Thread by @what5updoc

A thread on "badwill" in banking M&A: important, given the upcoming sector consolidation activity. Badwill in bank M&A is an odd concept. It is also, regrettably, misunderstood

What happens when you buy a bank for half its accounting value? Can you use the profit from the bargain to top up provisions or pay yourself a big dividend that part-pays the acquisition? Erm, NO!

Reported badwill is not the "double dip" free gift it's sometimes reported to be, nor the "fake capital" some would portray it as.

With most European banks valued below accounting book value, M&A is probably going to involve negative goodwill aka "badwill". So if we refuse to ignore it, we need to get our heads around it…

Big listed European banks have an accounting book value (BV) of €1,200bn. That's the total value of their assets (€27,000bn), minus their liabilities (€25,800bn). After regulatory adjustments, their CET1 capital is €1,100bn

But their market cap is only around €650bn! Why so low? In large part due to weak profitability. Market Value MV is focused more on earnings streams (about €80bn pa steady state).

If you buy European banks, you are buying an earnings stream of about €80bn pa. Investors think that's worth €650bn not €1,200bn. Harsh reality. MV < BV

Some banks have such weak or uncertain profitability outlook that they trade at a MV of only 20% of their BV.

Banks are SOLVENT (big excess of assets over liabilities, able to reliably service their debts and honour depositors) but sadly not highly VALUABLE (spew off large profits that can be distributed to shareholders). VALUE ≠ SOLVENCY

If that feels weird, think about a bank that makes profit of 0 but has super-high solvency capital levels. SOLVENT but not VALUABLE (would you buy a breakeven business?)

(We can also imagine a risky bank with little equity that's highly profitable and VALUABLE but not super SOLVENT)

(The adventurous would note that if BV>>MV then shrinking or running off a bank to liberate all of the BV may be value-creating, they may have a point… M&A is another route…)

A cynic could argue that bad loans are under-provisioned hence BV and solvency are overstated. If that's the case, profits and/or new capital will be needed to remedy the situation. But that's the case with or without M&A

So what happens when you buy the European banking sector for less than BV?

1. The accountants make you revalue bits of the balance sheet - "purchase price adjustments" and maybe raise extra provisions. These can be significant but are generally minor

2. The acquirer gets all the assets (€27,000bn) of the acquired and all of the liabilities (€25,800bn). Their equity goes up by the BV of €1,200bn. (Let's assume they raised €650bn of fresh capital to pay for the deal)

(In fact, that's important: in all these discussions, we have to assume that the cash paid out to sellers is equal to the cash raised by the buyers or it's an all-paper deal, there's no extra capital raised to distort matters)

3. Accounting rules say you got a bargain and got BV of €1,200bn for only €650bn so you made a profit of €550bn. That shows up in your P&L as "badwill" and in the BS as retained earnings

Then the fun begins. Some think the badwill "profit" should be deducted from regulatory capital; some think it should be taxed; some think it represents an incremental resource that should be used to bolster provisions or pay new owners a fat dividend

Deducting badwill out of regcap? Of course not. You'd only do that if you believe that the relevant solvency ratio is: market cap ÷ RWAs. But that's daft because VALUE ≠ SOLVENCY, see above

The ECB has no plans to filter badwill out of regcap, thank goodness bankingsupervision.europa.eu/legalframework…

Should badwill be taxed? A topic for a different thread…

Should badwill be used to bolster provisions or pay a dividend? No. The ability to redeploy capital is driven by the SOLVENCY situation not the P&L. To be solvency ratio neutral, all of the €1,200bn BV must remain to cover the €8,000bn RWAs

In other words, in bank M&A, badwill is always accompanied by extra RWAs that need to have solvency capital. The acquired capital, including the badwill component, is used up already

To be clear: If Bank A with a 12% CET1 ratio buys Bank X for €1 and Bank X's CET1 ratio was 12% then - guess what? - the new bigger bank has a CET1 ratio of 12%

That said, if there is a pre-existing surplus capital amount then that can be redeployed, whyever not? But it's nothing to do with badwill. Surplus capital can exist in banks that are sold at BV without badwill, for example. There's no connection.

Badwill isn't a profit like a normal operating profit. This has confused many people. Yes, badwill adds to CET1 but the acquisition also brings RWAs ie a need for CET1. The new solvency ratio is weighted average of the two combining banks components

Maybe they're also confused by the fact that goodwill is deducted and are seeking a symmetrical treatment for badwill. Which is also non-sensical.

(Goodwill is deducted from bank regulatory capital. Why? Because goodwill (where MV>BV) is the extra payment for future profits which are by their very nature uncertain. So best not to count on them for solvency. Experience supports this view.)

Disturbingly, the ECB SSM supervisor talks about badwill being "used" for extra provisions or restructuring investments (a good use) or dividends (supposedly bad…)
bankingsupervision.europa.eu/legalframework…

And The Economist says "this accounting technique enables banks to use badwill to offset restructuring charges". Wrong. There are plenty of other examples where the media misreports the nature of badwill.
economist.com/finance-and-ec…

It's not clear why authoritative voices would form or promulgate such erroneous views

If banks had excess solvency (ie. supply > requirements), or the ability to raise extra capital during the acquisition, they could consider provisions, restructuring charges or dividends. But if they don't, then badwill doesn't create excess solvency

We shouldn't be talking about badwill - we should be talking about solvency surpluses and deficits.

Misunderstanding badwill risks thinking that bank M&A can magically create a new source of solvency to finance distributions provisions or restructuring costs. It's misleading. It increases the burden on the acquirer and makes consolidation more difficult

The other mistake is to stoke excessive scepticism about solvency when bargain deals are done (eg. "badwill is fake capital"). VALUE ≠ SOLVENCY! When you buy €1,200bn of equity for €650bn, you get €1,200bn of equity, simple.

If only badwill didn't appear in the income statement but rather went straight to equity in the balance sheet! Then people wouldn't be lulled into thinking a free gift had arrived and inventing uses for it when in fact it's (probably) fully deployed. ENDS.