

Rating 2

- satisfactory

- average or above average performance

- adequately provides for safe and sound operation

Rating 3

- performance flawed to some degree

- considered fair

- neither satisfactory nor average but is characterized by below average quality

Rating 4

- marginal performance

- significantly below average

- weaknesses could evolve to threaten viability of bank

Rating 5

- unsatisfactory

- critically deficient and needs immediate attention

- such performance could threaten the viability of the institution

 

Text B

Analysis of Capital

 

In general terms, the function of bank capital is to support the volume, type and character of the bank's business, to provide for the possibilities of losses that may arise, and to enable the bank to continue to fulfill the reasonable credit needs generated within the community that it serves. Inasmuch as it is generally agreed that depositors are not meant to assume risks emanating from the operation of the bank, capital should be sufficient to absorb shrinkage in asset value and other losses that may be incurred.

The risk asset ratio is an objective measure of the amount of shrinkage that can be absorbed by a bank's capital structure and is to be used in rating bank capital. This ratio defines the relationship of gross capital to those assets which contain some potential for loss (i.e. risk assets) without attempting to specify the loss inherent in any given risk asset or risk asset category.

The risk asset ratio is calculated from the bank's most recent Consolidated Report of Condition (including foreign and domestic subsidiaries, when applicable) and is defined as follows:

 

Risk Asset Ratio = Gross Capital Funds

Risk Assets

 

The term gross capital funds includes total equity capital, the reserve for possible loan losses and subordinated notes and debentures. Risk assets are defined as total assets plus reserve for possible loan losses less cash and due from banks, U.S. Treasury securities, obligations of U.S. Government agencies, trading account securities, and Fed funds sold and securities purchased under agreements to resell.

Since the risk asset ratio does not distinguish the degree of risk associated with differing asset structures, it is to be used in tandem with the quality of assets rating to arrive at the final rating of bank capital. The following tables provide the ratio guidelines and the limiting conditions, which are to be used in arriving at the overall capital rating.

Analysis of asset quality

 

In rating asset quality, the system is designed to distinguish the degree of risk inherent in classified assets by ascribing weights to each category of classification, thereby providing a more reliable measure of the impact of risk on bank capital.

The following weights are to be used:

 

Classification	Weights
Substandard Doubtful Loss	20% 50% 100%

 

Total weighted classifications equal the aggregate of 20 percent of assets classified substandard, 50 percent of doubtful and 100 percent of loss.

The ratio of weighted classifications to gross capital funds (as defined above) is the primary criterion to be used in determining the quality of assets.

Analysis of earnings

Earnings are to be rated based upon their level (quantity) and their composition (quality). Both aspects of earnings must be appraised to derive the final rating. The quantitative aspect is to be evaluated by analyzing the bank's return on assets relative to its peer group mean or average. The peer group approach is utilized in appraising the quantitative aspect of earnings because income and expense items vary greatly depending upon the size and nature of a bank's operations. The preliminary assessment derived from peer group analysis is then modified, if necessary, to reflect the qualityorcomposition of the bank's net income. This step is essential. No rating is to be assigned to earnings without a careful consideration of the quality of earnings.

The quantitative aspect of earnings is evaluated through an analysis of the bank's return on assets (defined as net income divided by the average total assets) relative to the three-year mean for its particular peer group. The following total asset level cutoffs define the nationwide peer groups to be used for the earnings analysis:

under $50 million

$50 million to $100 million

$100 million to $300 million

$300 million to $1 billion

$1 billion to $5 billion

over $5 billion

 

A three-year mean return on assets is derived for each peer group and a three-year average return on assets is calculated for each peer group bank. This permits the determination of cutoffs, or benchmark ratios, based upon the three-year peer group array against which an individual bank's return for any given year can be compared. Cutoffs that divide the three-year peer group array into the highest 1 5 percent, the top 50 percent, the next 35 percent, and the bottom 15 percent will be used to set the ratio benchmarks. These benchmarks will then be used as standards against which an individual bank's return on assets for any given year will be evaluated. The use of three-year data to set standards diminishes the immediate effect of an industry-wide decline in earnings on the standards of performance, thus making the earnings criteria more stable and less subject to cyclical changes.

