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EPR

FEDERAL RESERVE BANK OF NEW YORK

ECONOMIC POLICY REVIEW

Why Do Supervisors
Rate Banking
Organizations?
James Bergin and Kevin Stiroh

Volume 27, Number 3
November 2021

Why Do Supervisors Rate
Banking Organizations?
James Bergin and Kevin Stiroh

OVERVIEW

• The rationale for assigning ratings to banking
organizations may seem
straightforward, but the
process involves considerably
more complexity and nuance
than many would recognize.
• Ratings provide discipline to
the regulatory process and a
means for clear communication
of supervisory assessments
to firms, regulators, and other
stakeholders. If done well,
ratings facilitate remediation
among supervised firms while
bolstering confidence in both
the supervisory process and
the banking system.
• The authors highlight three
channels by which the assignment of a supervisory rating,
in the context of its associated
consequences, can influence
the behavior of a financial firm:
as a communication tool, as a
direct risk mitigant, and as a
broad incentive mechanism.
• Understanding these channels, and their implications, is
important for both developing
effective supervisory assessments and considering the
optimal design of a rating
framework.

Federal Reserve Bank of New York

T

his article addresses a question that at first may appear
simple: Why do supervisors rate banking organizations?
Supervisors of banking organizations periodically
summarize their views of a banking organization into a
confidential assessment or rating—essentially, a grade for
the organization’s safety and soundness and compliance
with law. To banking organizations and their supervisors,
the assignment and use of supervisory ratings by their
examiners is so familiar that it may seem pedestrian to pause
to consider why it is done. At the same time, to outsiders to
financial supervision, the process is another opaque aspect
of a dimly understood craft.
In this article, we try to shed some light on the practice in a
way that will be illuminating for both insiders and outsiders.
We believe that there is considerable complexity and nuance
incorporated in the concept of rating banking organizations
and that it warrants a rigorous discussion of why supervisors
assign ratings and how they advance the statutory and regulatory goals of supervision. The recent Board of Governors and
FDIC joint notice seeking comment on the depository institution rating system is an invitation to join this discussion.1
Looking at the historical record and current practices,
we believe ratings have been an important tool for supervisors for two primary reasons. One, ratings add discipline to
the supervisory and regulatory process. Supervisors and

James Bergin is deputy general counsel in the Legal Group of the Federal Reserve Bank of
New York. Kevin Stiroh is senior adviser in the Supervision and Regulation Division of
the Federal Reserve Board. Emails: james.bergin@ny.frb.org, kevin.stiroh@ny.frb.org.
Disclaimer: The views expressed in this article are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve
System.To view the authors’ disclosure statements, visit https://www.newyorkfed.org/
research/epr/2021/epr_2021_bank-ratings_bergin.

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Why Do Supervisors Rate Banking Organizations?

regulators are assigned significant power under law to make judgments about the soundness
of private firms and to influence their activities. Ratings are an important means of ensuring
that supervisors and regulators make these judgments rigorously and consistently across
heterogeneous firms and over time. First developed as a sort of coordination mechanism,
ratings have been further deployed over time by Congress and regulators to help the official
sector make decisions with the best information possible. They now provide a meaningful
link between supervisory assessments of the current condition of a firm and official judgments about such matters as what areas supervisors should focus on and whether a firm
should be allowed to expand or offer new financial services. This adds to the legitimacy and
fairness of the supervisory and regulatory process and can help build confidence in the
financial system.
Two, ratings facilitate communication of supervisory assessments to the many stakeholders
of the examination process—directly to the supervised firms and other regulators, and indirectly to Congress and the public at large. Ratings allow supervisors to summarize and convey
the complexity of a financial firm assessment to each of the stakeholders. Among other things,
they enable supervised firms to anticipate the potential regulatory consequences of their
supervisory condition. This awareness facilitates remediation and behavioral changes that ultimately support the underlying supervisory objectives, while also adding to the legitimacy of
the process. Communication to Congress and the public is more attenuated because ratings are
generally confidential by law, but the practice of ratings is an important element of generating
reliable and consistent assessments internally within regulatory agencies, which allows these
institutions to effectively communicate with public stakeholders.2
With these purposes in mind, we then contemplate a number of questions about the proper
design of a rating framework. We examine how a supervisory rating actually influences firm
behavior in a way that is consistent with supervisory objectives. We consider three channels of
potential influence with respect to how ratings can affect regulatory judgments: (1) as a communication tool to raise awareness of the most salient risks and supervisory concerns; (2) as
activity restrictions that act as a direct risk mitigant by reducing the specific behavior of
concern; and (3) as activity restrictions that operate as a broad incentive mechanism to change
behavior. Discussing ratings practices and renewing our understanding of their purpose and
impact should provide clarity on the overall approach and hopefully inform the design of the
optimal supervisory ratings framework.

1. The Practice and Origin of Ratings
1.1 The Practice of Ratings
Supervision involves monitoring and overseeing financial firms to assess whether they are in
compliance with applicable laws and regulations and whether they are engaged in unsafe and
unsound practices. It involves visitorial powers and privileges that are not a feature of many
industries, and the authority to instruct firms to correct problems.3 As Vice Chair Randal
Quarles discussed in a recent speech, the banking industry is subject to a special form of government oversight because its crucial role in promoting economic growth means that it
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warrants a government safety net that other industries do not. Supervision of financial firms
goes beyond compliance with a rulebook.
“[I]t isn’t enough to set the rules and walk away like Voltaire’s god. The potential
consequences of disruption in the financial system are so far-reaching, and the
erosion of market discipline resulting from the government safety net sufficiently
material, that it is neither safe nor reasonable to rely entirely on after-the-fact
enforcement to ensure regulatory compliance.”4
Supervision is a process that enables the government to respond to the idiosyncratic circumstances of individual firms, to order corrections if merited under law, and to otherwise
guide firms toward prudent behavior. Financial supervision has a different character than
ensuring compliance with pre-set regulation or a rulebook. A banking organization can
comply with the letter of every relevant statute and regulation, and still act in an unsafe and
unsound manner. Therefore, supervision and regulation are complementary tools to achieve
the same broad objective of a banking system that provides critical financial services in a sustainable way.
This judgmental role of discerning whether an organization’s practices pose undue risk is
assigned to financial supervisors. To make their assessments, supervisors are granted the
authority to go where they need to go and to direct firms to make changes if necessary.5 This
type of governmental authority over private firms is not without its tensions, and places special
focus on ensuring that supervisory assessments have as much rigor as possible and are as
well-understood by the regulated firms as possible.
To make their assessments, supervisors conduct a wide variety of activities requiring analysis of multiple inputs, by many people, with different skillsets, across time. For a large and
complex firm, supervision may involve credit quality review of loan files; assessment of appropriate calibration of anti-money laundering filters; analysis of liquidity stress scenario
modeling; evaluation of the credibility of resolution plans in a bankruptcy; and appraisal of
managerial capability. Even for smaller and less complex firms, supervisory assessments
require a wide range of inputs and perspectives.
Supervisors generally sum their views into an overall rating at a certain point in the cycle,
and then communicate this rating to the management of a firm.6 In this article, we will focus
primarily on supervisory ratings of a firm’s prudential condition—its overall health and
robustness to stress—but there are other regulatory ratings. This supervisory rating is typically
a numeric or categorical distillation of a supervisor’s assessment of a firm, which serves as a
shorthand expression of a supervisor’s view about the firm. Ratings can provide a “composite”
view of a firm’s aggregate condition (for example, Bank ABC is “3” or “fair” overall), or they
can focus on a particular component of a firm’s performance, such as capital or earnings (for
example, the earnings of Bank XYZ are “3” or “fair”).7
Importantly, ratings are, for the most part, confidential. Because ratings reflect the assessment of supervisors, they are considered confidential supervisory information (“CSI”) that is
owned by the regulatory agencies. As such, banking organizations are generally not permitted
to share ratings information with other entities without the permission of the appropriate regulator and are even required to be careful about how much they share ratings information
internally.8 The rationale for the confidentiality of ratings, as with other CSI, comes from the
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plenary access that supervisors have to the information of supervised firms, and the necessarily subjective judgments that they are required to make about whether the risks they take are
sound ones. Public disclosure of a funding or operational risk, for example, could exacerbate
the risk. Moreover, CSI can contain proprietary information about a firm’s strategy and positions that would be inappropriate to share publicly.9
While commentators have suggested reform in this area, the confidentiality of ratings
remains fundamental to the current practice of supervision, and has important implications
for how ratings are used by regulators and firms and how the consequences of ratings are
understood by the public.10

