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  • Writer's pictureChris Thorne

Dear Prudence …won’t you come out to play?

Little did Lennon and McCartney envisage that fifty years on from their plea to Prudence to emerge from her meditation on the “White Album” would she indeed come out to play as a key principle in the regulation of banks. Regulators are indicating prudence should be a cornerstone for establishing the value of real estate held as loan collateral. Unfortunately, in contrast to the clear framing of the many qualities of Prudence by the Beatles, what the concept means in the context of valuation is currently far from clear.


The Basel Committee on Banking Supervision (BCBS) comprises central banks and bank supervisors from 28 jurisdictions including all the world major economies. Its mission is to set standards for the “prudential” regulation of banks, so it is not surprising that derivations of the “P” word feature regularly in those standards. The most recent package of standards, Basel III, was introduced in 2017 and included many detailed amendments to reflect lessons learned from the 2008 Financial Crisis. Governments around the world have been moving to align their regulations with Basel III ever since.

The Basel III provisions for lending secured against real estate explain that the value of the property:

“..must be appraised independently using prudently conservative valuation criteria. To ensure that the value of the property is appraised in a prudently conservative manner, the valuation must exclude expectations on price increases and must be adjusted to take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan. National supervisors should provide guidance setting out prudent valuation criteria where such guidance does not already exist under national law. If a market value can be determined, the valuation should not be higher than the market value.”

It will be noted that “prudent value” is not actually defined. Instead, BCBS leave setting detailed guidance on the criteria to national supervisors, reflecting the fact that BCBS is a forum for cooperation and collaboration between sovereign governments but has no enforcement powers of its own. However, the above explanation does raise a number of unanswered questions. It concludes by saying that, if market value can be determined, then the value used by the bank for determining its Loan to Value ratio should be no more than this. No definition of market value is provided. The IVS definition is the definition that is most widely recognised at present, at least for real estate valuation, and is already embedded in many existing regulations, for example in the European Central Bank’s Asset Quality Review Manual.

As a well-established and understood basis it might be thought that any figure at or below the IVS definition of Market Value would be a prudent valuation. However, Basel III introduces uncertainty to this interpretation with the two provisos that the valuation must exclude:

  • expectations on price increases and,

  • the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan.

With regard to the first point, the IVS definition requires the hypothetical buyer and seller to be acting “knowledgeably, prudently and without compulsion”. The accompanying conceptual framework goes on to explain that both parties are motivated to agree the price most favourable to their position. All prices agreed on a given date reflect the respective parties’ expectations for values to increase or decrease at a later date. Market Value requires the assumption that the parties are both knowledgeable about the market. All available data on prices agreed will reflect the parties’ expectations on the date of agreement. Does Basel III expect some unspecified adjustment to that data so it no longer reflects market behaviour and, if so, where does it come from?

The problem with the second point is that the IVS definition of Market Value (and for that matter most other value definitions) require an estimate of the value at a given date. Markets fluctuate and prices increase and decrease over time, generally in line with macro-economic trends. So, while the Market Value on a given date should reflect the general expectation of future trends in value, both in the long and short term, the actual value at a future date is unknown and unknowable. While historic data can be used to predict future trends and whether a fall in the current Market Value is probable over the life of the loan, this is an estimate of the Value at Risk (“VaR”) not a valuation. VaR is a risk assessment technique used across the financial markets which calculates a probability-based estimate of the loss that can expected over a given period. There are different statistical models used for different assets and examination of these is outside the scope of this article. The key point is that while a market valuation should reflect market expectations on the relevant date, the probability of these expectations proving to be wrong over time is a distinct exercise that has no effect on the current value estimation itself.

If the high level principles in Basel III introduce a level of uncertainty, can we hope that the regulations to implement these principles at a national level bring clarity? Unfortunately, the current indications are not promising. In the European Union the current regulations on banking solvency ratios are found in the Capital Requirements Regulations (“CRR”) 2013. These set out the risk weighting requirements for a bank’s exposure secured by a mortgage on immovable property (real estate). Article 229 requires the collateral to be “… valued by an independent valuer at or at less than the market value. An institution shall require the independent valuer to document the market value in a transparent and clear manner.” There is a further option for Mortgage Lending Value to be used instead of market value in those States that have rigorous criteria for its determination.

