Review of Quantitative Finance and Accounting, 19: 247260, 2002


C 2002 Kluwer Academic Publishers. Manufactured in The Netherlands.

The Changing Relationship Between CAMEL

Ratings and Bank Soundness during the
Indonesian Banking Crisis
DOMINIC GASBARRO
Murdoch University
E-mail: gasbarro@central.murdoch.edu.au
I GDE MADE SADGUNA
Bank of Indonesia
J. KENTON ZUMWALT
Murdoch University

Abstract. During the recent Southeast Asian financial crisis, numerous banks failed quickly and unexpectedly.
This study uses a unique data set provided by Bank Indonesia to examine the changing financial soundness of
Indonesian banks during this crisis. Bank Indonesias non-public CAMEL ratings data allow the use of a continuous
bank soundness measure rather than ordinal measures. In addition, panel data regression procedures that allow for
the identification of the appropriate statistical model are used.
We argue the nature of the risks facing the Indonesian banking community calls for the addition of a systemic
risk component to the Indonesian ranking system. The empirical results show that during Indonesias stable
economic periods, four of the five traditional CAMEL components provide insights into the financial soundness
of Indonesian banks. However, during Indonesias crisis period, the relationships between financial characteristics
and CAMEL ratings deteriorate and only one of the traditional CAMEL componentsearningsobjectively
discriminates among the ratings. The panel data results indicate systemic economy-wide forces must be explicitly
considered by the rating system.
Key words: bank soundness, financial crisis, CAMEL ratings, Indonesia
JEL Classification: G21, G28

1. Introduction
The allocation of scarce financial resources is a central issue in financial economics. Its
importance became particularly evident during the recent financial crisis in Southeast Asia.
In the years leading up to the crisis, most Southeast Asian economies were characterized by strong growth, low inflation, budget surpluses, low unemployment and declining

Address correspondence to: Dr. Dominic Gasbarro, School of Commerce, Murdoch University, Murdoch, Western
Australia, Australia 6150. Tel.: 61-8-9360-2126.

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government foreign debt. Because of these strong economic indicators, many financial
market participants were caught off-guard when the crisis was triggered by Thailands
devaluation of the baht in July of 1997.
Economists have attempted to understand what happened and why so many sophisticated
participants were taken by surprise. With hindsight, a number of problems have surfaced.
Bond markets are not well developed in Southeast Asia, so most of the borrowing came in
the form of bank loans. Miller (1998) points out that the Southeast Asian countries took
on short-term debt to finance long-term investments, creating substantial maturity risk. In
addition, much of the debt was denominated in U.S. dollars and was used to finance projects
tied to their own countries currency. This created substantial foreign exchange risk. Many
of the loans that later defaulted could not be considered arms-length transactions as they
were to companies that were closely tied to the banks and/or the government. These factors
can jeapordize the financial soundness of individual banks and the banking system.1
To anticipate banks financial deterioration, procedures have been developed to identify
banks approaching financial distress. These procedures, though varying from country-tocountry, are designed to generate financial soundness ratings and are commonly referred
to as the CAMEL rating system. This rating system is made up of five components: capital
adequacy, asset quality, management competence, earnings, and liquidity with the associated
acronym. Numerous prior studies have examined the efficacy of CAMEL ratings and they
generally conclude that publicly available data combined with regulatory CAMEL ratings
can identify and/or predict problem or failed banks.
Because Indonesia is an emerging economy, it is not known whether the variables used
in prior studies can be applied to banks in Indonesia even in normal economic times.
Also, the financial crisis was so devastating that many firms did not survive, and banks were
severely impacted as their loan portfolios deteriorated. Because of the severity of the crisis,
it is important to examine how the traditional CAMEL measures reflected bank soundness
during such a dramatic downturn and this is the central issue of the paper.
During a crisis, banks financial statements are unravelling. Capital adequacy declines
as the result of continuing losses. Asset quality deteriorates because of non-performing
loans. Management quality is even more difficult to measure during financial crises because management must focus on short-term survival. These first three components are
all intimately linked with earnings, and due to these interrelationships, earnings may best
signal a banks soundness. Although liquidity is reduced due to lower depositor confidence
and the non-marketability of loans, a bank run may not lead to closure unless regulators
expect continued losses.
During stable economic conditions, we expect all CAMEL components to be significantly related to the CAMEL ratings. However, as economic conditions deteriorate, the
CAMEL rating may not adequately reflect bank soundness. Additionally, the priorities that
management and regulators place on the individual components may change.
In fact, U.S. regulators recognized that the current global competitive markets had not
been adequately factored into CAMEL and, in 1997, added a sixth factor designed to
capture systemic risk. This systemic component, S, attempts to capture banks sensitivity to
market factors that include interest rate, foreign exchange and price risk. The importance of
systemic factors varies over time and across institutions, but is more pronounced in a crisis

