DP10965 Does the CAMEL bank ratings system follow a procyclical pattern?

Author(s): Nikolaos I. Papanikolaou, Christian C Wolff
Publication Date: November 2015
Keyword(s): CAMELS ratings, financial crisis, financial stability, procyclicality
JEL(s): C13, C20, C50, D02, G21, G28
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10965

The financial crisis which erupted in 2007-8 has illustrated the disruptive effects of procyclicality. The phenomenon of procyclicality refers to the mutually reinforcing interactions between the financial system and the real economy that tend to amplify business cycle fluctuations. These fluctuations can cause or exacerbate turbulences in the financial system and this explains why supervisory and regulatory authorities are so much concerned in mitigating the degree of procyclicality. In this study, we focus on the ratings system of the U.S. banking institutions and test how these are linked to the phenomenon of procyclicality. More concretely, we empirically investigate the sensitivity of CAMEL ratings system, which is used by the U.S. authorities to monitor the conditions in the banking market, to the fluctuations of economic cycle. Our results reveal that the overall state of the U.S. economy and CAMEL ratings are positively correlated. We find that CAMEL ratings largely depend on the course of the business cycle as they are lower during economic upturns and higher during economic downturns. This is to say that the performance and risk-taking behaviour of banks is rated higher when the conditions in the economy are favourable and lower when the economic environment is weak. This very important and rather unknown source of procyclicality should be taken into serious consideration by authorities.