How to Value a Bank: From Licensing to Resolution (Springer Texts in Business and Economics) 303143871X, 9783031438714

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Springer Texts in Business and Economics

Alessandro Santoni Federico Salerno

How to Value a Bank From Licensing to Resolution

Springer Texts in Business and Economics

Springer Texts in Business and Economics (STBE) delivers high-quality instructional content for undergraduates and graduates in all areas of Business/Management Science and Economics. The series is comprised of self-contained books with a broad and comprehensive coverage that are suitable for class as well as for individual self-study. All texts are authored by established experts in their fields and offer a solid methodological background, often accompanied by problems and exercises.

Alessandro Santoni • Federico Salerno

How to Value a Bank From Licensing to Resolution

Alessandro Santoni European Central Bank Frankfurt am Main, Germany

Federico Salerno (deceased) European Central Bank Frankfurt am Main, Germany

ISSN 2192-4333 ISSN 2192-4341 (electronic) Springer Texts in Business and Economics ISBN 978-3-031-43871-4 ISBN 978-3-031-43872-1 (eBook) https://doi.org/10.1007/978-3-031-43872-1 # The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Switzerland AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland Paper in this product is recyclable.

Dear Federico, I miss the bond that makes us look like family. Rest in peace, my darling friend. Alessandro

Authors’ Comment

The authors’ knowledge on the subject does not derives uniquely from their academic background but also from their professional experience at Institutions such as Goldman Sachs, the European Central Bank (ECB) and the International Monetary Fund (IMF). This book does not as represent the views of such institutions but only those of the authors. We would like to thank Ghislain Rossignol (Team Lead and Head of Mission at ECB specialised in Market Risk and Treasury) and Richard Ah-Koen (Senior Team Lead and Head of Mission at ECB specialised in Market Risk and Treasury) as coauthors of chapter “Solvent Wind Down”.

vii

Contents

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1 1

Main Features of the Banking Business Model . . . . . . . . . . . . . . . . . . . . Key Differences Between Banks and OFIs . . . . . . . . . . . . . . . . . . . . . . . . Opening a Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Valuation of Financial Projections for Licensing Approval . . . . . . . . . . . . . Example of Initial Capital Requirement Valuation . . . . . . . . . . . . . . . . . . . Banks and Capital Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . How are Capital Requirements Determined? . . . . . . . . . . . . . . . . . . . . . . . Risks Associated with Banking Activity . . . . . . . . . . . . . . . . . . . . . . . . . . Business Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5 5 6 7 7 7 8 9 11

Valuing a Bank in Going Concern . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Valuation Methodologies for Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . How Banks Differ from Corporates: Valuation Implications . . . . . . . . . . . . Capital as a Scarce Resource for Financial Institutions . . . . . . . . . . . . . . . . Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cash Flow . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Valuation Implications: Free Cash Flow Valuation and DDM Models for Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Free Cash Flow to Equity (FCFE) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Free Cash Flow to Assets (Firm) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividend Discount Models (DDMs) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividend Discount Model with Excess Capital . . . . . . . . . . . . . . . . . . . . . DDM Valuation of Hypothetical Bank XYZ: An Example . . . . . . . . . . . . . DDM Valuation of a Bank: Cost of Equity and Fair Value Per Share . . . . . FCFE Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Market Multiples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . PE Valuation: An Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Banks and Inflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Building a Value Map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Warranted Equity Value (WEV) Method . . . . . . . . . . . . . . . . . . . . . .

15 15 16 16 16 17 17 17 18 18 19 20 20 20 22 23 26 32 32 34 ix

x

Contents

Excess Return Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital—How to Treat It . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital and a Word of Caution on the Danish Compromise: A Numerical Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A Sum-of-the-Part Valuation: A Practical Example . . . . . . . . . . . . . . . . . . Market Multiples as a “Control” Method . . . . . . . . . . . . . . . . . . . . . . . . . ROE Dupont Decomposition for Banks . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Factor Models for COE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bottom-Up Approach to the COE for the SOTP . . . . . . . . . . . . . . . . . . . . Consistency Between Capital, Liquidity, and Cost of Equity . . . . . . . . . . . Consistency Between COCO Yields and Cost of Equity . . . . . . . . . . . . . . Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

35 35 37 39 39 41 42 42 42 43 43 44

Banks M&A: Strategy and Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . Rationale for Banking M&A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . M&A Transaction from the Supervisor’s Point of View . . . . . . . . . . . . . . . M&A Transaction from the Market’s Point of View: Key Criteria on Top of Regulators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accretive Versus Dilutive Deal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NPV Valuation in M&A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Premium over Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital Increase and TERP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Goodwill Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

45 45 47 48 51 52 52 54 55 57

Valuation in Resolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Resolution and Valuation Methodologies . . . . . . . . . . . . . . . . . . . . . . . . A Practical Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bridge Bank Operationalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchasing and Assumption Operationalization . . . . . . . . . . . . . . . . . . . .

. . . . .

59 59 60 64 66

Valuation in Liquidation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Liquidation Versus Resolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Historical Liquidation Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . High-Level Liquidation Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . A Practical Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

69 69 70 70 71 73

Loan Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Literature Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Loans Valuation: Cash Flow Adjustment Techniques . . . . . . . . . . . . . . . . . Bottom-Up Approach Loan Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . Top-Down Discounted Cash Flow Approach . . . . . . . . . . . . . . . . . . . . . . Options for Addressing NPLs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NPL Fire Sale: Valuation Considerations . . . . . . . . . . . . . . . . . . . . . . . . .