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249

period. In the U.S. the measurement of the market exposure component continues to evolve.
At the time of the study, Indonesia had not included this factor in their CAMEL ratings.
Hence, in a crisis period where the International Monetary Fund (IMF) and the World Bank
are called upon to provide financial support, it is unclear whether the original five-factor
CAMEL model does, in fact, provide an adequate and timely measure of bank soundness.
We add to the literature in the following ways. First, since the accuracy of the publicly
available Indonesian data may be suspect due to the quality of the annual reports and the
volatility of financial markets, models developed using these data may be suspect. We use
non-public banking information provided by the central bank of Indonesia, and presumably
the use of better data allow the development of better models. Second, Indonesian regulators
develop percentile information about the degree of bank soundness. These percentiles allow
the use of a continuous banking soundness measure rather than the ordinal measures used
in prior logit, probit, and discriminant analysis models. Third, since the same banks are
sampled over time, the pooled cross-sectional times-series data allow us to use panel data
regression procedures to consider both individual bank effects and time effects. Fourth, we
develop and compare CAMEL models for stable economic conditions, the pre-crisis period
and the crisis period and use panel data regressions to infer the importance of the systemic
risk factor in the CAMELS model.

2. Early warning system and CAMEL model research

Operating and financial ratios have long been used as tools for determining the condition
and the performance of a firm. Altmans (1967) seminal work on identifying distressed
firms radically changed a well-established tradition by introducing discriminant analysis.
Modern early warning models for financial institutions gained popularity when Sinkey
(1975) utilized discriminant analysis for identifying and distinguishing problem banks from
sound banks and Altman (1977) examined the savings and loan industry.
Since then, there have been numerous studies on early warning systems that focus on the
development of models to identify problem banks and/or to predict bank failure. Most of
these studies have used a dichotomous variable approach by defining the dependent variable
as a problem/non-problem or failure/non-failure bank.2 However, most studies have used
U.S. data because of the availability of data in the well-developed banking industry and the
sophisticated financial markets.
Banking authorities and academic researchers have tested the effectiveness of CAMEL
ratings information in indicating changes in the condition of banks. Using U.S. call report
data, Sinkey (1975), Martin (1977), and Espahbodi (1991) developed models to identify
factors that distinguish problem or failed banks from sound banks. A number of researchers
have combined call report data with regulators examination data to explore the efficacy
of CAMEL ratings.3 Most of these studies conclude that CAMEL ratings generally reflect
the soundness of financial institutions. Internal factors have been identified as the most
important causes of troubled banks, commencing with Sinkey (1979) and most recently
Hanc (1998). In particular, Sinkey points out that the internal factors causing bank failures
are decisions over which the managers and directors of the bank have direct control.

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Other studies attempting to improve upon the CAMEL ratings model have incorporated
external data such as local and regional economic conditions (Gajewski, 1990) or market
data (Pettway and Sinkey, 1980). Regulators have recognized that external market forces
impact on banks by the addition of a systemic risk component to the original CAMEL
system.
Finally, while researchers have used a number of estimation techniques, probit analysis,
logit analyses, and multivariate discriminant analysis seem to be the most popular. Although
these techniques are appropriate for dichotomous or ordinal dependent variables, bank
soundness is continuous. The data available to Bank Indonesia allows the use of a continuous
soundness dependent variable, and hence our models more accurately reflect the impact
of the individual CAMEL components.

