RATING SYSTEMS—International Examinations; CAMEO

The CAMEO rating system has been designed to provide a general framework to summarize the examiner’s views about key components of an Edge corporation’s operations. The rating system is intended to reflect in a comprehensive and uniform manner an institution’s financial condition, compliance with laws and regulations and overall operating soundness. (This methodology, with modifications for structural differences, will also be applied to other international operations, i.e., foreign subsidiaries and branches of U.S. banks and U.S. branches and agencies of foreign banks). Thus, similar to the approach employed in the BOPEC rating methodology when a component is not applicable, a “0” should be assigned to the capital component of the CAMEO rating for overseas branches of U.S. banks.

The terms and numerical ratings used to rate Edge corporations are similar to those used in the Uniform Bank Rating System (CAMEL) for commercial banks but have been modified to reflect the special characteristics of these corporations. The components rated are (in this order): Capital, Asset quality, Management, Earnings, and Operations and internal controls (CAMEO).

Each component should be rated on a scale of 1 through 5 in ascending order of supervisory concern. Thus, 1 represents the highest quality and lowest concern, while 5 represents the lowest quality and greatest concern.

Each corporation is also to be given a composite rating based on an evaluation of the key components. That numeric composite rating should be brought forward to the Examiner’s Comments page when discussing the corporation’s overall condition. In conjunction with disclosing the ratings, the meaning of the ratings should be clearly explained. The individual components of the CAMEO rating are to be summarized on the Analysis of Condition page. Furthermore, the complete numerical rating (CAMEO/composite) should be included in item 2 of the General Remarks section of the Edge Corporation Examination Report.

The level of capital plays a key role in the evaluation of any financial institution; if its capital is sufficient, other financial, managerial, and operational weaknesses can usually be absorbed. Consequently, the ratings of other components, especially asset quality and earnings, are closely related to capital.

The evaluation of capital adequacy of an Edge corporation differs somewhat between banking and nonbanking (investment) corporations in view of their structural differences. Banking Edge corporations present a special case, in view of their depository status which is noninsured. The Federal Reserve System has the sole supervisory authority for these entities and would be responsible for liquidating a failing Edge corporation.

Notwithstanding these structural differences, examinations of all active corporations will include a capital-adequacy assessment and be rated for this component of the CAMEO rating. In doing so, examiners are to follow the procedures employed in commercial banks in assessing capital adequacy using the primary capital/total capital quantitative measurement as the initial reference tool.

In both types of Edge corporations, the examiner should measure the corporation’s capital relative to (a) the size and quality of its consolidated assets and (b) the extent to which the corporation’s investment position and lending policies expose it to further risks.

All Edge corporations must meet the $2 million minimum capital stock requirement of section 25(a) of the Federal Reserve Act, and banking Edge corporations must also maintain capital and surplus of a minimum of 7 percent of risk assets in accordance with Regulation K. The capital of Edge corporations that do not meet either of these standards may not be rated better than 4 (marginal), regardless of the results of other calculations. The situation should also be temporary, and the corporation should have immediate plans to eliminate this violation.

The capital ratings which parallel the capital ratings of state member banks are as follows. Capital is rated (1 through 5) in relation to (a) the volume of risk assets; (b) the volume of marginal- and inferior-quality assets; (c) the corporation’s growth experience, plans, and prospects; and (d) the strength of management in relation to (a), (b), and (c).

Edge corporations rated 1 or 2 are considered to have adequate capital, although the former’s capital ratios will generally exceed those of the latter. A 3 rating should be ascribed to a corporation’s capital position when the relationship of the capital structure to points (a), (b), or (c) is adverse even giving weight to management as a mitigating factor. Corporations rated 4 and 5 are clearly inadequately capitalized, the latter representing a situation of such gravity as to threaten viability and solvency. A 5 rating also denotes that the corporation requires urgent assistance from shareholders or other external sources of financial support.

Asset quality is rated (1 through 5) in relation to (a) the level, distribution, and severity of classified assets; (b) the level and composition of nonaccrual and reduced-rate assets; (c) the adequacy of valuation reserves; and (d) the demonstrated ability to administer and collect problem credits.

In rating asset quality, examiners should consider the credit risk exposure of the corporation through its booked assets, as well as its off-balance-sheet activities, including credit risks resulting from country exposure. This approach is consistent with the procedures used to examine state member commercial banks. Risks to the corporation resulting from interest-rate movements should not be considered here, but rather in the evaluation of capital adequacy. Consequently, the rating for asset quality may be omitted for corporations that are engaged primarily in trading or settlement transactions and when credit risk is not an issue. Otherwise, examiners should measure the amount of risk inherent in classified assets and off-balance-sheet exposures by assigning the following weights to each classification category:

 Total weighted classifications equal the aggregate of 20 percent of assets classified substandard, 50 percent of assets rated doubtful and value-impaired, and 100 percent of assets rated loss. The 50 percent weight assigned to assets classified value-impaired reflects the exposure net of any allocated transfer-risk reserves. The weighted classification ratio (weighted classifications as a percent of total capital) is the primary criterion used to measure asset quality.