75 75 76 76 80 80 82

Contents

xi

Non-performing Loans Sale: The Difference Between the Seller and the Buyer Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The Regulator Approach on Gone Concern Scenario . . . . . . . . . . . . . . . . . NPL Sale: Capital Tied Up Sensitivity . . . . . . . . . . . . . . . . . . . . . . . . . . . Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

83 84 85 86

Financial Assets Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prudent Valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair Value Calculation Techniques . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair Value Hierarchy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Day One Profit—DOP . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Additional Valuation Adjustments (AVA) . . . . . . . . . . . . . . . . . . . . . . . . . Prudent Valuation Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

87 87 88 89 89 90 91 92

Solvent Wind-Down . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Wind-Down of Bank’s Trading Book . . . . . . . . . . . . . . . . . . . . . . . . . . . . Orderly Versus Disorderly Wind-Down . . . . . . . . . . . . . . . . . . . . . . . . . . Ongoing Policy Discussion Overview . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operationalization of Wind-Down . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Scenario Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Wind-Down Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operational Aspects to be Mitigated During the Wind-Down Strategy . . . . Valuation Assumptions in the Trading Book Wind-Down . . . . . . . . . . . . . Fair Value: A Partial View of a Solvent Wind-Down (SWD) Value . . . . . . Accounting and Capital Reserve . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fair Value and Market to Model Instruments . . . . . . . . . . . . . . . . . . . . . . From Fair Value to SWD Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ticket/Portfolio-Based Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Concentrated Risk Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Future Administrative Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Derivative Trading Wind-Down: XVA . . . . . . . . . . . . . . . . . . . . . . . . . . . Initial Valuation Adjustment: MVA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital Valuation Adjustment (KVA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other Additional Costs to be Considered . . . . . . . . . . . . . . . . . . . . . . . . . DOP Deferral: A Specific Balance Sheet Correction . . . . . . . . . . . . . . . . . Estimating Rump Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Reference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

95 95 97 98 99 100 100 102 102 103 104 104 106 107 107 108 109 109 109 111 111 112 113

Glossary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115

About the Authors

Alessandro Santoni worked at the International Monetary Fund (IMF) in the Financial Crisis Division and European Central Bank (ECB) manager responsible for Onsite Inspections and beforehand manager for Financial Crisis Management Interventions. Beforehand, he worked in the Banking industry at Goldman Sachs, BMPS and ABN. He has a PhD from the University of Siena, a Master in International Economics & Management from SDA Bocconi and an EMBA from Columbia University, LBS and Hong Kong University. He has three degrees in Economics, History and Political Science from the University of Siena. He teaches Risk Management, Financial Crimes at Bayes University of London, Frankfurt School of Management and University of St. Gallen. Certified Financial Crime Specialist (CFCS) and AML Specialists (CAMS). He is a co-author of the book “Corporate Governance in the Banking Sector”. Federico Salerno worked as a banking supervisor and beforehand for Financial Crisis Management Interventions in the ECB’s Single Supervisory Mechanism (SSM) in Frankfurt. He previously worked as equity research analyst, covering financial institutions ranging from small to large caps at both bulge brackets and boutiques, mainly out of Milan, London, and Paris. He held a Master in International Economics & Management from SDA Bocconi in Milan and degrees in Law and Political Science from the University of Siena. He was a CFA charter holder, CFA Institute.

xiii

List of Tables

Main Features of the Banking Business Model Table 1 Table 2 Table 3 Table 4 Table 5

Valuation of minimum capital requirement for licensing Banks capital composition . . . . . . . .. . . . . . .. . . . . . . .. . . . . . . .. . Risks associated with the banking activity . . . . . . . . . . . . . . . Originate-to-hold-EU style . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Originate-to-distribute-US Style . . . . . . . . . . . . . . . . . . . . . . . . . .

8 10 11 12 13

Valuing a Bank in Going Concern Table 1 Table 2 Table 3 Table 4 Table 5 Table 6 Table 7 Table 8 Table 9 Table 10 Table 11 Table 12 Table 13 Table 14 Table 15 Table 16 Table 17 Table 18

DCF formula . . .. . . .. . . .. . . .. . . .. . . .. . . .. . . .. . . .. . . .. . .. . . .. . DDM valuation of Bank XYZ—example . . . . . . . . . . . . . . . . Sensitivity analysis of Terminal Value PE for various levels of COE and G . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . DDM valuation of Bank XYZ—example (II) . . . . . . . . . . . DCFE valuation of Bank XYZ—example . . . . . . . . . . . . . . . Banking sector valuation sheet—example . . . . . . . . . . . . . . . Value map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Valuation metrics . . . . . .. . . . .. . . . .. . . . .. . . . .. . . . .. . . . .. . . . .. . Global default rates—S&P . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . PE valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Value map . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Valuation of Bank XYZ with regression . . . . . . . . . . . . . . . . . WEV valuation of Bank XYZ—an example . . . . . . . . . . .. . Excess return valuation of Bank XYZ—example . . . . . . . Capital relief from the Danish compromise—a numerical example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary of valuation methods . . . . . . . . . . . . . . . . . . . . . . . . . . . SOTP valuation of Bank XYZ . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank-ROE decomposition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17 21 22 22 24 27 28 28 30 31 33 33 35 36 38 38 40 41

xv

xvi

List of Tables

Banks M&A: Strategy and Valuation Table 1 Table 2 Table 3 Table 4 Table 5 Table 6

Costs synergies from Banks M&A (1999–2015) . . . . . . . . M&A valuation, value created . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bank acquisition simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NPV valuation (example with fictitious numbers) . . . . . . . Example M&A tangible book premium to core deposits Simulation TERP . . . . . . . .. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . .. . . .

47 50 51 53 54 55

Valuation in Resolution Table 1 Table 2 Table 3 Table 4 Table 5 Table 6 Table 7 Table 8

Valuation pre- and post-resolution . . . . . . . . . . . . . . . . . . . . . . . . Valuation 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Valuation 2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Balance sheet post bail-in . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Equity valuation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Summary valuation pre- and post-resolution .. . . .. . .. . . .. Operationalization of a Bridge bank . . . . . . . . . . . . . . . . . . . . . . P&A example. Bank failed balance sheet preand post-P&A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

60 61 62 63 63 65 66 67

Valuation in Liquidation Table 1

Banco X liquidation realization scenario . . . . . . . . . . . . . . . . .

72

Loan Valuation Table 1 Table 2 Table 3 Table 4 Table 5

Bottom-up approach loan valuation . . . . . . . . . . . . . . . . . . . . . . NPL strategies option . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . NPL value. A different perspective . . . . . . . . . . . . . . . . . . . . . . . NPL valuation methodology ECB (Guidance on NPL) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . From NPL capital relief to new assets . . . . . . . . . . . . . . . . . . . .

77 81 83 85 86

Financial Assets Valuation Table 1 Table 2 Table 3

Fair value and prudent value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Valuation techniques fair value . . . . . . . . . . . . . . . . . . . . . . . . . . . Risk categories for the calculation of AVAs . . . . . . . . . . . . .

