Financial due diligence for banks in Taiwan
View this page in: 中文Conducting due diligence on an acquisition target prior to a merger is a proactive way of helping to reduce risk in an M&A transaction. Financial due diligence is a key aspect of the overall investigation, though its investigative focus may vary depending on the nature of each M&A case. In corporate M&A deals, the focus is generally on the quality of the target’s earnings. For financial services transactions, the quality of net assets is just as, if not more, important, because financial institutions (banks, insurance companies, securities and investment firms, etc.) mainly source their capital from the public, and are susceptible to high degrees of financial leverage and credit risk.
For example, an asset impairment of 3%-5% against a bank’s total assets could potentially erode its shareholder value by as much as 30%-40%. As the financial services industry is heavily regulated, the due diligence process also needs to consider the potential impact of the regulatory environment and market conditions on both the business and financial aspects of the banking target.
Assets
The majority of a bank’s total assets generally comprise loans and receivables, followed by various financial instruments, and real estate-related interests, as detailed below:
Loans and receivables
Loans can be broadly classified as either secured or unsecured, and according to their duration (short, medium or long-term), product type (commercial loans, residential mortgages, personal loans, motor loans, cash and credit cards, etc.) and borrower type (government bodies, state-owned enterprises, large conglomerates, small and medium enterprises, etc.). When conducting due diligence checks, the underlying credit risks can be readily identified by distinguishing between corporate and consumer banking loans, rather than relying on financial statement descriptions alone.
In general, a loan’s status can be classified as normal, overdue or nonperforming, depending on the occurrence of certain default events. For normal loans and credit advances, the financial due diligence process is primarily concerned with assessing the credit risk and likelihood of default. The first step is to evaluate the corporate or individual borrower's ability to repay their loans, and to then determine the value of any pledged collateral. For corporate borrowers, their ability to repay their loans is subject to industry volatility and cyclical economic changes, while an individual borrower’s ability to repay is closely tied to their family circumstances and sources of income.
When a borrower experiences repayment difficulties, the collateral is evaluated to determine if it is sufficient to cover default risk. In general, the most common form of collateral accepted in Taiwan is real estate property, followed by machinery and shares. Real estate can be evaluated with reference to credit assessment and valuation reports made before and after the loan initiation. Also, an external expert, such as real estate appraiser, may be hired to provide a custom valuation report. Loans are classified as overdue or non-performing when borrowers are showing signs of insolvency. In this situation, it is common practice to move directly to valuing the collateral to determine the recoverable amount. Where the collateral is already under court auction, the auction price is taken as the property value (which is usually less than 20% or more than the normal market price).
Where the banking target has an offshore banking unit or overseas office, the due diligence checks must cover their compliance with the relevant foreign regulations. The overseas branches of Taiwan banks in the US and Europe are commonly involved in syndicated loans or interbank lending with local banking peers, or grant credits to local businesses run by Taiwanese or overseas Chinese. Where a Taiwan bank has branches in the US or Europe, these are considered less risky as American and European banking regulations are relatively more stringent than in Taiwan.
Financial instruments
Banks typically invest more in financial instruments than in other industries. The composition and size of their investment portfolios are relatively complex, and are another key focus area in the due diligence process. The proper evaluation method depends on the characteristics of the financial instrument. For example, those traded in active markets (such as shares or government bonds) are valued based on their market price (i.e., mark to market). If the market price is not readily available, then a valuation model is used to determine the instrument’s value (i.e., mark to model).
Taiwan’s Statement of Financial Accounting Standard No. 34 lists five categories of financial instruments for accounting purposes, all of which are evaluated according to their fair value.
- Financial assets carried at fair value through the profit and loss account;
- Available-for-sale financial assets;
- Held-to-maturity financial assets;
- Equity investments carried at cost; and
- Other financial assets (e.g. bond investments with no active market).
Financial assets carried at fair value and available-for-sale financial assets are already reflected at their fair values, with any changes recognized as gains or losses in the current period, or as adjustments to shareholders’ equity. For derivative instruments, however, the evaluation often depends on the specific type of instrument and the nominal amount incurred, in addition to recognizing any changes in its fair value. Financial derivatives also carry other potential risks given their high leverage nature and their exposure to market volatility in various exchanges worldwide.
