1. Liquidity Risk - - The “L” in CAMEL
IDC Financial Publishing, Inc. (IDCFP) uses the acronym
CAMEL and its component financial ratios to evaluate the
safety and soundness of commercial banks and savings
institutions. This article explains how IDCFP uses liquidity as a
component of its CAMEL ranking system and why it is valuable
and important to monitor.

2. Liquidity risk to the safety and soundness of a bank occurs when
loan delinquency (90 days past due and nonaccrual loans plus
repossessed assets) exceeds 4% of total loans and balance sheet
cash flow is substantially negative.
Balance sheet cash flow equals operating cash flow less financial
cash flow. Operating cash flow equals the annual change in
retained earnings less the annual changes in growth producing
assets. The purpose of measuring operating cash flow is to
determine the ability to internally finance the growth in producing
assets. Financial cash flow isolates the annual change in sources
and uses of funds, other than the change in retained earnings,
growth in producing assets and cash and equivalents. Financial
cash flow equals the annual change in liabilities (excluding retained
earnings) less the annual change in loans and investments and
other non-cash and equivalent current assets.

3. Balance sheet cash flow subtracts the financial cash flow from
operating cash flow. Major negative balance sheet cash flow
occurs if annual changes in retained earnings are negative and/or
the annual change in all other liabilities substantially exceeds the
annual changes in loans and investments. An institution with poor
loan quality or risky investments experiences asset write-offs or
write-downs, and at the same time, deposits increase or new
borrowings finance the asset base, the resulting negative balance
sheet cash flow threatens the safety and soundness of the
financial institution.
Commercial Banks and Savings Institutions with Major
Negative Balance Sheet Cash Flow as a Percent of Equity
Capital and Loan Delinquency in Excess of 4% of Loans are
Ranked by IDCFP Below the Rank Industry Standard for
Safety and Soundness of “125” (300 the Highest and 1 the
Lowest).

4. ALERT
The “E” Component of CAMEL, as Well as, the Total of
Banks Ranked Less Than “125”, Indicates Risk from our
Early Warning System of a Future Financial Crisis in 2020 or
2021.
The low risk level in the number of banks and savings institutions
of 146 ranked less than “125” in “E” in the 3rd quarter 2017,
caused a low for all institutions ranked less than “125” of 447 in
the 3rd quarter of 2017 (see Table I).

5. The risk in a bank or savings institution is a negative ROE, which
destroys equity capital. The risk is amplified, however, to the
institution’s safety and soundness, when ROFL is negative. The
operating earnings ratio (ROEA) is low or negative and the cost of
adjusted deposits and debt exceeds ROEA, causing a negative
leverage spread, and then, times financial leverage, creates an
even greater loss, as reflected in ROFL. Currently, a negative
ROFL has been exhibited in smaller banks. As the Federal
Reserve raises the fed funds rate by 1% to 1.5% in the next two
years, the low levels of operating returns (if not corrected)
accompanied with rising costs of funding, create continuous
future losses in net income for these 173 firms and, potentially,
more financial institutions. Given Reported and Continuing
Future Losses, Recent Tax Reductions Fail to Assist These
Institutions.

6. Table I

7. All 5 categories of rank, C-Capital, A-Adequacy of Capital, M-
Margins as a Measurement of Management, E-Earnings from
Operations and, separately, Earnings from Financial Leverage,
and finally, L-Liquidity all together provide a timely indication of
risk and potential failure. Additional components of CAMEL,
however, are required to increase in the count of banks under
“125” in other CAMEL components to confidently forecast the
severity of the coming banking crisis.

8. Early Warning Indicators in 2005 and 2006
(see Table II)
The low in the number of commercial banks and savings
institutions ranked below the industry standard as investment
grade “125” occurred in the 2nd quarter of 2006, two years before
the banking crisis in 2008. Most important, however, is that all but
1 of the 5 components of CAMEL reached a low in their number
of institutions from the 3rd quarter of 2005 through the 1st quarter
of 2006 – prior to the low count for all institutions ranked less than
“125” in the 2nd quarter of 2006.

9. As seen in Table II below, commercial banks and savings
institutions not well capitalized (“C” in CAMEL) reached a low of 47
in the 3rd quarter of 2006. Financial institutions measuring
adequacy of capital with adjusted Tier 1 capital below 5% (Tier 1
capital adjusted for bad and delinquent loans net of the loan loss
reserve), the “A” in CAMEL, reached a low count of 29 in the 3rd
quarter of 2005. Banks and savings institutions with a lack of
profitability or low and unstable margins, the “M” in CAMEL,
reached a low of 178 in the 4th quarter of 2005. The commercial
banks and savings institutions with severe negative
“Earnings due to Leverage” (the “E” in CAMEL) reached their
low of 185 in the 4th quarter of 2005, two quarters before the
total number of institutions ranked below “125” reached its
low in the 2nd quarter of 2006. Finally, institutions with high loan
delinquency and negative balance sheet cash flow – the “L” in
CAMEL – reached their low of 2 in the 1st quarter of 2006.

10. Table II
Components of CAMEL Forecast Banking Crisis in 2005, up to
Three Quarters Before the Total Ranked Below “125” in June
of 2006

11. IDCFP has been helping CD brokers and investors, insurance
companies, federal agencies and a host of other institutions make better
decisions using its unique and proprietary CAMEL rating methodology
since 1985. For more information on CAMEL go to www.idcfp.com or
call 1-800-525-5475.