88 89 92

Solvent Wind-Down Table 1 Table 2

Different wind-down strategies approaches . . . . . . . . . . . . . . 101 SWD financial assets . . .. . . . . . .. . . . . . .. . . . . .. . . . . . .. . . . . . .. . 104

Introduction

Abstract

Bank valuation analysis is very different from corporates, with greater emphasis to balance sheet examination. Complexity emerges also from the public role of banks and the potential impact from their default. This led to an enormous quantity of rules designed to manage the risk arising from this business. Difficulties emerge also from the different approach needed during the life cycles determined by diverse macroeconomic contexts and idiosyncratic events. In this book, we provide practical guidance of banks’ valuation methodologies juxtaposing practical examples to each valuation model to enrich the theoretical discussion and help practitioners build their own spreadsheets.

Overview If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem. JP Getty

According to the Basel-based Bank for International Settlements (BIS),1 banks are institutions whose business is to receive deposits and/or close substitutes for deposits and grant credits or invest in securities on their own account. This immediately characterizes the business model and the financial statement of banks as very different from other industries. Concepts such as working capital and operating income take on a wholly different meaning. The approach to financial analysis of a Bank is also very different from corporates, with greater emphasis on balance sheet examination. A profitable bank usually can generate profits from the spread between interest income obtained from the credit versus the cost of funding (deposits) net of 1

Guide to the International Banking Statistics, Bank for International Settlements, Basel, Switzerland, 2000, Part III—Glossary of Terms.

# The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 A. Santoni, F. Salerno, How to Value a Bank, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-031-43872-1_1

1

2

Introduction

other costs (including operating costs, cost of losses from non-performing credit and taxes). This apparently easy business model is, indeed, a complex one. The public role of banks and the potential impact from their default in society led to an enormous quantity of rules designed to manage the risk arising from this business. Given their peculiarities, banks and other financial services firms (such as insurance or fintech companies) can be particularly challenging to value and may require a wholly different approach relative to the methods used for industrial corporations. Investors must be aware of several potential pitfalls before embracing in banks valuation. In this book, we provide practical guidance of banks’ valuation methodologies. Chapter “Main Features of the Banking Business Model” describes the peculiarities of banks’ business model and the regulatory framework governing their risk management. In chapter “Valuing a Bank in Going Concern”, we delve into some more peculiarities of the banking business model and then describe the most popular valuation techniques for banks as a going concern. These are the time-honoured DDM and DCF, peer group multiples (price–earnings ratio in our example), excess return models or economic value-added valuation method (EVA) and their variant, the warranted equity value (WEV). We have tried to juxtapose practical examples to each valuation model to enrich the theoretical discussion and help practitioners build their own spreadsheets. The chapter also contains a description of how to carry out a sum-of-the-parts valuation (SOTP) including the allocation of available capital by business area as well as the description of a value map and the statistical valuation model based on the regression it provides. Given the capital-driven nature of banks’ business model, we find EVA and SOTP models particularly fitting. We also include a description of our bottom-up cost of equity model, which can be used, for instance, in a SOTP. Valuing a Bank in an merger and acquisition (M&A) scenario can be challenging, and several factors and points of views must be considered. The starting point of an M&A valuation can be the traditional methodologies used for valuing a bank in a normal scenario. In chapter “Banks M&A: Strategy and Valuation”, we investigate some of the critical aspects of a Banking M&A and the valuation implications from two points of view: the shareholders’ point of view and the supervisors’ point of view. From the shareholders’ point of view, the key aspects to be considered are the calculation of the synergies arising from the M&A and the potential earning accretion/dilution. On the other side, Banks M&A are always assessed by supervisors on a case-by-case basis. The main objectives from the supervisor’s point of view will be to ascertain, to the extent possible, the sustainability of the business model of the combined entity. In April 2014, following the early 2000 financial crisis, European Authorities published the Bank Recovery and Resolution Directive (BRRD). The Bank Recovery and Resolution Directive has been adopted to provide authorities with comprehensive and effective tools to deal with failing banks at national level and with cooperation arrangements to tackle cross-border banking failures. The overarching objective of the BRRD resolution regime is to make sure a bank can be resolved swiftly with minimal risk to financial stability. Banks’ valuation methodologies,

Overview

3

utilized by Supervisors and Resolution Authority to trigger the failing of a bank and the best resolution tool to utilize, constitute the key aspects of the BRRD. In chapter “Valuation in Resolution”, we revise the key principles of these valuation methodologies providing a real-case simulation study. While resolution is applied for systemic or banks with critical functions, normal insolvency or liquidation proceedings are the default procedures when a bank is failing. Liquidation value is the value of the assets that remain if the company goes from a going concern to a gone concern status. In the liquidation process, creditors, lenders, and shareholders based on seniority of their claims will receive the proceeds from the liquidator of the company’s assets. Banking assets included in liquidation value usually include loans, financial assets, tangible assets like real estate, equipment, investment. In chapter “Valuation in Liquidation”, we provide a practical example of liquidation valuation. In chapter “Loan Valuation”, we deep dive on key aspects of loan valuation. We analyse the performing and non-performing loan valuation methodologies. On the latter, we evaluate the different strategies to address NPL disposals as fire sales and the methodologies used by third parties when acquiring them and the methodologies used by Supervisors (as ECB) in their NPL manual. The most complex aspect of banks valuation is however the financial asset assessment (chapter “Financial Assets Valuation”). Accounting valuation is the process of valuing a company’s assets and liabilities for financial reporting purposes. Several accounting-valuation methods may be used while preparing financial statements to value financial instruments (and non-financial). Accounting International Financial Reporting Standards (IFRS) require market transactions being recorded at fair value. To obtain a prudent value of the assets, regulation requires the fair value to account for additional valuation adjustments (AVA). In chapter “Financial Assets Valuation”, we analyse prudent valuation methodologies for financial assets. In chapter “Solvent Wind Down”, we focus on some of the valuation and operational aspects of winding down a bank’s trading book portfolio. The topic follows SRB SWD guidance and FSB on the “solvent wind-down of derivatives and trading portfolios” and provides a deep dive on valuation principles and exit strategies currently considered by industry practitioners when designing a solvent wind-down plan. It also provides the reader with an overview of the most relevant concepts underpinning the valuation or pricing concepts (i.e. “Fair value,” “realisable value”, and “Solvent Wind Down value”). Ultimately it shows that the cost to wind-down a trading portfolio beyond the usual accounting carrying value might be mostly driven by wind-down operating costs (incl. Liquidity and funding costs) and two main pricing components, namely the Capital Valuation Adjustment and Margining Valuation Adjustment. We advocate that recovery plans and resolution plans should, contrary to the current practice, properly factor in these additional costs.