3. Panel data methodology

Panel data procedures allow the simultaneous investigation of a system of equations that
consider both firm-specific characteristics and changes over time.4 Two models used in panel
data analysis are the fixed-effects model and the random-effects model. The fixed-effects
model uses dummy variables that allow the intercept terms to vary both cross-sectionally
across banks and over time. Conversely, if the cross-section and time-series intercepts
are considered random variables, a generalized least square model should be used. The
random-effects model allows consideration of time-series errors, cross-section errors and
their interaction. The choice between the fixed-effects and random-effects models can be
resolved by applying the Hausman test.5
Following Greene (1997, 1998), both the fixed-effects and random-effects models are
examined. The fixed-effects model has the following form:
yit = 0 + i + t +  xit + it

(1)

while the random-effects model may be written as:

yit = +  xit + it + i + t

(2)

where yit are the CAMEL rating percentiles (0100), for bank i(i = 1, . . . , 52), and at time
t (t = 1, . . . , 12 or 3), 0 is the constant intercept term, i are the bank-specific intercept
terms, t represents the time-effect t (t = 1, . . . , 12 or 3),  is the vector of the regression
coefficients, xit represent the five variables for the 52 banks over 12 or 3 quarters, it represent
the idiosyncratic error terms for banks over time, i is the bank-specific error term in the
random-effects model, and t is the time-varying error term in the random-effects model.
Changing regulations leading to increased competition, increasing interest rates and the
devaluation of the domestic currency are expected to result in variations in the bank-specific
and the time-specific components. The importance of these components is isolated and quantified when the OLS model is compared with the bank- and time-effect model. In essence,

THE CHANGING RELATIONSHIP BETWEEN CAMEL RATINGS AND BANK SOUNDNESS

251

the systemic risk inherent in the Indonesian banking system is captured by the panel data
analysis.
While panel data analysis allows for changes over time, it does not automatically recognize when partitioning based on economic logic should occur. Because of the very significant
changes that occurred in Indonesias economic conditions, models were developed for three
different time periods. The first panel data set includes the stable economic conditions
model and is developed over the first twelve quarters. The next six quarters are split into
two, three-quarter data sets. These are the pre-crisis three quarters immediately preceding
the Thailand baht devaluation and the crisis three quarters immediately following the devaluation. It is during these last three quarters that the banks CAMEL ratings experienced
the dramatic decline. By partitioning the period in this manner we hope to gain insights into
the importance of systemic risk in the Indonesian banking system.

4. The Indonesian CAMEL system data

The sources of information used in this study are the monthly reports provided by the banks
to Bank Indonesia and the CAMEL information developed by Bank Indonesia.6 The data are
consolidated bank financial reports consisting of a balance sheet, an income statement and
the administrative accounts (off-balance sheet accounts) of individual commercial banks
operating in Indonesia. These reports are not publicly available.

4.1. Indonesian CAMEL ratings

A Bank Indonesia Board Decree requires that a banks condition and performance be regularly appraised according to predetermined procedures, rules and criteria. A single CAMEL
rating for each bank is the result of both off-site monitoring, which uses monthly financial
statement information, and an on-site examination, from which bank supervisors gather further private information not reflected in the financial reports. These examinations result
in the development of credit points ranging from 0 to 100. The regulators do not advise
the banks of the actual number of credit points awarded during the examination, but rather
inform management of the CAMEL ratings integers from 1 to 4.7 The 100-point rating
system is summarized below.
Indonesian CAMEL rating system
Credit Points

Rating

CAMEL

81100
66<81
51<66
0<51

Sound
Fairly sound
Poor
Unsound

1
2
3
4

Source: Bank Indonesia Circular Letter No. 26/5/BPPP,

29 May 1993.

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4.2. The Indonesian bank sample

