How A Tough Economy Could Affect The Goodwill Assets And Fi

Summary

In this episode of Credit Matters TV, Jeff and Jonathan News discuss goodwill impairments in banking, a significant issue affecting global balance sheets. Goodwill, an intangible asset from acquisitions, is not amortized but tested for impairment, with potential charges impacting banks' creditworthiness. The discussion highlights the substantial goodwill balances in top global banks, the real-world consequences of impairment charges, and how these can affect financial flexibility and overall credit health.

Takeaways

• 📈 Goodwill arises from business acquisitions and represents the premium paid to acquire another entity; it cannot be amortized and must be tested for impairment at least annually.
• 💹 Impairment charges can be substantial, impacting bank balance sheets and potentially leading to reputation risk, increased cost of capital, earnings expectation reductions, and breaches in debt covenants.
• 🌐 Goodwill impairment is a global concern, with the top 100 global rated banks holding goodwill and other intangibles worth approximately $814 billion.
• 🏦 Goodwill as a percentage of book value can be significant, sometimes representing 30-40% of a bank's book value, indicating a substantial exposure.
• 💼 The buildup of goodwill is often due to past mergers and acquisitions during more optimistic economic times, leading to sizeable goodwill balances that may not yet reflect current economic realities.
• 🔍 Accounting standards require goodwill to be tested for impairment, but the economic decline may not be fully recognized in the accounting, suggesting potential future charges.
• 📉 Companies may downplay goodwill impairment charges due to their non-cash and non-recurring nature, but these charges have real-world consequences that affect creditworthiness.
• 🔎 Indicators of potential goodwill impairment include operating in a challenging market environment, lower sustained market caps, and regulatory pressures affecting bank costs.
• 💡 The presence of goodwill impairment charges can signal potential issues with other assets on the balance sheet, as the bank's stress may not be fully reflected in asset valuation.
• 🏛️ Goodwill impairment can diminish a bank's financial flexibility and overall creditworthiness, affecting access to capital markets and potentially leading to changes in dividend policies.

Q & A

What is the accounting definition of goodwill?

Goodwill arises from a business acquisition and represents the premium one company pays to acquire another entity. It cannot be generated through organic growth and under US GAAP and IFRS, goodwill is not amortized but must be tested for impairment at least annually.

Why are goodwill impairment charges significant?

Goodwill impairment charges can be substantial and have real-world consequences such as increased cost of capital, reduced earnings expectations, potential breaches of debt covenants, and changes in future acquisitions, compensation structures, or dividend policy.

How widespread is the exposure to goodwill among the top global banks?

Goodwill exposure is fairly widespread, with the top 100 global rated banks having goodwill and other intangibles representing about $814 billion, and in some cases, constituting 30 to 40 percent of their book value.

How do banks typically build up goodwill on their balance sheets?

Banks build up goodwill primarily through acquisitions. There was significant M&A activity in the past decade, leading to sizeable goodwill balances as banks paid premiums to acquire other banks or branches.

Why might companies downplay goodwill impairment charges?

Companies may downplay goodwill impairment charges because they are non-cash and non-recurring, reflecting little or no immediate cash impact on their books. However, from a credit perspective, these charges have significant implications.

What are some indicators that might suggest potential goodwill impairment on a bank's balance sheet?

Indicators of potential goodwill impairment include operating in a difficult market environment, higher costs of capital, slower growth assumptions, ongoing regulatory and legislative actions, sustained low market caps, and recording DVA or dead valuation adjustments due to credit deterioration.

How can goodwill impairment affect a bank's overall creditworthiness?

Goodwill impairment can affect a bank's creditworthiness by diminishing financial flexibility due to factors such as increased headline reputation risk, reduced access to capital markets, and potential changes in dividend policies.

Why does the accounting for goodwill typically lag the economic reality?

The accounting for goodwill lags the economic reality because the economic value of goodwill may decline before the accounting standards fully recognize this decline, leading to a delay in the recognition of impairment charges.

What is the relationship between goodwill impairment and a bank's financial flexibility?

Goodwill impairment can directly impact a bank's financial flexibility by affecting its cost of capital, earnings expectations, and ability to meet debt covenants, which are all factors that influence the bank's overall creditworthiness.

How does Standard & Poor's view the potential future of goodwill impairment charges among banks?

Standard & Poor's expects to see more goodwill impairment charges in the coming months as the accounting catches up with the economic decline in goodwill values, especially given the challenging market conditions and regulatory pressures.