Resolution valuations: How much do you value your balance sheet?
October 12, 2015
Banks stand to benefit from incoming requirements to quickly value their balance sheets under the bank resolution framework. Banks will need to understand the value of their balance sheets better and faster to have a seat at the table when it comes to discussing resolution plans with the authorities. New rules on capital are being phased in by the European Banking Authority from January 2016. If banks are able to demonstrate to resolution authorities that they can value their assets and liabilities robustly in the event of a resolution, they may even be able to argue for a lower capital requirement.
What is bank resolution?
During the financial crisis and its aftermath, when it came to dealing with banks deemed “too big to fail”, bail-out was the order of the day. The cost of this recapitalisation by government was immense with European Commission figures putting the total for the period 2008-2013 at €448bn for the EU, of which €100bn was in the UK alone. Since the crisis, the regulatory landscape has evolved with the Banking Act in the UK in 2009 and the Bank Recovery and Resolution Directive (catchily known as the BRRD) coming into effect across Europe in 2015. This legislation provides authorities with greater powers when dealing with failing banks.
The new thinking is that financial institutions should be able to fail without significant consequences – in the same way that non-financial firms can (like Woolworths and Blockbuster). The significant consequences to be avoided are excessive disruption to the financial system, interruption to critical economic functions and exposing taxpayer money to losses. The European Commission has decided to ensure that the cost of such failure is borne by shareholders and creditors rather than the taxpayer.
How do you resolve a bank?
The powers or so called ‘stabilisation tools’ that the authorities have to resolve financial institutions are:
- bail-in - like we saw in Cyprus;
- sale to a private purchaser - most of Dunfermline BS to Nationwide;
- transfer to a bridge bank (temporary public ownership) - Dunfermline’s social housing portfolio was placed into a bridge bank;
- asset separation (often known as a ‘good bank/bad bank’ split) - for example Northern Rock; and
- bankadministration procedure or bank insolvency procedure - for example Southsea Mortgage and Investment Company Limited.
In thinking through the practical application of these tools, it quickly becomes clear that valuation is key to resolution. In the case of bail-in it quantifies the recapitalisation need. In the case of sale or transfer, the assets being sold or transferred must change hands at a fair value. The valuation need doesn’t stop at quantifying the balance sheet – any shares received by creditors as part of a bail-in must be valued to determine the terms of exchange. And overarching any resolution is the core principle that “No Creditor can be made Worse Off” (NCWO) than they would have been in an insolvency. In order to assess this we need – you guessed it – more valuations.
What valuations are required?
The EBA has issued draft legislation covering the various valuations banks need to be able to perform:
- An updated valuation of the balance sheet based on accounting standards to assess if the institution is in breach of its capital requirements
- A valuation of assets and liabilities on an exit value basis (both on and off balance sheet)
- A valuation of assets and liabilities (again both on and off balance sheet) on a long term economic value basis
- An equity valuation of the bank following resolution action (value of the business based on a new business plan post restructuring)
- A valuation of what would likely be received by each class of creditor in insolvency.
As the European authorities turn their attention to the “resolvability”, it should come as no surprise if valuation is seen as a “barrier to resolution” for a number of banks. The requirement to be able to perform valuations quickly, accurately, at short notice and possibly mid-month is likely to present a significant challenge for most institutions. Merely assembling the information required for such exercises can be tricky and time-consuming when dealing with multiple systems and data repositories, potentially in numerous jurisdictions. Performing such valuations might sound simple enough. But when you lift the lid and get into the finer details (such as the intricacies of loan portfolios, exotic derivatives, complex off balance sheet structures, pension scheme deficits, intra-group funding arrangements and contingent liabilities), things can get complicated very quickly.
So aren’t banks already doing these valuations?
Not quite. Financial institutions perform various valuations for existing risk management, accounting and regulatory requirements but none of them really fit the bill for resolution. They already estimate fair value for IFRS 7 disclosures, but the level of detail is usually much lighter than what is required for resolution valuations. There are similarities to IFRS 9, which will see banks estimating lifetime losses on loan portfolios. But IFRS9 does not incorporate the interest rate adjustment element of fair value, so only gets you part of the way. It is worth considering whether existing projects, such as IFRS 9 or stress testing, could be adapted or leveraged for this purpose. The long-term economic value may be less familiar to banks and will require assumptions to be modelled on a ‘through-the-cycle’ basis.
Is it worth investing in this?
Perhaps it may be. While the cost of establishing valuation capabilities may be significant, there are benefits to be had. It certainly wouldn’t hurt management teams or your investors to have a better understanding of the value of assets and liabilities on your balance sheet. When discussing contingency resolution plans with the authorities, having your own view on value enables you to have a seat at the table while regulators and advisors evaluate your assets. If the investor understands an institution’s risk profile, you can probably expect them to require less return on their investment, i.e. a lower required return on equity or debt, and as such your on-going funding costs could be reduced. But perhaps there is a bigger ‘win’ to be aiming for, as discussed below.
What about MREL?
One of the key cornerstones of the BRRD is that the taxpayer should not bear the cost for the failure of an institution. Before any taxpayers’ money can be used for a bail-out at least 8 % of an institution’s liabilities will need to have been exposed to losses. This is will be achieved through a minimum requirement for own funds and eligible liabilities, the so called “MREL”, which the European authorities are due to set for each institution individually in the near future. How MREL is being set is currently unknown, but we do know that it will be set in line with the resolution strategy of an institution, as set by the authorities.
If an institution is not able to perform valuations to an acceptable degree of accuracy and within a suitably short time frame, it is likely that a higher amount of liabilities would be earmarked for bail-in given the uncertainty. In addition to this, the institution could be exposed to earlier intervention by the authorities. This could manifest itself in a higher MREL requirement (i.e. higher capital requirement) to give authorities an additional buffer for uncertainty.
And so you may just have a financial incentive for institutions to fully understand the value of their assets and liabilities through investment in its infrastructure. The short-term costs of this may well result in lower funding costs in the long run, making it more important than ever for boards to appreciate the value of valuations.
To what extent do you think banks will be able to argue for a lower capital requirement this way? Share your thoughts below or schedule a meeting to discuss your situation in confidence.