There were 238 banks operating in Indonesia before the crisis. However, rating were available for 126 banks but not over the entire 18-quarter period. For example there were 82 banks
rated during the third-quarter of 1994 while a maximum of 119 were rated during the fourthquarter of 1996. During the crisis period many banks failed to report the necessary information to regulators. (The number of banks with ratings fell to 53 during the second-quarter of
1998.) Hence, CAMEL ratings and other information for the entire 18 quarters, December
1993 to March 1998, were unavailable for many Indonesian banks. We limit our sample
to those banks with complete information over the entire period. The data consists of five
financial ratios from 52 Indonesian banks over 18 quarters, beginning 15 quarters before
Thailands devaluation, resulting in 936 bank-quarter observations.8
Survivorship bias is present. While many of the banks with missing data are undoubtedly
poor, all of the banks with available data are used. Initially, most of the banks in the sample
were sound or fairly sound. However, due to the crisis, many of these banks were downgraded to poor and unsound. The nature of the data allows the examination of higher
rated banks during strong economic conditions and the same banks during crisis conditions.
The graph below shows the serious deterioration that occurred over the 18-quarter period.
Initially, from the 4th Quarter of 1993 through the 4th Quarter of 1997, over 80 percent of
the banks in the sample were rated in the two top categories. In contrast, in the 1st Quarter
of 1998, 50 percent of these Indonesian banks were considered poor or unsound. In
addition, the number of top rated sound banks had declined to only 11.5 percent. The
dramatic decline in the ratings occurred unexpectedly and very quickly.

4.3. CAMEL model variables

Unlike Altmans widely accepted bankruptcy prediction variables for non-financial firms,
there is no set of variables that is universally recognized for describing the soundness
of banks. Regulators appeal to CAMEL proxies, but researchers have neither identified a
precise financial variable that corresponds to each CAMEL component nor a unique set of
variables for the overall CAMEL rating. Instead, prior research has generated a number of
variables that are significantly related to CAMEL ratings.
Prior research was used to identify variables as potential proxies for the five CAMEL
components. Many of the variables considered measure the same component and, ex ante,
it is difficult to know which formulation of a particular component will provide a superior model. In practice, Indonesian regulators have identified a number of ratios designed
to reflect the CAMEL components. However, some ratios are difficult to quantify and
verify, others are qualitative, and all may be collinear. The choice of which variable to
use as a proxy for a particular CAMEL component is an empirical issue. We use the
individual correlations between potential proxies for the CAMEL components to select
the variables reported in the study.9 If our variable selection is appropriate, we expect
high significance levels and good explanatory power for the model during stable economic
conditions.

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THE CHANGING RELATIONSHIP BETWEEN CAMEL RATINGS AND BANK SOUNDNESS

100

The number of banks (%)

80

60

40
SOUND

20

FRSOUND
POOR

UNSOUND
0 Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q
4\ 1\ 2\ 3\ 4\ 1\ 2\ 3\ 4\ 1\ 2\ 3\ 4\ 1\ 2\ 3\ 4\ 1\
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19
93 94 94 94 94 95 95 95 95 96 96 96 96 97 97 97 97 98

Period
Figure 1. The CAMEL ratings of Indonesian banks.

Capital adequacy. Capital adequacy is often represented by a leverage ratio of core capital
to assets. In the U.S., this ratio has qualifications on the definition of core capital and the
assets are risk-weighted. Furthermore, the qualifications are not fine gradations but rather
divide banks into five categories ranging from critically undercapitalized through wellcapitalized. In this study, the net-equity-to-total-assets ratio is used as a proxy and is a
continuous variable. Net equity is simply end-of-quarter shareholders equity. A positive
sign is expected on this variable for two reasons. First, regulators view a higher level of
equity as a cushion against future losses. This protects the depositors from loss and reduces
potential bailout costs to taxpayers. Second, the higher the value of equity, the greater is the
alignment of owners interest with the success of the bank, thus reducing moral hazard.
Asset quality. Asset quality is generally associated with credit risk and at any point in
time a banks assets are composed of a range of qualities. U.S. bankers and regulators designate substandard, doubtful, and loss loans as classified loans. Indonesia uses these same
categories and we use classified loans as non-performing assets. Hence, non-performingassets-to-total assets, is our proxy for asset quality. In an Indonesian context, non-armslength loans, crony capitalism and rapid growth could involve lower screening and monitoring efforts by banks, and non-performing loans may be more apparent during the crisis
period. It is expected that higher levels of non-performing assets will result in lower asset
quality ratings, and a correspondingly lower CAMEL rating.
Management. In the CAMEL rating system, management quality is treated as the most
qualitative aspect and is subjectively assigned by supervisors based on their judgment of
bank management systems, compliance, and prudential practices. Direct measures of these

