CAEL Rating System Using PCA & DWD BIOS 740 Introduction to Statistical Learning and Personalized Medicine CAEL Rating System Using PCA & DWD Duyeol Lee April 26th, 2018

Credit risk Credit risk is the risk of financial loss owing to counterparty failure to perform its obligations. To a bank Borrower’s default To a regulator Financial institution’s default Problem bank identification tools CAMELS rating system Early Warning System

CAMELS rating system CAMELS ratings are a point-in-time assessment of all significant financial and operational factors related to six key components of bank health: (C)apital adequacy (A)sset quality (M)anagement capability (E)arnings (L)iquidity (S)ensativity to market risk

CAMELS rating system Rating Meaning 1 Indicates strong performance and risk management practices that consistently provide for safe and sound operations 2 Reflects satisfactory performance and risk management practices that consistently provide for safe and sound operations.  3 Represents performance that is flawed to some degree and is of supervisory concern. 4 Refers to poor performance that is of serious supervisory concern. 5 Considered unsatisfactory performance that is critically deficient and in need of immediate remedial attention.

National Agricultural Cooperative Federation The National Agricultural Cooperative Federation (NACF) was established in 1961 to enhance the social and economic status of its membership and to promote a balanced development of the national economy. The NACF supports the operations and management activities of member cooperatives by providing education and training for their members. At the end of year 2011, the NACF comprised 1,167 regional banks with total asset size 280 billion dollars.

Main goal of the project Develop quantitative CAEL model (C)apital adequacy (A)sset quality (M)anagement capability (E)arnings (L)iquidity (S)ensativity to market risk

Client’s requirements Simplicity Interpretability Include all key variables being used by the examiners Avoid overfitting Consistency between component ratings and overall rating

Methodology Component rating Overall rating 1 Overall rating 2 Step1. Select appropriate variables Step2. Find the 1st PC and its scores Step3. Determine the thresholds for ratings (1 ~ 5) Overall rating 1 Step1. Find 1st PC’s of the components (C1, A1, E1, L1) Step1. Find the 1st PC and its scores Step2. Determine the thresholds for ratings (1 ~ 5) Overall rating 2 Step1. Estimate DWD using components (C1, A1, E1, L1)

Dataset Observations 44 Variables Financial statements items Financial ratios Other variables from bank’s DB Year 2001 2002 2003 2004 2005 2006 2007 Total Default 38 12 9 15 32 1 108 Normal 1,338 1,347 1,319 1,306 1,261 1,216 1,192 8,979 1,376 1,359 1,328 1,321 1,293 1,217 1,193 9,087 Training set Test set

Capital adequacy Key factors to consider Capital level and trend analysis Compliance with risk-based net worth requirements Composition of capital Interest and dividend policies and practices Adequacy of the Allowance for Loan and Lease Losses account Quality, type, liquidity and diversification of assets, with particular reference to classified assets Loan and investment concentrations Volume and risk characteristics of new business initiatives

Capital adequacy Selected variables Total capital ratio Fundamental capital ratio Simple capital ratio Net capital ratio

Asset quality Key factors to consider The appropriateness of investment policies and practices. The investment risk factors when compared to capital and earnings structure. The effect of fair (market) value of investments vs. book value of investments.

Asset quality Selected variables NPL (nonperforming loan) ratio Delinquency ratio Net NPL ratio Risk weighted NPL ratio

Earnings Key factors to consider Level, growth trends, and stability of earnings, particularly return on average assets Quality and composition of earnings Adequacy of valuation allowances and their effect on earnings Adequacy of budgeting systems, forecasting processes, and management information systems Future earnings prospects under a variety of economic conditions Net interest margin Quality and composition of assets Sufficiency of earnings for necessary capital formation

Earnings Selected variables Net income to total asset ratio Net interest margin Operating expense ratio Demand deposit ratio

Liquidity Key factors to consider Interest-rate risk exposure at the instrument, portfolio, and balance sheet levels Balance sheet structure Liquidity management Qualifications of risk management personnel Quality of oversight by the board and senior management Prudence of policies and risk limits Business plan, budgets, and projections Integration of risk management with planning and decision-making

Liquidity Selected variables Liquid asset ratio Core deposit ratio Cumulative liquidity gap ratio

Factor loadings Capital adequacy Asset quality Variable Sign 1st PC 2nd PC 3rd PC 4th PC Total capital ratio + 0.506 -0.499 0.000 -0.702 Fundamental capital ratio 0.507 -0.484 0.712 Simple capital ratio 0.489 0.562 0.666 Net capital ratio 0.498 0.447 -0.743 Variable Sign 1st PC 2nd PC 3rd PC 4th PC NPL ratio - -0.532 -0.407 0.187 -0.719 Delinquency ratio -0.387 0.298 0.691 Net NPL ratio -0.402 0.805 0.434 0.000 Risk weighted NPL ratio -0.522 0.190 -0.829

Factor loadings Earnings Liquidity Variable Sign 1st PC 2nd PC 3rd PC 4th PC Net income to total asset ratio + 0.563 -0.293 0.311 -0.707 Net interest margin 0.464 0.604 0.541 0.356 Operating expense ratio - -0.516 0.601 0.160 -0.589 Demand deposit ratio 0.449 0.434 -0.765 -0.158 Variable Sign 1st PC 2nd PC 3rd PC Liquid asset ratio + 0.624 -0.516 -0.587 Core deposit ratio 0.192 0.829 -0.525 Cumulative liquidity gap ratio 0.758 0.215 0.616

Factor loadings Overall rating1 with PCA Variable Sign 1st PC 2nd PC 3rd PC 4th PC PC1 of Capital adequacy (C1) + 0.525 0.000 -0.809 0.253 PC1 of Asset quality (A1) 0.565 0.290 0.159 -0.756 PC1 of Earnings (E1) 0.552 0.166 0.560 0.594 PC1 of Liquidity (L1) 0.316 -0.939 -0.107

Distance Weighted Discrimination Overall rating2 with DWD Variable Sign Coef. Intercept NA 3.580 PC1 of Capital adequacy (C1) + 0.311 PC1 of Asset quality (A1) 0.357 PC1 of Earnings (E1) 0.144 PC1 of Liquidity (L1) 0.116

ROC curve

Performance Comparison