The CRR are currently being amended to reflect Basel III. The European Commission is proposing that Article 229 be replaced by the following:

"(b) the value is appraised using prudently conservative valuation criteria which meet all of the following requirements:

(i) the value excludes expectations on price increases;

(ii) the value is adjusted to take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan;

(c) the value is not higher than a market value for the immovable property where such market value can be determined."

All the Commission has done is to lift text from the Basel III explanation and with it the inherent ambiguities. The Commission has indicated that the European Banking Authority (“EBA”) will be tasked with providing Regulatory Technical Standards on prudential valuation criteria before the likely operational date of the amended CRR. Unfortunately, a recommendation by the European Parliament’s Committee on Economic and Monetary Affairs (ECON) that this amendment should be withdrawn and the current Article 229 reinstated has not carried through to the “final draft” of the new CRR. ECON argued that changing the well establish valuation requirements for an alternative for which there is no operational experience or consensus on interpretation would be disruptive to markets and create uncertainty. We couldn’t agree more. Even if the EBA does produce new standards over the next twelve months, it will surely take significant time for these to be promulgated and consistent application agreed across the diverse real estate markets in the EU.

One potential problem is that “prudent value” is not a concept which is confined to real estate in either the Basel accords or the CRR. The EBA already has technical standards for the "prudent value" of financial instruments held in an institution's Trading Book. These define prudent value as a value with a confidence level of 90%. Many instruments are traded in high volumes on a daily basis and therefore the data is available to establish a confidence interval. The EBA does acknowledge that for some illiquid instruments there may not be sufficient data to statistically achieve a specified level of certainty but nevertheless consider specifying a target level was the most appropriate way to achieve greater consistency in the interpretation of a “prudent value”.

Compared with the millions of instruments traded on a daily basis, real estate is very much at the illiquid end of the asset scale. It has to be hoped that EBA recognises that its statistical solution for requiring adjustments to Fair Value under Article 105 of the CRR will not be operational in relation for real estate collateral. If it considers IVS Market Value as properly applied does not meet the Basel prudent value criteria then it is going to have to find another way of determining what adjustments are needed.

It is therefore important that the real estate profession seeks engagement with the EBA as soon as it becomes clear that the wording in the final draft of the new CRR is that which will be enacted. The case needs to be made that:

  1. no valuation based on market based evidence can exclude all expectations of future price increases, just any which are highly speculative and which would not be made by a buyer acting knowledgeably and prudently in accordance with the IVSC definition of Market Value. There is therefore no reason why a Market Value based on the IVS definition should not be regarded as prudent.

  2. while adjustment may be required to a Market Value at any given point in time if there is potential for it to be “unsustainable” over the length of the loan, this is a Value at Risk exercise to be undertaken by the bank, and is distinct from the independent assessment of Market Value that is required.

  3. due to the relative illiquidity and heterogeneous nature of real estate whether a Market Value can be considered prudent cannot be determined by reference to confidence intervals.

This is not to say that the Market Value of real estate collateral at a given point in time is necessarily the best measure on which to base lending decisions. Market Value can act pro-cyclically, i.e. it can amplify fluctuations in value arising from cyclical changes in demand. A recent study “Approaches for Prudent Property Valuations across Europe” supported by RICS, IVSC and TEGoVA found that there was widespread acceptance that additional valuation advice to lenders and borrowers is required. It examined the potential for “through the cycle” or “long term“ valuation models. This paper has led to funding being obtained by the lead authors for detailed research into the feasibility and acceptability of such models. The report on that research is due soon and although this may well recommend changes to current practice, much further work and consultation with all stakeholders will be required before any changes can be agreed and made operational whether that be by regulators, lenders or valuers.

In the meantime, perhaps it is better to just leave Prudence to her meditations in the hope that clarity of thinking emerges.

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