Valuations for resolution planning - what do banks need to do and could it save them time and money?
August 25, 2016
The latest challenge for banks in the recovery and resolution planning world is to demonstrate that they are “resolvable” in the event of failure. One of the key barriers to this is the ability of banks to provide the necessary valuations robustly, accurately and at short notice. Establishing better valuation capabilities won’t necessarily be easy, but there are gains to be had by taking a smart approach to existing projects. There are areas of overlap with IFRS 9 and stress testing that mean these projects should be considered in the context of future needs, rather than just the immediate requirements they are addressing.
I have blogged previously about the valuations that banks need to be able to perform for resolution. As the focus moves to resolvability, the ability to prepare resolution valuations is likely to come under increasing levels of scrutiny. The final Regulatory Technical Standard (RTS) on valuations under the Bank Resolution and Recovery Directive (BRRD), which will formalise the requirement, was originally due to be released in the summer of 2015. It is now expected in the autumn of 2016. Despite the delay, we aren’t expecting a substantial re-write of the RTS. Nor do we expect the UK’s vote to leave the EU to have any immediate impact on the requirements as the UK will remain part of the EU for at least two years in the event of Article 50 being triggered.
While the RTS hasn’t been finalised, banks are keen to understand what existing capabilities or projects can be adapted to meet the resolution requirements. A number of banks have been asking me about the overlap between resolution valuations and other requirements (particularly IFRS 9, the new standard on loan provisioning, and stress testing). And so it is a topic I have been exploring with interest and will be blogging about over the next few weeks.
Firstly, let’s recap on the resolution valuations being asked for:
1. An updated valuation of the balance sheet based on accounting standards to assess if the institution is in breach of its capital requirements. This is the simplest of the valuations required. The extra work will come from banks having to produce a balance sheet at short notice and make key period-end adjustments (such as provisioning) as at any date. It is unlikely this valuation will need to be exact, but it is required to give a view on the financial and capital position within an acceptable level of materiality.
2. A valuation of assets and liabilities on an exit value basis. A number of trading asset classes, such are derivatives, are already at fair value but having to take netting into account may add complexity. For more complex derivatives, banks may be able to use their prudential valuation framework for these purposes. The real challenge here lies with assets that are held at amortised cost i.e. loan portfolios. At a high level, exit value needs to incorporate two key elements: (i) lifetime losses and (ii) an interest rate adjustment. For exit value, the assumptions should be based on the disposal proceeds in today’s market, which may be illiquid or even based on a specific buyer (in a distressed situation it may be that there are limited buyers and the exit value needs to reflect this).
3. A valuation of assets and liabilities on an economic hold value basis. Exit value and hold value for certain asset classes such as derivatives are unlikely to differ significantly (unless they are more complex, illiquid derivatives). Again loan portfolios are the key challenge here. This valuation drives at what the assets are worth, assuming they are held rather than sold. It allows a change in perspective from current market conditions to a longer term, ‘through the cycle’, view. The key assumption that changes is the loss given default, as there is the option of delaying enforcement on bad loans until market conditions are more favourable i.e. until property markets recover.
4. An equity valuation of the bank following resolution action. This valuation is asking for the value of equity in the business once it has been restructured and, crucially, has a new business plan. The bank could look quite different post resolution if certain assets or activities have been sold or phased out. So rather than looking at whether there is a detailed set of forecasts available, the question is whether there is a forecasting process in place. Ideally banks would develop flexible forecasting tools that are able to accommodate, say, the disposal of certain non-core activities, or reflect a particular economic outlook as required by the resolution authority.
5. A valuation of what would likely be received by each class of creditor in insolvency. This valuation requires two key things: (i) a view on what is realisable from assets in insolvency; and (ii) and understanding of how this would flow down the creditor waterfall. Pre-resolution, banks might be required to provide an initial view of liquidation value, but the final analysis would be performed by an independent valuer post resolution. The more important challenge for banks is to understand and document their creditor waterfall in all material jurisdictions reflecting local insolvency law. This may include analysis of key financial contracts as insolvency can trigger a change to the creditor waterfall.
While the focus of this blog has been resolution planning, it’s also worth noting that valuation is equally important for recovery planning. Valuation should be used to demonstrate that recovery options are credible and that the recovery option will result in a viable bank going forward.
No significant change anticipated
The finalisation of the valuation RTS has been delayed but we are not expecting significant changes. Banks have been wanting to discuss what they can be doing to start preparing. In my next blog, I will discuss how the valuation RTS should be kept in mind as banks implement IFRS 9, the new accounting standard on loan provisioning.
Get in touch to find out how much preparation you will need to do to implement the requirements of the EBA’s valuation RTS. Or share your thoughts in the comments box below.
