Collateral valuation of immovable and movable property
This section sets out the key elements for collateral valuation of immovable and movable property pledged for NPEs.
9.1Governance, procedures and controls
9.1.1General policy and procedures
A credit institution should have in place a written policy and procedures governing the valuation of property collateral. The policy and procedures should be fully aligned with the credit institution’s RAF.
The policy and procedures should cover the valuation of all immovable and movable property collateral irrespective of its eligibility for prudential purposes in accordance with the requirements of Article 208 and Article 210 of Regulation (EU) No 575/2013.
The policy and procedures should be approved by the management body and should be reviewed at least on an annual basis.
9.1.2Monitoring and controls
Credit institutions should monitor and review the valuations performed by internal or external appraisers on a regular basis as set out in this section.
Credit institutions should develop and implement a robust internal quality assurance policy and procedures for valuations conducted internally and externally, considering the following:
a) The quality assurance process should be carried out by a function that is independent from the function conducting the initial valuation, loan processing, loan monitoring and the underwriting process.
b) The independence of the external appraiser selection process should be tested on a regular basis as part of the quality assurance process.
c) An appropriate, similar sample of internal and external valuations should be compared with market observations on a regular basis.
d) Back-testing of both internal and external valuations should be carried out on a regular basis.
e) The quality assurance process should be based on an appropriate sample size.
In addition, the internal audit function should regularly review the consistency and quality of the valuation policy and procedures, the independence of the appraiser selection process and the appropriateness of the valuations carried out by both external and internal appraisers.
9.1.3Individual valuation of immovable property and use of indexation
Credit institutions should monitor the value of immovable property collateral on a frequent basis and at a minimum as specified in Article 208(3) of Regulation (EU) No 575/2013.
Indexation or similar methods may be used to monitor the value of a collateral and identify the collaterals requiring revaluation. This should be in line with the institution’s policy and provided that the collateral to be assessed is susceptible to accurate assessment by such methods.
Indices used to carry out this indexation may be internal or external as long as they are:
a) reviewed regularly, with the results of this review being documented and readily available, and with the review cycle and governance requirements being clearly defined in a policy document approved by the management body;
b) sufficiently granular, with the methodology being adequate and appropriate for the type of collateral in question;
c) based on a sufficient time series of observed empirical evidence of actual property transactions.
Valuations and revaluations of immovable property collateral should be performed on an individual and a property-specific basis. Valuations and revaluations of immovable property collateral should not be carried out using a statistical model as the sole means of undertaking the review of the property valuation.
Competent authorities should define a common threshold for the individual valuation and revaluation of the collaterals used for NPEs by an independent appraiser. This threshold should be applicable to all credit institutions in the authority’s jurisdiction and should be publicly disclosed.
9.1.4Appraisers
All valuations of immovable property, including updated valuations, should be performed by an independent and qualified appraiser, internal or external, who possesses the necessary qualifications, ability and experience to execute a valuation, as specified in Article 208(3)(b) and Article 229 of Regulation (EU) No 575/2013.
For the purposes of external appraisals, credit institutions should establish a panel of independent and qualified appraisers, based on the criteria set out below. The appraisers’ performance should be assessed on an ongoing basis and a decision should be made about whether each appraiser should remain in the panel or not.
Credit institutions should ensure that external appraisers on the panel have adequate and valid professional indemnity insurance.
The credit institution should ensure that each qualified appraiser on the panel:
a) is professionally competent and has at least the minimum educational level that meets any national requirements for carrying out such valuations;
b) has appropriate technical skills and experience to perform the assignment;
c) is familiar with, and able to demonstrate ability to comply with, any laws, regulations and property valuation standards that apply to the appraiser and the assignment;
d) has the necessary knowledge of the subject of the valuation, the relevant property market and the purpose of the valuation.
A panel of appraisers should contain expertise in various areas of the property sector appropriate to the lending business of the credit institution and the location of lending.
In order to mitigate any conflict of interest sufficiently, credit institutions should ensure that all internal and external appraisers who are going to carry out the actual appraisal of a given property and their first-degree relatives meet the following requirements:
a) They are not involved in the loan processing, loan decision or credit underwriting process.
b) They are not guided or influenced by the borrower’s creditworthiness.
c) They do not have an actual or potential, current or prospective conflict of interest regarding the result of the valuation.
d) They do not have an interest in the property.
e) They are not a connected person to either the buyer or the seller of the property.
f) They provide an impartial, clear, transparent and objective valuation report.
g) The fee they receive is not linked to the result of the valuation.
Credit institutions should ensure adequate rotation of appraisers, i.e. two sequential individual valuations of the immovable property by the same appraiser should result in the rotation of the appraiser, resulting in the appointment of either a different internal appraiser or a different external appraisal provider.
9.2Frequency of valuations
For prudential purposes, credit institutions should update valuations of all secured exposures in accordance with the requirements of Article 208(3) and Article 210(c) of Regulation (EU) No 575/2013.