In practice, the examiner will compare a bank's most recent full year's return on assets with the benchmarks to determine a bank's preliminary earnings rating. Interim year-to-date earnings, especially for examinations conducted later in the year, must also be considered in assigning a final rating. As discussed below, the quality or composition of earnings is also a factor to be weighed in arriving at a final earnings rating.

Since the return on assets ratio alone does not always present a wholly reliable picture of a bank's earnings performance, the quantitative evaluation must be modified, if appropriate, to reflect the quality or composition of net income. Judgment must be brought to bear in determining the adequacy of transfers to valuation reserves and the extent to which securities transactions, tax effects, or any other unusual items contribute to net income. The quantitative evaluation may be modified upward or downward in a manner consistent with the definitions below in the event that an analysis of the composition of net income supports such an adjustment. Other things equal, net income that reflects, to an overly large degree, inadequate loan loss provisions, substantial tax credits, outsized securities gains, or significant non­recurring income items, is generally of lower quality than net income of similar magnitude that derives basically from operations and has not been materially influenced in any of the foregoing ways. Thus, earnings that are judged to be of inferior quality may be downgraded from the rating suggested in the preliminary assessment, since an inability to generate sufficient income from operations constitutes a serious deficiency and must be properly reflected in the final earnings rating.

Analysis of liquidity

Liquidity must be evaluated on the basis of a bank's capacity to promptly meet the demand for payment of its obligations and to readily fulfill the reasonable credit needs emanating from the community or communities which it serves. Since banks of varying sizes operate under vastly different circumstances attendant to local, regional, national and international markets, analyses of liquidity will vary greatly from bank to bank depending upon the magnitude, nature and scope of a bank's operations. Thus, no single ratio or formula adequately captures and summarizes the many-faceted dimensions of liquidity for all sizes and categories of banks. Instead, liquidity must be judged with regard to a bank's ultimate ability to fund its obligations and commitments. In practice, then, the examiner must review the bank's current liquidity position and ask how liquidity would be affected by certain events in the bank's relevant economy or service area that might reasonably be expected to occur given the nature of the bank's operations and past experience. Thus. scenarios that include reductions in the level of deposits or shocks within the money markets should be considered and analyzed for their likely effect on an institution's liquidity position. Similarly, consideration should be given to the expected impact on funding requirements emanating from the bank's responsibility to provide for the credit needs arising from the market which it serves.

An individual bank's liquidity, therefore, is rated (1 through 5) with respect to (a) the volatility of deposits; (b) the degree of reliance on interest-sensitive funds; (c) availability of assets readily convertible into cash; (d) accessibility to money markets; (e) overall effectiveness of asset-liability management strategies and policies; (f) compliance with internal liquidity policies; and (g) the nature, volume and anticipated usage of credit commitments. It is recognized that these factors will have varying degrees of relevance for different banks depending on their size and particular financial structure, and that any evaluation of liquidity must necessarily address an individual bank's unique circumstances.

Analysis of management

Inasmuch as management is rated on the effectiveness with which it conducts the bank's business, the responsibilities with which it is charged vary in complexity depending on the conditions inherent in any given situation. These conditions are affected by size and type of business and, for a given bank, will vary through time. Therefore, management that is competent to effectively discharge responsibilities under given conditions may be less than competent as these conditions are altered by size, type of business, or through time. Management should, then, be rated accordingly.

Management's performance is evaluated against a wide variety of objective and subjective factors. In addition to evaluating performance in light of adequacy of capital and liquidity, asset quality and profitability, management is also rated with respect to (a) technical competence, leadership, and administrative ability; (b) compliance with banking regulations and statutes; (c) ability to plan and respond to changing circumstances; (d) adequacy of and compliance with internal policies; (e) depth and succession; (f) tendencies toward self-dealing; and (g) demonstrated willingness to meet the legitimate banking needs of the community. Management is rated in accordance with the following guidelines.

 

Questions:

 

1. What are your views on this topic?

2. What is the function of bank capital?

3. What does the term gross capital funds include?

4. How can we assess risk inherent in classified assets?

5. How do we rate earnings?

6. What do you know about liquidity?

7. Do you agree that sound management equals sound banking? Explain it in more detail.