Beyond CAMELS

THE VERIBANC COLOR CLASSIFICATION SYSTEM

“It’s simple and it works!”

VERIBANC, Inc.’s two-part color code and star classification system rates financial institutions from two perspectives -- present standing and future outlook. It takes into account many financial ratios and measures, including all six factors Federal regulators utilize in determining the government’s “CAMELS” ratings. These factors include an institution’s Capital strength, Asset quality, Management ability, Earnings sufficiency, Liquidity, and Sensitivity to market risk.

This summary describes several tests of the financial strength of a bank, thrift institution or credit union. The outcome of two of these tests is a color - GREEN, YELLOW or RED. Green is the most favorable result; Red is the least favorable. Additional criteria are used to assign three stars, two stars, one star or no stars to an institution. Three stars are most preferred. No stars are least preferred.

Of course, tests such as these can provide only an overview of an institution’s financial condition. A Green, three stars rating does not necessarily guarantee that the institution is healthy, nor does a Red, no stars rating mean that it will fail. However, these tests utilize key measures employed by the federal banking agencies to evaluate the safety of financial institutions. More details are presented below.


THE EQUITY TEST

A financial institution such as a bank, a thrift institution such as a savings and loan association (S&L) or a credit union does business by lending money that it has borrowed from its depositors. Thus, its business is controlling investments of other people’s funds. In addition, it uses (and, of course, controls) money and other items of value which belong to the institution’s owners. This portion is called equity. The total of its own equity and investments which really belong to others, i.e., all that an institution controls, is called assets.

It is both good business practice and a federal requirement for financial institutions to "have a stake" in the monies they control, namely, that a certain percentage of their assets must consist of equity. In fact, if the equity of an institution drops to zero or less, it is referred to as "insolvent". For this reason, equity is often referred to as a financial cushion. It allows an institution to withstand money-losing situations without having to go out of business. The VERIBANC equity test places an institution in one of three categories:

1) If the equity is a modest percentage of assets or higher, an institution is ordinarily
    assigned the classification Green.

2) If the equity is a minimal percentage of assets, it is ordinarily assigned the classification
    Yellow.

3) If the equity is less than a minimal percentage of assets, the color Red is assigned.

For institutions, which are losing money, the color can also be affected by the Income Test described as follows:


THE INCOME TEST

Even though earning money is the purpose of any business, profitability can sometimes be elusive. Banking, like any other endeavor, can encounter difficulties that cause an institution to lose money. One way of measuring the seriousness of losses is to pose the question, "How much of the institution’s remaining equity does the most recent loss represent?" The VERIBANC income test considers results in three possible ranges:

1) If the institution had no net loss (i.e., is operating profitably),
    it is ordinarily classified GREEN.

2) If the institution had a modest net loss, it is ordinarily classified YELLOW.

3) If the loss rate was significant, the color RED is assigned.


The color classification blends the results of both the Equity and Income Tests as follows:

GREEN The institution’s equity exceeds a modest percentage of its assets and it had positive net income during the most recent reporting period. Of the three color categories, this is the highest based on the criteria described.
YELLOW The institution’s equity is at a minimal percentage of its assets or it incurred a net loss during the most recent reporting period. Both of these conditions may apply, if there was a net loss, the loss was not sufficient to erode a significant portion of the institution’s equity. The items which result in a yellow classification, merit your attention.
RED The institution’s equity is less than a minimal percentage of its assets or it incurred a significant net loss during the most recent reporting period (or both). The items, which result in a red classification, deserve your close attention.

HOW THE COLOR CLASSIFICATION CRITERIA RELATE TO THOSE USED BY THE FEDERAL BANK REGULATORY AUTHORITIES AND FINANCIAL ANALYSTS

Banks and thrift institutions are required by law to meet a variety of capital measures. When these measures decline below certain norms, the Office of the Controller of the Currency ("OCC"), the Federal Reserve Board ("FRB"), the Federal Deposit Insurance Corporation ("FDIC") or the Office of Thrift Supervision ("OTS") initiate remedial measures and the bank is subject to additional monitoring. One norm used in the financial industry is whether or not an institution’s equity is at least 5 percent or more of assets. If an institution’s equity does not meet specified minimums, regulatory authorities usually take corrective action in the form of compliance orders.

PROBLEM LOANS

The color classification discussed on the Color Code page indicates the institution’s actual financial condition as of the reporting date. To help determine the possible future trend of an institution’s health, VERIBANC considers information about the amount of money that it has lent or invested in securities for which repayment is late or in doubt. Many institutions maintain loan loss reserves to provide a first line of defense against borrowers who default on their loans and securities investments that go sour. The amount of problem loans, problem securities and securities-type contracts, in excess of an institution’s loan loss reserve, measures the degree its equity could suffer as a result of future loan losses. Since they do not directly impact equity or earnings, problem loans, securities and contracts do not affect an institution’s color classification. However, these items are incorporated into VERIBANC’s star rating as described below.


