Valuation in Resolution

The global financial crisis 2007-09 revealed the need for developing adequate, effective tools and methods to deal with severe crises in the banking sector and for increasing financial and operational resilience of financial institutions to avoid future reliance on bank bail-outs by taxpayers’ money and to prevent contagion in the case of bank failure.

Answering this need, recovery and resolution planning (RRP) has been introduced into regulation, starting in 2011 with the Financial Stability Board’s (FSB) Key Attributes which set out essential features of RRP and which have been endorsed as international standards by the G-20. Since then, RRP has been incorporated into legislation in various countries globally. In Europe, after multiple cycles of drafting recovery and resolution plans, RRP is reaching a steady state with the focus shifting towards operationalization and finetuning of requirements.

One recent policy initiative focuses on operationalizing valuation in resolution: to inform resolution decisions and ensure the effectiveness of resolution actions, different valuations are to be performed within a short timeframe during a crisis and prepared in resolution planning.

Why is valuation in resolution important?

Valuation is the basis for determining whether an institution is failing or likely to fail. If this is the case[1], a more comprehensive valuation informs the choice of resolution tools and the amount of losses to be absorbed. After resolution, another valuation is required to ensure that shareholders and creditors did not receive worse treatment under resolution than under normal insolvency proceedings.

Regulators expect well-documented valuations by independent valuers to ensure informed decision making, accountability, and transparency.

What are the requirements and implications for banks?

To be robust, a valuation must rely on the timely provision of high-quality data. Banks are expected to have adequate management information systems (MIS), valuation, and data provision capabilities in place to support valuation in resolution and test abovementioned capabilities by means of self-assessments.

What are the key challenges banks need to overcome?

In the following, the above-mentioned requirements and implications of valuation in resolution are examined in more detail.

 

Valuation is an essential aspect in resolution (planning); operationalizing valuation in resolution has become a recent focus of authorities

The general criteria and requirements that valuations for purposes of resolution must comply with are set forth in the Single Resolution Mechanism Regulation (SRMR)[2] Article 20 as well as in the Banking Recovery and Resolution Directive (BRRD)[3] and its national transpositions:

  • Article 36 BRRD – Valuation for the purposes of resolution,
  • Article 74 BRRD – Valuation of difference in treatment, and
  • Article 49 BRRD – Derivative close-out and valuation.

 

The BRRD delegates responsibility to supplement and specify the general law to the European Banking Authority (EBA) to ensure effective and consistent implementation of BRRD across the EU.

With respect to valuation in resolution, EBA has developed several technical standards enacted in the form of Commission delegated regulations (CDR)[4]:

  • CDR 2018/345 – Regulatory technical standards (RTS) specifying the criteria relating to the methodology for assessing the value of assets and liabilities
  • CDR 2018/344 – RTS specifying the criteria relating to the methodologies for valuation of difference in treatment in resolution
  • CDR 2016/1401 – RTS for methodologies and principles on the valuation of liabilities arising from derivatives
  • CDR 2016/1075, Articles 37-41 – RTS specifying the requirements for independent valuers.

 

Furthermore, in order to operationalize the valuation process, both the EBA and the Single Resolution Board (SRB) have published guidance on valuation in resolution:

  • EBA Handbook on valuation for purposes of resolution (incl. data dictionary), and
  • SRB Framework for valuation.

 

This guidance represents the best practice approach and industry standards which should be adhered to.[5]

In 2019, SRB and EBA have further specified their expectations regarding valuation in resolution

The EBA Handbook on valuation is intended to support (national) resolution authorities (NRAs) in the context of valuation and facilitate the valuation process in times of crisis. It provides details on considerations and methodological issues, such as:

  • Measurement bases: hold value vs. disposal value,
  • Best point estimate vs. value ranges,
  • Preliminary vs. final valuation, and
  • Resolution tool-specific considerations.

 

The SRB Framework for valuation is addressed to the general public and future potential valuers. It specifies the expectations of the SRB regarding the principles and methodologies for valuations in resolution and details the main elements to be included in a valuation report. Though still being relatively principle-based in nature, it provides some specific expectations and guidance, e.g. regarding:

  • The length of projection periods to be used in DCF valuations depending on the resolution tool(s), and
  • The appropriate valuation range around the best estimate (± 5-10 %).

