Bank Examination

What Is a Bank Examination?

A bank examination is an evaluation of the financial health and resilience of a bank. Bank examinations are primarily concerned with the strength of the bank’s balance sheet. However, they also include a review of its regulatory compliance and internal controls.

In the United States, examinations of national banks are carried out by the Office of the Comptroller of the Currency (OCC), while examinations of state-chartered banks are carried out by the Federal Deposit Insurance Corporation (FDIC). For bank holding companies, examinations are carried out by the Federal Reserve.

How Bank Examinations Work

The process for conducting bank examinations is based on the so-called CAMELS Rating System, which is an acronym outlining the six major areas of examination. These consist of examinations of the bank’s capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to systemic risk.

Based on these six characteristics, banks are assigned a rating on a scale of 1 to 5. Each bank will receive a separate rating for each category, along with an overall result. A score of 1 indicates a very positive result, while 5 indicates a very weak result. If a bank scores 4 or 5 on its overall review, it will be placed on a special watchlist for further scrutiny by regulators.

The capital adequacy criteria relates to the bank’s tier one and tier two capital, and whether these funds are sufficient to support its banking operations under conditions of stress. Likewise, the asset quality condition relates to questions such as whether the bank’s loan portfolio is sufficiently diversified, and whether its loss provisions are in line with industry norms. 

With regard to the management criteria, regulators will want to ensure that the bank’s executive team have a clear operational strategy and understanding of their organization’s unique risks, as well as a robust protocol for ensuring legal and regulatory compliance. In regard to the earnings criteria, regulators will examine the earnings quality of the bank, and whether those earnings appear stable enough to support the bank should it come under strain.

Lastly, the liquidity and sensitivity criteria pertain to the bank’s level of stability in the face of potential shocks to the financial system. Regarding liquidity, regulators will measure the bank’s ability to meet its financial obligations, using liquidity tests such as the current ratio, acid test, quick ratio, and cash ratio. 

When evaluating the bank’s sensitivity to systemic risk, regulators will often use complex financial models that simulate the bank’s financial performance subject to various potential adverse changes in financial markets. Examples of such changes include rising interest rates, increased loan default rates, declines in the value of investment holdings, and defaults by derivative counterparties.

Real World Example of a Bank Examination

Dana is an investor who regularly reviews the examination results of major banks. As part of his investment screening process, he reads through the most recent bank examination for a national bank called XYZ Financial.

In summarizing the results from the examination, Dana notes that XYZ received a CAMELS score of 5 in the asset quality category. Intrigued, he dug deeper to discover that XYZ’s loan portfolio is highly concentrated in a particular sector which is currently facing disruption from new entrants.

Given the uncertainty in that industry sector, the regulators raised concerns as to whether XYZ’s debtors may be unable to repay their debts. In that scenario, XYZ could face higher than normal loss rates on its loan portfolio, calling into question its profitability, liquidity, and capital reserves.

With this information in hand, Dana decides to avoid XYZ Financial until there is less uncertainty surrounding the quality of its loan portfolio.