Contents

Cover

Title Page

Copyright

Preface

Acknowledgments

Chapter 1: Bank Business Models

1.1 ECONOMICS OF BANKING

1.2 COMMERCIAL BANKS

1.3 INVESTMENT BANKS

Chapter 2: Financial Statements Analysis for Banks

2.1 BALANCE SHEET

2.2 THE US GAAP FOR BANKS

2.3 PROFIT & LOSS STATEMENT

2.4 MAJOR DIFFERENCES BETWEEN IAS/IFRS AND US GAAP

2.5 EXAMPLE OF IAS/IFRS APPLICATION

Chapter 3: The Regulatory Capital for Banks

3.1 REGULATORY CAPITAL REQUIREMENTS

3.2 BASEL II

3.3 THE REFORM OF BASEL III

3.4 MANAGING THE REGULATORY CAPITAL

Chapter 4: Assessing and Preparing the Business Plan for a Bank

4.1 STATUS QUO ANALYSIS

4.2 INTERNAL CONSISTENCY

4.3 EXTERNAL CONSISTENCY

4.4 THE FORECASTING MODEL OF A BANK

Chapter 5: Bank Valuation

5.1 WHY BANK VALUATION IS DIFFERENT

5.2 DISCOUNTED RETURNS MODEL

5.3 RELATIVE VALUATION

5.4 ASSET/LIABILITY-BASED VALUATION

5.5 THE SUM OF THE PARTS FRAMEWORK

5.6 BANK VALUATION IN M&A

5.7 THE VALUATION OF WELLS BANK

Chapter 6: Insurance Business Models and Financial Statements

6.1 THE BUSINESS MODEL OF INSURANCE COMPANIES

6.2 SEGMENTATION BY PRODUCTS

6.3 DISTRIBUTION CHANNELS

6.4 INSURANCE BALANCE SHEET UNDER US GAAP

6.5 INSURANCE CONTRACTS UNDER IAS/IFRS

6.6 CASE STUDY

Chapter 7: Regulatory Capital for Insurance Companies

7.1 INSURANCE INDUSTRY REGULATION IN THE US

7.2 CURRENT US SYSTEM

7.3 SOLVENCY II – EUROPEAN-BASED REGULATION

7.4 MAIN DIFFERENCES BETWEEN SOLVENCY II AND US REGULATION

Chapter 8: Assessing the Business Plan for an Insurance Company

8.1 STATUS QUO ANALYSIS

8.2 INTERNAL CONSISTENCY

8.3 EXTERNAL CONSISTENCY

8.4 THE FORECASTING MODEL

Chapter 9: Insurance Companies Valuation

9.1 APPRAISAL VALUE

9.2 RELATIVE VALUATION

9.3 THE CASE OF “GENERAL INSURANCE”

Chapter 10: The Valuation of Other Financial Companies

10.1 THE VALUATION OF FINANCE COMPANIES

10.2 THE VALUATION OF FUNDS

References

Index

This edition first published by John Wiley & Sons Ltd in 2014
© 2014 Mario Massari, Gianfranco Gianfrate & Laura Zanetti

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Preface

If there is a lesson learnt from the on-going economic crisis, it is that financial companies play a key role in the economic life of nations. The understanding of how banks, insurance companies, and other financial institutions actually work is therefore of paramount importance, not just for scholars but also for managers, investors, regulators, and policy makers. A sound understanding of how financial companies work should be reflected in reliable methodologies in order to value them. However, how to value banks and other financial institutions is a topic that has not received due attention so far.

The most popular valuation manuals devote relatively little attention1 (or no attention at all) to the valuation frameworks that should be applied to financial companies. Academia started to look in-depth into this issue only recently. In fact, for both practitioners and academics, the problem with the valuation of financial companies is that these are inherently complex organizations. The raw materials they process are often very complex risks embedded in highly sophisticated financial contracts. In some cases, to fully understand the structure of certain assets in the bank Balance Sheet – not to mention the estimation of the technical reserves of life insurance companies – a PhD in physics or mathematics is necessary. No wonder that, as vividly emerged from some official parliamentary hearings about the financial crisis and subsequent scandals, even top managers and board directors of global leading financial companies are often not aware about and proficient in what the organizations they lead are actually doing and about how much risk they carry.

If a proper comprehension of a financial company's actual situation is difficult for insiders in the top posts, the analysis and valuation from the outside is even more challenging. This is also because, unfortunately, the accounting standards leave the opacity and ambiguity that obfuscate the financial statements of banks and insurers mostly untouched – even the largest and “systemically important” ones.

In this book we have not found the Holy Grail for the valuation of banks or of other financial institutions. But on the basis of our professional experience, academic research, and discussion with bankers and equity research analysts, we have encapsulated what appears to be the best practice for valuations in the financial sector. Our aim is to provide the reader, already familiar with the main corporate valuation models, with the coordinates to apply them specifically to financial companies. Therefore, the focus is eminently practical and we have tried to address the very problems that usually arise when dealing with the valuation of banks or insurance companies. Along the same lines, we have excluded the most complex econometric models, which are of intellectual fascination for academics but of little utility for real life application.

