A Bottom-Up Approach To Value Financial Institutions And Their Business Units

The valuation of Financial Institutions from a bottom-up approach to valuate banks showing the differences between capital aggregation methods, diversification and target rating

To the extent that the capital becomes such a determinant factor in a bank´s capacity to grow. It is clear that it also determines its economic value. The current economic crisis has shown the importance of calculating accurate capital estimates. As a consequence, it may be logical to determine a bank´s intrinsic value by first estimating the economic value of the resources it must own to meet the minimum level of solvency required by the investor.

Usually Investment Bank´s valuations use a top down approach to calculate bank’s capital. Most of them consider only regulatory capital (BIS I, II or III). Those calculations do not address completely key issues like portfolio and risk type diversification, solvency level desired by the bank (target rating) or capital aggregation methodology used.

In a recent paper, we address the valuation of Financial Institutions from a bottom-up approach to valuate banks showing the differences between capital aggregation methods, diversification and target rating.

Our approach is presented in a complete bank valuation and in the valuation of the different business units.  The approach used is particularly relevant when doing the due diligence valuation in M&A transactions or in internal capital requirements in the Capital Management Unit as it will provide a range of risks adjusted values of the bank.

A financial entity may be defined as a risk manager that plays an intermediating role by taking resources from clients (e.g., deposits) or in the market and investing them in other financial assets (e.g. mortgages), earning a spread or margin in the process, i.e., the difference between the cost of deposits/cost of carry and return on the assets.

In this context, it is important to understand clearly what role the borrowed resources, i.e., deposits or money market, plays in a financial entity or bank. In short, borrowed resources are for a bank something similar to what steel may be for a manufacturer of ball bearings for example, i.e. a basic raw material. Accordingly, capital then becomes a central component for leveraging the total resources of the bank. In this way, the solvency and profitability of a bank can be monitored by a financial regulator and investors by keeping tabs on the minimum level of the bank´s Equity required, through capital by means of solvency ratios. The level of required resources is defined by a domestic regulator (e.g. The Federal Reserve), an international organization (e.g. The Bank for International Settlements) or internally presenting bottom up internal capital estimates in annual reports.  Given the crucial role of a bank´s capital, it then becomes a scarce and valuable component whose level determines the capacity that a bank has to grow its assets and investments.  

To the extent that the capital  becomes such a determinant factor in a bank´s capacity to grow, it is clear that it also determines its economic value. Undoubtedly, it may be logical to determine a bank´s intrinsic value by first estimating the economic value of the resources it must own to meet the minimum level of solvency required by the investor/regulator.

Banks are significantly more leveraged than other firms in different industries and that’s one of the reasons why diversification of the risk portfolio is a key determinant of fair value of the bank (i.e. the lower the diversification the higher amount of capital needed). There are different sources of diversification such as:
1.    within portfolio: for example what are the chances that a significant amount of credit cards will default simultaneously
2.    within business unit: what are the chances that the retail business unit will default?
3.    within business units: what is the correlation between retail and wholesale business untis?
4.    within risks: how diversified are credit, market, ALM, operational and reputational risk?
5.    Geographical diversification: includes the benefits of having business in countries with different economic cycle

The economic value  of a financial entity may be obtained in a similar way that it is obtained in case of any firm that operates in the real economy (i.e., the non-financial sector) by using references given by markets (extrinsic value) or by internal indicators (intrinsic value). The former may be given by the market capitalization of the financial entity while the latter may be provided by the value of the discounted cash flows it generates  and the implicit economic capital requirements.

Both of these approaches present advantages as well as limitations. The overriding advantage of using the intrinsic or fundamental value is that it allows measuring the impact of specific value-drivers in the overall value of the entity. By using this approach the source of the entity´s value being generated can be isolated and understood.

However, the use of discounted cash flows for valuing financial entities presents some peculiarities due to the nature of their business. These peculiarities can be summarized as follows:
1)    Distributable Net Earnings must include a realistic and regulated provisions for bad debts, expected funding costs, etc.
2)    Economic Capital and Available Financial Resources become  a determinant factor in a bank´s capacity to grow, and it also determines its economic value
3)    Free Cash Flows to be discounted must be calculated taking into account the minimum level of solvency required taking into account its diversification
4)    Similar risk profile in financial services entities can have a different solvency target (credit rating)
In a paper we look at some of those peculiarities in order to develop a discounted cash flow methodology that properly takes them into account. This approach is applied to evaluate a real bank by evaluating the economic value of its Equity; by analyzing the economic impact of changes in some key value drivers; and by breaking down the total value into the main business units of the bank.

As it´s known, to estimate the intrinsic value of Equity we have to discount the expected free cash flow for shareholders at its cost of capital . However, in the case of a financial entity the resulting cash flows are themselves determined by the required solvency ratio. This crucial fact differentiates its cash flow generating process from the one found in a non-financial entity. We propose to evaluate the Equity of a bank by discounting the Free Cash Flows to Shareholders that maximize dividends policy (pay-out ratio) and fulfill the capital required (economic and regulatory).  

Our paper develops an approach to value a bank using a discounted cash flow methodology, taking into consideration the diversification of the portfolio, the target rating and different capital aggregation methodologies. Intrinsic economic value of a bank can be measured through an estimation of the intrinsic economic value of the Equity, which by the international capital accords Basel I, II and III has to follow certain solvency ratios or internal economic capital models. In this paper we propose to evaluate the Equity of a bank by discounting the Free Cash Flows to Shareholders that maximize dividends policy (pay-out ratio) and fulfill the capital requirements (regulatory and economic). Free Cash Flows to Shareholders are calculated based on the Net Earnings and on the distribution in dividends of all the resulting cash flow after covering the required level of capital.  Also we take into consideration to what extent regulatory existing regulations consider risk diversification of the portfolio and the desired solvency (or rating) target.   

We show the advantages of this approach by applying it to the following cases:
1) A Valuation of a real bank.
2) A sensitivity analysis to show the impact in bank´s value due to changes in some key value drivers.
3) A breaking down of the value into the main business units of the bank, and a ranking of them in terms of contribution to the economic value of the total entity.

Finally, in this paper we show the limitations of using exclusively regulatory capital to evaluate a bank and the advantages of using economic capital considering portfolio specific diversification characteristics and financial institutions’ solvency target


1 Should be kept in mind that there are, at least, two different ways of defining capital when it refers to a bank: regulatory capital (as described by the regulators BIS I, II and III) and economic capital where it is measured according to the portfolio specific risk. Usually the main differences are the measurement of diversification (in regulatory terms is constant for all Financial Institutions) , the capital aggregation once it is diversified and the desired solvency or target rating.
 2 The fair amount of money an investor is willing to pay for an asset.
 3  See, for example, Z. Rezaee (2001)
 4 An excellent application of this approach is described in Chris Matten (1998).
 5  “Koller, T., Goedhart, M., Wessels, D., (2005).

[This research paper has been reproduced with permission of the authors, professors of IE Business School, Spain http://www.ie.edu/]

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