 

Banks are expected to have adequate MIS, valuation, and data provision capabilities in place to support valuation in resolution; resolution authorities will monitor progress and may impose measures if progress is deemed insufficient

In its “Expectations for banks 2019” document[6], the SRB emphasizes the need for banks’ MIS to provide accurate and timely information in the context of resolution preparedness for the reliability and robustness of valuations.

The availability of reliable data in an accessible format is a fundamental prerequisite for the performance of valuation work. Banks are expected to demonstrate their capabilities in resolution planning and increase their preparedness with respect to the SRB framework for valuation. As a first step, banks are expected to perform self-assessments regarding their in-house valuation and data provision capabilities, identifying any gaps and including those in their comprehensive resolvability work program.

In this resolvability work program, banks shall propose how to address potential impediments to resolution, outlining concrete deliverables, timelines, and milestones, which they will be held accountable against by SRB and NRAs. Progress will be monitored via a resolvability progress report which banks will have to submit at least semi-annually.

If banks’ valuation and data provision capabilities do not meet the resolution authorities’ expectations, do not represent best practice and progress is insufficient, this may be deemed as a ‘substantive impediment to resolution’.

SRB and NRAs have formal legal power to impose measures to reduce or remove impediments to resolution onto institutions (Art. 17 BRRD). Additionally, identification of shortcomings may be reflected in higher MREL requirements.

Generally, three distinct valuations are required in the resolution process

Valuation 1 is an accounting valuation aimed at determining whether an institution is failing or likely to fail. It informs the determination of whether the conditions for resolution and for write-down or for conversion of capital instruments are met. Valuation 1 is performed irrespective of the resolution strategy.

Valuation 2 is a much more detailed valuation to determine the economic value of the institution in resolution’s assets, liabilities and equity, ensuring that all losses are fully recognized and aimed at informing the choice and design of resolution tool(s). Hence, valuation methodology depends on the respective resolution tool(s) chosen as part of the (preferred) resolution strategy.

Valuation 3 is an ex-post counter-factual valuation, comparing actual resolution actions taken to a liquidation scenario. It aims at ensuring that shareholders and creditors do not receive worse treatment under resolution than what would have been expected in regular national insolvency proceedings (“No creditor worse off” principle) and hence safeguards the rights of shareholders and creditors against decisions adopted on the basis of valuation 2.

Figure 1 provides additional details regarding the three types of valuation required in resolution:

 

While valuation 1 largely follows the institution’s existing valuation methodologies for accounting purposes amended by applying assumptions made by the independent valuer, valuation approaches applied for valuations 2 and 3 may differ depending on the specific circumstances and due to different emphasis of the inherent time-accuracy trade-off. Broadly speaking, valuation 2 focuses more on informing timely decision-making while valuation 3, conducted post-resolution, requires best possible accuracy.

 

EBA and SRB emphasize their preference for the discounted cash-flow (DCF) valuation approach, which relies most heavily on the timely provision of a large set of accurate data.

From both a theoretical perspective and a practical standpoint, the method that best incorporates all factors affecting the value of an institution is the DCF valuation method.

A DCF valuation in the context of resolution requires the determination of three main parameters:

  • Projection period (depending on the resolution strategy / resolution tools applied, contractual / behavioral lifetimes of assets, time to normalization, cyclicality),
  • Cash flows over the projection period plus any terminal value (considering the restructuring / reorganization plan, macroeconomic / financial scenarios), and
  • Discount rate(s).

In practice, however, the adjusted book value method is a pragmatic alternative in case of significant time pressure. Adjustments and haircuts are applied to the balance sheet in order to consider the effects of resolution (e.g. fire sales leading to depressed prices).

A third valuation approach is the comparative market valuation, i.e. the use of multiples derived from market capitalization of similar entities or from comparable transactions. Typically, a DCF should be validated by a second valuation as a sanity check, giving a valuation range of ± 5-10 % around the best point estimate.