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characteristics do not appear in the financial statements. However, managements pricing

policy and risk taking behavior can be inferred by examining the interest rates charged on
loans.10 Higher rates are associated with more risky loans and/or higher funding costs and
lower rates indicate conservative lending policies and/or access to lower cost funds. Therefore, Interest-rate-charged-on-credit-extended-in-Rupiah, calculated as the weighted average of the interest rates charged on Rupiah denominated loans, is used to proxy management
quality. An inverse relationship is expected between this variable and the CAMEL rating.
Earnings. The variable used to measure earnings is the ratio of operating-profit-to-totalassets. This ratio describes the profitability of the bank and avoids the volatility of earnings
associated with extraordinary items. This a better measure of managements focus on the
banks core business than is net income. A higher value indicates greater profitability and
a positive relationship with the CAMEL ratings is expected. If no extraordinary items are
present in a financial statement, the measure is equivalent to the commonly used operating
return on assets.
Liquidity. Liquidity is an indication of the banks ability to meet its customers day-to-day
cash needs and to respond to sudden cash withdrawals. Liquidity can be either stored or
purchased. The liquidity measures used by Indonesian regulators focus on stored liquidity.
The loan-to-deposit ratio is highly correlated with the capital adequacy ratio and thus appears
redundant. Purchased liquidity represents not only depositor confidence, but interest rate
conditions. A bank facing a liquidity problem will be forced to purchase funds at higher
interest rates. The rates a bank pays on medium-size deposits is one measure of liquidity
risk as these depositors focus on interest income and seek a higher rate for greater risk.
Thus, the variable used to proxy liquidity risk is medium-size-deposits-to-total-liabilities,11
and a negative relationship with CAMEL is expected.
CAMEL component weightings. The Indonesian CAMEL rating components have the
following weights: capital adequacy 25%, asset quality 30%, management 25%, earnings
10%, and liquidity 10%. The weightings are subjective and based on regulators past experience. The last adjustment to the component weights occurred in 1993 when the weight on
the capital component was increased from 20% to 25% and the weight on the management
component was reduced from 30% to 25%.
Systemic risk and crisis conditions. Bank Indonesia does not explicitly consider systemic
risk in its CAMEL ratings. Systemic risk is important, and all variables that contribute to the
CAMEL ratings are impacted by such economic factors as interest rates, inflation, foreign
exchange risk, and price risk. These factors change over time and their impact on individual
banks is dissimilar.
During a crisis, capital adequacy declines, asset quality deteriorates, and management
quality is even more difficult to assess. Furthermore, earnings, the most visible of the
components, declines, and liquidity is reduced as depositor confidence falls loans become
less marketable. Since all of the components are deteriorating, it becomes an empirical issue
to determine their relative importance during the crisis.

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255

4.4. Multicollinearity issues

There is reason to expect multicollinearity to be present in the data. The nature of the
CAMEL ratings causes the five components to be related. A sound bank will have favorable
credit points on all five components. Thus, a profitable bank will exhibit good capital
adequacy, good asset quality, and good liquidity. With all of these favorable attributes,
management will receive a good rating as well. Conversely, poor banks will have lower
credit points on each of these components. While some components will be stronger than
others, in general, the components will point in the same direction.
However, since the ultimate purpose is to understand how CAMEL ratings are related
to financial variables during a financial crisis when many companies and banks are failing,
and since these variables are expected to be used by regulators in future ratings, the multicollinearity pattern is expected to prevail in the future. Hence, multicollinearity must be
recognized but need not detract from the significance of the study.12
The factors that influence bank safety and soundness include both bank-specific factors
and macroeconomic factors. It is reasonable to assume that over time all banks will be
affected by changes in Indonesias macroeconomic factors. This suggests the likelihood
that the regression error terms are correlated both across banks and across time. However,
due to differences in risk-taking preferences and management quality, banks may react differently to the similar factors that affect their operations over time. Accordingly, panel data
procedures, which are designed to allow for bank-specific and time-varying coefficients,
are used to examine the pooled cross-sectional, time-series data.13

