The role of a CAMEL downgrade model in bank surveillance

This article examines the potential contribution to bank supervision of a model designed to predict which banks will have their supervisory ratings downgraded in future periods.Bank supervisors rely on various tools of off-site surveillance to track the condition of banks under their jurisdiction between on-site examinations, including econometric models.One of the models that the Federal Reserve System uses for surveillance was estimated to predict bank failures.Because bank failures have been so rare during the last decade, the coefficients on this model have been "frozen" since 1991.Each quarter the surveillance staff at the Board of Governors provide the supervision staff in the Reserve Banks the probabilities of failure by the banks subject to Fed supervision, based on the coefficients of this bank failure model and the latest call report data for each bank.The number of banks downgraded to problem status in recent years has been substantially larger than the number of bank failures.During a period of few bank failures, the relevance of this bank failure model for surveillance depends to some extent on the accuracy of the model in predicting which banks will have their supervisory ratings downgraded to problem status in future periods.This paper compares the ability of two models to predict downgrades of supervisory ratings to problem status: the Board staff model, which was estimated to predict bank failures, and a model estimated to predict downgrades of supervisory ratings.We find that both models do about as well in predicting downgrades of supervisory ratings for the early 1990s.Over time, however, the ability of the downgrade model to predict downgrades improves relative to that of the model The Role of a CAMEL Downgrade Model in Bank Surveillance 3 estimated to predict failures.This pattern reflects the value of using a model for surveillance that can be re-estimated frequently.We conclude that the downgrade model may prove to be a useful supplement to the Board's model for estimating failures during periods when most banks are healthy, but that the downgrade model should not be considered a replacement for the current surveillance framework.