Against the backdrop of recent European bank mergers, it is worthwhile examining the effects of acquisitions on regulatory capital. This is interesting because many European banks trade below book value. Normally, firms that acquire other firms pay a premium over book value to purchase the target firm. This premium is called goodwill. However, with the current low valuations of European banks, goodwill is nowhere to be seen. Instead, what matters in this context is the ugly ‘twin’ of goodwill: badwill.

There are some misconceptions about badwill. The Economist, for example, mentions that accounting for badwill “enables banks to use [it] to offset restructuring charges”. The ECB in July warns banks not to waste badwill. Instead, it should “be used to increase the sustainability of the business model of the combined entity, for example by increasing the provisioning for non-performing loans, to cover transaction or integration costs, or other investments”.

However, I am not so sure. Accounting is not alchemy. Combining two weak banks into one should not magically create profits that can subsequently be wasted or put to good use.

In this post, I will attempt to illustrate the accounting for badwill. But, before I start, I’d like to thank Adrian Docherty, who wrote on the accounting treatment of badwill. My contribution to this discussion is to show some examples to clarify.

Workings of the base case:

Suppose there are two banks: a big EU bank and a Buying bank. See the picture below. EU bank data are from the ECB Statistics Data Warehouse, amounts are in billions. The Buying bank will acquire the EU bank, a bank that currently trades at a value below its book value: €1,520 versus €487. ‘TA’ is Total Assets, ‘Liab’ is liabilities, ‘EQ’ is Equity, and ‘MV’ is the market value of the bank. RWA is Risk-weighted assets, and CET1 is Common Equity Tier 1, the numerator of the headline solvency ratio: the CET1 ratio. Feel free to explore the workings using this link to the underlying Google Sheet.

Note that both banks are about the same size and have the same CET1 ratio (14.4%). The buying bank has a book value of €1,586, which, for the sake of illustration, equals its market value. Note also that the proportion of CET1 capital to Equity is the same for both banks (79%): the quality of capital for banks is the same.

The next picture shows the buying bank preparing for the take-over. It issues equity capital to its shareholders to buy the EU bank for €478.

The issuing bank obviously sees its CET1 ratio jump: more equity but zero effect on RWAs because cash has zero risk weight. The target bank remains unaffected.

The next picture shows the post-acquisition balance sheets. The main item that changes is ‘Cash’, which now becomes ‘Share in EU bank.’ The risk weights of the buying bank also change because of Art 49.4 CRR: whereas cash has no risk weight, a holding in a bank has. At the bank-level, a holding gets a 250% risk weight.

Now, I hear you say, the Buying bank has a higher CET1 ratio than before. It is now 17.6%, up from 14.4% How come?!? But the elevated CET1 ratio is kinda misleading because the increase in the ratio is primarily driven by the shares that the bank issued, not by the purchase of the EU bank.

Supervision at the consolidated level.

More importantly, under Basel III rules, bank supervisors focus on the consolidated accounts of a banking group, not on individual accounts:

You obtain the values of the consolidated accounts by i) summing the assets (and liabilities, but not equity) of the individual banks, and ii) eliminating any cross-holdings between individual banks. The value of Total Assets at the consolidated level thus is the sum of the post-acquisition assets net of the value of the holding in the EU bank sub of €487: €25,487 + €23,959 – €487 = €48,959. Likewise, the value of Liabilities is €23,414 + €22,439 = €45,853.

Note that the value of Total Assets is also the sum of the pre-acquisition assets of €25,000 + €23,959 = €48,959. The value of the Risk-weighted assets is the sum of the pre-acquisition RWA’s.

What have we learned?

The base case example shows that the acquisition has neither created nor destructed any value. Total assets, Risk-weighted assets, and liabilities are unaffected. CET1 capital is €2,450, which is, as before the acquisition 79% of Equity. Because of this all, the CET1 ratio should be the same: 14.4%. The quality and the quantity of capital have not changed after the acquisition, and the acquisition did not create any gains or overcapitalisation.

Workings of the base case with badwill:

The base case does not mention badwill – at all. I deliberately left badwill out because it is a distraction. For risk-management purposes, the base case offers the relevant information. Nevertheless, it is worth illustrating the example and highlight badwill.

The next pictures show what happens when one applies accounting rules for the treatment of badwill.

The picture shows that badwill is now separately recorded to highlight the effects of the journal entry. In reality, if the bank applies IFRS3, the amount of badwill will be recorded as a gain in the profits and loss account:

This gain subsequently boosts equity, that is, of the acquiring bank:

Thanks to the dovish Articles 49.2 and 49.4 of the CRR, the CET1 ratio shoots up to 22.2%. But, as you may have noticed from the IFRS3 quote above, the gain in equity should not be taken for granted: “the acquirer is required to undertake a review to ensure the identification of assets and liabilities is complete, and that measurements appropriately reflect consideration of all available information. [IFRS 3.36]”. The IFRS has done most of the legwork on the treatment of badwill, there is no need per se for the supervisor to step in.

But, at the consolidated level, applying the same logic as above, plus ça change:

What have we learned?

Again, nothing changes at the consolidated level, the point of focus of the supervisor. One should appreciate that there are many issues that affect the solvency ratios of individual banks. Most of these (but not all*) wash away in consolidation. It is therefore unclear to me why the ECB, the supervisor who is meant to primarily supervise at the consolidated level, warns about the improper use of badwill.

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* See this book by Charles Morris on the Law of Financial Services Groups. Morris highlights the point I make in this post, solvency calculations at the bank-entity level only imperfectly aggregate into group-level capital.