What Is a Bank Rating?
The Federal Deposit Insurance Corporation (FDIC) and/or other private companies provide a bank rating to the public on its safety and soundness. This applies to banks and other thrift institutions.
A bank rating will usually assign a letter grade or numerical ranking, based on proprietary formulas. These formulas typically originate from the bank’s capital, asset quality, management, earnings, liquidity, and sensitivity to market risk (CAMELS).
Bank Ratings Explained
Government regulators assign the CAMELS rating on a scale of 1 to 5, with 1 and 2 being assigned to financial institutions that are in the best fundamental condition. A rating of 4 or 5 often indicates serious problems that require immediate action or careful monitoring. A rating of 5 is given to an institution that has a high probability of failure within the next 12 months.
Agencies do not always release CAMELS ratings to the public. They can be kept confidential. For this reason, private bank-rating companies also use proprietary formulas in an attempt to replicate the information. Because no rating service is identical, investors and clients should consult multiple ratings when analyzing their financial institution.
Bank Rating and Examples of CAMELS Criteria
As stated above, many agencies use CAMELS or similar criteria to rate banks. For example, if an agency looks at the “A” in CAMELS: “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 (e.g. what policies have been put in place to limit credit risk and how efficiently operations are being utilized).
Agencies might also look at “M” for management. They 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, alongside their peers. Visualizing what is possible, placing a bank in context with industry trends, and taking risks to grow the business are all required of strong leaders.
Finally, organizations could focus on “E” or earnings. Bank financial statements are often harder to decipher than other companies, given their distinct business models. Banks take deposits from savers and pay interest on some of these accounts. To generate revenues, they will turn around these funds to borrowers in the form of loans and receive interest on them. Their profits are derived from the spread between the rate they pay for funds and the rate they receive from borrowers.