DEFINITION of Bank Examination

A bank examination is an evaluation of the safety and soundness of a bank. The primary focus is an examination of the banks assets and liabilities, but the exam also commonly includes a review of its adherence to regulations and standards, its compliance with various laws (such as truth-in-lending), and an examination of its electronic data processing systems.

The Comptroller of the Currency conducts examinations for national banks, while the Federal Deposit Insurance Corporation (FDIC) or the state banking department conducts those, for state chartered banks. For bank holding companies, the U.S. Federal Reserve Board conducts examinations.

BREAKING DOWN Bank Examination

In evaluating the safety and soundness of an institution, examiners follow the CAMELS system: capital adequacy, asset quality, management, earnings, liquidity and sensitivity (to systemic risk). Banks receive a ranking on a scale of one to five in each category, along with an overall assessment, with one being the strongest and five the weakest. Regulators will place banks with CAMELS of four and five on a watch list and monitor them closely.

Bank Examination and CAMELS Criteria

Breaking down CAMELS even further:

C stands for capital adequacy, ensuring that a bank maintains level of required capital to withstand any shocks to its system. The capital adequacy ratio (CAR) measures a bank’s tier one capital and tier two capital.

A stands for asset quality, which could entail a review or evaluation of credit risk associated with a bank’s interest-bearing assets, such as loans. Ratings organizations may also look at whether or not a bank’s portfolio is appropriately diversified.

M stands for management. Regulators will want to ensure that the leaders of banks understand where their institution is headed and have made specific plans to move forward in a given regulatory environment.

E represents earnings. Bank financial statements are often more complex than companies’ given banks’ distinct business models. Banks take deposits from savers and pay interest on some of these accounts. To generate revenues, banks will turn around these funds to borrowers in the form of loans and receive interest on them. Their profits come from the spread between the rate they pay for funds and the rate they receive from borrowers.

L stands for liquidity. This is a measure of the bank’s ability meet its financial obligations with readily available assets. Common liquidity tests include the current ratio, acid test or quick ratio (which excludes inventories from the current ratio), and the cash ratio.

Finally, S represents bank sensitivity, or the magnitude by which systemic factors, such as political turmoil or interest rate changes, could impact the bank.