CAMELS measurements and variable selection

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Development in the European Union

Since the financial crisis in 2007, researchers as well as legislators have tried to find the right way to regulate and curb the risk taking in the financial sector. The BCBS updated their Basel accords with the new Basel III framework in response to the financial crisis and the European Union launched their CRD IV package, a package that transposes the Basel accords. The commonly referred to CRD IV package contain two different types of legislation. One regulation that is directly applicable law in the member states, this regulation touches upon the aforementioned capital requirements and in addition to this it regulates a new leverage coverage ratio and a solution to the liquidity problems that have prevailed in Europe since the financial crisis. This regulation, Capital Requirements Regulation, henceforth referred to as CRR, and the capital requirements it put into legislative action will be the main focus of this study. The CRD IV, containing both a directive and a regulation, was needed for two reasons. Firstly, the Basel accords are international set standards that act as guidelines while the CRD IV package is a legislative action. Secondly, the Basel accords are only applicable to large international banks; the capital directives are instead pertinent to all financial institutions in the member states (European Parliament, 2013). The legislation also extends to other aspects that had been identified as the cause to the financial crisis and the banking instability that have been present in the European Union. These aspects include remuneration and bonuses, prudential supervision and corporate governance (European Parliament, 2013).
Demirgüc-Kunt, Kane & Laeven (2015) found in an extensive overview of deposit insurance that deposit insurance was one of the measurements governments around the world used in order to stabilize the financial market. The countries that could afford to broaden the deposit insurance coverage did so in order to increase the safety net and restore confidence among depositors. The European Commission was no exception to this trend and 2014 the Commission updated their deposit insurance regulation, Directive 2014/49/EU. The directive maintained a deposit protection of €100,000 but did update other features. The key changes concerned: shortened time limit for pay-outs from twenty to seven days by 2024, improved information to depositors and ensured that the funds of the guarantees are funded by the banking sector (The European Parliament, 2014). Having explicit deposit insurance is an important cornerstone in order to understand both the need and impact of minimum capital requirements since it plays a vital part in the existence of capital regulations.
Another argument that has been expressed by researchers such as Boyd, Chang, & Smith (1998) is that banks that are widely dispersed in their activities and are able to build their efficiency on economies of scale, often become huge institutions that are subjected to the problem of “too big to fail”, and this in turn may lead to moral hazard problems. Moral hazard is defined as when someone takes the decision on how much risk to take, while someone else bears the consequences of the action (Krugman, 1999, 2008). This is an important aspect when understanding the additional legislation the CRD IV package contained in regards to these types of institutions. The capital requirements launched in the legislation, mentioned specifically the problem of banks that are subjected to the “too big to fail” problem. These types of large institutions, called global systemically important banks (G-SIBs) in the legislation, are addressed because of the problems they can create in case of their failure. The CRR ensures that in the event of their failure, the banks will have sufficient funds available in order for authorities to implement a resolution that will minimize the impact on the stability in the financial sector (The European Parliament, 2014). This will ensure that the depositors are protected and will hinder the exposure of public funds to loss. The problem with organizations of this size, and the problem the European Commission tries to minimize is the moral hazard that comes from the implicit deposit insurance that these types of organization are subjected to. Since the impact of a potential bankruptcy will afflict a large number of stakeholders, the banks expect that they will be protected by implicit deposit insurance, anticipating that the government will intervene in case of their failure. The Financial Stability Board (FSB) and BCBS regularly report and update the list of G-SIBs. These types of institutions face extra capital requirements due to their large size. Currently 30 banks in the world have been identified; out of these, 13 banks reside in the European Union member states (FSB, 2015). The additional capital requirements are applied in five different buckets depending on how large the institutions are (see appendix 1).

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CAMELS rating system

Due to the recent financial crisis, both national and international legislators and researchers have found a renewed interest in investigating the soundness and well-being in the financial system, but most importantly in the banking sector. This renewed interest comes from the recent bank failures that have spurred both governments and private depositors to find the best way both to curb the risk of losing their deposits but also to detect banks on the verge of failure. There exists two main reasons for supervising bank information; problem in the banking sector might serve as an early warning sign to deteriorating conditions in the world economy in general. The second reason is by the use of bank supervision, one could detect changes in lending behaviour, something that could affect the economy as a whole (Peek, Rosengren, & Tootell, 1999). The Federal Reserve and the FDIC developed a rating system, known as the CAMELS framework. This framework was specifically developed for detecting financial distress in the banking sector. The need for a rating system of this sort originated from the previous unregulated view on banking monitoring which lead to banks being bailed out with tax-payers’ money, something that wanted to be avoided at all cost. Originally the CAMELS rating system was developed in order to identify risky banks, but the usefulness of the rating system has led to wider uses in research, such as identifying the soundness of the financial system or predict bank failures.

1. Introductio
1.1 Background
1.2 Problem discussion
1.3 Purpose
2. Frame of reference
2.1 Literature review
2.2 Theoretical framework
3. Method
3.1 Research Design
3.2 CAMELS measurements and variable selection
4. Empirical findings
4.1 Capita
4.2 Assets
4.3 Management
4.4 Earnings
4.5 Liquidity
4.6 Size
5. Analysis
5.1 Development of the banking sector
5.2 CAMELS ratings
6. Conclusion
7. Discussion
8. Bibliography