Bank stocks have underperformed in the broad market since the beginning of the year and many currently trade below book value, which begs the question, is goodwill impaired? We discussed this topic most recently in June 2020 as banking stocks (along with the broad market) were pressured in 1Q20 based on fears from the COVID-19 pandemic. However, the market recovered quickly in 2H20 and set new highs in 2021 as interest rates were at historical lows, many banks benefitted from PPP and mortgage banking income, and immense liquidity flooded into the economy via government stimulus.
What once was the solution for the economy in 2020 now is a contributor to headaches for bankers in 2023. A combination of the influx in liquidity to the economy (and banking system) via government stimulus, supply disruptions from COVID and geopolitical events, and pent-up demand from reopenings led to higher inflation in 2021 and 1H22. The Federal Reserve attempted to cool inflation with an increase in short-term policy rates, from a range of 0.00-0.25% in March 2020 to 5.25-5.50% as of July 2023. However, the rise in interest rates led to unrealized losses on bond portfolios and pressure on deposit retention and funding costs.
Public bank stocks performed well when compared to the broader markets in 2022. The median stock price change of the 343 banks and thrifts traded on the NYSE and NASDAQ, was negative 9% in 2022, compared to negative 19% for the S&P 500 and negative 33% for the NASDAQ. However, banking stocks diverged from the broad market in 2023 with declines during the Spring of 2023 (March and April) as concerns about higher cost of funds, unrealized bond losses, and the collapse of three high profile banks (SVB, FRC, and SBNY) arose. Banking stocks generally bottomed during early to mid-May before recovering a portion of the decline more recently.
However, of the nearly 300 banking stocks we analyzed that trade on the NYSE and NASDAQ, approximately half continue to trade below book value as of July 25, 2023. Deal activity also slowed in 2H22 and year-to-date 2023 due to a combination of factors including fair value marks on bonds and loans, widening buyer and seller expectations, and pressures on profitability and public bank stocks. For perspective, there have been 43 whole bank acquisitions announced in the year-to-date period ended July 26, 2023. This compared to 86 deals in the same period in 2022 and 103 transactions in 2021.
Against this backdrop, the remainder of this article will discuss two common questions that arise for companies considering an impairment test.1
Goodwill impairment testing is typically performed annually, usually near the end of a Company’s fiscal year. In fact, many companies may have completed an impairment test as of year-end 2022. However, the factors noted above may raise questions about whether an interim goodwill impairment test is warranted for many banks.
The accounting guidance in ASC 350 prescribes that interim goodwill impairment tests may be necessary in the case of certain “triggering” events. For public companies, perhaps the most easily observable triggering event is a decline in stock price, but other factors may constitute a triggering event. Further, these factors apply to both public and private companies, even those private companies that have previously elected to amortize goodwill under ASU 2017-04.
For interim goodwill impairment tests, ASC 350 notes that entities should assess relevant events and circumstances that might make it more likely than not that an impairment condition exists. The guidance provides several examples, several of which are relevant for the bank industry including the following:
The guidance notes that an entity should also consider positive and mitigating events and circumstances that may affect its conclusion. If a recent impairment test has been performed, the headroom between the recent fair value measurement and carrying amount could also be a factor to consider.
Once an entity determines that an interim impairment test is appropriate, a quantitative “Step 1” impairment test is required. Under Step 1, the entity must measure the fair value of the relevant reporting units (or the entire company if the business is defined as a single reporting unit). The fair value of a reporting unit refers to “the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date.”
For companies that have already adopted ASU 2017-04, the legacy “Step 2” analysis has been eliminated, and the impairment charge is calculated as simply the difference between fair value and carrying amount.
ASC 820 provides a framework for measuring fair value which recognizes the three traditional valuation approaches: the income approach, the market approach, and the cost approach. As with most valuation assignments, judgment is required to determine which approach or approaches are most appropriate given the facts and circumstances. In our experience, the income and market approaches are most commonly used in goodwill impairment testing. However, the market approach may be limited in the current environment given the lower amount of transaction activity in 2023. In the current environment, we offer the following thoughts on some areas that are likely to draw additional scrutiny from auditors and regulators.
Are the financial projections used in a discounted cash flow analysis reflective of recent market conditions? What are the model’s sensitivities to changes in key inputs
At Mercer Capital, we have experience in implementing both the qualitative and quantitative aspects of interim goodwill impairment testing. To discuss the implications and timing of triggering events, please contact a professional in Mercer Capital’s Financial Institutions Group.
1A portion of the following text was excerpted from an article from my colleague Lucas Parris entitled “Goodwill Impairment Testing in Uncertain Times” https://mercercapital.com/article/goodwill-impairment-testing-in-uncertain-times/