5. Empirical results
Limdep statistical package procedures sequentially reports on different models ranging from
the ordinary least squares (OLS) to fixed-effects and random-effects panel data regression
models. The models examined include those that consider (1) group effects, (2) variable
effects, (3) group and variable effects, and, (4) group, variable, and time effects. In addition,
the procedures provide a Hausman statistic that distinguishes between the fixed-effect and
random-effect models.14
The results of the OLS and panel data regressions for three separate time periods are
presented in Table 1. Panel A exhibits the 12-quarter stable period, Panel B reports the
3-quarter pre-crisis period, and, Panel C documents the 3-quarter crisis period. The OLS
model represents a pooled, cross-sectional and time-series regression, which ignores the
fact that the same 52 banks are being repeatedly sampled over the respective quarters. The
panel data model considers both bank- and time-effects, thus incorporating systemic risk
into the analysis.
From Panel A, the importance of the bank and time effects are shown through a substantial increase in the adjusted R 2 , the improvement in the log-likelihood function, and the
statistically significant chi-square. The Hausman statistic indicates the fixed-effects model
better explains the data than the random-effects model. The fixed-effect model highlights

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Table 1. Panel data regressions for 52 Indonesian banks for the 18 quarters from December 1993 through
March 1998.
Panel A: 12-quarter stable period from December 1993September 1996
Description

OLS Model

Bank and Time Effect Model

Adjusted R 2
Observations
Degrees of freedom
F-value
Log-likelihood
Chi-square
Hausman statistic

0.380
624
618
77.21**
2520.94

0.886
624
555
72.52**
1956.98
1126.80**
98.08**

CAMEL Variables

Coefficient

t-Ratio

Coefficient

t-Ratio

Intercept
Capital adequacy
Asset quality
Management quality
Earnings
Liquidity

115.63
2.61
27.00
1.79
696.75
8.49

18.38**
0.70
6.38**
5.73**
15.91**
1.72

113.37
18.02
72.27
1.25
67.68
3.58

17.77**
4.10**
18.09**
3.84**
2.16*
0.76

Panel B: 3-quarter pre-crisis period from December 1996June 1997

Description

OLS Model

Adjusted R 2
Observations
Degrees of freedom
F-value
Log-likelihood
Chi-square
Hausman statistic

0.554
156
150
39.57**
596.10

Bank and Time Effect Model

0.952
156
96
53.38**
386.28
418.01**
106.77**

CAMEL Variables

Coefficient

t-Ratio

Coefficient

t-Ratio

Intercept
Capital adequacy
Asset quality
Management quality
Earnings
Liquidity

104.43
10.40
19.98
1.04
527.63
4.81

7.88**
1.24
2.75**
1.56**
10.92**
0.56

77.86
0.61
11.31
0.56
10.25
16.45

3.29**
0.06
0.86
0.46
0.34
1.38

Panel C: 3-quarter crisis period from September 1997March 1998

Description

OLS Model

Adjusted R 2
Observations
Degrees of freedom
F-value
Log-likelihood
Chi-square
Hausman statistic

0.253
156
150
11.51**
667.59

Bank and Time Effect Model

0.774
156
96
9.98**
538.82
255.91**
12.03*

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Table 1. (Continued)
CAMEL Variables

