A proposed overhaul of the CAMELS rating system could be a tailwind for bank M&A by enabling institutions to secure better ratings under less stringent management criteria.
On May 19, the interagency Federal Financial Institutions Examination Council released a long-awaited proposal to revise the CAMELS rating system, which measures an institution's capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk on a scale of 1 to 5, with 5 being the worst. The proposed changes would shift regulatory focus toward an institution's financial condition and risk profile, while deemphasizing management factors. Limiting the scope of the management component should boost bank M&A, industry experts told S&P Global Market Intelligence.
"One of the things that kind of holds back M&A is when ratings are low, whether you're on the buy side or on the sell side," said James Stevens, partner and co-leader of Troutman Pepper Locke's financial services industry group. "And so to the extent that those CAMELS ratings are elevated, I think that could encourage M&A. Same thing with branching and growth."
The proposed CAMELS changes and other regulatory changes, like updates to the Federal Reserve's Large Financial Institution rating system, enhance transparency, according to Neil Bloomfield, co-head of financial regulatory advice and response at the law firm Moore & Van Allen. With greater clarity into the ratings, banks can avoid the unfavorable ratings that inhibit M&A.
Regulators typically scrutinize banks rated 3, making it difficult to obtain approval for growth initiatives, while 4 and 5 ratings are "nonstarters," Stevens said. Similarly, Capital Alpha Partners analyst Ian Katz said regulators have usually discouraged banks rated 3 from engaging in M&A, believing they should prioritize internal improvements.
The proposal would make it harder for banks to receive a CAMELS rating of 3, Katz wrote in a research report.
"So if fewer banks get 3 ratings, at least in theory, more could get M&A deals approved by regulators," Katz wrote.
Vexing management component
Historically, the management component of CAMELS has been a source of frustration for bank executives. Executives often pushed back if they did not receive a good management rating, fearing their boards would view them as less competent, said Victoria Reider, partner at Dilworth Paxson and former head of the Pennsylvania Department of Banking, referring to her time as a regulator.
Moreover, the management rating "was given excess consideration when the composite ratings were assigned," Reider said in an interview.
Stevens echoed these concerns, noting that the management rating has often reflected other component ratings rather than serving as an independent assessment.
"That management rating has basically become just sort of a reflection of whatever is in the other ratings," Stevens said. "So if you had a bad rating in one of the categories, capital or asset quality, you kind of just could predict that the management rating would mirror that."
The management component has also been used as a catchall for concerns that do not fit neatly into other categories, Stevens added.
After the proposal was unveiled, Comptroller of the Currency Jonathan Gould raised concerns that the proposed revisions may not go far enough in addressing the issue of "double counting" across management and other components.
Despite Gould's concerns, all the regulators being aligned on the proposal and proposing it together is "a bit miraculous," Reider said.
Safety and soundness
While industry experts agreed that the proposal could help banks secure better ratings and encourage M&A, they were torn on whether the proposal could impact safety and soundness.
MRV Associates managing principal Mayra Rodríguez Valladares said it could undermine bank safety and soundness by deemphasizing risks that are more subjective and often less well understood.
"You need, if anything, more scrutiny on some of those things that are harder to quantify. Market risk, credit risk, we know how to do this, right? Trying to quantify cybersecurity attacks and not just how often do they happen, but how damaging they could be, that's much harder. Or misuse of AI or things like that," Rodríguez Valladares said in an interview. "So you actually need more eyes on that right now, not less."
Limiting examiners' ability to comment on management or reputational risks also increases the likelihood that "numerically, a bank will look better, but it may not be," Valladares said.
Bloomfield said it is possible that a lack of focus on nonfinancial risks — such as succession planning — could lead to an issue that develops into a material concern for a bank. However, the regulatory pendulum swings in both directions, he added.
"It went too far in the sort of focus on nonmaterial risks," Bloomfield said. "And it's sort of coming back the other way. Is this proposal too far? I think we'll have to see."
Other industry experts said examiners will still keep a close eye on factors that pose safety and soundness risks.
"Banks that are operating in a way that's not safe and unsafe or unsound, they will be found and they will be rated accordingly," Stevens said.
Moreover, Silicon Valley Bank's failure and subsequent events remain fresh in examiners' minds.
"Because they're aware that banks can fail, they will still be cautious in looking at a whole host of issues," Reider said. "They will catch any issue within a particular institution that could lead to insolvency."
