CAMELS Ratings: Liquidity

By: Julie Stackhouse

In the last post, we addressed the examiner's process for reviewing and rating bank earnings. This week, we examine the fifth component of the safety and soundness rating system for banks (called CAMELS): liquidity. ¹

To understand the importance of liquidity, it is important to remember that a fundamental purpose of a bank is to redeploy consumer and business deposits and other liabilities into loans requested by other consumers and businesses. Because loans and deposits may not pay off (or mature) at the same time, the bank must manage its liquidity. Stated simply, liquidity is the ability of bank management to meet deposit outflows while continuing to fund demand for loans.

Sources of Funds: Liabilities

Banks accept deposits—typically called “core” deposits—from consumers and small businesses. For the most part, the federally insured portion of these deposits tends to be stable, lower cost than other funding sources and less sensitive to rising interest rates.

Banks can also supplement funding needs through other sources called “noncore” or wholesale funds. Examples include:

  • Certificates of deposit and other time deposits that exceed the federally insured limit
  • Federal Home Loan Bank and/or Federal Reserve bank discount window borrowings
  • Insured brokered deposits

Noncore funding sources are often short term in nature and may be sensitive to interest rate changes, depending on maturity. Examiners closely review the strategies of banks with an unusually heavy reliance on noncore funding sources. In such a situation, examiners will typically request a comprehensive contingency funding plan that contains a strategy for addressing funding shortfalls should a bank’s financial health come under stress.

Uses of Funds: Assets

Banks generate earnings primarily by making loans. However, many loans are comparatively long term in nature relative to sources that fund them. For that reason, banks maintain other assets on their balance sheets that can quickly be converted into cash to meet expected and unexpected withdrawals or a loss of funding sources. These assets are considered sources of liquidity and include:

  • Cash and similar balances
  • Interest-bearing balances from other banks
  • Loans held for sale
  • The investment securities portfolio

The Liquidity Rating

Examiners review the structure of a bank’s assets and liabilities, as noted above. They also examine a bank’s liquidity policies, procedures and management information systems, including the efforts of bank management to test hypothetical deposit outflows under a variety of assumptions, like a changing interest rate environment.

Banks that perform well in these scenarios typically exhibit a sufficient level of asset liquidity, a high reliance on core deposits, and adequate or better funds management practices. Examiners will rate the liquidity of these banks as strong (1) or satisfactory (2).

On the other hand, banks with low levels of liquid assets, a high reliance on noncore/wholesale funding sources and weak funds management practices raise more concerns. As such, examiners will rate the liquidity of such banks as needs improvement (3), deficient (4) or critically deficient (5). Banks in these situations are typically required to develop plans to improve liquidity and to submit those plans to regulators for review.

Notes and References

¹ The first component that we addressed was capital adequacy, followed by asset quality, management and earnings. After liquidity, the remaining component is sensitivity to market risk. See Stackhouse, Julie. “The ABCs of CAMELS.” St. Louis Fed On the Economy, July 24, 2018.
Julie Stackhouse is Senior Vice President and Managing Officer of Banking Supervision, Credit, Community Development and Learning Innovation for the Federal Reserve Bank of St. Louis.

This post is the sixth installment in a series titled “Supervising Our Nation’s Financial Institutions,” first published on the St. Louis Fed On the Economy blog.