Coefficient

t-Ratio

Coefficient

t-Ratio

Intercept
Capital adequacy
Asset quality
Management quality
Earnings
Liquidity

83.76
13.71
8.45
0.35
506.99
6.28

7.90**
1.02
0.98
1.00
7.06**
0.42

98.22
20.38
21.66
0.86
228.20
2.94

5.64**
1.17
1.54
1.60
3.75**
0.15

Note: The statistics presented above are based on the fixed effect model (The fixed effect model was identified
by the Hausman statistic as appropriate for this data set. See Greene (1998, pp. 621633)).
yit = 0 + i + t +  xit + it
yit are the CAMEL percentile ratings (0100) for bank i(i = 1, . . . , 52) at time t (t = 1, . . . , T ), where T is 12
in panel A and 3 in panels B and C, 0 is the constant intercept term, i is the bank-specific intercept term that
represents the individual bank-effect, t represents the time-effect,  is the vector of regression coefficients for
the 5 independent variables, xit are the 5 variables for the 52 banks over the respective quarters, and it represent
the idiosyncratic error terms for banks over time.
The five variables for the Bank and Time Effect Model are: Capital adequacy; net-equity-to-total-assets, Asset
quality; non-performing-assets-to-total-assets, Management quality; interest-rate-charged-on-credit, Earnings;
operating-profit-to-total-assets, and Liquidity; medium-size-deposits-to-total-liabilities.
*indicates significance at the 0.05 level.
**indicates significance at the 0.01 level.

the existence of heterogeneity among the banks and demonstrates the impact of systemic
factors during the period.
In the CAMEL variables analysis, in the OLS model, surprisingly, the capital adequacy
variable has an incorrect sign, but is not statistically significant. However, when the bank
and time effect model is used, the coefficient, as expected, is highly positively significant.
The liquidity measure is not significant in either model.
The overall statistics for the 3-quarter pre-crisis models presented in Panel B again shows
the superiority of the panel data model. The Hausman statistic shows the fixed-effect model
outperforms the random-effect model. Surprisingly, none of the CAMEL proxies have statistically significant coefficients. This fact, plus the high R 2 , means the substantial differences
between the intercepts of the banks and the time variable are important explanators of the
CAMEL ratings. Unfortunately, the panel data result provides limited information other
than the CAMEL model variables are not helpful and a one-by-one examination of the
respective banks is required. Importantly, the panel data statistics indicate that the OLS
model results should be viewed with caution.15
Panel C shows the 3-quarter crisis-period. Although the bank- and time-effect model
outperforms the OLS model, the adjusted R 2 shows that neither model performs as well
as in the stable and pre-crisis periods. The chi-square indicates the panel data regression is
superior to the OLS regression, and the Hausman statistic again confirms the fixed-effects
model is appropriate. During this period, both models identify earnings as the critical
variable in explaining the ratings.

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Interestingly, our liquidity measure is not significant during any period or in any model.
There are several possibilities for this result. First, regulators attach only a 10% weight
to that measure and liquidity is a small percentage of a banks balance sheet. Second,
our measure may not adequately capture a banks liquidity. Third, collinearity with other
variables may diminish its significance. Finally, although the importance of liquidity is
crucial, during crisis periods liquidity will not be provided by medium-size depositors or
any other depositors. In fact, liquidity may not show up on a banks balance sheet, but may
be provided by such external parties as Bank Indonesia and/or the IMF.16
6. Summary and conclusion
A unique data set provided by Bank Indonesia is used to examine the changing relationships
between the financial characteristics of Indonesian banks and their CAMEL ratings during
the recent economic crisis. While the U.S. introduced a systemic risk component creating
the CAMELS rating system, it has not yet been adopted in Indonesia. Systemic factors
characterize economic crises. Previous U.S. studies have found that the traditional CAMEL
ratings perform well during stable economic conditions.
Using panel data regression models, we generate results that show the changing importance of the CAMEL components during different economic conditions in Indonesia. We
find that different CAMEL factors are important in different economic environments and
the statistically generated coefficients are not consistent with the weightings assigned by the
bank regulators. The inconsistency is most pronounced in the pre-crisis and crisis periods.
The implications for both bank management and regulators is that the weightings of the
CAMEL components should change in response to the deteriorating economic climate.
In addition, we confirm a bank-specific and time-effect and, indeed, find support for the
inclusion of sensitivity to market risk to the traditional CAMEL ratings. Like the original
CAMEL factors, the systemic factor is difficult to quantify, but regulators must acquire
and assess the exposure of banks to systemic market risk. By using panel data procedures,
we indirectly quantify the importance of systemic risk. The systemic component adds
substantially to the explanatory power of the CAMEL ratings and argues for adoption of a
CAMELS rating system in Indonesia.
Acknowledgments
The authors would like to thank Gary Monroe and an anonymous reviewer for his/her
helpful comments. Any errors are the responsibility of the authors.
Notes
1. An anonymous reviewer observed that the issues surrounding the Southeast Asian crisis are similar to those
of the LDC debt crisis of the 1980s.
2. A number of studies have used the CAMEL ratings to differentiate sound banks from problem banks. For
example, Gilbert (1994) and Swindle (1995) classify problems banks as those with CAMEL ratings of 4 and 5

