Board of Governors

We investigate whether the bank examination process provides useful insight into bank future outcomes. We do this by conducting textual analysis on about 5,500 small to medium-sized commercial bank examination reports from 2004 to 2016. These confidential examination reports provide textual context to the components of supervisory ratings: capital adequacy, asset quality, management, earnings, and liquidity. Each component is given a categorical rating, and each bank is assigned an overall composite rating, which are used to determine the safety and soundness of banks. We find that, controlling for a variety of factors, including the ratings themselves, the sentiment supervisors express in describing most of the components predict relevant future bank outcomes. The sentiment conveyed in the asset quality, management, and earnings sections provides significant information in predicting future outcomes for problem loans, supervisory actions, and profitability, respectively, for all banks. Sentiment conveyed in the capital adequacy section appears to be predictive of future capital ratios for weak banks. These relationships suggest that bank supervisors play a meaningful role in the surveillance of the banking system.