1.2 The Origin of CAMEL and BOPEC
Assigning a numeric rating seems to be a practice of long vintage. Rating systems date back
to at least 1926, when the Federal Reserve Bank of New York used a simple system to categorize the 900 state member banks then under its supervision. Other federal supervisors appear
to have been using their own individualized rating scales by the 1930s, although enthusiasm
for their use seems to have waxed and waned over time.11
Uniformity in ratings received its real boost in the 1970s when Congress and policymakers
began to worry about the difficulty of effectively supervising increasingly complex bank
holding companies. Bank failures had increased from the early to mid-1970s, and a number of
the banks that failed had holding company affiliations that were considered to have contributed to their problems. Some observers pointed out that the Federal Reserve, in particular, had
not identified issues that bank holding companies under their purview were causing those
banks before they failed and was not coordinating integrated supervision of the firms. Further,
some observers noted that banking regulators differed in how they determined which banks
deserved special supervisory attention, and that these differences hampered their ability to
coordinate with one another.12 It was felt that the lack of effective coordination would only
grow worse “as the holding company movement spreads and as the banking industry becomes
more sophisticated and complex.”13
In response, Congress passed the Financial Institutions Regulatory and Interest Rate
Control Act (FIRA) in 1978. Among other things (such as increasing the Federal Reserve’s
enforcement powers), FIRA formalized a new Federal Financial Institutions Examination
Council (FFIEC) of the bank regulators, including at the time the Federal Reserve, the Office
of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation
(FDIC), and the National Credit Union Administration. Among other things, the FFIEC was
charged with prescribing “uniform principles and standards for the Federal examination of
financial institutions” by bank regulators and to “make recommendations to promote uniformity” in their supervision. The statute did not mandate the creation or use of ratings or any
particular rating system as such, but it did call for FFIEC recommendations to identify firms
“in need of special supervisory attention.”14
The new FFIEC adopted the Uniform Financial Institutions Rating System for depository
institutions later in 1978. It quickly became known as the CAMEL rating, after its component
parts (Capital, Asset quality, Management, Earnings, and Liquidity). It has been a durable
instrument, despite modifications over time. John Heimann, the Comptroller of the Currency,
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who served as the chair of the FFIEC as it developed the CAMEL rating, described two purposes for the rating system:
“The rating system proposed by the Council has a two-fold purpose. First, it is
designed to reflect in a comprehensive and uniform fashion an institution’s compliance with applicable laws and regulations, and its overall soundness. Second, the
rating system the Council proposes is meant to assist the public and the Congress
in assessing the aggregate strength and soundness of the financial system.”15
Later in the adopting interagency release, the first purpose was extrapolated and emphasized: Heimann said that the “primary purpose [emphasis added] of the uniform rating
systems is to help identify those institutions whose financial, operating or compliance weaknesses require special supervisory attention and/or warrant a higher than normal degree of
supervisory concern.”16 At the beginning, it appears that the focus was on consolidating information in order to make informed decisions about supervisory resources. To do this,
supervisors must assess firms in a “comprehensive and uniform” way—taking advantage of all
information to hand, and in a manner that is comparable across firms and across regulators.
The primary purpose of this assessment is to direct scarce supervisory resources to the right
ends, in accordance with FIRA’s goals.
Second, there is a focus on communication—providing a means for disseminating these
confidential assessments to those who need to know about them. In Heimann’s telling, at the
outset of CAMEL, the external stakeholders who needed this confidential knowledge were
Congress and the public at large. Congress had held hearings in the 1970s because of concerns
about large bank failures, including Franklin National Bank in the Second Federal Reserve
District, and whether regulators were up to the task of preventing them; so it makes sense that
communication with external stakeholders was considered important.17
We can infer, by its absence, that communicating effectively to the supervised firms was less
of a priority at the time. Importantly, CAMEL enabled communication within the supervisory
community. The great benefit of CAMEL was its uniformity, so that the multiple regulators
involved in overseeing a complex entity could communicate efficiently and coordinate their
activities.18 The OCC’s adopting release emphasized that uniform ratings will enable identification of issues “in such a way that does not depend solely upon the nature of its charter…or the
identity of its primary Federal regulator.”19
The adoption of the CAMEL system was followed closely by the Federal Reserve’s adoption of a rating system for bank holding companies—the “BOPEC” system (named for its
component parts: Bank subsidiaries, Other nonbank subsidiaries, Parent company, Earnings, and Capital, along with F/M – Financial composite and management composite).
What did the Federal Reserve think it was doing with these two rating systems? Testifying
before the Senate banking committee shortly after the introduction of CAMEL and
BOPEC, Governor Charles Partee sounded notes similar to Heimann’s and focused on
bringing discipline to the supervisory process and directing resources to problem institutions. CAMEL “should help us identify more precisely those banks in need of particularly
close supervisory attention” and BOPEC “standardized the evaluation of the financial condition of holding companies and has helped to identify those companies with significant
financial problems.”20
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2. The Evolution of Ratings and Their Purposes
The rating systems for banks and bank holding companies have each been revised a number of
times in response to changes in regulatory philosophy and in the industry, and regulators have
also created entirely new rating systems. It is instructive to review what regulators—and here
we will focus on the Federal Reserve—have articulated as the purpose of these rating systems
each time they changed or adopted them. In some ways, one can see the evolution of rating
systems as indicating changes in supervisory policy and priorities, even while the main goal of
the prudential rating system has remained consistent over time.
We focus particularly on the bank and bank holding company rating systems here, but there
are many others. This review shows consistency with the underlying drivers of discipline and
communication but also substantive variation that reflects the evolving environment. See
Table 1 for an overview of rating system evolution over time.

2.1 CAMEL to CAMELS
BOPEC and CAMEL were each modified over the course of 1995 and 1996. In 1995, the
Federal Reserve required the assignment of a new rating for risk management at the bank and
bank holding company level. This “reflect[ed] the view that properly managing risks has . . .
become even more important as new technologies, product innovation, and the size and speed
of financial transactions have changed the nature of banking markets.”21 In 1996, these factors
led CAMEL to become CAMELS, as sensitivity to market risk was added as a sixth factor.

One can see the evolution of rating systems as indicating
changes in supervisory policy and priorities, even while the main
goal of the prudential rating system has remained
consistent over time.
The interagency adopting release reflected on the original articulated purposes of CAMEL
and largely affirmed them. Similar to the views of Heimann and Partee, it focused on three
main attributes of ratings: that they enable “comprehensive and uniform” evaluations; that they
direct supervisory resources to firms exhibiting “weaknesses or adverse trends;” and that they
“assist Congress in following safety-and-soundness trends.”22

2.2 BOPEC to RFI/C(D)
The next significant change to the bank holding company rating system came in 2004. The
passage of the Gramm-Leach-Bliley Act in 1999 enabled bank holding companies to enter new
areas of business and expand their footprints. The Board’s new system, RFI/C(D) to reflect
Risk management, Financial condition, Impact on depositories/Composite (Depository institution rating), was intended to focus less on evaluation of legal entities and more on an
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evaluation of a firm’s ability to manage risk and implement sound controls across business
lines. RFI/C(D) was said to reflect a recognition of how the Federal Reserve’s supervisory processes had evolved over time, together with the changes in the banking industry.23
The adopting release for this new rating system made some changes to the Heimann/
Partee explanation of why the Federal Reserve rates firms. Ratings are a “management information and supervisory tool” that “serves three primary purposes in the
supervisory process:”
“First and foremost, the BHC rating provides a summary evaluation of the BHC’s
condition for use by the supervisory community. Second, the BHC ratings form
the basis of supervisory responses and actions. Third, the BHC rating system provides the basis for supervisors’ discussion of the firm’s condition with BHC
management.”24
Discipline and communication continue to characterize these purposes, but there are shifts in
emphasis. We see that ratings are intended to facilitate communication with the management of
firms, rather than with Congress and the public. It seems obvious now that this should be a major
purpose of ratings, but we do not see it in the adopting releases until 2004. In addition, there is a
subtle re-characterization of the old “primary purpose,” moving from a focus on problem firms
to a more neutral description of ratings forming the basis of supervisory responses and actions.
This may reflect the increasing use of ratings as a statutory and regulatory decision-making criterion during this period, or the consequences of Gramm-Leach-Bliley.

