Bank resolution was the regulatory answer to the question, how do we fix banks which are “too big to fail” and avoid the taxpayer funded bailouts which exacerbated the 2008 financial crisis.

Following the disorderly collapse of Lehman Brothers, regulators globally recognised that systemic banks could not be subject to the same insolvency regimes as corporations. In Europe, the Bank Resolution and Recovery Directive (BRRD) and the Single Resolution Mechanism (SRM) were the legal architecture created to harmonise rules across the continent, known as “resolution regimes”, for the orderly resolution of failing banks.

The Single Resolution Board (SRB) is the authority, headquartered in Brussels, which prepares and supervises resolution planning for systemic banks in Europe. The purpose of resolution is to stabilise the failing bank and ensure financial stability. To achieve this, the SRB, together with national authorities, has wide powers to write down debt, dispose of assets and transfer the bank into government ownership.

Image: SRB

A detailed valuation of the assets and liabilities of the failing bank is a necessary part of the resolution process as it guides the difficult decisions that financial regulators must make to maintain financial stability and ensure creditors, not taxpayers, bear the financial losses.

In light of recent events in the European banking sector, valuation is currently at the top of the regulatory agenda.

Following several taxpayer funded bailouts of smaller Italian banks this year, the SRB and the Spanish resolution authority were applauded by market participants for their resolution of Banco Popular Espanol S.A., a significant retail bank in Spain which collapsed. The bank was auctioned off to Santander, for the nominal price of €1 and some of its multi-billion euro capital instruments were reduced to zero. Deloitte was appointed for the valuation and estimated an economic value of the bank of negative €8.2 billion in the most adverse scenario.

Since the resolution, the noise surrounding Banco Popular’s valuation has increased and disgruntled creditors have allegedly instigated legal proceedings to recover investments in the capital instruments written off by the SRB to rescue the bank. Banco Popular was not systemic. Its business was principally domestic and retail based, this made its valuation arguably less onerous than where a systemic investment bank fails.

This has given rise to a new concern. If a systemic bank fails, is a fair valuation realistic given the stringent time constraints, franchise value destruction and financial market upheaval in which it could take place? Could some European banks be “too big to value”?

Image: Bank of England

Under existing rules, the valuation is performed by an independent third party, according to regulations established by the European Banking Authority (EBA). In addition, the EBA has issued regulations on the parameters of the valuation, including more esoteric rules for valuation of derivatives.

The valuation is not a singular snapshot in time of the bank’s worth; it is a continuum. The initial valuation, known as the “ex ante” valuation, is designed to determine if the bank is “failing or likely to fail”. Secondly, the assets and liabilities valuation focuses on the economic and not the accounting value of the assets of the failing firm. It also informs the decision on which resolution tools are most appropriate, if any. Note that the SRB declined to intervene in the collapse of smaller Italian banks this year, as it stated there were no regulatory or private sector solutions that could rescue the bank.

The final equity valuation seeks to ensure that creditors have not suffered greater losses under the resolution regime than they would have done if the bank was subject to ordinary insolvency proceedings. This is known as the “no creditor worse off” (NCWO) principle. The observance of this principle is critical, as aggrieved creditors may be legally entitled to certain compensation payouts if it is demonstrated that the NCWO principle has been violated.

In practice, it is naïve to assume that a valuer will singlehandedly navigate the geographical scale and complexity of a global bank’s business model in the limited timeframes inherent in bank resolution.

The way ahead

To address this concern, the UK resolution authority, the Bank of England (BoE), has taken the lead in Europe, issuing a consultation paper over the summer entitled “Valuation capabilities to support resolvability”. Its purpose is to consult on the enhanced valuation capabilities which, among others, UK banks and UK subsidiaries of foreign banks, will need to develop.

The BoE is unapologetic in its view that “it is unreasonable to expect that resolution valuation will be sufficiently timely and robust unless firms themselves have suitable valuation capabilities in place prior to resolution. These capabilities include the data, systems, and processes that collectively support valuations of a firm’s assets, liabilities, and shares.”

The legislative intent is clear; to place the onus on contingency planning for a robust valuation on the entity best capable of performing it: the bank itself. The BoE’s rules significantly expand the existing internal valuation requirements in the BRRD and contemplate the creation of valuation models to be maintained prior to, and during resolution.

In addition, the rules propose requiring banks to collate more accessible data on the bank’s loan portfolio, trading positions, liquidity management, creditor hierarchies and collateral. An example of this is the establishment of virtual data rooms to act as a centralised access portal in order to accelerate the valuation due diligence process. These preemptive measures are designed to expand the window of opportunity during which the valuation recommendations are made, improve the credibility of underlying financial data and reduce litigation risk.

Ultimately valuation is an art, not a science. The acrimony surrounding the Banco Popular litigation has brought into sharp focus the link between time-sensitive valuations and creditor losses. Requiring banks (particularly where they are systemic) to document and establish valuation data and modelling capabilities is prudent contingency planning. These capabilities, if properly implemented, will serve as preliminary answers to the question, are banks “too big to value”?