Banks Run on Standards

Oct 04, 2013

Standards are fundamental to lending. Financing necessarily involves judging both risk and reward and standards enable these judgments to be made in a consistent, predictable fashion. Lenders must evaluate a borrower’s ability to repay; therefore they must understand the borrower’s financial capabilities and the value of any offered collateral. Similarly, borrowers must understand lender’s terms and cost of funds to be borrowed.

Without standards these steps can be conducted but not in a meaningful way. Standards allow participants in the financial markets to make comparative judgments regarding alternatives. Borrowers can reasonable make comparisons among different lenders and lenders can consider different lending opportunities. Investors can compare different lenders and determine which to invest in. With standards, participants can be reasonable assured of speaking the same language. Without standards, evaluating data in order to reach a sound conclusion is highly challenged if not impossible.

As global commerce has increased, so have international standards. For example, international banking standards for capital requirements have been set with the Basel Accords beginning in 1988 with Basel I, in 2004 with Basel II and in 2013 with Basel III. Basel II emphasized three “pillars” including Minimum Capital Requirements, expectations for a Supervisory Review process for both internal management and for supervisors, and Market Discipline which standardizes disclosures to help market participants understand an institution’s capital adequacy.

Valuations are fundamental to lending. Lenders must have an understanding of the worth of collateral offered to support a loan. Valuations are a snapshot in time of the estimated value of the collateral, not a guarantee of its worth over the term of a loan and events subsequent to a valuation may significantly change market conditions and the value of the collateral. Nonetheless, valuations properly conducted by an unbiased valuer provide critical insight into the economics of the credit decision.

Standards underlie all valuations. Clients rely upon standards when engaging valuers for assignments. The standards set expectations for the work product. Adherence to standards allows the client and any other users, to gauge the credibility of the value estimate. Trust in that estimate is diminished to the extent the valuer deviates from the agreed-upon standard.

Standards set expectations for users and set performance criteria for valuers. To understand the valuation, one must understand the standards it was prepared under. Any review of a submitted valuation must start with a complete understanding of the standard it was prepared under.

There are four common elements underlying all valuations which must be addressed by a valuation standard. These four elements provide a foundation like legs on a chair to support the valuation and its credibility.

The first is the definition of value to be used. There are a surprising number of definitions and this is a fundamental decision that reverberates through the rest of the assignment. Is the value estimate to reflect the value to another market participant or to the current owner? Does the definition allow for the most probable value, the highest, or the lowest? If the definition presumes a hypothetical sale, are the parties to the transaction knowledgeable? Are the parties to the transaction unrelated? To understand a valuation, one must first understand the type of value used.

The second fundamental element is the relationship of the valuer to the parties and to the asset under consideration. If the valuer has a current or anticipated future relationship with the parties or the asset being valued, or has a vested interest in the outcome, the potential for bias on behalf of the valuer calls into question the credibility of the assignment result and can negate the user’s confidence in the value estimate. If the valuer does not have a relationship with the parties or the asset and does not have an interest in outcome of the assignment result, the question of bias is removed and the user can better trust the assignment results.

The third fundamental element is the valuer’s scope of work. The scope of work is the steps the valuer took to reach the valuation conclusion. This is the extent to which the valuer:

  • Identified the property and its characteristics
  • Searched for market data with which to value the property
  • Verified the market data considered
  • Conducted analyses using the market data
  • Reconciled estimates from analyses if more than one was used

The scope of work can reasonably vary depending upon the user’s intended use of the assignment results. The valuer is responsible for understanding the user’s intended use and for exercising professional judgment in determining the scope of work necessary to provide an assignment result that will be credible for the user in the specific context.

The fourth is the manner in which the valuation results are communicated with the client. Is the report to be written or is it oral? Is the asset to be described and if so to what extent? Is the supporting data to be provided or simply the concluded inputs used in the analyses? Is the analysis itself to be provided or simply the conclusion? These aspects should be understood and agreed upon by both client and valuer. Which standard is to be used? In some cases, neither the client nor the valuer have a choice in which standard is to be met. Standards can be imposed by regulators or professional organizations. In other circumstances no regulations require adherence to a particular standard, in which case the valuer may still choose to comply with a standard.

And why in the world would anyone chose to bring on standard compliance upon themselves? For the valuer, standards enhance credibility and trust in the assignment results. It helps frame the client’s expectations which can help the valuer in the event of a subsequent dispute with the client.

Globally, numerous standards exist. Some were developed by professional organizations, others by local or national governmental agencies. Regardless of the individual merits of such standards, the drawback they share is the burden they place on users who must re-learn a new standard each time a border is crossed or another professional group is encountered.

“It makes no sense for a similar valuation being undertaken in Moscow, Madrid or Melbourne to be conducted in entirely different ways. The financial community needs the valuation profession to come up with one accepted set of high quality, global valuation standards.”

—Sir David Tweedie, Chairman, IVSC Board of Trustees

International Valuation Standards are published by the International Valuation Council, a not for profit organization. International Valuation Standards provide the best opportunity for consistency and uniformity of expectations for valuation of assets and liabilities globally. Use of these standards will reduce the variations seen in valuations prepared under differing standards making review and acceptance of the valuation easier for lenders and regulators alike. Sir David Tweedie, Chairman of the IVSC Board of Trustees noted: “It makes no sense for a similar valuation being undertaken in Moscow, Madrid or Melbourne to be conducted in entirely different ways. The financial community needs the valuation profession to come up with one accepted set of high quality, global valuation standards.”

A common set of standards would benefit lenders, borrowers, investors and valuers providing services to lenders. Basel is setting common standards for capital adequacy. The International Valuation Standards has created common standards for valuation. So, as banks run on standards, the International Valuation Standards will help create a level and consistent road.

—Thomas D. Boyle, MAI is Chief Appraiser and Senior Vice President for U.S. Bank Real Estate Technical Services. He is responsible for appraisal and environmental services nationally. Boyle has provided valuation services for financing, litigation support, condemnation and assessment appeals. He was a national Board member of the Appraisal Institute (2000-2003), a certified instructor of the Uniform Standards of Professional Appraisal Practice (USPAP) and a member of the IVS Standards Board.