 The level of concentrations of the corporation’s assets and the volume of those assets rated as other transfer risk problems (while not classified) should also be considered. Based on the weighted classification ratio and these and other factors that the examiner considers relevant, one of the following ratings should be assigned:

Guidelines for Rating Asset Quality

Management should be evaluated on the basis of the corporation’s capital adequacy, asset quality, profitability, liquidity, adequacy of internal controls, and adherence to policies.

The rating should also reflect—

1. the technical competence of the management team and the internal auditors;

2. the degree to which management responds to audit and examination criticisms and promptly corrects cited deficiencies;

3. management’s demonstrated leadership abilities;

4. management’s ability to plan and respond to changing circumstances, such as effectively managing new products;

5. the effectiveness of supervision by the board of directors and the parent bank;

6. the extent to which the corporation’s policies and procedures ensure management continuity; and

7. tendencies toward self-dealing.

The rating assigned should meet the description below.

Rating 1 (Strong). Management is fully effective with respect to the above criteria, taking into consideration the type, size, and strategic thrust of the corporation.

Rating 2 (Satisfactory). Management measures well under the stated criteria. However, the corporation exhibits minor weaknesses, which management is adequately addressing.

Rating 3 (Fair). Ratings for operations and internal controls and for other components reflect management weaknesses, and the corporation requires more than normal supervision. However, the corporation’s overall condition and the quality of its management should not impair its future viability.

Rating 4 (Marginal). Significant managerial deficiencies have contributed to a deterioration in the condition of the corporation. Management is not adequately addressing these deficiencies.

Rating 5 (Unsatisfactory). Management problems are sufficiently severe that management must be immediately strengthened or replaced to prevent further and serious deterioration in the condition of the corporation.

Earnings for both banking and nonbanking Edges are to be rated based upon their volume and quality, with consideration given to the parent company’s policy and philosophy regarding the corporation’s profits. This rating reflects (a) the ability of earnings to cover losses and to provide for adequate growth of capital; (b) earnings trends; (c) the corporation’s return on assets and equity; and (d) the contribution of the corporation’s earnings and services to its parent institution. Generally, the examiner in rating earnings should consider the extent to which the profitability of the Edge corporation enhances or reduces the overall profitability of its parent.

The quantitative aspect of earnings should be based on the corporation’s return-on-assets ratio (net income divided by average total assets) and its return on average equity. Examiners should determine, based on the structure and nature of the corporation’s operations, which of the two measures is the more appropriate indicator as the first step in applying a rating to earnings. Averages for corporations engaged in banking that do not have branches or subsidiaries should be computed using the average total assets on line 2(g) of the Memoranda section of each of the quarterly call reports for a full calendar year. Average total assets for all other corporations (including virtually all nonbanking Edges) should be obtained on a consolidated basis from records or data submitted by the corporation for inclusion in quarterly reports of its parent.¹

Although the profitability ratios of Edge corporations vary widely, the corporations (or their subsidiaries) are essentially banking institutions, and virtually all Edge corporations are consolidated into the financial statements of other banking organizations. Consequently, their earnings will have a clear positive or a negative effect on the profitability ratios of their parents and will either enhance or reduce the earnings performance of their affiliates. The following guidelines reflect average profitability measures for different sized U.S. banks and could be used as an initial basis for measuring whether the corporation is “carrying its weight.” The final rating, however, should incorporate other factors to reflect the general descriptions stated below.

The examiner should adjust these initial ratings to reflect the second important factor—earnings quality—based upon such factors as the adequacy of the corporation’s valuation reserves and the extent to which its net income results from securities transactions, tax credits, and other items that may be nonrecurring. An inability to generate sufficient income from normal operations constitutes a serious deficiency and should be reflected in the earnings rating. Finally, since reported earnings may not fully reflect the corporation’s contribution to its parent’s profits, the examiner may upgrade the earnings rating by a maximum of two levels to take into account any services provided by the corporation to its parent or to its customers on behalf of the parent. However, in making any adjustments, the examiner should assess the corporation’s performance relative to its budget plans and should also fully explain the adjustment in the closed section of the report.

Rating 1 (Strong). Earnings are characterized by high quality and strong operating results. They are sufficient to make full provisions for possible losses and the accretion of capital, given the examiner’s evaluation of asset quality and growth.

Rating 2 (Satisfactory). Earnings are of high quality and reflect satisfactory operating results. They are also sufficient to make full provision for the absorption of losses and the accretion of capital. In general, any negative or downward trend is transitory and does not reflect any serious future earnings problems.

Rating 3 (Fair). Earnings are not sufficient to make full provision for the absorption of losses and the accretion of capital in relation to asset growth. The earnings trends are static or erratic, and asset quality may be less than satisfactory. The quality of earnings may be weak, and operating results may raise serious questions about future earnings.

Rating 4 (Marginal). Earnings are generally above break-even but may be characterized by wide fluctuations or downward trends, intermittent losses, or a substantial drop from the previous year. In general, such earnings reflect poor operating results, are wholly inadequate to make full provision for absorption of losses and accretion of capital, and may rely heavily on tax credits, security gains, or other nonrecurring sources.