 

In valuation 2, one main determinant of the valuation parameters is the resolution strategy, impacting for example the following:

  • Use of hold vs. disposal values,
  • entity level vs. portfolio / asset view (The entity level view is suitable in case of a share deal or if all or the majority of assets are to be transferred. The portfolio / asset view is suitable in case of an asset deal or when assets can be grouped into relatively homogeneous portfolios in terms of risk profile, business line, or similar characteristics (stratification)), and
  • whether to include franchise value or resolution costs (e.g. set-up and running costs of a bridge bank, workout costs and benefits of an asset management vehicle (AMV)).

Furthermore, institutions are expected to leverage their internal capabilities such as systems in place to meet IFRS 9 requirements, stress tests, AQR exercises or portfolio reviews and consider data from historical bank failures.

Figure 2 details the impact of resolution strategies on valuation 2:

 

Institutions are expected to perform self-assessments as to their preparedness for supporting valuation in resolution and propose how to close any identified gaps

One of the main challenges for institutions is the need for providing a large set of accurate data within a very short timeframe (e.g. 12-24 hours)[7] during or leading up to resolution.

A robust valuation is essential to the effectiveness of resolution actions, including the legitimacy and soundness of the decision, and the achievement of the resolution objectives. To be robust, a valuation must rely on the timely provision of high-quality data and information to the independent valuer:

  • Data must be provided within a very short period of time (target: 12-24h),
  • Data provided need to be complete, correct, and consistent, and
  • Data must be up-to-date as per the chosen reference date.

To ensure smooth resolution in actual crises, there is the need to enhance institutions’ preparedness in the course of the resolution planning phase.

As a starting point, EBA has developed its so-called data dictionary as best practice to structure, store and link data for purposes of valuation in resolution, detailing a large number of required data points with a “one-fits-all” approach. As indicated in its “Expectations for banks 2019” paper, SRB is currently working on its own best practice dataset for valuation in close collaboration with EBA.

Institutions are asked to do a self-assessment of how they would approach the valuations and to map their current data infrastructure to the data dictionary, thereby identifying any gaps and providing insights for future resolvability work programs (mentioned above). With regard to their existing internal valuation models which may be used as a starting point for valuation in resolution, banks are asked to document underlying assumptions, methodologies, and parameters.

Figure 3 summarizes information required for valuation in resolution according to the EBA data dictionary:

PwC suggested approach

PwC is at your disposal to further discuss implications of mentioned requirements and possible ways to approach the self-assessments.

Based on our extensive experience in bank valuation, resolution planning, and actual bank resolution we have developed an approach for completing the self-assessments in a strategic and goal-oriented manner.

If you are interested in discussing any implications of the abovementioned requirements and expectations, our project approach and how it may be adjusted to your institution’s individual needs, or would like to address any questions, please do not hesitate to contact us using contact details as provided below.

 

 

Marc-Alexander Schwamborn

Telephone    +49 69 9585 5824

Mobile       +49 175 432 3885

marc-alexander.schwamborn@pwc.com

 

Stephan Lutz

Telephone   +49 69 9585 2697

Mobile       +49 151 146 23538

stephan.x.lutz@pwc.com

 

Stefan Linder

Telephone   +49 69 9585 2915

Mobile       +49 160 539 5454

stefan.linder@pwc.com

 

Dr. Philipp Völk

Telephone   +49 69 9585 3991

Mobile       +49 160 743 5320

philipp.voelk@pwc.com

 

Sarah Kirmse

Telephone    +49 40 6378 2762

Mobile       +49 170 569 1678

sarah.kirmse@pwc.com

 

 

 

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[1] And if there is no private sector alternative and a resolution is in public interest (see conditions to resolution, Art. 32 BRRD).

[2] Regulation (EU) No. 806/2014, article 20

[3] The BRRD has incorporated RRP into EU law, transposed into national law by each country (in Germany via the Sanierungs- und Abwicklungsgesetz, SAG) – so-called “level 1 regulation”. Additionally, various specifications of the general law, so-called “level 2 regulation”, as developed by the EBA, apply.

[4] Regulatory and implementing technical standards drafted by EBA become directly applicable law in all EU member states by publication as CDR in the official journal of the EU Commission.

[5] Though legally subordinate to the Level 1 and Level 2 regulation

[6] Consultation paper specifying the capabilities the SRB expects banks to demonstrate, reflecting best practice and setting benchmarks for assessing resolvability.

[7] See e.g. Ma Bail-in (BaFin Circular 05/2019).

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