2.3 RFI/C(D) to LFI/RFI
The Board significantly changed the rating system in 2018 with the adoption of the new LFI
(large financial institution) rating system. The rationale for this new rating system was
explained not in terms of changes to industry structure, as with the adoption of RFI/C(D), but
rather in terms of changes to supervisory practice. The Board determined that its supervisory
program for systemically important firms had changed so materially since the financial crisis
of 2008 and the Dodd-Frank Act of 2010 that the RFI/C(D) system was no longer
useful. Instead, the LFI system evaluates capital, liquidity, and governance and controls on a
firmwide basis, with much less specific emphasis on the bank.
“The explanation of the purpose of the new rating system continued to evolve as
well. The adopting release explains LFI’s intentions in three parts. It is designed to:
[a]lign with the Federal Reserve’s current supervisory programs and practices; [e]
nhance the clarity and consistency of supervisory assessments and communications of supervisory findings and implications; and [p]rovide transparency related
to the supervisory consequences of a given rating.”25
With the LFI ratings, the communication theme from the 2004 release evolves further with
an emphasis on enabling clarity not only of supervisory messages, but also their implications
and consequences. Vice Chair Quarles observed:26
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“Ratings are an essential vehicle for supervisory feedback—a clear, concise way
to convey whether a firm meets expectations, with tangible, predictable consequences for those that fall short. Our ratings system for large institutions had
remained unchanged since 2004, even as our supervision of those institutions
evolved significantly after the crisis. The new rating system will better align
ratings for these firms with the supervisory feedback they receive, and will focus
firms on the capital, liquidity, and governance issues most likely to affect safety
and soundness.”
The release goes on to discuss explicitly what effect a given rating might have on the Federal
Reserve’s posture toward an enforcement action against, or an application by, a given firm. And
again, transparency to the public is not part of the articulated justification.
The rationale for the LFI rating system also, and importantly, has a more
backward-looking component, namely, the alignment with current supervisory practices for
the largest firms. Following the financial crisis, the Federal Reserve introduced its revised
framework for large bank supervision.27 This framework focused on capital, liquidity, and
governance, and the LFI rating system followed along. In addition, the new framework took
a much more macroprudential perspective with consideration given to both the probability
of distress at a large firm and the potential impact of the distress on the broader financial
sector and economy.28
Table 1

Evolution of Certain U.S. Bank and Bank Holding Company Rating Systems
Rating system

Period

Notes

Various

Pre-1978

A number of systems seem to have been employed by different regulators,
at least informally, for many years. A simple system was in use at the New
York Fed since at least 1926.

CAMEL

1978–1996

Established by the Federal Financial Institutions Examination Council.
Formally the Uniform Financial Institutions Rating System, it quickly
became known as the CAMEL rating, after its component parts: Capital,
Asset quality, Management, Earnings, and Liquidity.

BOPEC

1978–2004

The Federal Reserve’s standardized rating system for bank holding companies, named for its component parts: Bank subsidiaries, Other nonbank
subsidiaries, Parent company, Earnings, and Capital (along with F/M –
Financial composite and management composite).

CAMELS

1996–Present

CAMEL system expanded to include a sixth factor: Sensitivity to market risk.

RFI/C(D)

2004–2018

With bank holding companies entering new business areas, the Fed adopted RFI/C(D) to gauge Risk management, Financial condition, Impact
on depositories/Composite (Depository institution rating). The new
system put less focus on the evaluation of legal entities and more on an
evaluation of a firm’s ability to manage risk and implement sound controls
across business lines.

LFI

2018–Present

The Fed determined that its supervisory program for systemically important firms had changed so materially since the financial crisis of 2008 and
the Dodd-Frank Act of 2010 that the RFI/C(D) system was no longer
useful. Instead, the LFI (large financial institution) system evaluates capital, liquidity, and governance and controls on a firmwide basis, with much
less specific emphasis on the bank.

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2.4 Other Rating Systems
This article focuses on prudential ratings, particularly those that relate to banks and bank
holding companies, but there are other regulatory rating systems. In some ways, one can track
a path through evolving regulatory priorities by their reflection in existing and new rating
systems. A recent example is the rating system developed by the Federal Reserve that applies to
nonbank entities that have come under federal financial supervision, such as financial market
utilities. This responds to a post–Dodd-Frank Act focus on overseeing the systemic risk that
exists within clearing and settlement systems.29
A different example is the role that Congress asked financial regulators to play in assessing the
success of banking institutions in meeting the credit needs of their local communities. Under the
Community Reinvestment Act, first passed in 1977 and significantly revised in 1989, supervisors
are required to assess whether certain banking institutions are “meeting the credit needs of its
entire community, including low- and moderate income neighborhoods.”30 These ratings are
required to be taken into account when assessing certain applications for regulatory approval
from such institutions. In significant contrast to prudential ratings, these ratings are required by
statute to be made public. The public availability of these ratings is very much the point: Congress wanted examiners to make public judgments on which depositories were doing better than
others in enabling access to credit. Many papers have been published on whether the incentive
scheme produced by this approach is helpful or harmful.31 For this article’s purpose, we will just
observe that the incentive scheme is different than that for prudential ratings.

3. How Are Ratings Used?
Ratings are a powerful tool for making sure that supervisors are disciplined in their assessments and communicate those assessments effectively. The communication of these
assessments then enables the supervised firms to anticipate the probable consequences. Firms
can then take informed decisions and appropriate actions—whether it be to invest to address
the issues, to exit certain activities, or to avoid actions that would exacerbate the issues.
This section examines how ratings affect regulatory and supervisory judgments to constrain
financial institutions. From the banking industry’s perspective, ratings are a predictor of how
tightly the regulators will constrain their activities. While organic growth is usually possible
even without permission from a regulator, firms often find it onerous to be prevented from
expanding by acquisition or into a new activity or business line when they might consider it
strategically desirable.
From a supervisor’s perspective, these constraints can serve a variety of purposes. Sometimes, they are a means of directing a firm’s attention to material weaknesses. Sometimes, the
constraints are required by underlying statutes to be imposed when an institution’s condition
degrades – as measured by a downward adjustment in the rating. And sometimes supervisors
may use ratings as a convenient and intelligent way to make a hard regulatory decision based
on the best information to hand.
Again, we will focus primarily on Federal Reserve requirements, and we will look at three
broad types of the potential consequences of ratings: to inform supervisory prioritization and
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expectations; to assess the use of enforcement tools; and to inform regulatory decisions such as
those related to enforcement or permissible activities.

3.1 Supervisory Implications
From the beginning, regulators have stated that ratings are a tool for directing scarce supervisory resources to the right ends. Ratings, in other words, are a means for making robust
decisions about the amount and type of supervisory attention to devote to a specific firm based
on its risk profile and financial condition. This is described in the ratings definitions themselves. For example, the RFI rating system states that firms rated “fair” are “vulnerable and
require more than normal supervisory attention and financial surveillance” and that firms
rated “marginal” “require close supervisory attentional and substantially increased
surveillance.”32
How this process of devoting more supervisory resources to weaker firms actually operates
can be a little opaque in public materials, although presumably it informs prioritization decisions. The recent release asking for comment on the use of CAMELS states that “the agencies
increase supervisory activities, which may include targeted examinations between regularly
scheduled examinations, if an institution’s CAMELS ratings are less than satisfactory.”33 A
public example of supervisory prioritization can be found in a recently revised provision of
Regulation H, required by a recent regulatory reform law, which provides that state member
banks with assets of $3 billion or less will be examined on an eighteen-month cycle, rather
than a twelve-month cycle, as long as they have a CAMELS rating of at least “1” or “2.”34 Stronger firms with higher ratings presumably receive less supervisory attention—although one
could reasonably question just how much less, especially given the increasing focus on regular
horizontal exercises in large bank supervision, such as stress testing and resolution planning.

How ratings affect enforcement decisions is not hard-wired, but
ratings are understood to play a role in the supervisory judgment
as to whether an action is merited.
Related to prioritization decisions is the use of ratings to inform the expectations that supervisors will have for firms. A public example from guidance is the BHC Supervision Manual’s
discussion of funding expectations, which says that BHCs with less-than-satisfactory ratings should
be asked to prepare specific action plans for reducing short-term obligations without undermining
their affiliated banks.35 Similarly, an insured bank is required, by regulation, to have an audit at the
bank level, rather than the holding company level, when its rating falls below a 1 or a 2.36

3.2 Enforcement Tools
Ratings may play a role in supervisors’ decision making about when to employ enforcement
tools with respect to individual firms, ranging from informal nonpublic actions such as Board
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resolutions and memorandums of understanding (MOUs) to formal and public actions such as
written agreements and cease and desist orders. How ratings affect enforcement decisions is
not hard-wired, but ratings are understood to play a role in the supervisory judgment as to
whether an action is merited.
The recent LFI rating is relatively forward leaning in discussing how ratings are tied to
enforcement tools. It says that there is a “strong presumption” that a firm with a “Deficient-1”
rating will be subject to an informal or formal enforcement action and that a firm with a
“Deficient-2” rating will be subject to a formal enforcement action. The recent CAMELS release
states that “composite and component ratings…are significant indicators of the need for heightened supervisory attention including enforcement actions for more problematic issues.”37
Bank regulators’ statutory authority to order banks to correct unsafe and unsound practices
creates a presumption that an insured depository institution may be deemed to be engaging in
an “unsafe and unsound” practice if “in its most recent report of examination, [it received] a
less-than-satisfactory rating for asset quality, management, earnings, or liquidity.”38 Other official statements do not directly connect enforcement decisions with rating decisions, although
the circumstances that lead to a poor rating may be similar to those that lead to an enforcement decision. For example, the FFIEC BSA examination manual provides guidance on what
level of program breakdown will lead an examining agency to take an enforcement action, but
does so without referring to the rating process.39
Less-than-satisfactory ratings also allow regulators to use prompt corrective action to
require conservation measures by adequately or undercapitalized state member banks. If the
Board has determined, after notice and opportunity for hearing, that in the most recent examination of the bank, the bank received and has not corrected a less-than-satisfactory rating in
certain CAMELS categories, then the Board can impose requirements such as capital distribution limits or limits on growth.40

3.3 Regulatory Judgments
In certain cases, ratings inform regulatory judgments, and in other cases, the rating itself has
direct regulatory consequences by operation of statute or regulation. Although the distinction
with the supervisory judgments category described above can be a little blurry at times, we
think it is useful to describe regulatory judgments separately.