The group of collaterals that are subject to individual valuations and revaluations on a regular basis should be updated at the time when the exposure is classified as non-performing and at least annually while it continues to be classified as such. Credit institutions should make sure that, for the collateral subject to indexation or other similar methods, the indexation is updated at least annually.
For properties with an updated individual valuation that has taken place within the past 12 months (in line with all the applicable principles and requirements as set out in this section), the property value may be indexed up to the period of the impairment review.
Credit institutions should carry out more frequent monitoring where the market is subject to significant negative changes and/or where there are signs of significant decline in the value of the individual collateral.
Therefore, credit institutions should define criteria in their collateral valuation policy and procedures for determining if a significant decline in collateral value has taken place. Where possible, these will include quantitative thresholds for each type of collateral, based on the observed empirical data and any relevant qualitative credit institution experience, bearing in mind relevant factors such as market price trends or the opinion of independent appraisers.
Credit institutions should have appropriate processes and systems in place to flag outdated valuations and to trigger valuation reports.
9.3Valuation methodology
9.3.1General considerations
Credit institutions should have defined collateral valuation approaches for each collateral product type; these should be adequate and appropriate for the type of collateral in question.
All immovable property collateral should be valued on the basis of market value or mortgage lending value, as specified under Article 229 of Regulation (EU) No 575/2013. Movable property should be valued at its market value.
For movable property, credit institutions should, in accordance with the requirements of Article 199(6) of Regulation (EU) No 575/2013, periodically assess the liquidity of the property. If there is material volatility in the market prices, the institution should demonstrate that the valuation of the collateral is sufficiently conservative.
For movable property, credit institutions should, in accordance with the requirements of Article 210 of Regulation (EU) No 575/2013, conduct a sufficient legal review confirming the enforceability of the collateral, including an assessment of the legal right to enforce and liquidate the collateral in the event of default, within a reasonable timeframe.
Overall valuations based only on the discounted replacement cost should not be used. For income-generating properties, a market-comparable or discounted cash flow approach can be used.
9.3.2Expected future cash flow
Credit institutions should estimate discounted cash flow in a prudential manner and in line with applicable accounting standards.
Calculation of discounted cash flow should take into account cases where:
a) the operating cash flow of the borrower continues and can be used to repay the financial debt, and collateral may be exercised to the extent that it does not influence operating cash flow; and
b) the operating cash flow of the borrower ceases and collateral is exercised.
When the estimation is based on the assumption that the operating cash flow of the borrower will continue, including cash flow being received from the collateral, updated and reliable information on cash flow is required.
When the estimation is based on the assumption that the operating cash flow of the borrower will cease, the future sale proceeds from collateral execution should be adjusted to take into account the appropriate liquidation costs and market price discount.
In addition to the above liquidation costs, a market price discount, if appropriate, should be applied to the updated valuation as outlined below.
The property price at the time of liquidation should take into account current and expected market conditions.
Time-to-sale considerations in connection with the disposal of mortgaged properties should also be included, based on debt enforcement practices and experiences from judicial proceedings at national level and on empirical evidence, and back-tested accordingly. These considerations should include any operational costs or capital expenditures to be incurred before the time of sale.
The execution of collateral may include both consensual and non-consensual (forced) liquidation strategies.
The liquidation cost discount should reflect the manner of collateral execution, i.e. whether it is consensual or non-consensual.
The market price discount should reflect the liquidity of the market and the liquidation strategy. It should not reflect fire sale conditions unless the anticipated liquidation strategy actually involves a fire sale.
Credit institutions should apply adequate market price discounts for the purposes of IFRS 9, for the calculation of regulatory capital and for risk control purposes. A market price discount may be close to zero only for highly liquid and non-distressed collateral types that are not affected by any significant correlation risks.
All credit institutions should develop their own liquidation cost and market price discount assumptions based on observed empirical evidence. If insufficient empirical evidence is available, discount assumptions should be based on, at a minimum, liquidity, passage of time, and the quality/ageing of the appraisal. If a credit institution faces the situation of a frozen property market and only a small number of properties have been sold or the sales history has to be considered insufficient, a more conservative market price discount should apply.