THE VERIBANC STAR RATING SYSTEM

In addition to the color code, VERIBANC classifies each institution with Three Stars (***), Two Stars (**), One Star (*) or No Stars (None - "U"). The star rating considers future trends and contingencies not accounted for in the color classification. The star rating also incorporates problem assets (along with equity strength and profitability) as a measure of an institution’s future prospects. The criteria used by VERIBANC to determine the number of stars assigned to an institution are as follows:

***
An institution must meet the following primary conditions: equity which exceeds five percent of assets, equity as a percentage of assets after deducting problem loans, securities and derivatives contracts in excess of its loan loss reserves must not fall significantly below five percent and the institution must have positive net income for the indicated reporting quarter. An institution (where applicable) must also satisfy all three regulatory capital requirements (see below) and not have any recent serious regulatory sanctions against them. If the institution is a one-bank holding company, neither the holding company nor its member bank has been subject to a recent serious regulatory sanction. In addition, insider lending as a percentage of equity must not be substantial. If the bank is owned by a holding company, all of the holding company's banks, taken together as if they were a single bank, must meet the criteria necessary to receive at least a Two Stars rating. An institution may only have two or fewer volatile periods of asset growth/shrinkage over the past ten quarters. Problem investments also include securities being held to maturity that, if sold, would realize less than their cost.
**
An institution meets any two of the three primary conditions for the Three Stars category and has equity that exceeds its unreserved problem loans, securities and derivatives contracts. If the institution had a net loss during the most recent reporting quarter, the loss was not significant. An institution (where applicable) must also satisfy all three regulatory capital requirements (see below) and not have any recent serious regulatory sanctions against them. If the institution is a one-bank holding company, neither the holding company nor its member bank has been subject to a recent serious regulatory sanction. Additionally, if the bank is owned by a holding company, all of the holding company's banks, taken together as if they were a single bank, must meet the criteria necessary for the group to receive at least a Two Stars rating. A Two Stars rating is applied to an institution that has three volatile periods of asset growth/shrinkage over the past ten quarters. For institutions (where applicable) that have held-to-maturity securities investments with a current market value that is less than their cost, that difference must not exceed equity.
*
An institution meets at least one of the primary conditions required for the Three Stars category, reports equity which exceeds three percent of assets and also exceeds unreserved problem loans, securities and derivatives contracts. If the institution had a net loss during the indicated reporting quarter, the loss was not significant. Moreover, the institution (where applicable) meets at least two of the three federal capital requirements for tier one (core) capital and total capital as a percentage of risk weighted assets and tier one capital as a percentage of average assets. An institution may receive no higher than a One Star rating if it has been subject to a serious regulatory sanction. A one-bank holding company may receive no higher than a One Star rating if the holding company has been subject to a recent serious regulatory sanction. Moreover, if all of the banks in its holding company, taken together as if they were a single bank, receive a One Star or No Stars ("U") rating, the bank may not receive a higher rating than One Star. A One Star rating is assigned if an institution has four or more volatile periods of asset growth/shrinkage over the past ten quarters. Also, an institution (where applicable) may receive a One Star rating if, absent other reasons for downrating as stated above, the difference between cost and current market value of its held-to-maturity securities investments exceeds the institution's equity.
U
NO STARS - The institution does not meet the criteria above.

DATA THAT VERIBANC USES

All federally-insured commercial banks, S&Ls, savings banks and credit unions, by law, must make certain financial records available to federal bank regulatory agencies such as the OCC, FRB, FDIC, OTS and the National Credit Union Administration ("NCUA"). The data must be provided to these agencies at specified intervals, usually quarterly. VERIBANC, Inc. has taken the portions of this information which are released to the public periodically by such agencies and has assembled a database that considers every financial institution operating under federal deposit insurance. This includes approximately 20,000 depository institutions.

A Warning Signal - If VERIBANC’s rating system produces a high rating in the color code but confers a low score in the star classification, a warning signal exists. In such a case, the color code indicates the institution’s reported basic financials appear strong but the star classification projects some possible deficiencies in other areas. Since the two parts of the rating system examine different criteria, the full color and star rating often hints about the specific nature of an institution’s problems.

An Investment Grade Rating or Better - In 1994, the VERIBANC Green, Three Stars rating was recognized by the Office of Management and Budget as an investment grade or better rating and as such was acceptable for a letter of credit in which the U.S. Government is the beneficiary.

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