Bankers will be interested in a recent appellate court order in a bank regulatory case. Their lawyers will be astonished by it because the ruling lights a flicker of hope in an area where there has been none for many years:  the judicial review of CAMELS ratings.

The ruling came early in a litigation seeking to contest the imposition of a CAMELS rating of 4. A CAMELS rating is a summary rating regulators use to quantify the condition of banks at a given point in time.  For the uninitiated, the term stands for Capital, Assets, Management, Earnings, Liquidity and interest rate Sensitivity.  It is a fundamental element of the relationship between banks and their regulators.  The rating impacts how much banks pay for federal deposit insurance, among other matters.  A bad rating increases the cost of this insurance.

There are very few bankers of any experience who have not in their heart of hearts wished that they could contest an unsatisfactory CAMELS rating. The prospect of an even-handed judicial review might be a popular choice for many bankers.

What is not contestable however is a directive from a bank regulator to a bank regarding its capital level. That has been clear under applicable law since 1983 when Congress enacted a statute making such directives essentially a matter of regulatory discretion.

So the current decision even if it became final would not change that result regarding bank capital directives. But the reasoning employed in the decision suggests an important change to the way bankers and regulators think of CAMELS ratings may be in the offing.

Why is capital different than the rest of the factors measured by a CAMELS rating? In a nutshell, bankers think of the bank’s capital, along with the bank’s debt, as the means to finance the bank.  Bank regulators acknowledge the financing function of bank capital but they are especially focused of the fact it also provides an all-important buffer between losses at an insured financial institution becoming losses borne by the Federal Deposit Insurance Fund.

In 1983, Congress enacted 12 U.S.C. Section 3907(a)(2). It provides in pertinent part:

Each appropriate Federal banking agency shall have the authority to establish such minimum level of capital for a banking institution as the appropriate Federal banking agency, in its discretion, deems to be necessary or appropriate in light of the particular circumstances of the banking institution.

This section was enacted in response to a Fifth Circuit Court of Appeals decision concluding that a regulator’s capital directive to a bank was not supported by substantial evidence. First National Bank of Belliare v. Comptroller of the Currency, 697 F.2d 674 (5th Cir. 1983).

The statute overturned the idea that judicial review applied to capital directives. Because the statute expresses no standards for how a court is to review a capital directive, courts have concluded the intention of Congress in enacting the statute must have been to relegate the subject area of capital adequacy entirely to the discretion of the banking regulatory agencies without any provision for judicial review.  This is clear under well-established federal administrative law.

So 12 U.S.C. Section 3907(a)(2) long has been the wall the FDIC has raised against that unhappy banker who wished to go to court to challenge a CAMELS rating.

The holding in the recent Seventh Federal Circuit Court of Appeals decision in Builders Bank v. FDIC Insurance (NO. 16-2850), 2017 U.S. App. LEXIS 996, opens the possibility of a judicial review of CAMELS ratings other than the capital rating.

The FDIC argued in the case that the plaintiff’s challenge to a CAMELS rating was just an end run around 12 U.S.C. Section 3907(a)(2). Speaking of CAMELS ratings generally the Seventh Circuit said however:

Each of the six factors is rated separately on a scale of 1 to 5 and the rating as a whole aggregates those six factors. Suppose the FDIC’s team of examiners were to conclude that the Bank had an adequate capital deserving a rating of 1 but the other components were unfavorable, leading to an overall rating to 4.  The examiners may be right or wrong about those other issues, but the district court could ask whether the FDIC’s final rating was arbitrary or supported by substantial evidence, without making any inroad into the agency’s discretion to evaluate a bank’s capital adequacy.

The Seventh Circuit sent the case back to a lower court for a separate determination whether bank was “just trying to disguise a challenge to a capital decision protected by Section 3907(a)(2),” among other things.

So here is a court proceeding bankers, and their lawyers, are likely to take interest in. And I suspect their interest will be keen.