4

Introduction

In summary, this book touched upon the key valuation methodologies of a Bank starting from its licensing process, the equity valuation, and the M&A approach up to the possible wind-down. We investigated resolution and liquidation valuation methodologies focusing on performing and non-performing loan, fair value, and AVA for financial assets.

Main Features of the Banking Business Model

Abstract

Banks are very different from other industries. The business model is mainly based on collecting deposits from customers and granting credits or invest in securities on their own account. This apparently easy business model is, in fact, a complex one. The public role of banks and the potential impact from their default in society has led regulators to introduce a significant quantity of rules designed to mitigate the risks arising from this business. Given their peculiar business model, banks can be particularly challenging to value and require a wholly different approach relative to industrial entities.

Key Differences Between Banks and OFIs According to the Basel-based Bank for International Settlements (BIS),1 banks are defined as institutions whose business is to receive deposits and/or close substitutes for deposits and grant credits or invest in securities on their own account. Financial institutions, other than banks, according to the BIS2 engage primarily in the provision of financial services and activities auxiliary to financial intermediation, such as fund management. Non-bank financial corporations, sometimes referred to as “shadow banks”, include special purpose vehicles, hedge funds, securities brokers, money market funds, pension funds, insurance companies, financial leasing corporations, central counterparties (CCPs), unit trusts, other financial auxiliaries, and other captive financial institutions. Thus, it can be argued that, according to the BIS, the key difference between a Bank and other financial institutions is that a Bank collects deposits. The protection 1

Guide to the International Banking Statistics, Bank for International Settlements, Basel, Switzerland, 2000, Part III—Glossary of Terms. 2 https://www.bis.org/statistics/glossary. # The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 A. Santoni, F. Salerno, How to Value a Bank, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-031-43872-1_2

5

6

Main Features of the Banking Business Model

of the customer deposits and ensuring the financial stability in the country are the main tasks of supervisors and regulators. In most markets, banks represent the largest kind of financial institution by asset size, followed by insurance companies and asset managers. Incidentally, we point out that the difference between banks and insurance companies is threefold: 1. Insurance liabilities are long term and substantially less liquid, which renders insurers less prone to “runs” than banks 2. On the other hand, insurers’ liabilities are estimated with probabilistic assumptions, which can lead to the need to revise them upwards and hence to P&L losses even many years after the contract is entered into. Asbestos claims in US insurance are a case in point 3. The assets of insurance companies are largely quoted financial products, which allows markets to form a good idea about the evolution of net asset value. In times of high volatility, this can, arguably, reinforce contagion effects 4. As regards their P&L account, insurers are characterized by the inversion of the revenues-costs cycle. They collect revenues (premiums) long before they sustain the costs (claims) associated with said revenues. It can even be the case that the cost is never incurred (e.g. a life insurance policyholder dies before the contractual age to withdraw his/her savings and counter-insurance is not present; a motor insurance contract expires with no accident and no claims). As a matter of fact, this is a defining feature of the insurance business and not just a difference to banks.

Opening a Bank The process of setting up a banking business starts with a written authorization from the local authority (usually a Central Bank). In Europe, this kind of authorization is granted by the European Central Bank (ECB) in consultation with the National Supervisory Authority under Article 4(1) of the SSM Regulation. There are several criteria that need fulfilling. The main one is constituted by the minimum or initial capital to be invested. The entrepreneur must demonstrate that he/she can commit a minimum or initial capital, which depends on the nature of the intended business, but in general, at least EUR 5 m in the Eurozone. Additionally, the authorization application must contain a business plan showing that the Bank can be sustainably profitable, along with a description of its internal control systems and risk management processes. In addition, as regards personnel, the application should contain a description of the organizational structure and of qualified resources. In the management board, the Bank should appoint people who have acquired sufficient knowledge and practical experience during their professional careers.

Banks and Capital Requirements

7

Valuation of Financial Projections for Licensing Approval Supervisors have a detailed assessment process to validate the licensing request.3 This valuation process should allow supervisors to assess the viability and sustainability of the business model. The applicant request should contain financials covering at least three years’ projections of balance sheet and profit and loss account statements. The projections should contain the base case scenario and an adverse one to evaluate the potential impact on capital and liquidity ratios. The projections should contain the macroeconomic expectations, as for example GDP, loan growth, interest rates, unemployment rates. The assumptions used should be based on data provided by Institutions such as IMF, World Bank, ECB. There are two main points of attention on the assessment of the valuation: (1) the capacity of the applicant to have adequate funding sources to face possible negative liquidity scenarios; (2) adequate capital level to sustain absorb losses from loans and/or financial assets depending on the business model of the applicant.

Example of Initial Capital Requirement Valuation The examples below illustrate the capital expected for the authorization when the authority establishes a higher threshold for the initial capital requirement. The initial minimum capital of EUR 5 m is used as the minimum threshold. The authority may have, given the business profile of the applicant, a higher yearly minimum threshold, in our example starting at EUR 7 mln. The highest amount capital requirement in the third year (EUR 14 mln in our example) is added to the projected cumulative losses of the first three years (EUR 7 mln in our example), for a total of EUR 21 mln, which is the amount of capital expected at the time of authorization for the applicant (Table 1).

Banks and Capital Requirements The main reason why Banks are required to hold capital is represented by the need to protect depositor–holders from potential losses stemming from unexpected losses (typically in a bank’s assets). Capital, therefore, constitutes a buffer against losses that could originate from loans defaulted upon, a decline in the market value of financial assets, losses from fraud, rogue trading, and others. An additional reason for capital requirements is, arguably, represented by the need to reduce contagion and negative feedback loops to other financial institutions as well as to shield taxpayers from losses.

