Bank-specific features and its implications for financial modelling and valuation

Several specifics concerning the banking business make it difficult to apply the valuation methods commonly used for nonfinancial companies. Such limitations require several adjustments of standard valuation metrics in order to take into account of banks’ peculiarities. Let me start with a different role for equity (the regulatory constraints). Banks are subject to pervasive regulation and the power of enforcement and control lies with the international and national supervisory authorities. The standards with which banks are required to comply represent real operating and budget constraints and, consequently, they have a considerable impact on the way banks are managed in the short and in the long term. Generally, banking regulation affects many aspects of financial institutions’ operations both on the assets and liabilities side. Among them, the most important factor affecting valuation is widely acknowledged to be the capital constraints imposed by the Basel framework [1].

According to the latest release of the Basel framework, banks have to meet specific requirements of capital adequacy and liquidity standards. Basically, the Basel framework forces banks to set aside a minimum amount of capital in relation to their assets’ riskiness, which are measured in terms risk weighted assets. In particular, Basel’s minimum capital requirements are related to the traditional risks of banking activity (credit, counterparty, market and operational risk), also known as

Pillar 1 risks. Therefore, as long as risk weighted assets grow in terms of size along the cash flows projections of a hypothetical business plan, all other things remaining equal, the capital requirements must be proportional to the planned level of risk weighted assets. In this way, there can be an internal equilibrium between assets at risk and the capital base. Similarly, if management foresees an increase in the assets’ riskiness, all other things remaining equal, capital requirements will move upward to reflect the increasing asset risk. Therefore, there is a clear proportional relation between risk weighted assets and capital that is clearly defined by the minimum capital ratio of the Basel framework [2].

As one can imagine, such potential restrictions are particularly significant in valuation, since the regulatory capital and its internal composition are a formal constraint on growth opportunities. In fact, a capital shortfall reduces bank capacity to increase assets, or even to manage their internal composition in relation to their intrinsic risk. Such a rigidity of asset and capital management might affect bank’s ability to produce earnings and, therefore, to distribute dividends [3]. Therefore, when we run a bank valuation, we should assess not only its growth in asset and earnings, but also its strategy for meeting the increasing capital requirements. In particular, it must be ensured that all the business options allow regulatory requirements to be met over time. In other words, strategic vision and operational actions must be conceived in light of the regulatory needs imposed by national and international authorities.

Thus, regulation undoubtedly affects banks’ future performance, as it affects reinvestment and growth rates. Additionally, the uncertainty linked to the incremental level of macroprudential regulation, or the change of specific national rules (such as specific capital buffers, limits on dividends distribution, and so on), may, once again, affect the pace of growth for banks, their capacity for earnings production and, consequently, dividends distribution [2]. In particular, regulation usually tightens and becomes more uncertain during periods of financial turmoil, as a response to negative shocks in the financial system. In addition, in order to maintain keen attention to exposure to risks, plural regulatory authorities undertake reviews on asset quality and capital adequacy. Finally, differences in national regulation may even affect value. As a matter of fact, different regulatory regimes may have differing degrees of rigor in their application of banking law. Thus, a bank’s risk profile needs to be contextualized in light of the legislation to which that bank is subject to. On the one hand, different sets of rules may affect the comparison of banks between countries. On the other hand, in the case of international players, analysts should evaluate the effect of varying regulatory overlay on banks’ cash flows.

Now we shall move to another peculiarity of the bank which is a different role of debt. Banks, on average, are characterized by a high level of indebtedness. Four basic reasons contribute to this situation. The first reason is that regulatory authorities define the minimum capital standards and, therefore, the most part of liabilities is made up by debt. The second reason is that the role of debt in banking is different from that of industrial companies since debt may be considered as the raw material of banks and, at least theoretically, it could be defined as the only source of funding, since the equity capital, according to the Basel framework, has the primary function of absorbing losses. The thirds reason is that debt creates value. The fourth reason is that operating with too much capital beyond the regulatory limit and/or industry average is costly and inefficient, if it is not invested in profitable assets or external growth like mergers and acquisitions [4].

The problem of operational and financial debt separation derives also from the fact that a bank’s income statement does not provide any specific section or item for financial expenses, as would be the case for industrial companies’ financial statements. In other words, we cannot separate the flows of the different typologies of debt instrument. Another important issue involving bank debt is that it cannot be entirely subtracted by the market value of assets when an asset side model is employed, since debt is a source of value. This is so because banks raise the most part of their funding from retail and other banks’ deposits at a lower cost than other common technical instruments like bonds. In particular, the spread between the interbankratio and the cost of deposits is known as «mark-down», which, as we will see in the following paragraphs, is an important source of value in banking. Accordingly, banks create value even on the liabilities side, which creates some important issues to take into account in the valuation process [5].

The last but not the least complications in bank valuation concern quantifying free cash flows, which are more difficult to estimate compared with those of industrial companies. The problems related to cash flow measurement arise from the critical nature of separating operations, investment and financing activities. In terms of cash flow to equity derivation, while net income adjustments for noncash operations are feasible (as is the case for industrial firms), net working capital, capital expenditures and debt reimbursement are defined in a different way in banking [5].

With regard to the definition of net working capital, inventory is not easily recognizable since all products and services are basically intangibles and, consequently, cannot be physically stored. Moreover, current assets and liabilities are of a commercial nature, if we follow the theoretical framework of the not-indebted bank, but that amount would be clearly characterized by a strong instability, even in the short-term. With regard to capital expenditures, banks are characterized by a low level of amortizations as the majority of their investments are not tangible assets. Rather, banks invest in human capital, processes and procedures enhancement, Information and Communication Technology and brand [6].

The practical convention is to adjust for the regulatory ratio in relation to the risk weighted assets’ growth. However, such an adjustment would be partial, since banks need to have a larger capital base in order to meet the overall capital adequacy and operational flexibility. In other words, in order to adjust correctly for the degree of risk of assets, it might be necessary to consider a retention ratio that is higher than the formal regulatory requirements. The third net income adjustment concerns debt issuance and reimburse- ment. As we argued in before in this para- graph, it is very difficult to separate commercial and financial debt. This is because, fundamentally, financial operations may even be considered commercial operations. Therefore, from the perspective of an outside analyst, the adjustment for financial debt is very complex so that it cannot be carried out in practice. Finally, from a cash flow to equity point of view, the adjustment for preference share dividends can be made in the same manner as for industrial companies.

On the whole, considering all the limits we have discussed so far, in the quantification of cash flow, earnings are adjusted for cashineffective transactions, regulatory capital needs and preference share dividends, but this does not consider working capital and other capital expenditures.