The book is structured as follows. Before presenting the bank valuation techniques (Chapter 5), we briefly introduce the various business models banks run (Chapter 1), the main accounting frameworks and issues that are relevant for banks (Chapter 2), and the regulations that define the capital to be held by banks (Chapter 3). Financial statements analysis and the comprehension of the regulatory frameworks are indeed the ingredients necessary to prepare and assess the business plan of a bank (Chapter 4).

We adopt a similar approach for the insurance companies. We first introduce insurers' business models and accounting practices (Chapter 6). A sketch of the main capital regulations follows (Chapter 7) along with the guidelines to assess and prepare the business plan (Chapter 8). The valuation issues that are peculiar to these companies are eventually presented (Chapter 9). We finally offer (Chapter 10) a few stylized elements about the valuation of other financial institutions such as funds and leasing, factoring, and asset management companies.

In terms of depth of discussion about business models, accounting features, and capital requirements, we have decided to present the bare minimum knowledge necessary to perform a proper valuation. This is because our objective is to offer the reader an agile reference book rather than a comprehensive encyclopedia on the topic. But the choice of being concise has also been made because the debate among policy makers – especially on accounting rules and capitalization requirements – is still (fiercely) going on and more details about current and proposed regulatory frameworks would become outdated quickly. The reader willing to know more about those aspects is strongly encouraged to refer to other sources and specialized handbooks (we shall provide some references in the footnotes where appropriate).

We have particularly focused our attention on the US and European financial industries because they are the ones we know best, but most of the considerations we make, especially in terms of valuation frameworks, apply to financial institutions located outside those geographies as well.

We expect financial companies' valuations to become a topic of growing interest in forthcoming years for both practitioners and scholars. We hope that this book will spark more curiosity and intriguing questions on the matter.

1. For example, Damodaran (2012) and Koller et al. (2010).

Acknowledgments

Of course, we owe a very great debt of thanks to friends, colleagues, and students who have contributed to this work. First, we thank greatly two extremely experienced professionals who read and commented on chapters: Paola Sabbione of Deutsche Bank and Giuseppe Sica of Morgan Stanley. A number of former students ran empirical analyses to test various propositions presented in the book: Isabella Baruzzi of Morgan Stanley, Paolo Bergamelli of UBS, Paolo De Bona of Citi, Davide Natale of Goldman Sachs, Kim Salvadori of Goldman Sachs, Matteo Santecchia of Credit Suisse, and Roberto Vincenzi of Bocconi University. We are grateful to the Wiley team who assisted us in the book preparation, and especially to: Werner Coetzee, Jennie Kitchin, Grace O'Byrne, and Vivienne Wickham. Finally, Lynette Woodward provided excellent professional support for the editing of the manuscript.

1

Bank Business Models

From an economic point of view, banks carry out the crucial role of intermediating between individuals and/or organizations (corporations, financial institutions, national and local governments, and non-profit entities) with financial surpluses and those suffering from (temporary) money deficits. Such a definition is quite general and falls short of fully representing the complexity and articulation of an industry that is essential for economic development and national growth. When the banking system does not work properly the costs for the economy may be severe as the last financial crisis has made painfully clear. To sketch the main features of the banking business, we will segment the industry into a few categories in order to identify the different business models' economics, profitability drivers, and, eventually, valuation metrics. Nevertheless, it's worth underlining that, as Paul Volcker,1 former Federal Reserve Chairman used to say, fiduciary responsibility is at the very core of every banking organization, regardless of the specific activities carried out.

1.1 ECONOMICS OF BANKING

Bank valuation can build only on a sound understanding of what banking business involves, what the different business models are over time, and now coexist in most countries. For valuation purposes, we will identify the main revenue-generating activities that a bank may carry and outline the business models behind such activities. While some banks are “mono-business” in the sense that they offer solely one type of service, most actually are “multi-business” with a wide array of financial products and services. When the portfolio of financial products is wide and encompasses both commercial and investment banking services the bank is usually referred to as “universal”. Table 1.1 introduces the relationship between business models and types of revenues that we will analyze in detail in the next paragraphs. The nature and mechanics of the insurance business will be presented in Chapter 6.

Table 1.1 Types of banking revenues and business models

Types of revenues | Business model
Net interest income | Commercial banking
Fee and commission income | Commercial banking. Investment banking. Asset management
Trading income | Investment banking
Premium underwriting | Bank assurance

Historically the core source of revenues for commercial banks has been the issue of loans to customers (individuals and/or corporate) and the gathering of money in the form of deposits. Net interest income is typically the difference between the interest earned from loans and interest paid to depositors, in this sense commercial banking is a “spread business”. Net interest income also includes earned and paid interest on other financial instruments. Collecting deposits and lending money are not value creating activities , but they are so if two more aspects are taken into account:

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