Permissibility decisions
Ratings are crucial determinants of regulatory judgments about when supervised firms are
entitled to the privilege to acquire, hold, and retain subsidiaries that engage in certain activities. A prominent example is the provisions of Section 4 of the Bank Holding Company Act
added by the Gramm-Leach-Bliley Act, which permits financial holding companies (FHCs) to
engage in certain nonbanking activities as long as, among other things, those firms are well
capitalized and well managed.41 “Well managed” is defined by the statute (and further implemented by regulation) with specific reference to ratings assigned by regulators. The
consequences for failing to remain well managed mean that financial holding companies,
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among other things, have to enter into an agreement—commonly referred to as a 4(m) agreement—with the Board of Governors and lose the ability to make new investments in FHC
permissible activities without Board approval. This is a matter of consequence for firms and
may be one of the least desirable aspects of a poor rating from their perspective.42

Expansion decisions
Ratings inform regulatory judgments about when firms may expand or reorganize their activities. A number of regulations use ratings to assess how much expansion a firm can undertake
without seeking specific regulatory approval. For example, Regulation H, which governs the
activities of state member banks, uses management ratings to determine both how much banks
may invest in their own premises and whether they may make public welfare investments,
without specific approval.43
Ratings are also frequently used as a decisional factor when a formal regulatory application
approval is sought. For example, Section 3 (and Regulation Y) of the Bank Holding Company
Act requires an application to the Federal Reserve when a bank holding company seeks to
acquire a bank, and the Federal Reserve is then required to consider (among other things) the
financial and managerial resources of the applicant, its CRA performance, and its record of
Bank Secrecy Act compliance. The Federal Reserve considers ratings in making each of these
decisions, including ratings assigned by the regulator of subsidiary depository institutions.44
In 2014, the Federal Reserve issued a guidance letter, SR 14-2, to “enhance transparency in
the . . . applications process and provide . . . better insight into the issues that could prevent the
Federal Reserve from acting favorably on a proposal.” This letter placed strong emphasis on
ratings in making these decisions. It established a high bar for favorable consideration of applications from organizations “that are rated less than satisfactory.” It stated that the Federal
Reserve will consider applications from organizations with one or more component ratings of
“3” or a composite rating of “3” only in “very limited circumstances” and where they could
demonstrate, among other things, that the acquisition would strengthen the organization.
Consumer compliance and CRA ratings are similarly given great weight in this letter.45
Notably, the industry has argued that the relatively hard boundaries in this letter have worked
to make supervisory decisions about ratings practically binding and rule-like in their consequences for the supervised firms.46

Special restrictions for problem firms
Consistent with the original Heimann “primary purpose,” ratings are used to inform regulatory judgments about special restrictions that firms should be subject to when they are in weak
condition. For example, Regulation O, which governs loans to insiders, provides for a lower
loan limit when the firm is not in a satisfactory condition.47
Less-than-satisfactory ratings lead to a number of restrictions meant to protect the FDIC’s
Deposit Insurance Fund (DIF). The DIF’s assessment levied upon bank deposits uses a bank’s
supervisory rating as part of its calculation methodology—the worse your rating, the more you
pay in.48 Discount window access can also be restricted by a bank’s rating. A Federal Reserve
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Bank faces certain statutory restrictions in lending to an “undercapitalized institution,” which
includes, among other things, an institution that received a composite “5” rating or its equivalent.49 Not by statute, but by policy, Federal Reserve Banks use ratings to discern which
institutions are eligible for primary and secondary credit.50
Firms with insured depository institutions (DIs) that are in “troubled” or worse condition,51
or that have a composite CAMELS rating of 4 or 5, are restricted, by statute and implementing
regulation, from making (or agreeing to make) “golden parachute payments” to
institution-affiliated parties.52 Firms with insured DIs that are in troubled or worse condition
(or meeting certain other conditions) are required, by statute and implementing regulation, to
submit prior notice of changes in their senior executive officers and directors to the Board of
Governors, and the Board can disapprove of those appointments.53

3.4 Growth of Consequences of Ratings over Time
It has been observed that the consequences of a rating seem to have grown since CAMEL was
first formalized.54 This seems to be true and represents a mix of choices by Congress and by
regulators to make use of this assessment tool to more closely link constraints to the current
condition of a firm.
Since the formalization of the ratings process in the late 1970s, Congress has explicitly made
use of the availability of rating systems a number of times as a means to determine which
financial firms should be subject to certain limitations, penalties, incentives, and other consequences because their condition had either improved or declined. These include a number of
the measures discussed above.
For example, in 1991, Congress amended the Federal Reserve Act to include the limitations
about advances to “undercapitalized” state member banks, and it defined “undercapitalized” by
reference to the composite CAMEL rating of 5.55 In 1994, Congress streamlined audit requirements for highly rated banks, as discussed above.56 In 1996, Congress amended the Bank Holding
Company Act to provide for expedited processing of nonbanking proposals by bank holding companies and subsidiary depository institutions that are “well managed,”57 and defined the term by
linking it to ratings. In that same 1996 legislation, Congress also amended the Federal Reserve Act
to eliminate the requirement that a state member bank seek prior approval before making an
investment in bank premises if it meets certain criteria, one of which is a CAMEL composite
rating of 1 or 2.58 The Gramm-Leach-Bliley and the Dodd-Frank Act each saw Congress add the
statutory provisions under which a firm cannot engage in a number of activities unless the holding
company and its depository institutions are “well managed.”59
Regulators also made use of ratings as a mechanism for guiding and constraining their discretion to make certain decisions with respect to a number of regulatory consequences. For example,
in 1990, the Board revised Regulation Y to implement the statutory requirements of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), to require firms in “troubled
condition” to provide prior notice of director and senior executive changes.60 It did so by defining
“troubled condition” with reference to the most recent exam rating.61 In 1992, when the Board
amended Regulation H to implement the prompt corrective action framework under the Federal
Deposit Insurance Corporation Improvement Act of 1991, the Board defined “unsafe or unsound
practice” to mean that the agency has determined, after notice and opportunity for hearing, that in
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the most recent exam, the firm received and has not corrected a “less-than-satisfactory rating” for
any of the CAMELS component ratings.62 In 1994, the Board revised Regulation O to include the
higher loan limit for state member banks with deposits of less than $100 million if the bank,
among other things, receives a satisfactory composite rating in its most recent exam. Outside of
rulemaking, regulators also employed ratings in guidance documents in order to provide guidance
to firms regarding how they will evaluate certain judgments.63
The increased interest of administrative law scholars in the process of bank supervision over
the past several years has increased scrutiny of the link between ratings and their consequences, and how comfortably that links sits within administrative law. What exactly is a
supervisory rating for purposes of administrative law? It represents the considered judgment
of the official sector overseer and it has consequences, whether they be direct and immediate—
such as changing deposit insurance assessments—or indirect and subject to further
judgment—such as what type of new supervisory intensity is appropriate. We do not take a
position on this question in this article, but note that it is an area of increasing inquiry.64

4. How Do Ratings Influence Outcomes?
The ultimate goal of supervision is to influence the behavior of supervised financial firms so that
outcomes are consistent with statutory and regulatory objectives such as the safety and soundness
of a particular depository institution, the efficient and sustained provision of financial services to
the real economy, consumer protection, and the stability of the financial system as a whole. An
obvious next question is how, precisely, does the use of supervisory ratings within the regulators’
toolkit influence firm behavior to achieve those goals? Again, this might seem to be a simple question, but we think it is important to be clear in order to design the most effective ratings regime.
As we describe above, a rating is a supervisor’s assessment, using all available information and
judgment, of the current condition of a firm. In all cases, the rating itself is the same—a summary
statistic that reflects a wide range of perspectives about the safety and soundness of a financial
firm. The supervisor’s assessment is then used, in either a mandatory or permissive way, to make
statutory and regulatory judgments about the constraints that a firm should be subjected to or
relieved from. These constraints, naturally, inform the incentive structure for the firm.
We identify three distinct channels by which a supervisory rating can influence the behavior
of a financial firm: as a communication tool, as a direct risk mitigant, and as a broad incentive
mechanism. It is helpful to distinguish between these channels so that we can employ a supervisory rating in the most effective way and design the rating framework accordingly. We note that
this framework is relevant for both microprudential and macroprudential objectives. That is, all
three channels could influence how firms respond to concerns about idiosyncratic behaviors and
broader macroprudential ones. See Table 2 for a summary of these channels.

