Regulators and investors should be sceptical of paper profits generated by high bids, writes Simon Samuels.
Andrea Enria, who chairs the European Central Bank’s supervisory board, signalled earlier this year that the body is actively looking at ways to make bank mergers and acquisitions easier. But the ECB is deploying more than just warm words. It is also smiling favourably on an accounting manoeuvre that will make deals more possible — the creation of negative goodwill or, as it is more widely referred to, “badwill”.
Indeed, leaders of Italy’s second-largest bank, Intesa Sanpaolo, specifically cited the generation of several billion euros of badwill as an important rationale for their recent unsolicited €4.9bn bid for smaller rival UBI Banca. That is because, in the sometimes topsy-turvy world of bank accounting, badwill is good and goodwill is bad.
[...] valuations are upside down today for most European banks: most of them have a market capitalisation that is below their book value. In the case of UBI Banca, despite Intesa’s offer price of €4.9bn being 30 per cent higher than its current share price, it is below UBI Banca’s book value of nearly €8bn. Intesa is paying less than the accountants say UBI Banca is worth. This gap between the price paid and the book value is badwill.
For banks, this badwill could have enormous value. The ECB has been hinting that banks will be able to boost their capital ratios, by generating a one-time paper “profit” that counts as capital. Mr Enria alluded to this possibility last summer when commenting on potential badwill arising from the aborted Deutsche Bank/Commerzbank merger.
Intesa is so certain that this badwill will be available that it has already outlined to investors how it would use it. And with most European banks currently trading well below their book value — thus creating the possibility for badwill — the ECB’s generous treatment could encourage bank-sector M&A.
But is this sensible? It is widely accepted that paying €100 for assets valued at €50 creates a negative charge that needs be written off. But does paying €50 for assets valued at €100 really create a windfall that can then be spent? The answer depends on whose valuation we should trust. Is UBI Banca worth the €3.8bn the stock market awarded it before the bid, the €4.9bn Intesa is offering, or the €8bn the accounting book says its assets are worth?
Back in 2011 Andy Haldane, now chief economist at the Bank of England, tried to address this issue by comparing banks’ published capital ratios, which are based on book values, with “market based” capital ratios, where the book value was replaced with the stock market value. When he applied this to pre-2008 capital ratios, the results were emphatic. The accounting-based ratios completely failed to identify banks that would subsequently collapse, but the market-based ratios proved unerringly accurate. The collective wisdom of the stock market crowd knew more than accountants or regulators.
This conclusion has important implications for European bank M&A. Rather than presuming that a lender’s book value is accurate and considering adjustments during the sale process, perhaps regulators and investors should assume the stock market valuation is correct and acquirers should be forced to justify a higher offer. After all, it’s just possible that badwill really is bad.
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