3

https://www.bankingsupervision.europa.eu/ecb/pub/pdf/ssm.201901_guide_assessment_credit_ inst_licensing_appl.en.pdf.

8

Main Features of the Banking Business Model

Table 1 Valuation of minimum capital requirement for licensing

Source: Authors own’s elaboration

Regulatory capital that a Bank needs to hold is predominantly in the form of common stock, paid-in capital as well as retained earnings. The amount of capital that a bank needs to hold depends mainly on its dimension as well as on the amount of risk that it is taken on and off its balance sheet. In this sense, the amount of assets a bank owns is the starting point to calculate how much capital a bank needs to hold. Assets have different risks and hence risk weights. Internal models or standardized approaches are used to calculate risk-weighted assets, starting from (mainly) on-balance sheet exposures. Off-balance sheet credit exposures are converted to on-balance sheet equivalents using credit conversion factors.

How are Capital Requirements Determined? Following turmoil in international currency and banking markets caused by a host of well-known banking crises (notably the failure of Bankhaus Herstatt in Germany in mid-1974) the Central Bank Governors of the Group of Ten countries, at the end of 1974, created the Basel Committee on Banking Supervision. This aims to develop global regulatory standards for banks and seeks to strengthen micro- and macroprudential supervision. The capital of the Bank for International Settlements (BIS) is currently underwritten by 63 central banks and monetary authorities from around the world. In June 2004, the Committee released a detailed capital framework aimed at setting minimum capital requirements for Banks, which sought to develop and expand the standardized rules set out of the 1988 Accord. This agreement is known as “Basel II”, the revised framework comprised three pillars of which the minimum capital requirement was the first one. The other two comprise: • Supervisory review of an institution's capital adequacy and internal assessment process

Risks Associated with Banking Activity

9

• Effective use of disclosure as a lever to strengthen market discipline and encourage sound banking practices The capital requirements under which the minimum is set consist of three main elements for a Bank: • Minimum capital requirements, known as Pillar 1 capital requirements • An additional capital requirement, known as the Pillar 2 capital requirement • Buffer requirements The minimum total capital requirement (called Pillar 1 requirement) or total capital ratio is set by BIS at 8% of banks’ risk-weighted assets. The ratio is composed of two elements: the capital as numerator and risk-weighted assets (RWA) as denominator.4 RWA are the results of the total assets a bank has, multiplied by their respective risk factors (risk weights). Risk factors reflect how risky a certain asset type is and is perceived to be according to historical average and statistical models (we will see later how these are modelled). For example, a mortgage loan that is secured with collateral (typically a dwelling) is less risky— has a lower risk factor—than an uncollateralized loan. As a result, a bank needs to hold less capital to cover for such a mortgage loan than it does to cover for the uncollateralized loan. The second element to calculate capital requirements (above the required minimum) is constituted by Pillar 2 requirements. This is where Bank Supervisors play a key role. Indeed, supervisors analyse the idiosyncratic risk of each Bank and may demand it holds additional capital above and beyond regulatory minimum if they conclude that its risks are not sufficiently covered by minimum capital requirements. Since minimum and additional capital requirements are binding there would be legal consequences if they are not adhered to, the magnitude of which will depend on the amount of the breach and the capacity of the Bank to close this gap. The maximum consequence could be the withdrawal of the license (Table 2).

Risks Associated with Banking Activity Banks have an important social and economic function impact as they are supposed to protect savings while utilizing them to provide the necessary resources for the economy to grow. In a simplified way, Banks collect resources from depositors which have generally short maturity (most are sight deposits), limited in amount and 4 Assets weighted according to their riskiness. Generally, the higher the risk, the higher the weight. It serves as the denominator of capital ratios (e.g. CET1 ratio and Total Capital Ratio). US regulators continue to rely on non-risk-weighted measures as well, mainly the leverage ratio. Since an institution is required to hold capital sufficient to cover the higher of the two sets of indicators (both risk weighted and not), the importance of risk-weighted capital indicators ends up being somewhat lower in some jurisdictions such as the US.

10

Main Features of the Banking Business Model

Table 2 Banks capital composition

Source: Authors

with, up to a certain level, guarantee to be reimbursed (the deposit guarantee amount depends on local regulations). Once collected these resources, for which an interest is recognized to depositors, Banks’ job is to invest these liabilities into assets. Banks have a vast array of choices to make. They can invest by lending money to borrowers (via loans), by buying financial assets, or by investing in real estate. Many of these investments have characteristic that could create risk management issues for Banks. These investments often have long maturities (e.g.: 20 years mortgages, 10 years government bonds), can be large and the repayment is, at times, uncertain (Table 3). The risks associated with banking activity are defined by BIS as: Credit Risk is defined as the risk of default on a debt derived from the incapacity of a borrower to fulfil the required payments. Borrowers usually pay monthly instalments and part of the capital initially provided by the Bank. If the borrower stops making these payments, then the Bank would need first to provide provisions on the number of payments missed and then eventually, when found out that for the borrower it would be impossible to repay the loan, writes off the loan. Liquidity Risk: Liquidity is defined as the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses. The so-called Bank run materialized when a few depositors decided to withdraw the sum deposited in the Bank at the same time. This could make impossible for the Bank to meet the obligation to repay the deposit since the Bank may not have enough cash or liquid assets to sell. Market risk is the risk of losses resulting from changes in the prices of instruments such as bonds, shares, and currencies. Market risk arises also from interest rate risk

Business Models

11

Table 3 Risks associated with the banking activity

Source: Authors

associated with a mismatch between fixed and floating interest rates at which assets and liabilities are priced. Operational risk: The Basel Committee defines the operational risk as the “risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”. The losses from operational risk could arise from internal fraud, external fraud, physical damages to Banks infrastructures, IT incidents, legal issues.

Business Models Banks’ business model can differentiate a lot ranging from pure retail bank dedicated to selling via local branches basic financial services, such as checking and savings accounts to investment banking specialized in more sophisticated products as underwriting new debt and equity securities for all types of customers ranging from government to corporates. An alternative way to differentiate business models is to distinguish between an originate-to-hold model typical of European banks and an originate-to-distribute model typical of US banks. In the first case, the business model is quite simple with banks collecting deposits and use them for providing loans monetizing their competitive advantage by applying a spread between interest paid and received. In this model, banks accept the credit default risk of the counterpart by holding the asset on their balance sheet. The risk management activity will be focused on monitoring borrowing customers’ behaviour while protecting the depositors by holding appropriate levels of capital to cover unexpected risk.