4.1 Channels of Influence
Supervisory ratings can influence behavior as a communication tool to inform senior managers
and boards of directors about supervisory concerns. This raises awareness of the most salient issues
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and helps both financial firms and supervisors allocate resources and focus in order to address the
most material risks. Supervisors and firms have complex and ongoing interactions, and the rating
distills and focuses the supervisory message so that concerns can be properly understood.
Challenges to communication can be especially hard at large, complex firms. In 2017, the
Board proposed guidance to clarify the role of directors of large financial institutions, including how supervisors should communicate with them.65 Large financial firms are complex and
ratings offer a simple, clear signal of supervisory concerns that can inform managers and
directors of their concerns. The LFI rating system is a notable step forward in terms of communication because it allows more focused discussions with bank management about
supervisory assessments of the most critical supervisory findings related to key areas such as
capital, liquidity, and governance and controls. Boards can and do take actions to change management based on supervisory messages. It is also an effective tool for senior management to
prioritize and communicate remediation efforts.
As discussed above, communication to Congress and the public seems to have been
de-emphasized as a stated purpose of ratings over the past forty years, while there is an
increased focus on communication with the firm. For good reasons, supervisory ratings—
again, with the important exception of CRA ratings—are not made public and are considered
one of the most sensitive assessments of a financial firm. As such, the communication channel
in its current form is primarily about influencing firms directly through interaction with
senior management and boards of directors, rather than the public at large or Congress.
A second channel for how a supervisory rating influences behavioral outcomes for a financial institution is as a direct risk mitigant—that is, by linking the rating, categorically or
persuasively, to consequences that constrain the specific activity that creates the risk or fails to
support supervisory objectives. In this view, supervisors identify a material risk that leads to a
supervisory rating, and this identification leads to direct constraints on the underlying, and
undesired, behavior. The direct constraints could take the form, for example, of supervisory
prioritization decisions, enforcement tools, or regulatory judgments.
A firm with identified weaknesses in governance and controls that create a material risk
may receive a less-than-satisfactory rating in that area. The associated rating of the deficient
area, and the supervisory judgment that underlies it, could lead to consequences that mitigate
Table 2

Channels of Influence: Three Functions of Supervisory Ratings
Function

Action

Goal

Communication
tool

Supervisors use ratings to directly express
concerns to a financial firm’s senior managers and board of directors.

Clarify the most salient issues and the level
of supervisory concern; help both the
firm and its supervisors allocate resources
to address the most material risks.

Direct risk
mitigant

In their rating assessment, supervisors iden- Mitigate the harms caused by the identified
tify a material risk that leads to constraints
deficiency, supporting regulators’ prudenon the firm’s undesired behavior.
tial or consumer protection mandate.

Broad incentive
mechanism

A weak supervisory rating triggers a wider
Provide management with a broader
set of restrictions that aren’t directly linked incentive to fix the firm’s problems and
to the underlying supervisory finding or
induce changes in behavior in a range of
risk-generating behavior.
areas.

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the harms caused by the deficiency. For example, it could occasion an increase in supervisory
intensity in that area, a potential enforcement action that restrains expansion of related activities, or the firm could be prevented from expanding into certain new activities related to that
activity. Imposing one or more of these constraints reduces the chance that the weak control
environment would affect a related set of activities that undermine safety and soundness objectives. Similarly, a firm with consumer compliance issues might receive a low supervisory rating
and be restricted from expansion via new branches. Again, this constraint directly reflects the
risk that would be imposed on consumers because of the weakness in this area and supports
the regulator’s consumer mandate.
A third channel for how a supervisory rating can influence firm behavior is as a broad incentive
mechanism. In this view, a weak supervisory rating and the resultant activity restrictions impose a
general cost on the firm, but the restriction and cost need not be directly linked to the underlying
supervisory finding or risk-generating behavior. In this framing, the purpose of the consequences
of the rating regime is to provide management with a broader incentive to fix its problems. For
example, a 4(m) agreement might limit a wide set of expansionary activities, including activities
that are not directly related to the negative supervisory assessment. This can constrain expansionary activities that are executed well or even those that are potentially risk-reducing via increased
revenue streams or diversification because the firm is not considered “well managed” as a whole.
By contrast, the successful remediation of a supervisor-identified risk and the resultant rating
upgrade may relax a constraint and allow the firm to expand.
The recent LFI rating system requires that a firm meet expectations in all three pillars to
meet the “well managed” standard. To the extent that low-rated firms face more activity constraints that firms would like to avoid, this approach imposes a strong incentive for firms to
change behavior in a way that is consistent with supervisory objectives, irrespective of the
underlying issue. While not stated explicitly, this appears to be most consistent with the
broader incentive mechanism approach rather than a direct risk mitigant approach.
The key difference with the risk mitigation view is that a supervisory rating and resultant
restrictions may act as a sufficiently punitive constraint to induce changes in behaviors in
other, unrelated areas. As discussed below, this distinction has implications for optimal
policy design.

4.2 Design Implications
Understanding how supervisory ratings and their consequences actually influence firm behavior is important because these different channels have different implications for the optimal
design of the rating framework.
The communication tool approach, for example, has implications for the disclosure of
ratings. As mentioned above, communication of supervisory ratings is now aimed primarily at
firm managers and boards. If the goal is to send a powerful signal about supervisory views,
however, public disclosure, at least on an aggregate level, could amplify that clarity and impose
additional market discipline to promote the desired behavioral change. This is the judgment
that Congress made in the context of CRA ratings, for instance.
Effective communication can also provide additional transparency and help build the legitimacy of the supervisory process. The Federal Reserve has made a concerted effort recently to
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increase transparency of the supervisory process. Since November 2018, the Board of Governors has begun to produce a semi-annual Report on Supervision and Regulation designed to
increase transparency to the public and increase the legitimacy of the supervisory program.66
These reports now notably include aggregate information on ratings. This report does not
reveal firm-specific assessments, so it does not directly promote market discipline, but it does
increase transparency and provide an industry-wide view on the issues that supervisors deem
to be most important. This can serve as an effective discipline on the supervisory process itself,
and thus helps build the legitimacy, trust, and effectiveness of the supervisory process.
Public disclosure, of course, is not a panacea, and one must consider a wide range of potential implications. Any disclosure regime needs to be robust to a wide range of possible
outcomes. For example, would supervisors be comfortable disclosing that a supervisory rating
reflected underlying issues with cybersecurity controls or difficulty meeting its funding
requirements? That type of disclosure could be counterproductive and even induce exactly the
wrong type of response from counterparties, clients, or bad actors. Aggregate reporting of
rating information on a periodic basis, as is currently done, may be the right balance to strike.
The agencies could also consider disclosing individual rating information with an appropriately long lag, although that raises different issues.
Returning to the consequences of ratings, under the direct risk mitigant view, any restriction imposed as a consequence of that rating should be tied directly to the underlying risk.
This approach likely has the most beneficial impact for customers or consumers because the
consequence directly stops, or prevents the expansion of, the harmful behavior. One implication, however, is that the ratings framework would need to clearly identify each behavior and
potential supervisory concern. This might create complexity that could work to undermine
other objectives, such as clear communication. It also requires a high degree of precision in
terms of both issue identification and remediation.
One can also consider the incentive structures that are created for a firm if they perceive
certain regulatory consequences to be more or less onerous than others. For example, if the
consequence of poor capital planning is a regulatory halt on dividends, and the consequence of
poor BSA/AML controls is the payment of a fine, then, at least in theory, a firm may decide
that it cares more about the former than the latter. In a world of scarce resources, will this
create incentives for the firm to focus resources on capital and not BSA/AML? Would a supervisor want that outcome?
By contrast, the broad incentive mechanism implies a less direct link to the underlying
behavior. That is, a regime could be designed where a low supervisory rating restricts a range
of activities, not just those that create the fundamental concern that drives the rating. This
creates a potentially broader set of options for the design of the consequence framework
because the most powerful incentives can be utilized across a full set of risk concerns.
As a hypothetical example, if firms find restrictions on capital distributions to be a particularly
painful constraint, then that restriction could be used as a penalty for any supervisory issue, not
just those related to capital adequacy or the capital planning process. Similarly, if poorly rated
firms find it burdensome to seek prior approval when replacing senior executives, there is a powerful incentive for them to change behavior, exit that rating category, and have the constraint lifted.
As a more positive example, the benefits that highly rated firms get from the expedited processes
for applications (for example, in domestic branching or international banking) may serve as a positive inducement to invest broadly in remediating supervisory concerns.
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To be clear, this incentive mechanism does not free supervisors from the need to be clear
about the underlying issues and expectations for remediation, but it does sever the direct link
between the concern and the consequence. This perspective also severs the direct link with
harmed parties if the impact of the incentive is miscalculated and the underlying behaviors
continue. An advantage is that supervisors may want firms to build up their resiliency and risk
management across the entire firm because supervisors (and bank management) do not always
know where a breakdown in controls will manifest next. This overall risk management perspective would argue for a broader incentive-based framework, rather than the direct risk
mitigant approach.
This distinction between the direct risk mitigant approach and the broad incentive mechanism approach also has implications for how supervisors conduct their processes. In a world
where the information content of ratings degrades quickly and ratings are slow to adjust, it
may be less appropriate to impose broad penalties.67 This is particularly true when penalties
are nondiscretionary. It also suggests that supervisors need to ensure that their rating judgments have not grown stale when they are acting as a particularly powerful, broad-based
constraint, by refreshing examination work on a regular basis. It seems appropriate that firms
facing broad, disruptive penalties should have the expectation that the penalty be removed
quickly once the underlying issue is remediated and validated by supervisors. The consequences suggest that supervisors have an obligation to ensure the rating systems are working
as intended.68
A final observation is that if ratings have real consequences for financial firms, then supervisors should actively survey that package of consequences to ensure they are consistent with
the underlying policy objectives. The recent CAMELS release calls for public feedback on how
ratings are used in considering applications and enforcement actions, which seems like a
healthy step. It appears, for example, that the consequences of ratings have increased since the
CAMEL/BOPEC/LFI framework was first implemented, but it is not clear whether the link
between ratings and consequences has been revisited in a comprehensive way in order to
understand the whole package of incentives facing the supervised firms. A core part of that
assessment is to be clear about the desired channel and to understand how information and
constraints flow through to affect firm behavior.