Regarding held-to-maturity financial assets and other financial assets, trading information is usually not readily available, so their amounts are accounted for at cost after amortization; but their fair values need to be re-evaluated during the due diligence process. For securitized financial instruments or structured bonds, such as collateralized debt obligations, collateralized bond obligations and asset-backed securities, the default risk and potential losses will vary according to market conditions. It is advisable to discuss with management when evaluating these types of instruments so as to obtain more insight on the valuation models and monitoring systems adopted.
For equity investments accounted for under the cost or equity method, investment gains or losses are recognized based on the original cost and shareholding percentage. Any impairments are recognized in accordance with Taiwan’s Statement of Financial Accounting Standards No. 35. For due diligence purposes, however, both figures are determined by using the fair value approach.
Liabilities and shareholders’ equity
A bank’s liabilities and shareholders’ equity are also subject to financial due diligence, with the specific focus on the sources of capital, unaccounted balances, and any contingent liabilities.
Deposits and remittances. Bank deposits are subject to various structural analyses. For example, the current-to-fixed deposit ratio indicates whether a bank has high funding costs or is susceptible to liquidity risk. Also, the loan-to-deposit ratio analyzes whether the bank is making effective use of its funds. These and other ratios (including the savings deposit ratio and foreign currency deposit ratio) can also be compared with industry peers or tracked over certain periods for trend analysis.
Pension liabilities and collective agreements. Based on our past M&A experience, the employees of an acquired financial institution usually prefer to settle their existing years of service, whether or not they meet the retirement criteria. The amount for each individual may range from 1.5 months pension pay for each year of service and upwards. As the number of employees may be in the thousands, with salaries averaging higher than most non-high tech businesses, the overall settlement payout could be sufficiently large to materially affect the net worth of the acquisition target.
Another factor for a buyer to consider is the likelihood of having to deal with Taiwan labour unions to discuss and finalise collective settlement agreements on behalf of the affected employees. As labour union involvement may affect the timing and synergy of the merger, it may be advisable for the buyer to engage human resource experts to help ensure a smooth negotiation process.
Convertible and financial bonds. The conversion terms of any convertible bonds issued by a banking target may affect how the merger proceeds. For subordinated financial bonds, in particular, their issuance terms and repayment timing need to be thoroughly studied and analyzed.
Capital adequacy requirements. Banks are particularly concerned about compliance with the requirements of the Basel II Accord on capital adequacy and liquidity. A third accord is under discussion, which aims to raise the Tier 1 capital ratio to 7.25% by 2017, and the percentage of common equity of risk-weighted assets to 7% by 2019. Banks with low capital adequacy ratios will be forced to raise additional funds, or may even have stop paying out cash dividends.
Profitability
Net interest and commission revenue. A bank’s main source of income is the interest spread (i.e., the difference between its average lending rate and average deposit rate). An interest rate trend analysis should be performed for the bank’s various products, while taking into account any related operating expenses, debt recovery costs and write-offs. Also, the evaluation should examine the make-up of the bank’s net commission revenue, which is typically derived from wealth management product distribution, etc. The interest spread, loan-to-deposit ratio and commission revenue profile may provide insights as to bank's future business growth and profitability.
Operating expenses. Operating expenses generally consist of personnel costs and rental and depreciation expenses. In Taiwan, the long-established state-owned banks incur larger depreciation than the newer midsize banks, which tend to rent their office premises and so incur higher rental expenses. The due diligence evaluation should examine the major details of such lease and rental agreements in order to identify any potential opportunities, costs or risks after the merger.
Overall, the focus of the financial due diligence process will vary according to the background and circumstance of the target. This article highlighted the key banking areas which are typically subject to investigation in Taiwan, as well as some of the investigate methods used. However, it takes years of practice and experience for an investigator to be able to quickly grasp the key elements of each M&A deal. It is therefore important for a buyer considering to engage professional consultants with considerable experience of M&A transactions in Taiwan and abroad. Professional support can help the buyer to increase their chances of accomplishing their post-merger expectations.
