1. 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

2. 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

3. 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

4. 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.

5. 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.

6. 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

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

8. 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)

9. 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

10. 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

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

12. 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.

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

14. 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

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

16. 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

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

18. 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

19. 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

20. 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

21. 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

22. ROC curve

23. Performance Comparison