Adopting UK accounting policies may create a slightly headache for CYBG - the owner of Clydesdale and Yorkshire banks - upon its £1.7 billion acquisition of Virgin Money.
UK card operators use an accounting method called the “effective interest rate”. Lenders that offer zero per cent balance transfer cards are allowed to book upfront some of the revenue they expect to gain once a customer ends the interest-free period and starts paying a high rate.
But it assumes customers will still have debt on the card when the deal ends.
And, according to CLSA’s Ed Henning, if the proportion of customers who repay their balance post-promotion differs from management’s estimate, it can have a big impact on the revised future cash flows.
Virgin Money booked around 13 per cent of its net interest income in 2017 using this practice.
Ticking time bomb
Labelled a “ticking time bomb” by some, EIR has been widely scrutinised over the past two years in the UK.
However, as Henning points out, it is new to CYB/Australian shareholders.
Anyway, he believes that CYBG will take a more conservative approach than Virgin Money did leading to a potential write-down, capital reduction and a hit to the forward profit and loss.
Yet Henning says the changes are very manageable.
“Overall, despite the likely slight EIR accounting headwind on P&L and capital, the issue is well and truly outweighed by the positives from the Virgin Money deal; the very strong cost synergies, the growth potential using the Virgin Money brand, improved scale and funding costs," he said.
“There is a lot to like and we remain bullish on the deal.”
The deal comes just as the UK regulator has flagged concerns about the EIR modelling. A review is now underway which could see credit card operators being forced to hold additional capital against EIR assets on zero balance transfer portfolios.
“We do see a risk that the PRA not only increases the capital requirement but makes the EIR intangible asset a capital deduction given this is not real capital,” Henning added.
“While this does not seem to be on the agenda for the Prudential Regulatory Authority, it remains a risk.”
Despite this regulatory backdrop, Henning went on to say, Virgin Money management remains confident about their assumptions, models and capital position.
Importantly, the UK lender’s use of the EIR is somewhat aggressive compared to peers as Virgin currently uses a seven-year modelling period and EIR of 6.8 per cent.
Henning expects CYBG to cut that period to five years and use an EIR of 5 per cent to be in-line with Barclays and Lloyds.
Also, Lloyds, the largest credit card player in the UK, only carries around £70 million of EIR assets with Barclays’ EIR income less than £40 million.
Writing down asset value
First off, Henning thinks CYBG will write-down a proportion of Virgin Money’s much higher £159.8 million EIR asset.
By reducing the modelling period, he can see a reduction of between £40 and £50 million drop off which is around 15 basis points of core equity tier one capital.
“The worst-case scenario would be a write-down of the entire £159.8 million asset which is around 50 basis points of CET1."
According to Henning, the P&L impact of a shorter modelling period will likely result in a one-off write-down of around £40 and £50 million as well as an ongoing accrual assumption cut.
On Virgin Money 2017 figures, if that period had been restricted to five years, the profit for the year would have been lowered by about £25.2 million.
The analyst says that equates to an impact of between 4 and 5 per cent for 2019's underlying profit which he estimates at £77 million.
And aside from the hefty costs savings the merger will bring, CYBG is on track for accreditation in October.
Achieving IRB status will see CYBG with a surplus capital position of £250 million - after excluding the EIR impact - which means it will sit on a CET1 capital ratio of 13 per cent.
This compares to the regulator's requirement of around 10.4 per cent.