9.4Further considerations on estimating cash flow from property collateral liquidation
In estimating cash flow from property collateral liquidation, credit institutions should use appropriate and credible assumptions. In addition, credit institutions should pay attention to the requirements for valuing cash flow under IFRS 13 on fair value measurements. In particular, financial institutions should comply with the following requirements:
a) They must determine the assumed time of disposal taking into account current and expected market conditions as well as the underlying national legal framework regarding the disposal of mortgaged properties.
b) They must ensure that the property price used to determine the estimated market value of property collateral at the point of liquidation is not based on macroeconomic projections/assumptions that are more optimistic than the projections produced by the relevant authorities and organisations such as International Monetary Fund (IMF) and the European System of Central Banks (ESCB)/ the European Systemic Risk Board (ESRB), and therefore does not assume an improvement on the current market conditions. c) They must ensure that income from property collateral is not assumed to increase from the current levels unless there is an existing contractual arrangement for such an increase. Moreover, current income from property should be adjusted when calculating cash flow in order to reflect the expected economic conditions. Credit institutions should consider whether it is appropriate to project a flat income in a recessionary environment in which vacant properties are increasing and/or demand for transportation is decreasing, putting downwards pressure on income.
d) A hold strategy on property collateral is not acceptable. A hold strategy is defined as holding the asset at above market value assuming that the asset will be sold after the market recovers.
When using the value of collateral in assessing the recoverable amount of the exposure, at least the following should be documented:
a) how the value was determined, including the use of appraisals, valuation assumptions and calculations;
b) the supporting rationale for adjustments to appraised values, if any;
c) the determination of selling costs, if applicable;
d) the assumed timeline to recover;
e) the expertise and independence of the appraiser.
When the observable market price is used to assess the recoverable amount of the exposure, the amount, source and date of the observable market price should also be documented.
Credit institutions should be able to substantiate the assumptions used when assessing the recoverable amount by providing to the competent authority, if requested, details on the property market value, the market price discount, legal and selling expenses applied, and the term used for the time to liquidation. Credit institutions should be able to fully justify their assumptions, both qualitatively and quantitatively, and explain the drivers of their expectations, taking past and current experience into account.
9.5Back-testing
Credit institutions should demonstrate via sound back-testing that the assumptions used when assessing the recoverable amount were reasonable and grounded in observed experience. In this context, credit institutions should regularly back-test their valuation history (last valuation before the exposure was classified as non-performing) against their sales history (net sales price of collateral). Depending on the size and business model of the credit institution, it should differentiate by collateral type, valuation model/approach, type of sale (voluntary/forced) and region for its back-testing process. The back-testing results should be used to determine haircuts on collateral valuations supporting exposures remaining on the balance sheet.
Alternatively, credit institutions using the advanced internal ratings based (A-IRB) approach may use secured loss given default (LGD) to determine haircuts.
9.6IT database requirements in respect of collateral
Credit institutions should have databases of transactions to enable the proper assessment, monitoring and control of credit risk, to respond to requests from management and supervisors, and to enable the provision of information in periodic reports and other timely and comprehensive documentation. In particular, databases should comply with the following requirements:
a) sufficient depth and breadth, in that they cover all the significant risk factors;
b) accuracy, integrity, reliability and timeliness of data;
c) consistency – they should be based on common sources of information and uniform definitions of the concepts used for credit risk control;
d) traceability, such that the source of information can be identified.
These databases should include all the relevant information on properties and other collateral for the credit institutions’ transactions and on the links between collateral and specific transactions.
9.7Valuation of foreclosed assets
Credit institutions should strongly consider classifying foreclosed assets as non-current assets held for sale under IFRS 5. This accounting treatment implies that the asset must be available for immediate sale in its present condition (IFRS 5.7), that the management body should approve an individual plan to sell the asset within a short timeframe (normally one year) and that an active sales policy should be pursued (IFRS 5.8); thus, it favours recoveries.
Foreclosed assets received should be valued at the lower of:
a) the amount of the financial assets applied, treating the asset foreclosed or received in payment of debt as collateral;
b) the fair value of the repossessed asset, less selling costs.
When fair value is not obtained by reference to an active market but is based on a valuation technique (either level 2 or level 3), some adjustments are necessary, in particular as a result of two factors: a) The condition or location of the assets. Risk and uncertainty regarding the asset should be incorporated in the fair value estimation.
b) The volume or level of activity of the markets in relation to these assets. The credit institution’s previous experience of the entity in realisations and of the differences between amounts arrived at using the valuation technique and the final amounts obtained in realisations should be incorporated into the calculation. The assumptions made in order to measure this adjustment may be documented, and should be available to the supervisor on request. Illiquidity discounts may be considered.
When credit institutions’ foreclosed assets are still under construction and it is decided to complete construction before selling the asset, they should demonstrate the merits of such a strategy and the cost should not exceed the fair value less costs to complete and sell the asset taking into account an appropriate illiquidity discount as described above.
When a foreclosed asset has exceeded the average holding period for similar assets for which active sales policies are in place, credit institutions should revise the illiquidity discount applied in the valuation process described above, increase it accordingly. In these circumstances, the credit institution should refrain from recognising write-backs/reversals of existing accumulated impairment on the asset, as its prolonged presence on the balance sheet provides evidence that the credit institution is unable to sell the asset at an increased valuation.
The frequency of valuation of foreclosed assets and the applicable procedures should follow the treatment of immovable property as set out in sections 9.1.2 and 9.2.