12

Main Features of the Banking Business Model

Table 4 Originate-to-hold-EU style

Source: Authors

In the originate-to-distribute model, Banks act as brokers in credit risk. Banks collects deposits and use them to provide loans. However, Banks do not keep the loans on their balance sheet but rather sell the loans. Loans can be bundled into a mortgage pool as MBS (mortgage-backed securities) or asset pool as ABS (assetbacked securities) to SPV (special purpose vehicle). These financial instruments as MBS, ABS can be issued by third-party financial company such as Investment Banks or, in the case of USA, Government sponsored enterprises (GSE) known as Fannie Mae or Freddie Mac. SPV shares are distributed to investors that receive cash on monthly basis from the monthly instalments paid by the initial borrowers. This model allows to significantly increase the volumes of loans provided to the economy since initial deposits are leveraged several times. Moreover, by offloading the assets out of balance sheet, Banks reduce the associated risk. The scheme allows the banks to (1) increase leverage and liquidity; (2) hold less capital since the asset side of the banks’ balance sheets usually incorporated high-rated (AAA) securities which required no significant capital reserves (low RWA); (3) increase the profitability since upfront fees on sale of the loans (a significant portion of the loans overall profitability) are multiplied several times (Table 4 and 5). There are several reasons why EU Banks are not replicating the US model. Among the most important ones is that to operate such a business model a very developed secondary capital market is needed, with instruments as SPVs and investors willing to purchase and hold certain kinds of securities. Moreover, the presence in US of Government agency as Fannie Mae and Freddie Mac, created by the US Congress to provide liquidity, stability, and affordability to the mortgage market significantly facilitate this mechanism. Fannie Mae and Freddie Mac buy mortgages from Banks and/or package the loans into mortgage-backed securities (MBS) that may be sold or retained. Thanks to this mechanism, banks can raise cash to engage in further lending. This process has the additional benefit of attracting to the secondary mortgage market investors who might not otherwise invest in this kind of assets, providing further liquidity for the housing market and decreasing the cost of borrowing for the consumers.

Business Models

13

Table 5 Originate-to-distribute-US Style

Source: Authors

The difference of the two models is so relevant that the level of US securitization in the period 2007–2017 has been ranging between 7 and 10 times the EU ones.5

5

Lucia Quaglia. It Takes Two to Tango: The European Union and the International Governance of Securitization in Finance. JCMS 2021.

Valuing a Bank in Going Concern

Abstract

In common with other financial institutions, banks exhibit some specific features relative to industrial companies. This has led the analyst community to opt for certain valuation methods rather than others, over the years. In this chapter, we investigate the most common methodologies used by analysts in valuing Banks in going concern status. The warranted equity value (WEV) method, an adaptation of the EVA approach, is used to value both the entity as a whole or individual business areas in a sum-of-the-parts. It responds to the need to take a bank’s capital absorption and capital position into account. The DDM is a universal method which suits banks as well as industrials. And so is the free cash flow to equity (FCFE), in a sense an expansion of the DDM in that it adds potential dividends to actual dividends.

Valuation Methodologies for Banks We touch upon the key differences between a bank and industrial entities, including the implications of such differences for the valuation of banks and then delve into the most widely used valuation methodologies for banks. These are: 1. 2. 3. 4. 5. 6.

Dividend discount model (DDM) Discounted free cash flow to equity (DFCFE) Valuation with market multiples Statistical approach with a value map Warranted equity value method (WEV) Excess return (EVA)

We present examples of various valuation approaches for a hypothetical bank, which we call “XYZ” but point out that the numbers shown in the valuation # The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 A. Santoni, F. Salerno, How to Value a Bank, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-031-43872-1_3

15

16

Valuing a Bank in Going Concern

examples are there purely for illustration purposes and do not refer to any actual entity. We discuss our preferred approach to the allocation of capital, an essential step for a sum-of-the-parts valuation. Having recapped the result of the various valuation approaches, we show an example of a sum-of-the-parts. Hence, after briefly discussing the effects of inflation on banks, we close the chapter with a description of our bottom-up cost of equity model.

How Banks Differ from Corporates: Valuation Implications We highlight three key differences between banks and industrial companies: 1. Capital 2. Balance sheet, namely debt and property, plant & equipment 3. Cash flow

Capital as a Scarce Resource for Financial Institutions As mentioned in the previous chapter, one of the key differences between banks and industrial companies, in fact, arguably, the most significant, is the fact that banks face regulatory constraints as for their use of capital in the business. Beginning with the first Basel agreement, banks were required to hold 8% of RWA as Tier One capital (mainly equity). Regulation aside, financial institutions must keep their capital ratios at levels consistent with a solid rating agencies’ rating to prevent funding costs from rising to levels that might endanger an institution’s profitability.

Debt Secondly, debt can be considered as part of ordinary working capital for a financial institution: an industrial entity typically issues debt to fund investment in plants & equipment which will generate cash flow. This is not the case for a bank or insurance company: issuing debt is part and parcel of a financial institution’s day-to-day activity aimed at attracting the public’s savings and thus perform its core business of financial intermediation.1 1

A. Damodaran, Investment valuation, Chap. 21, where the author states that some banks see debt as “raw material” to be transformed into high value-added financial products to be sold to clients. Indeed, we notice the statement made by a UK bank’s head of mortgages in the wake of the turmoil in the mortgage market of September 2022, as reported by the Financial Times: “we were taken aback by how quickly some people withdrew their products”. “if you are a supplier of any product and relying on raw materials, you have a period of time in which you should be planning. You shouldn’t need to act in a knee-jerk way”.

Valuation Implications: Free Cash Flow Valuation and DDM Models for Banks

17

Table 1 DCF formula Discounted Cash Flow =

CF2 CFn CF1 þ þ⋯þ 1 2 ð 1 þ drÞn ð1 þ drÞ ð1 þ drÞ

CF = Cash Flow dr = discount rate Source: Authors own elaboration

Fixed Assets Conversely, a bank is unlikely to have significant investment in Plant & Equipment. In this respect, leverage for a financial institution should be assessed with respect to the presence/absence of excess capital.