Rating 5 (Unsatisfactory). The corporation has incurred losses or has inadequate earnings which may erode capital. The parent institution may need to provide assistance to rebuild capital and improve the profitability of the corporation.

The existence of adequate operating procedures and internal controls are critical elements in the overall evaluation of the corporation. Without them, the long-term safety and soundness of the institution is jeopardized, and any successful performance can be only temporary. For purposes of rating this component, the examiner should consider the extent to which the corporation conducts its business in a safe and sound manner and whether its records, reports, systems, and audit procedures are adequate.

More specifically, the examiner should consider these factors:

The rating assigned should meet the description below.

Rating 1 (Strong). Operations and internal controls are sufficient to ensure a high degree of safety and soundness with respect to the nature and volume of current and planned activities.

Rating 2 (Satisfactory). Operations and internal controls are generally sufficient to ensure safety and soundness, but management actions are necessary to correct certain deficiencies.

Rating 3 (Fair). Deficiencies in operations and internal controls may moderately compromise the safety and soundness of the corporation if they are not corrected.

Rating 4 (Marginal). Deficiencies in operations and internal controls may severely endanger the overall safety and soundness of the corporation unless management takes prompt corrective action.

Rating 5 (Unsatisfactory). Operations and internal controls are critically deficient and threaten the integrity of financial records and the viability of the corporation.

Each Edge corporation must be given a summary or composite rating that is based upon the ratings of individual components. This rating should initially be the average of the individual component ratings, but should then be adjusted, if necessary, to reflect the general descriptions provided below and any views of the examiner that the components should not receive equal weight. The composite rating, therefore, should reflect the examiner’s judgment regarding the most appropriate summary rating, rather than automatically represent an arithmetic average. However, if the composite rating is different from that average, an explanation should be given in the confidential section of the report. The numerical composite rating should be reflected in the open section on the Examiner’s Comments page along with a clear definition of the rating assigned. The composite ratings are defined below.

Composite 1 (composite range 1 through 1.4). The corporation is strong in almost every respect. Any critical findings are relatively minor and can be handled routinely. The corporation is resistant to normal external economic and financial disturbances and is better prepared to withstand the vagaries of business conditions than Edge corporations with lower composite ratings.

Composite 2 (composite range 1.5 through 2.4). The corporation is fundamentally sound but may reflect modest weaknesses correctable in the normal course of business. Its business is stable, and it should also be able to withstand business fluctuations well. Certain areas of weakness, however, could create concern. To the extent that these minor problems are addressed in the normal course of business, the supervisory response should be limited.

Composite 3 (composite range 2.5 through 3.4). The corporation exhibits a combination of weaknesses ranging from moderately severe to unsatisfactory. It is only marginally resistant to adverse business conditions, and could easily deteriorate if concerted action is not effective in correcting the weaknesses. Consequently, the corporation is vulnerable and requires more than normal supervision. Its overall strength and financial capacity, however, are still such that its future viability should not be impaired.

Composite 4 (composite range 3.5 through 4.4). The corporation has an inordinate volume of asset weaknesses, or a combination of other conditions that are less than satisfactory. Unless prompt action is taken to correct these conditions, the problems could reasonably be expected to impair the corporation’s future viability. Close supervisory attention and possibly financial surveillance is required.

Composite 5 (composite range 4.5 through 5). The condition of the corporation is worse than described under composite 4, above. The volume and character of its weaknesses require urgent aid from the shareholders or other sources. Immediate corrective action and constant supervisory attention are needed.

As a general rule, either formal or informal supervisory action should be considered when routine actions, such as formal discussions with the corporation’s principals or directors and normal followup procedures, have failed to resolve supervisory concerns. The Edge corporation rating system should clearly identify those corporations with serious problems and should distinguish them from institutions whose weaknesses or deficiencies warrant less supervisory concern.

Since prompt and effective remedial action may prevent the condition of a weak corporation from deteriorating further, the examiner should clearly define all material weaknesses and should suggest corrective measures. In some cases, a memorandum of understanding between the corporation’s board of directors and Reserve Bank officials may be needed. This document is not a formal agreement as prescribed in the Financial Institutions Supervisory Act of 1966, but rather is a good-faith understanding between the corporation’s directors and the Reserve Bank concerning the appropriate response to the corporation’s principal problems.

Corporations rated composite 4 or 5 are clearly problem institutions that require close and constant supervisory attention. Except in unusual circumstances, these corporations are presumed to warrant formal supervisory action—that is, written agreements or cease-and-desist orders, as provided for in the Financial Institutions Supervisory Act of 1966. If necessary, the Board of Governors may suspend or remove offending officers and directors of corporations for certain violations and activities.

Although the decision to pursue formal or informal supervisory actions belongs to the Board of Governors and the Reserve Bank, the initial consideration of whether such action is necessary usually results from the examination process. By carefully identifying both the corporation’s weaknesses and deficiencies as well as management’s plans to correct those problems, the examiner will contribute heavily to informed decision-making concerning the appropriate supervisory action. SR-90-21; June 22, 1990.