Goodwill towards bank M&A has misrepresented badwill
An accounting practice called badwill is central to debates about European bank M&A — but it probably should not be, as it leads to some confusing rhetoric.
Badwill is an accounting gain, triggered when Company A buys Company B at a price below B’s net asset value or net fair market value. Badwill recognises the difference between these two figures as profit for Company A.
Even if the name sounds more interesting than the definition, badwill is a hot topic because a wave of European bank consolidation may be underway.
Intesa Sanpaolo successfully bid for UBI Banca in a deal generating around €2.8bn of badwill, according to Intesa’s interim report. CaixaBank and Bankia have said they are exploring a merger, which would be likely to generate a lot of badwill too.
More tantalisingly for enthusiasts of European finance, UBS’s chair Axel Weber has reportedly looked into a deal with Credit Suisse. Both firms are trading at a price-to-book ratio of less than one, indicating that the badwill produced by such a merger would not just come from those investment bankers losing their jobs as a result.
Badwill is presented as helpful for banks: analysts say it could be used to absorb restructuring costs or loan provisions after a deal. Indeed, Intesa, in its interim report, suggested that it would deploy the gain for exactly those purposes. Its presentation said the gain “fully covers integration costs… and additional loan loss provisions to accelerate NPL [non-performing loans] deleveraging”.
The European Central Bank has also joined the badwill hype, saying in a recent guide on its approach to bank M&A that it would recognise the gain from a prudential perspective in principle.
However, it expected badwill “to 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”. This is as opposed to distributing the profits out to shareholders.
So, what’s the problem? Well, from the perspective of how well capitalised a bank is, badwill is actually irrelevant, as Adrian Docherty, head of FIG advisory at BNP Paribas, and co-author of the book Better Banking, points out.
Say that the proportion of equity to assets is the same at two different banks — or more specifically, the proportion of common equity tier one (CET1) to risk-weighted assets (RWAs) is the same. This means the banks have the same CET1 ratio.
If they merge, all their assets and liabilities are combined, and they end up with the same proportion of CET1 and RWAs as before, so the CET1 ratio remains the same.
Except, we are forgetting the cost of purchase here. If one bank paid the other’s shareholders in cash, that would reduce the capital ratio, everything else being equal. But the bank could, of course, have funded that through an equity raise — in which case the net effect on equity is zero.
So what matters for the resultant entity’s capital position after M&A is the starting capital position of the two merging banks, and whether there is a difference between what the acquirer pays in cash and the amount of equity it has raised.
Badwill is generated when banks are sold on the cheap (or to put it another way, when the market doubts their ability to turn net asset value into profits) and in this scenario an acquisition may be more easily funded through an equity raise or at least without affecting the balance sheet too much. So lots of badwill is likely to go hand-in-hand with an attractive acquisition opportunity. But that accounting gain itself is not really relevant.
A bank may generate so many millions in badwill and then deploy that amount towards restructuring costs or dividends. But the badwill is not in this case being “used” for restructuring or dividends, because the restriction on these types of activities is likely to be the capital position of the bank. And while badwill may raise the amount of CET1 in absolute terms in and of itself, the bank has also taken on all the RWAs from the sellers, plus perhaps paid up for them too.
GlobalCapital has to admit it has tripped up on this point before. But, in fairness, the way the ECB, Intesa and analysts talk about it also appears distorted.
Intesa’s investor relations team disagreed with GlobalCapital’s assessment, saying: “It’s not misleading. The negative goodwill is to be accounted for as revenue in the income statement and is part of the capital increase serving the acquisition against contribution in kind.”
It said that it has committed to maintaining a CET1 ratio of at least 13%.
An ECB spokesperson said: "The ECB welcomes a public debate about banking consolidation. It has recently launched a public consultation where we invite comments on our draft ECB guide on the supervisory approach to consolidation.
"This will allow us to further clarify our approach, including on aspects such as badwill, and enhance transparency and predictability of supervisory actions."
Many are urging on further European banking consolidation as the only way for the sector to be sufficiently profitable. This is quite possibly true. But goodwill shouldn’t mean reading too much into badwill.