Supervisors face a trade-off between making ratings uniform and
consistent versus recognizing the broad range of idiosyncrasies
that both amplify and mitigate risk.
Finally, this observation introduces the familiar policy question of rules versus discretion. In this context, should the supervisory consequences from a particular rating be fixed
and hard-wired ex ante or judgmental and left up to the discretion of the supervisor ex post?
Both approaches feature in different places in our current statutes and regulations. Either is a
valid approach for any of the channels of influence described in the prior section and the
choice reflects additional considerations linked to uncertainty, transparency, and fairness.
A supervisory rating, for example, is a summary statistic that will be an imperfect indicator
of supervisors’ assessments. In developing the approach, supervisors face a trade-off between
making ratings uniform and consistent versus recognizing the broad range of idiosyncrasies
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that both amplify and mitigate risk. If ratings are too blunt and fail to capture those
firm-specific differences, one might prefer additional discretion when it comes to imposing
consequences. That discretion, however, reduces transparency and potentially calls into question the fairness and legitimacy of the entire supervisory process.

5. Conclusions
Supervisory ratings are a core part of the current and historical practice of bank supervision.
While the emphasis and stated goals have evolved over time, the underlying rationale for their
use has remained centered on providing discipline to the supervisory process and communicating complex assessments to a broad range of stakeholders. These are constructive goals that
help build the trust in and legitimacy of the supervisory process and confidence in the
banking system.
Understanding current views on the purpose and use of ratings is a necessary step in designing the most effective framework. Supervised firms need to understand the framework so they
can respond appropriately to supervisory expectations and supervisors need to be clear on the
framework to develop and maintain an internally consistent and efficient approach to oversight.
This requires assessing complex topics such as the precise channel of influence, communication
and transparency goals, and the need to design and implement a framework that is transparent
and fair in a world with underlying uncertainty and vast heterogeneity across firms.
This article contributes to that assessment, but there is surely more work to be done. To
facilitate further work, we conclude by raising several open issues that warrant further
investigation.
It appears that the statutory and regulatory consequences that are linked to ratings have
grown over time. Is this an intended or unintended consequence? One view is that if the tool is
a good one, it should be used more frequently when important decisions are to be made.
Moreover, linking consequences to ratings promotes the communication channel, enabling
firms to anticipate what will happen if their underlying condition declines. On the other hand,
this places considerable weight on the tool, perhaps more pressure than the tool was designed
to withstand. One can also question how a confidential assessment should be linked to public
consequences. For example, one sees this tension when banks seem to choose not to expand,
even when there is no information in the public domain that would seem to prevent them
from doing so.
As a related point, it is useful to recall Goodhart’s law. This is the idea that if a measure
becomes a target, it ceases to be a good measure, for the simple reason that those subject to
the target will be motivated to take actions that undermine the measure’s usefulness.69 If
firms care too much about how they are rated, and if they learn too much about how the
ratings are determined, it is reasonable to ask whether they will take steps to “game” their
rating without actually improving their safety and soundness or compliance with law. This
could be a problem, although there are a number of reasonable mitigants, such as the judgment of trained supervisors, the breadth of what is being assessed, and confidentiality.
Understanding the strengths and limitations of such mitigants seems like a fruitful topic for
further inquiry.
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Supervisory ratings represent a confidential judgment based on confidential information.
What can be learned by a comparison with other assessment models? For example, the ratings
produced by credit rating agencies are mostly public judgments based on mostly public information. As another example, CRA ratings are public judgments. A more formal comparison of
the pros and cons of these different assessment models would likely inform our understanding
of the supervisory approach.
Finally, the focus on stress testing following the financial crisis of 2008–09 marked a fundamental shift for supervision. Capital stress testing incorporates a supervisory viewpoint into an
assessment of a banking organization’s balance-sheet capacity to withstand a range of severe
but plausible shocks. An essential element of stress testing is that it involves a substantial
amount of disclosure to the public, even as the precise nature of the disclosure has evolved
over the years. It has involved a public consequence as well, which raises questions about the
information content of the public stress test results relative to the confidential supervisory
ratings. This involves many of the trade-offs mentioned earlier and raises further questions
about the consistency of the disclosure regimes for different supervisory tools.

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Notes
Acknowledgements: The authors thank Alexandra Rubin, Angela Sun, and Won Chai for their assistance with research
for this article. In addition, the authors appreciate the review and comments of a number of helpful colleagues, including
João Santos, Dianne Dobbeck, Anna Kovner, Bev Hirtle, Nicola Cetorelli, Michael Hsu, Benjamin McDonough, Lauren
Hargraves, William Brodows, HaeRan Kim, Rosanne Notaro, Janine Tramontana, Richard Charlton, and Michael Held,
and others they may have neglected to mention here.
1

See “Request for Information on Application of Uniform Financial Institutions Ratings System.”
Federal Deposit Insurance Corporation and Board of Governors of the Federal Reserve System (October 18, 2019)
[hereinafter CAMELS Release]. See also Randal K. Quarles, “The Eye of Providence: Thoughts on the Evolution
of Bank Supervision,” remarks at the Federal Reserve Board, Harvard Law School, and Wharton School Conference:
Bank Supervision: Past, Present, and Future (December 11, 2020). https://www.federalreserve.gov/newsevents/
speech/quarles20201211a.htm.
2

For example, the FDIC publishes aggregate information about troubled banks with FDIC insurance. See the
FDIC’s Quarterly Banking Profile. https://www.fdic.gov/bank/analytical/qbp/.
3

Various statutory examination and reporting authorities provide the federal banking agencies with broad authority
to oversee and exercise visitorial powers with respect to depository institutions and their holding companies.
For example, the Federal Reserve’s authorities to examine and supervise bank holding companies can be found in the
Bank Holding Company Act, 12 U.S.C. §§ 1841 et seq. The federal banking agencies’ authority to issue cease and desist
orders to correct unsafe and unsound practices can be found in 12 U.S.C. § 1818(b)(1). Federal banking agencies also
rely on 12 U.S.C. § 1818(b)(1) to issue matters requiring attention (MRAs) based on safety-and-soundness matters
in their reports of examination. For a broader discussion of financial supervision, see, among many other sources,
Gerald Dunne, “The Legal Basis of Bank Supervision,” in Bank Supervision (Federal Reserve Bank of St. Louis, 1963).
4