Cash Flow Cash flow differs from industrials to banks: fixed assets are likely to account for a small share of the total in a financial institution. Therefore, depreciation is likely to be minor. Bar the presence of intangibles, e.g. goodwill from acquisitions, stated earnings are usually a good proxy for cash flow for a bank. These peculiarities impact the way banks can be valued. Looking at free cash flow valuation methods, we notice, for instance, that only the free cash flow to equity method is applicable to banks (see below).

Valuation Implications: Free Cash Flow Valuation and DDM Models for Banks The value of any asset is represented by the sum of the cash flows generated by the asset, discounted to the present at an interest rate consistent with the riskiness of said cash flow. For a listed equity, the cash flow (or dividends if a more conservative dividend discount model (DDM) is used) should be discounted at the bank’s cost of equity (see Table 1). We distinguish among two methods, in line with the doctrine:2 1. Free cash flow to equity 2. Free cash flow to assets (FCFA). Or, alternatively, free cash flow to the firm (FCFF) 2 A. Damodaran, Investment Valuation: Tools and Techniques for Determining the Value of any Asset, University Edition, Wiley, Chap. 14 (free cash flow to equity discount models) and Chap. 15 (free cash flow to the firm), Wiley Finance Series, April 2012. And, by the same author: https:// pages.stern.nyu.edu/~adamodar/pdfiles/eqnotes/fcff.pdf

18

Valuing a Bank in Going Concern

Free Cash Flow to Equity (FCFE) Banks can be valued using a free cash flow to equity method. As mentioned, a bank is unlikely to have significant investments in Plant & Equipment, requiring depreciation. The latter will normally be a small item on a bank’s P&L, which implies that the difference between FCFE and stated earnings will be limited. This is a key difference relative to an industrial entity, for which depreciation can represent a substantial item. Other factors include: 1. Capital strain. Incremental capital required to run the business should be subtracted from free cash flow in that it cannot be distributed as dividends but must be retained to satisfy regulatory capital requirements. 2. Add excess capital (or subtract a capital shortfall to the value of the business determined with a DCF). To avoid double-counting, the analyst should ideally identify the portion of the cash flow generated by excess capital and remove it from the valuation. 3. No differently to what is the case with industrial entities, intangibles’ amortization and write-downs should be added back to earnings to calculate the FCFE. It is easy to infer from the formula for the free cash flow valuation model, that the terminal value is going to represent the bulk of the overall valuation, in most instances. The analyst should, therefore, make sure that the inputs for the terminal value are carefully chosen: Estimated earnings and hence the cash flow should not be overly optimistic but, rather, sustainable. The terminal growth in earnings should not exceed growth in nominal GDP in the bank’s reference markets. As said, it must also be borne in mind that part of the institution’s earnings must be reinvested in the business to satisfy regulatory requirements and, consequently, cannot be distributed. Therefore, the cash flow used for the terminal value should be adjusted to reflect this.

Free Cash Flow to Assets (Firm) The free cash flow to assets approach is hardly applicable to banks given that, for a bank, it is conceptually impossible to identify financial debt separate from the core business.3

Damodaran: Investment valuation, Wiley finance, University edition, Chap. 21 (Valuing financial services firms). According to the author, many banks see financial debt as a sort of “raw material”, to be moulded into higher value financial products. 3

Dividend Discount Models (DDMs)

19

Dividend Discount Models (DDMs) The DDM is one of the most established valuation methods for listed shares. It is more conservative than discount free cash flows to equity (DCFE) in that it considers only the portion of earnings that is distributed. To the contrary, DCFE considers potential dividends as well as actual ones. DDM models can be used for listed banks just as with any other listed entity. To use a DDM, the analyst should project stated earnings into the future (3–5 years) along with a sustainable dividend payout ratio. Then, he/she should discount the stream of dividends back to the present at the institution’s cost of equity. It must be borne in mind that not all earnings may be distributable: a portion of these must be retained to support growth in assets, e.g. because of new loans being extended, hence growth in the loan book or because the bank’s asset management arm is enjoying net inflows, etc. As regards the terminal value in the DDM formula, the same considerations we expressed for DCF still apply (see above). Even in the DDM, the analyst should, therefore, make sure that the inputs for the terminal value are carefully chosen: • Estimated earnings and hence the cash flow should not be overly optimistic but, rather, sustainable • The terminal growth in earnings should not exceed growth in nominal GDP in the bank’s reference markets. A growth rate higher than nominal GDP would, indeed, imply that the bank’s market share is continuously increasing, arguably an aggressive assumption • It must also be borne in mind that part of an institution’s earnings must be reinvested in the business to satisfy regulatory requirements and, consequently, cannot be distributed. The dividend payout used for the terminal value should be adjusted to reflect this4 The terminal value should hence be calculated according to the following formula: Terminal Value =

Last Explicit Dividend × ð1 þ gÞ ð K e - gÞ

Where k is the cost of equity and g is the long term (LT) growth rate in dividends. where:

4 A. Damodaran: Investment valuation, Wiley finance, University edition, Chap. 21 (Valuing financial services firms), Chap. 12 (estimating terminal value), and Chap. 13 (Dividend discount models). Also, See Koller, Tim, Goedhart, Marc, Wessels, David (McKinsey & co.): Valuation: measuring and managing the value of companies, Chap. 14 (estimating continuing value).

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Valuing a Bank in Going Concern

g indicates the nominal growth rate sustainable over the long term (“Sustainable Growth Rate”) and was calculated based on estimated growth in real terms plus inflation. Ke indicates the discount rate, equal to the Cost of Equity.

