In a recent blog post, the Bank Policy Institute's Greg Baer, President and CEO, and Bill Nelson, Chief Economist, critique the subjectivity of the Management ("M") component of the CAMELS bank examination system, calling for it to be redefined entirely.
CAMELS ratings are based upon six factors: Capital, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk. However, Baer and Nelson contend that regulators disproportionately rely on "M" to determine a bank's composite rating and enforce sanctions. Additionally, every other CAMELS component already considers management, they argue, leaving the standalone "M" redundant and prone to examiner bias.
The authors highlight the 2023 banking turmoil, where banks with high interest rate risk saw minimal downgrades in Liquidity (L) and Sensitivity to Market Risk (S). Instead, the composite ratings, driven by the "M," failed to reflect actual financial risk, Baer and Nelson recount. They reference research which identified "economically large levels of and variations in absolute discretion" among examiners, with changes in ratings often stemming from examiner turnover rather than “true bank quality.”
Baer and Nelson proposed redefining the "M" to focus on Market Signals like credit spreads, analyst ratings, and credit default swaps. For smaller banks, they suggest eliminating "M" entirely, shifting to a CAELS system.
"Ultimately, the question is what would tell agency principals more about the condition of a large bank, and what would be a better basis on which to focus its future examination and potentially take action to restrict a bank's activities: (1) a wholly subjective assessment of management untethered to financial risk or (2) some combination of market signals," they conclude. “Given both theory and practice, it is difficult to understand how anyone could claim the former.”
As the authors point out, removing the “M” score as a component won't necessarily eliminate management assessments as they are embedded in other scores. Nor is it clear that doing so will necessarily remove supervisory judgment from the exercise. Alternatively, in an article published by the FT's Banking Risk and Regulation last year, Starling Founder & CEO Stephen Scott discusses how technology can be used to produce objective metrics to replace subjective assessments of Management capabilities.
"Reliance on subjective assessments and opaque decision-making, coupled with a system that penalizes firms without offering them a fair chance to contest or even to understand the basis for those penalties, stifles innovation, restricts growth, and undermines trust," he writes. "It's time to embrace technologies that ensure greater transparency, consistency, and fairness in how we assess the effective management of qualitative operational risks." ▸ Read More
For more from Greg Baer, read his article, “Rethinking Bank Examination,” from the 2024 Compendium.
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