Randal K. Quarles, “Spontaneity and Order: Transparency, Accountability, and Fairness in Bank Supervision,”
remarks at the American Bar Association Banking Law Committee Meeting 2020 (January 17, 2020). https://www.
federalreserve.gov/newsevents/speech/quarles20200117a.htm.
5

See Cuomo v. Clearing House Association, 557 U.S. 519. When the National Bank Act was enacted in
1864, “visitation” was accordingly understood as “[t]he act of examining into the affairs of a corporation” by
“the government itself.” 2 J. Bouvier, A Law Dictionary 790 (15th ed. 1883). Lower courts understood “visitation”
to mean “the act of a superior or superintending officer, who visits a corporation to examine into its manner of
conducting business, and enforce an observance of its laws and regulations.” First Nat. Bank of Youngstown v. Hughes,
6 F. 737, 740 (CC ND Ohio 1881).
6

For a description of how ratings operate as part of the supervisory process, see Thomas Eisenbach,
Andrew Haughwout, Beverly Hirtle, Anna Kovner, David Lucca, and Matthew Plosser, “Supervising Large,
Complex Financial Institutions: What Do Supervisors Do?” Federal Reserve Bank of New York Staff Reports No.
729 (May 2015); Jose A. Lopez, “Using CAMELS Ratings to Monitor Bank Conditions,” Federal Reserve Bank of
San Francisco Economic Letter (June 1999).
7

For example, in the CAMELS framework, firms are assigned a rating of 1 (strong); 2 (satisfactory); 3 (fair); 4
(marginal); or 5 (unsatisfactory). See Commercial Bank Examination Manual (Federal Reserve Board, May 2019).
8

See, for example, Rules Regarding Availability of Information, 85 Fed. Reg. 57616 (Sept. 15, 2020) (codified at
12 CFR Part 261); Interagency Advisory on the Confidentiality of the Supervisory Rating and Other Nonpublic
Supervisory Information (Feb. 28, 2005). https://www.federalreserve.gov/boarddocs/press/bcreg/2005/20050228/
attachment.pdf.
9

A good description of the rationale for protecting the confidentiality of the supervisory process can be found in
In Re: Subpoena Served Upon the Comptroller of the Currency, 967 F. 2d 630 (D.C. Cir. 1992): “Bank safety
and soundness supervision is an iterative process of comment by the regulators and response by the bank. The success
of the supervision therefore depends vitally upon the quality of communication between the regulated banking firm
and the bank regulatory agency. This relationship is both extensive and informal. It is extensive in that bank
examiners concern themselves with all manner of a bank’s affairs: Not only the classification of assets and the review of
financial transactions, but also the adequacy of security systems and of internal reporting requirements, and even
the quality of managerial personnel are of concern to the examiners.”
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Notes (Continued)
10

See Annette L. Nazareth and Margaret E. Tahyar, “Transparency and Confidentiality in the Post Financial Crisis
World – Where to Strike the Balance?” 1 Harvard Bus. L. Rev. 145 (2011); Clifford S. Stanford, “Toward a
Coherent and Consistent Framework for Treatment of Confidential Supervisory Information,” 22 N.C. Banking Inst.
41 (2018); and Peter Conti-Brown, “The Curse of Confidential Supervisory Information,” (2019). https://www.
brookings.edu/research/the-curse-of-confidential-supervisory-information.
11

See George R. Juncker, “A New Supervisory System for Rating Banks,” Federal Reserve Bank of New York
Quarterly Review (Summer 1978); Statement of Brenton C. Leavitt, Board of Governors of the Federal
Reserve System, before the Commerce, Consumer and Monetary Affairs Subcommittee of the House Committee on
Government Operations, Federal Reserve Bulletin, 62, No. 2 (February 1976).
12

See “Federal Supervision of Bank Holding Companies Needs Better, More Formalized Coordination,”
Government Accountability Office, GGD-80-20 (1980); “Federal Supervision of State and National Banks: A Study
by the Comptroller General of the United States,” OCG-77-1, Section 6-8 (1977); “Staff Analysis of Testimony
Presented by Comptroller General Elmer B. Staats before the Commerce, Consumer and Monetary Affairs
Subcommittee of the House Committee on Government Operations and the Financial Institutions Supervision,”
Regulation & Insurance Subcommittee of the Senate Committee on Banking, Finance & Urban Affairs
(February 1, 1977); see also Mark Greenlee, “Historical Review of ‘Umbrella Supervision’ by the Board of Governors of
the Federal Reserve System,” Federal Reserve Bank of Cleveland, Working Paper 08-07 (October 2008).
13

Financial Institutions Regulatory Act of 1978, H.R. Rep No. 95-1383, cited in Michael Barr, Howell Jackson,
and Margaret Tahyar, Financial Regulation: Law and Policy (2018): p. 835.
14

92 Stat. 3694, § 1002.1006(b)(1).

15

Press release, “Uniform Financial Institutions Rating System,” Federal Financial Institutions Examination Council
(November 21, 1979). https://fraser.stlouisfed.org/files/docs/historical/frbdal/circulars/frbdallas_circ_19791129_
no79-191.pdf [hereinafter UFIRS Release].
16

UFIRS Release.

17

See “Oversight Hearing into the Effectiveness of Federal Bank Regulation (Franklin National Bank Failure),”
House of Representatives Subcommittee of the Committee on Government Operations, February 1976; Report to
Accompany Financial Institutions Regulatory Act of 1978, Senate Committee on Banking, Finance and Urban Affairs,
95 H.R. Rep. No. 95-1383 at 17 [hereinafter FIRA Report].”
18

See FIRA Report, p. 24.

19

“Uniform Financial Institution Rating System,” Office of the Comptroller of the Currency, 1979 OCC CB LEXIS 5, p. 6.

20

Statement of Governor Charles Partee before the Senate Banking Committee, Federal Reserve Bulletin 65, No. 6
(June 1979): 463.
21

Rating the Adequacy of Risk Management Processes and Internal Controls at State Member Banks and Bank
Holding Companies, Federal Reserve Board SR Letter 95-51.
22

Board of Governors of the Federal Reserve System, FRRS 3-1575 (1996).

23

See “Bank Holding Company Rating System,” Board of Governors of the Federal Reserve System, 69 FR 43996
(2004); Scott Alvarez, “Risk Management and Compliance from the Fed’s Perspective,” speech at the Second
Annual Minnesota CLE Banking Law Institute (March 7, 2005), cited in Michael E. Bleier, “The Federal
Reserve Board’s New Rating System for Bank Holding Companies and Financial Holding Companies” (2007) .
24

Board of Governors of the Federal Reserve System, FRRS 3-1575 (1996).

25

“Large Financial Institution Rating System; Regulations K and LL,” Board of Governors of the Federal
Reserve System, 83 FR 58724 (Nov. 21, 2018).

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Why Do Supervisors Rate Banking Organizations?

Notes (Continued)
26

Statement of Randal K. Quarles before the Senate Committee on Banking, Housing and Urban Affairs
(November 15, 2018).
27

See “Consolidated Supervision Framework for Large Financial Institutions,” Federal Reserve Board, SR Letter 12-17
(Dec. 17, 2012).
28

The Board kept RFI/C(D) in place for other banking organizations, on the basis that the nature of their
supervision had not changed materially since the crisis. Its discussion of the purpose of the system bears much
more resemblance to the 1996 releases than it does to the articulated purpose of the new LFI system (or even the 2004
release). Its purpose is consistency (“comprehensive and uniform”); identifying problem or deteriorating companies;
and informing the Federal Reserve (not Congress or the public this time) about the aggregate strength of the industry.
See “Supervisory Ratings System for Holding Companies with Total Consolidated Assets less than $100 Billion,”
Federal Reserve Board, SR Letter 19-4 (Feb. 26, 2019) [hereinafter SR Letter 19-4].
29

81 Fed. Reg. 58932 (Aug. 26, 2016).

30

12 U.S.C. 2903.

31

Compare, for example, Michael S. Barr, “Credit Where it Counts: The Community Reinvestment Act and Its
Critics,” 80 N.Y.U. Law Review, 513 (2005), and Jonathan R. Macey and Geoffrey P. Miller, “The Community
Reinvestment Act: An Economic Analysis,” 79 Va. L. Rev. 291 (2003).
32

SR Letter 19-4.

