The M in Camels ratings is about to become a whole lot more important.

Of the six components — Capital, Asset Quality, Management, Earnings, Liquidity and Sensitivity to Risk — the grade given to managers has mostly been a derivative of the other five. It's the only component that is more qualitative than quantitative.

Barbara A. RehmIn the past, a bank making money with plenty of capital and not too many nonperforming loans would automatically get a high management grade.

But regulators say that free ride is ending.

The management rating will be more independent of the other components; no longer will examiners wait until nonperformers are piling up to downgrade management.

"I have had a window on a lot of bad situations over the last couple years and I know from experience that management should be the leading indicator, not the lagging indicator," said John Quill, deputy comptroller of special supervision at the Office of the Comptroller of the Currency. "All the regulators need to be more prospective in assessing management ahead of the numbers turning bad."

State regulators agree.

"Where supervision is really headed is an expectation that examiners will hold management to a higher standard … and be expected to downgrade management even when they don't have the numbers to back them up," said Michael Stevens, senior vice president for regulatory policy at the Conference of State Bank Supervisors. "Bank supervisors are going to have to look to the future. Is management doing the things they need to do today to ensure that risks are contained in the future?"

Under the Camels system, banks are graded from 1 to 5 — with 1 being the best — on six components and then assigned a composite rating. These ratings are not made public, but a massive wave of downgrades has hit the industry over the past two years as asset quality deteriorated, capital declined and funding sources dried up.

The number of banks rated 4 or 5 — those that land on the government's "problem list" — soared to 839 on June 30, from 76 on Jan. 1, 2008. A record number of banks are under enforcement actions.

William S. Haraf, the commissioner of the California Department of Financial Institutions, said regulators need to prevent these recurring cycles of boom and bust.

"In order to do that, you have to identify management weaknesses and poor risk-control processes in good times and get out ahead of them," Haraf said. "Examiners often identify management weaknesses — excessive risk-taking, a CEO who is too dominant or a board that is too weak, risk management systems that are either not strong enough or ignored — but feel they cannot" do anything about it.

"It's a little harder to stare down management and tell the board that even though the bank is profitable … their risk management is inadequate," he said.

Stevens agreed: "It has been difficult for examiners to aggressively downgrade management if they didn't have the other components heading in the same direction."

Beyond the problems Haraf cited, regulators said other issues include an overemphasis on ROE targets, violation of bank policies such as underwriting standards and executive compensation tied too closely to growth.

This renewed interest in management comes just as managing a bank is getting harder.

Today's bank executives need to be well versed in stress testing and forecasting how capital levels or liquidity needs will change as the economic environment changes.

"Say liquidity is well positioned today but we see problems coming in liquidity, we are going to hit you on the management grade," Stevens said. "So M becomes the component that is most forward-looking."

The regulators understand that making the management grade more independent of the other five components is likely to set off bankers.

"It does create a situation that could turn adversarial real quick," said Charles A. Vice, commissioner of Kentucky's Department of Financial Institutions. "What's critical from both sides is communication."

There could be an upside to tougher assessments of management. Well-run banks could see higher M ratings than they otherwise might, and Quill noted that these banks could be spared competing against reckless banks that may be driving up deposit costs or driving down loan prices.

And Stevens noted that the search for weak managers is happening on both sides of the exam line. "To be fair, regulators, state and federal, are finding the same things with their examiners. They are identifying the examiners that they can't count on," he said. "This plays on both sides of the fence."

Barb Rehm is American Banker's editor at large. She welcomes feedback to her weekly column at Barbara.Rehm@SourceMedia.com.

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