Banking is regulated primarily to ensure its safety and soundness. The potential importance of bank credit to small-business and community development tempts policymakers to impose additional social and political responsibilities on banks and their regulators.
However admirable their objectives, they should pause before yielding to those temptations. They should first examine regulatory effectiveness in its primary mission more closely.
Public as well as private objectives require above all else that banks remain financially healthy and competitive. This "soundness" requires the ability to attract and retain capital. Promotion of shareholder value must therefore precede all other objectives.
Short-Lived Benefit
The Camel rating relied on by bank supervisory authorities deny this basic principle. Camel's superficial plausibility is rather like the soothing short-term effects of its tobacco namesake.
Its deleterious effects on shareholder value only gradually become apparent. The consequent debilitation in banking's ability to achieve public as well as private goals is similarly more corrosive than visible. Because other areas of public policy rely on them for guidance, regulatory perceptions underlying Camel have pernicious secondary effects as well.
Like its "smooth" cousin Joe in the cigarette ads, Camel has engaging attributes. It provides a seemingly simple, unambiguous summary assessment of financial condition and performance. Camel rates each institution according to capital, assets, management, earnings, and liquidity.
Composite Score
Each variable receives a numerical grade, enabling a single composite scoring of financial health. A variety of variables represents recognition that none alone is sufficient. The ratings simplify and impart maximum objectivity to bank supervision.
Four of the five variables are susceptible to quantitative analysis. Detailed standards governing them all serve to minimize subjectivity and arbitrariness.
Even more satisfying, accountants and the financial community endorse much of what Camel represents. The underlying measures of capital, assets, and earnings mostly correspond to the generally accepted accounting principles that govern public financial reporting.
Addiction Reinforced
Accordingly, they are the same measures that financial analysts rely on for credit ratings, investment recommendations, and merger and acquisition advice.
They are also the basis for peer comparisons that bankers use for corporate restructuring as strategic planning. Camel thus reinforces an addiction among bankers to its standards.
Camel nevertheless is substantially incomplete, misleading, and short-sighted. Accepting it as a decision guide is to misunderstand banking fundamentals by neglecting banking's underlying foundation as a service business.
This distortion becomes more perilous as competitive survival depends more on service quality and customer loyalty and less on intermediary functions.
Key Investment Ignored
The earnings portion in Camel is a deceptive measure of financial performance. It misstates investment in customer relationships - the foundation of any service business - as current expense, and recovery of prior relationship investment as current earnings.
Consequently, significant components of assets and capital escape observation, misstating sources of future earnings and risks.
Reliance on these measures, whether by bank directors, regulators, or investors, unavoidably distorts assessments of management as well.
Management, investment, and public policy decisions are thus diverted from long-term financial health objectives. Haphazard decisions due to misperceptions of financial soundness perhaps increase the significance of liquidity as a last resort when other indicators fail.
Breaking the Habit
Bankers should prefer that they themselves be responsible for the financial health of their business. They are, in any event, responsible to their shareholders to promote public understanding of the sources of their financial vitality.
Camel demonstrates the unreliability of bank supervisory agencies. The investment community is similarly unreliable, too often pursuing short-term opportunities with little heed to long-term consequences.
Bankers, regulators, and investors alike recognize the necessity of earnings as returns on capital. They often do not understand "true" earnings.
Added Risk Taking
Interest spreads from intermediation alone cannot begin to provide sufficient returns on bank capital. Absent their service functions and the associated customer relationships, banks must pay market rates for funds,
In that event, interest spreads are obtainable only by assuming additional risks and mismatching asset and liability maturities. Yet, for much of the past two decades, at least, yield curves have thwarted strategies based on maturities while earnings margins from bank securities portfolios usually exceed loan margins.
If book assets - loans and securities - do not provide sufficient income, how can banks obtain adequate returns on capital?
Low-Cost Funds
The answer lies in their relationship assets - previously developed bank customer relationships. They are lifeblood of banking. They account for banking's ability to obtain deposit funds at much lower costs than the interest income it can earn on those funds.
Of growing significance, they are also the source of most noninterest bank income. In other words, the income generated by relationship assets must provide much of the return on "tangible" (book) capital in addition to adequate returns on relationship investment.
The 1980s' thrift crisis provided some demonstration of the significance of relationship assets. Some savings institution operators took deposits and depositors for granted while speculating on real estate.
Weakened depositor relationships caused funding problems. Relationship assets are of no more uniform quality than other assets. Their characteristics similarly depend on the manner of their development and management.
Newly Appreciated
The importance of relationship assets - the loyalty and predictability of customer relationships - is hardly new in banking. It only becomes more obvious with shrinking interest margins, more stringent capital requirements, growing reliance on direct (as contrasted with implicit) fee income, and emergence of new forms of competition.
Yet, the official fashion among the bank supervisory agencies has been to ignore, and often to disparage, the significance of these assets, dismissing them as mere accounting tax gimmicks.
Bank regulatory agencies risk being unwitting accomplices of the more short-sighted, less constructive elements of private enterprise. Their capacity for administering a variety of public policy goals should await demonstration that they fully understand the business fundamentals of banking.
Their traditional focus of concern - credit quality - is an entirely insufficient measure of financial health.
Banks certainly might be called upon to pursue socially desirable goals. Public policy can provide various inducements to do so in ways consistent with maintaining their financial vitality.
On the other hand, pursuing these objectives by mandate and regulation can be counterproductive.
