When a bank acquires another one, goodwill as intangible asset goes on its balance sheet. When a medium bank acquires a smaller one, goodwill is created onto the balance sheet. But, when the medium bank is acquired by a larger one, there is a compounding effect given that the larger bank will also create some more goodwill of its own and therefore inflates its balance sheet.
As the process goes on and on, for banks on the acquisition war path, you find more and more goodwill making up the capital.
On June 29, 2001, The Financial Accounting Standards Board (FASB) unanimously voted in favor of Statement 142, Goodwill and Other Intangible Assets. Prior to this statement, goodwill was amortized over its useful life not to exceed forty years. Under FASB 142, goodwill will still be recognized as an asset, however, amortization of goodwill will no longer be permitted. Instead, goodwill and other intangibles will be subjected to an annual test for impairment of value. This will not only affect goodwill arising from acquisitions completed after the effective date, but will also affect any unamortized balance of goodwill.
According to the Financial Accounting Standards Statement No. 142, goodwill is not amortized but is instead tested for impairment at the reporting unit level at least annually.
An exemple of Goodwill Impairment Test can be found here:
Deutsche Bank Annual report:
On the 13th of February 2008, this was the situation for some well known American Banks:
Bank Goodwill/ Capital
Bank of America 53%
Capital One 53%
Sovereign Bank 54%
And what is the return on goodwill? Probably zero given it cannot be easily deployed.
Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks:
Following the financial crisis, there have been a steady rise in Goodwill impairments for many financial institutions.
Charlotte-based Wachovia, now owned by Wells Fargo & Co., took more than 24 billion USD in goodwill impairment charges in 2008 as it struggled in the financial crisis.
Royal Bank of Canada took in April 2009 a non-cash related impairment of 850 millions USD impairment related to its US banking business impacted by the declining US housing market as stated below.
Global Banking News-20 April 2009-Royal Bank of Canada to take goodwill impairment(C)2009 ENPublishing - http://www.enpublishing.co.uk
"Royal Bank of Canada (TSX:RY) has announced that it is expecting to take a goodwill impairment charge.
The bank is expected to take a USD850m non-cash goodwill impairment charge for the second quarter on its US banking business. The bank said that the charge would be taken because of the declining US housing market and overall economy. The charge followed a two-step review started last quarter.
In a statement, the bank said, 'This expected charge reflects the impact of prolonged challenging economic conditions that have affected our international banking reporting unit. We have now completed the second step of the testing process and have determined that the international banking reporting unit goodwill is impaired, resulting in the expected charge to second quarter earnings."
More recently DBS posted a second quarter loss on a 747 Millions USD Impairment charge:
"DBS Group Holdings Ltd., Southeast Asia’s biggest bank, reported an unexpected second-quarter loss as it booked a one-time goodwill impairment charge at its Hong Kong unit because of pressure on interest margins.
The loss of S$300 million ($220 million) compares with net income of S$552 million a year earlier, the company said in a statement today. The average estimate of eight analysts surveyed by Bloomberg was for a profit of S$572.9 million. Excluding the S$1.02 billion goodwill charge, DBS’ net income for the second quarter rose 30 percent to S$718 million."
Goodwill impairment charge is sometime viewed that a bank or one of its franchise is impaired.
The questions you need to ask yourself when looking at the valuation of a bank is: What the bank is going to do with its business and the capital deployed in it, and, how it is going to increase the return on that capital?
"Banks wrote down more than $25 billion in good will in 2008, up sharply from $790 million a year earlier, according to data compiled by Frank Schiraldi of Sandler O’Neill & Partners. By the end of the year, banks still had $291 billion worth of good will on their books. An incomplete tally of write-downs from the first quarter showed that banks had taken a $3.5 billion hit to good-will values."
The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks.
As indicated clearly by Susan Osterfelt in her article Goodwill Hunting:
"A large amount of goodwill on a company's balance sheet could be an indication that the company's acquisition premiums, which may have been justified at the time of acquisition, may result in future write-downs based on the annual test for impairment. This puts us all in the position of being goodwill hunters."
As a reminder:
AOL Time Warner recorded a goodwill impairment of 54 billion USD in 2002, reflecting its "difficulty in realizing the value of the merger of AOL with Time Warner", which represented for me at the time the best representation of the internet bubble, when the over pumped AOL merged with the solid Time Warner. I know the story, it was different this time...
Large Goodwill Impairments increase the debt to equity ratio.
Bank of America had a total of 85.8 billion USD in goodwill counted as part of its 2.4 trillion USD in assets as of the end of the second quarter 2010. Bank of America Corporation reported a net loss of 7.3 billion USD, or 0.77 USD per diluted share, in the third quarter of 2010, including a non-cash, non-tax deductible goodwill impairment charge of 10.4 billion USD.
As we can see in the above example for Bank of America, Goodwill Impairments can hurt income significantly, without impacting capital. Countrywide represents 4.4 Billions USD of Goodwill in Bank of America's balance sheet.
It is therefore paramount to track goodwill impairments in relation to future banks earnings. As we can see in the case of Bank of America and DBS, the impact on the income can be very significant.