05 July 2018

European Parliament: Valuation reports in the context of banking resolution: What are the challenges?

This paper gives an initial assessment of the preparation of valuation reports in resolution. It finds that there are still substantial uncertainties regarding the outcome of these valuations due to organisational, legal and economic challenges.

Accurate valuation reports are essential for the overall success of a bank resolution. If valuation reports are inaccurate they can drag out the financial distress or prompt shareholders and creditors to file suit and ask for compensation. This holds even more so now than in the past, when systemically important banks in need were supported by their national governments. Those valuations performed on an ad hoc basis were often inaccurate: For almost half of the banks that received public recapitalisation the initial estimated losses and capital requirements were too low, resulting in multiple rounds of public capital injections.

The introduction of the Single Resolution Mechanism with the bail-in of creditors has increased the importance of valuations, leaving less margin for error. If the valuation is too high, it might require additional capital injections including bail-ins later on. If the valuation is too low, it might require the Single Resolution Fund to compensate creditors in order to respect the ‘no creditor worse off’ principle and cause higher losses (hard bail-ins), which potentially might lead to more significant negative spillover effects on the economy, especially during systemic crises.

At the same time the valuation has been formalised in the single resolution mechanism, which includes three types of valuations, respectively, to determine whether a bank is failing or likely to fail (valuation 1), to inform the use of the resolution tools including bail-in (valuation 2), and to ensure that the no creditor worse off principle is respected (valuation 3). This analysis focuses on the second and third valuations, which are performed by independent valuators.

There are still major challenges to providing more robust results.

The main challenges include the time and information available to prepare the valuation, but there are also legal and economic challenges. The legal challenges, on the one hand, make it more difficult to come up with robust valuations (non-harmonised national insolvency regimes and misselling), while on the other hand they affect the credibility of the valuation (disclosure). The economic challenges primarily involve predicting the impact of deteriorating conditions just before the resolution and credible estimations of the economic developments afterwards.

Although there will always be some degree of uncertainty in valuations, there are definitely measures imaginable that could improve the accuracy of the valuations, in particular:

• improving the IT systems of the banks;
• increasing the use of historical data on previous bank failures;
• shortening the procedures to select the valuator;
• introducing a moratorium to allow a short suspension of payments if necessary; and
• harmonising the insolvency regime for eurozone banks in a way that integrates both resolution and insolvency.

The proposed measures address most of the challenges except for misselling, which could be addressed with consumer protection regulation and supervision to limit malpractice.

Full paper

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