Prudence arising from the mist
In an article last year, I commented on the potential for confusion arising from regulations being introduced to implement revisions to the Basel III framework* , sometimes referred to as Basel 3a. Among the revisions was a new requirement that, when calculating loan to value ratios (LTV), the value of real estate should be appraised using “prudently conservative” valuation criteria. This led, and is still leading, some valuers to believe that this necessitates them providing something called “prudent value” when valuing for lenders.
The first point is that “prudent” or its derivations have been used throughout the history of the Basel Accords to describe different actions banks need to take in calculating their capital adequacy. In 2004, Basel II introduced “prudent valuation guidance” for a bank’s positions in their trading book, which was significantly enhanced more than ten years ago in Basel III. Using this adjective to generically describe the valuation approach required for non-financial collateral in Basel 3a made it more consistent with that used for financial assets and liabilities. It does not imply a radical change in approach.
My previous article Dear Prudence …won’t you come out to play? specifically addressed the then proposed amendments by the European Union to its Capital Requirements Regulations (CRR) for lending institutions. Basel 3a indicated that national supervisors should provide guidance on prudent valuation criteria where such guidance does not already exist under national law. It did not provide its own explanation beyond saying the value should exclude expectations of price increases and the potential for the current price to be significantly higher than a value that would be sustainable over the life of the loan. In its draft CRR the European Commission simply lifted the text from the Basel document into a proposed new Article 229, while indicating that the European Banking Authority (EBA) would be tasked with providing Regulatory Technical Standards on prudential valuation criteria before the operational date of the amended CRR.
The new CRR, now known as CRR 3, was finalised in June this year with an operational date of 1 January 2025. Article 229 has been amended and extended to include more prudence criteria since the draft I commented on last year and can be viewed here Valuation principles for eligible collateral other than financial collateral.
There has been one minor amendment in CRR 3 to the wording taken from the Basel framework. The Basel document says the value of the collateral must be adjusted to “take into account the potential for the current market price to be significantly above the value that would be sustainable over the life of the loan”. The CRR has replaced “market price” with “market value”. This change blurs a distinction that may have been intended by the Basel framework between basing a collateral value on the asset’s price rather than its market value where this is lower. However, since Basel does not define either term, and the CRR only defines “market value”, the reason for this change is unclear. It is likely of little consequence since the value of the collateral has always been capped at the market value of the asset, even if the price paid was more.
The question of whether the market value is sustainable over the life of the loan is at least partly answered by the next CRR amendment. This is a new requirement. Where a property is revalued, the collateral value must not exceed the higher of:
the average value measured for that property, or for a comparable property, over the last six years for residential property or eight years for commercial property, or
the value at loan origination.
How is this “average value” determined? The amendment goes on to provide that lending institutions may use the results of models for the monitoring of property values in accordance with Article 208. Article 208 requires lending institutions to keep the values of immoveable property collateral under review. It too has been amended in CRR 3 with requirements to take into account changes in ESG criteria and more stringent requirements for the use of “advanced statistical or other mathematical models” to monitor market movements.
Finally, the amended Article 229 also provides that the EBA shall develop draft regulatory technical standards to specify the criteria and factors to be considered for the assessment of the term “comparable property” for the purposes of estimating the “average value” and submit these to the Commission by July 2027. Since such a project is not included in the EBA’s recently published 2025 Work Programme, it will be some time before we see any more detail on this. Most valuers will, of course, be familiar with the concept of comparable property.
The amended regulations are clearly requiring lenders to have in place robust systems for monitoring movements in the property markets and to commission independent revaluations where these indicate there may have been a significant fall in the value of real property collateral. These records of past movements can also be used to predict likely future movements over the life of the loan and could lead to “haircuts” being applied by the bank to the current market value.
So, what is the significance of the changes for real estate valuers providing valuations for lenders based in the EU? A point that should be obvious but seems to be sometimes overlooked by some commentators is that these are banking not valuation regulations. The purpose of the CRR is to set requirements for lending institutions on how to calculate their capital for regulatory purposes. Article 229 does not stand in isolation and should not be interpreted as a type of valuation standard. Valuers are not expected to understand the detail of how a bank’s credit risk or solvency ratio is calculated, and neither should they risk advising on adjustments to their valuations involving matters which are either outside their expertise or to which they should not be privy as independent valuers.
I believe to be the main points that valuers need to aware of are:
“Prudent value” is not a type of value. Along with all the other inputs required to calculate an institution’s capital adequacy it describes the overarching principle of prudence a bank needs to follow when calculating the value of loan collateral. It is no coincidence that some bank regulators call themselves prudential regulators.
The starting point remains an independently determined market value, which is defined in the CRR for “immoveable property” using the IVS definition, which incidentally includes the assumption that the buyer and seller are both acting prudently.
If a market value can be determined it can be considered “prudentially conservative” if correctly estimated unless other considerations to which the lender is privy arise. This could create difficulties for unusual assets for which there is no active market, but few lenders would accept such property as the sole collateral for a loan. There remains the proviso that to be considered prudent the market value needs to be correctly estimated and there remain problems with this as discussed in this paper by the ECB, but that is a separate issue.
The valuer can usefully provide commentary of the relevant market and where it is in the usual economic cycle on the valuation date but should not try predicting future values.
The Basel requirement to exclude expectations of future price increases should not be interpreted as having to ignore the current expectations of typical market participants reflected in the current market value. It is reinforcement of the point that collateral must be measured at its current value not at some future date when values may be anticipated to have improved, for example once improvements have been completed.
The lender may need to make prudential adjustments to the collateral value some of which are based on data they should have recorded from monitoring the relevant market, or on other factors related to the loan or the borrower which are totally outside the valuer’s remit.
I have focused this discussion on the new CRR introduced in the EU. There are 27 countries in membership of the Basel Committee on Banking Supervision (BCBS), which include the world’s major economies, including seven that are members of the EU. The EU is also a member of BCBS in its own right and effectively extends the Basel standards via the CRR to all 27 countries in its membership. However, the remaining twenty members of the BCBS will each have considered the implications of Basel 3a on their own regulations around real estate loans. I am aware that the regulator in the United Kingdom, The Prudential Regulation Authority, is updating its equivalent of the CRR, and RICS is not expected any material changes to the valuations required by lenders. Although my experience in other jurisdictions is more limited I have yet to encounter any other significant changes in the way that valuers provide lenders with valuations arising from Basel 3a.
*Basel III: Finalising post-crisis reforms, BCBS 2017