THE CHANGING RELATIONSHIP BETWEEN CAMEL RATINGS AND BANK SOUNDNESS

3.
4.
5.

6.

7.
8.

9.
10.
11.

12.
13.
14.

15.
16.

259

while Whalen and Thomson (1988), Thomson (1991) and Cole and Gunther (1995) also include banks with
ratings of 3.
See Meyer and Piffer (1970), Korobow and Stuhr (1975), Korobow, Stuhr and Martin (1976; 1977), Pettway
and Sinkey (1980), and Bovenzi, Marino and McFadden (1987).
Further benefits and limitations of using panel data procedures are outlined in Hsiao (1985, 1986), Klevmarken
(1989), and Solon (1989) and are summarized in Baltagi (1995).
The random-effects model is appropriate if there is no correlation between the error and the explanatory
variables, otherwise the fixed-effects model is appropriate. The Hausman test is asymptotically distributed as
chi-squared and large values indicate the fixed-effects model is appropriate.
The monthly reports are selected on quarterly basis, e.g., end of March, June, September, and December in
the respective year because most previous studies use quarterly reports (Call Reports). In Indonesia, only
semiannual and annual reports are available to the public. In an effort to increase transparency, new regulation
went into effect December 31, 2001 that requires a summary of monthly reports and selected performance
indicators be made public. This increased disclosure should improve market discipline.
In the U.S., CAMEL ratings for each bank are generally on a scale of 1 (highest) to 5 (lowest) with banks
rated 1, 2, or 3 being considered sound and banks rated 4 or 5 being considered problem banks.
There were 238 banks in Indonesia before the crisis, only 21 of which were publicly listed. In the two quarters
following our study the number of rated banks fell to 53 in the second-quarter of 1998 and then to 35 in thirdquarter of 1998. At the end of 2001, there were only 145 still operating. Seventy-one had been closed, 13 had
been merged, and 9 are undergoing recapitalization in the Indonesian Bank Restructuring Agency program.
Formulations other than those reported here were examined. While the best results are presented, the models
are robust as to the particular formulation chosen.
Hanc (1998) indicates that bank examiners appear reluctant to rate the management component much below
the other CAMEL components.
In the U.S. deposits of over $US 100,000 are not FDIC insured and the onus is on the depositor to screen and
monitor the bank. In Indonesia, no deposit insurance exists and it would be expected that larger depositors
would behave similar to large U.S. depositors.
Baltagi (1995) indicates panel data regression procedures mitigate collinearity problems. See Kennedy (1998)
for a discussion of multicollinearity issues.
See Baltagi (1995, pp. 37).
Greenes Limdep (1998) statistical package is used to generate the panel data analysis results accommodating
both individual bank heterogeneity and changes over time. Limdep reports the log-likelihood statistic for
selecting the best of the alternative models. In addition, the model identifies random and fixed effects. If fixed
effects are significant, then a least squares dummy variable (LSDV) model is the appropriate model to use.
Conversely, if the random effects dominate, a generalized least square (GLS) model should be used.
In fact, an OLS model using only dummy variables for each individual bank and for the three time-periods
resulted in a high R 2 of 0.954, confirming the CAMEL variables are not helpful during this period.
At the suggestion of an anonymous reviewer, all of the regressions were re-run without the liquidity measure.
The results are indistinguishable from the 5-variable CAMEL model.

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