33

“Request for Information on Application of the Uniform Financial Institutions Rating System,” Board of
Governors of the Federal Reserve System and Federal Deposit Insurance Corporation, 84 FR 58383 (Oct. 31, 2019).
34

See Economic Growth, Regulatory Relief, and Consumer Protection Act § 210, Pub. L. No. 115-174, 132
Stat. 1306, 1316 (codified at 12 U.S.C. § 1820(d)(4)(A)); 12 CFR § 208.64(b)(3). A second example is the BHC
Supervision Manual, which, in discussing prioritization decisions for regional BHCs, states that Federal Reserve
holding company supervisors should “heavily rely” on the ratings assigned by regulators of banks when the BHC is
noncomplex and the CAMELS ratings are “1” or “2.” Similar to supervisory prioritization, the agencies have agreed
on enhanced coordination of examinations for the lead bank within a BHC, when the lead bank is rated 4 or 5 or the
BHC or lead bank is a composite whose financial condition has worsened significantly since the last inspection.
Bank Holding Company Supervision Manual, Consolidated Supervision of Regional BHCs 1050.2.5.13 (July 2016).
35

See Bank Holding Company Supervision Manual, Funding (Bank Holding Company Funding and Liquidity),
2080.05.03 (July 2010).
36

12 CFR § 363.1 et seq.

37

CAMELS Release.

38

12 U.S.C. § 1818(b)(8).

39

See BSA/AML Manual, Federal Financial Institutions Examination Council, Core Examination Procedures for
Assessing the BSA/AML Compliance Program and Appendix R: Interagency Statement on Enforcement of Bank
Secrecy Act/ Anti-Money Laundering Requirements. The Government Accountability Office (GAO) recently criticized
the Federal Reserve for not having more formal criteria for when to escalate supervisory judgments to enforcement actions.
This criticism is similar to others the GAO has made in recent decades, recommending that the Federal Reserve adopt
“tripwires” for the use of enforcement actions. See, for example, “Regulators Improved Supervision of Management Activities
but Additional Steps Needed,” Government Accountability Office, GAO-19-352 (2019); “Lessons Learned and a
Framework for Monitoring Emerging Risks and Regulatory Response,” Government Accountability Office, GAO-15-365
(2015); “Prompt and Forceful Regulatory Actions Needed,” GAO, T-GGD-91-15 (1991).
40

12 CFR § 208.43(c).

41

See 17 USC § 1843(m).

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Why Do Supervisors Rate Banking Organizations?

Notes (Continued)
42

12 CFR § 225.83. Similarly, state member banks may hold “financial subsidiaries” (subsidiaries with the power
to invest in financial activities not permissible for the state member banks themselves) when they are, among other
things, “well-managed,” and if their rating falls below that threshold, they need to execute a 4(m)-like agreement. 12
CFR § 208.74.
43

See 12 CFR §§ 208.21–208.22; see also SR Letter 13-7.

44

See 12 CFR § 225.13.

45

See SR Letter 14-2, “Enhancing Transparency in the Applications Process,” Federal Reserve Board (Feb. 24, 2014).

46

See Greg Baer and Jeremy Newell, “How Bank Supervision Lost Its Way,” Bank Policy Institute (2017). https://bpi.
com/how-bank-supervision-lost-its-way.
47

12 CFR § 215.4(d)(2). As another example, the qualified financial contracts (QFC) rule provides that institutions
with a troubled rating have to meet heightened supervisory expectations for how they keep records of QFC, to ensure
that the QFCs will be readily identifiable in case of resolution. 12 CFR § 371.3.
48

12 CFR § 327.9. For a recent case where the translation of ratings into consequences had an effect on the
analysis of the case, see Builders Bank v. FDIC, 846 F. 3d 272, 275 (7th Cir. 2017) (“[t]he effect of CAMELS ratings on
insurance premiums creates a concrete stake that makes the current dispute justiciable”).
49

See 12 USC § 347(b)(D)(ii); 12 CFR § 201.3(c).

50

See Federal Reserve Discount Window Payment System Risk, General Information, Primary and
Secondary Lending Programs. https://www.frbdiscountwindow.org/pages/general-information/primary-andsecondary-lending-programs#elig. 12 CFR § 201.4.
51

The FDIC’s implementing regulation defines “troubled” to mean, among other things, having a
composite CAMELS rating of 4 or 5.
52

12 USC § 1828(k).

53

12 CFR § 225.71 et seq.

54

See Comment Letter from the Bank Policy Institute, “Substantive Review & Revision of the Uniform
Financial Institution Rating System” (Jan. 10, 2020).
55

See Pub. L. No. 102-242 § 142, 105 Stat. 2279–81 (Dec. 19, 1991) (codified as amended at 12 U.S.C. § 347b(b)).

56

See Pub. L. No. 103-325 § 314, 108 Stat. 2221–22 (Sept. 23, 1994) (codified as amended at 12 U.S.C. § 1831(m)(i)).

57

See Pub. L. No. 104-208 § 2208, 110 Stat. 3009-405–3009-406 (Sept. 30, 1996) (codified as amended at 12 U.S.C. §
371d(a)).
58

See Pub. L. No. 104-208 § 2206, 110 Stat. 3009-405–3009-406 (Sept. 30, 1996) (codified as amended at 12 U.S.C. §
371d(a)).
59

See Pub. L. 106-102, 113 Stat. 1338, 1342–52 (Nov. 12, 1999) (codified as amended at 12 U.S.C. § 1843(k) et seq.);
Pub. L. 111-203 § 606, 124 Stat. 1376, 1607 (codified as amended at 12 U.S.C. § 1843(l)(1)(C).
60

See Pub. L. No. 101-73 § 914, 103 Stat. 183, 484–47 (July 21, 2010) (codified as amended at 12 U.S.C. § 1831i).

61

See 55 Fed. Reg. 6787 (Feb. 27, 1990) (codified as amended at 12 C.F.R. §§ 225.71–225.73).

62

See 57 Fed. Reg. 44866-01 (Sept. 29, 1992) (codified as amended at 12 C.F.R. § 208.43(c)).

63

See, for example, note 46 above and the accompanying text; see also SR Letter 15-11/CA 15-9, “Examinations of
Insured Depository Institutions Prior to Membership or Merger into a State Member Bank,” Federal Reserve Board
(Oct. 13, 2015).

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Why Do Supervisors Rate Banking Organizations?

Notes (Continued)
64

See Builders Bank v. FDIC, 846 F.3d 272 (7th Cir. 2017). See also Daniel K. Tarullo, “Bank Supervision and Administrative
Law,” Columbia Business Law Review (forthcoming), for a systematic consideration of how administrative law
doctrines apply to banking supervision. https://custom.cvent.com/20310C03166C4C11B1AA63B0D6300264/files/
event/67aec69c628d459d8366466979e3f8af/28c97d0e935940c0b705ae832b63af55.pdf.
65

See “Proposed Guidance on Supervisory Expectations for Boards of Directors,” Board of Governors of the Federal
Reserve System, 82 FR 37219 (2017); see also Clifford S. Stanford, “Towards a Coherent and Consistent Framework
for Treatment of Confidential Supervisory Information,” 22 N.C. Banking Inst. 41 (March 2018).
66

Federal Reserve Board of Governors, “Federal Reserve Supervision and Regulation Report.” https://www.
federalreserve.gov/publications/supervision-and-regulation-report.htm.”
67

For analysis of how long information revealed by supervisory ratings is likely to be superior to market signals, see,
for example, Rebel A. Cole and Jeffrey W. Gunther, “A CAMEL Rating’s Shelf Life,” (November 2008), https://papers.
ssrn.com/sol3/papers.cfm?abstract_id=1293504; Beverly J. Hirtle and Jose A. Lopez, “Supervisory Information and the
Frequency of Bank Examinations,” Federal Reserve Bank of New York Economic Policy Review 5, no. 1 (1999).
68

See Randal K. Quarles, “The Eye of Providence: Thoughts on the Evolution of Bank Supervision,”
remarks at the Federal Reserve Board, Harvard Law School, and Wharton School Conference:
Bank Supervision: Past, Present, and Future, Dec. 11, 2020. https://www.federalreserve.gov/newsevents/
speech/quarles20201211a.htm. See also Daniel K. Tarullo, “Bank Supervision and Administrative Law,”
Columbia Business Law Review (forthcoming). https://custom.cvent.com/20310C03166C4C11B1AA63B0D6300264/files/
event/67aec69c628d459d8366466979e3f8af/28c97d0e935940c0b705ae832b63af55.pdf.
69

See “Goodhart’s Law” in Oxford Reference. https://www.oxfordreference.com/view/10.1093/oi/
authority.20110803095859655.

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FEDERAL RESERVE BANK OF NEW YORK

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