Dividend Discount Model with Excess Capital As an alternative to our preferred method of treating excess capital (see below), the analyst can assume that excess capital will be returned to shareholders via ordinary dividends, hence a higher payout than would otherwise have been the case. A FCFE method will be preferrable when the bank’s dividend is unsustainably high but estimates about future payout ratios are unreliable.5 We, show, below, an example of a DDM valuation: 1. The cost of equity is obtained with a capital asset pricing model (CAPM) and is equal to 10% 2. Perpetual g (2%) is equal to the LT growth in nominal GDP. Hence, we implicitly assume that the bank’s market share will remain unchanged 3. Free cash flow is obtained by subtracting the increase in required capital (CET1) from the accounting free cash flow, the latter being constituted by earnings plus depreciation, amortization, and goodwill write-downs 4. There is no excess capital nor shortfall and the pension fund is adequately funded

DDM Valuation of Hypothetical Bank XYZ: An Example The terminal value is obtained with the formula shown above. The analyst can run a sensitivity analysis of the terminal value price-earnings (PE)6 for various levels of k and g (Tables 2 and 3).

DDM Valuation of a Bank: Cost of Equity and Fair Value Per Share We show, below, the derivation of the CAPM cost of equity and fair value per share. This is compared to the current share price to detect an over/undervaluation, which can inform a trading strategy (Table 4). As a “sanity check”, we calculate PE and P/TE implied in our valuation, i.e. the multiples at which the bank would trade if it was valued exactly in line with our

A Damodaran: Investment valuation, Chap. 14 (Free cash flow to equity discount models) Market price divided by earnings per share. These can be estimates of future years’ earnings, in which case we will have a forward PE, or data from the past, in which case we have a trailing PE. PE ratios along with P/TE are arguably the most popular ratios to compare banks’ market valuation.

5 6

Source: Authors

Year (eur mn) Earnings Amortisation & depreciation Goodwill write-downs Cash flow Risk weighted assets CET1 capital (@ 12% CET1 ratio) Increase in CET1 capital Free cash flow to equity (FCFE) Dividends paid out Payout ratio Dividends as % of FCFE Discount factor NPV of dividends

2022A 7500 200 400 8100 4,12,000 49,440 0

Table 2 DDM valuation of Bank XYZ—example 1 2023E 7690 200 401 8291 4,19,828 50,379 939 7352 4411 57% 60% 0.910 4015

2 2024E 7885 200 402 8487 4,27,805 51,337 957 7529 4668 59% 62% 0.829 3869

3 2025E 7964 200 402 8566 4,35,933 52,312 975 7590 4858 61% 64% 0.754 3665

4 2026E 8044 200 402 8646 4,44,216 53,306 994 7652 5050 63% 66% 0.687 3468

5 2027E 8125 200 402 8727 4,49,546 53,946 640 8087 5337 66% 66% 0.625 3337

6 2028E 8206 200 402 8808 4,54,941 54,593 647 8161 5223 64% 64% 0.569 2972

7 2029E 8289 200 402 8891 4,60,400 55,248 655 8236 5106 62% 62% 0.518 2645

DDM Valuation of a Bank: Cost of Equity and Fair Value Per Share 21

22 Table 3 Sensitivity analysis of Terminal Value PE for various levels of COE and G

Valuing a Bank in Going Concern COE/G 3.0% 2.5% 2.0% 1.5% 1.0% 0.5%

6.85% 26.0 23.0 20.6 18.7 17.1 15.7

8.85% 17.1 15.7 14.6 13.6 12.7 12.0

9.85% 14.6 13.6 12.7 12.0 11.3 10.7

10.85% 12.7 12.0 11.3 10.7 10.2 9.7

11.85% 11.3 10.7 10.2 9.7 9.2 8.8

Source: Authors Table 4 DDM valuation of Bank XYZ—example (II)

Risk-free rate Beta Risk premium Cost of equity Perpetual growth rate Terminal PE Terminal value Total value Terminal value as % of total value Shares outstanding (mn) Value per share Current share price Upside potential Implied PE (2024) Implied P/TE (2023)

4% 1.3 4.5% 10% 2.0% 12.7 33,699 57,671 58% 3000 19.2 6.0 220% 7.3 1.14

Source: Authors

valuation for it. Such multiples can be compared with those of peers to glean whether we have been too harsh or too lenient in valuing the bank. Implied multiples that are much lower than the peer group average, for instance, might suggest that we have erred on the side of caution in our valuation. Vice versa, implied multiples that are above peers might warn us that we have been too optimistic in our estimates and/or valuation assumptions.

FCFE Valuation The DDM valuation shown above can easily be converted to a DCFE one by replacing the projected stream of dividends with the free cash flows to equity. A DCFE will generally value the firm more generously than a DDM, given that the cash flow stream includes potential dividends along with actual ones. According to A. Damodaran, the difference between the two represents the value of the control premium for the firm: a new management could theoretically increase dividends to

Market Multiples

23

keep in line with cash flows. If a market is characterized by openness in corporate control, then it is correct to use a DCFE to value a firm (Table 5).7

Market Multiples The analyst risks running into a circularity problem when using market multiples. Therefore, we do not recommend using these as a primary valuation tool. Nevertheless, market multiples can usefully be employed as a control method in the valuation of the whole entity or individual business areas, especially in markets where a significant number of listed peers is present for a division/business area. PEs8 and P/BV are the most used market multiples. Unlike what is the case for an industrial entity, it makes limited sense to refer to earnings before interest and taxes/earnings before interest, taxes, depreciation, and amortization (EBIT/EBITDA) for banks: interest income and expense are an integral part of the core business. On the other hand, depreciation is usually a minor item given the lack of sizeable, fixed assets. • We also use PE methodology as a “sanity check” for our divisional values in sum-of-the-parts approaches. This makes sense when a significant number of listed peers exist for a division or business area. Similarly, the analyst can check whether multiples implied in his valuation are consistent with those paid in recent M&A transactions in the same market. Some analysts use price to pre-provision profits to neutralize the volatility of loan loss provisions (LLP). The assumption is that loan loss rates for banks operating in the same market will converge towards similar levels over the medium term. For example, some equity research houses estimate LLP at around 40 bps of loans in the period 2023–24, for European banks. This compares with LLP of >100 bps for the years immediately following the 2006–08 financial crisis. • A variant of the popular PE ratio is represented by the price/earnings-to-growth (PEG). This is none other than a PE divided by a growth rate. The PEG allows the analyst to rank stocks based not only on their relative price like a PE but incorporate different growth prospects too. • Last, the analyst should extend the comparison to other multiples such as those based on asset under management (AuM) for asset management or embedded value for insurance operations. Research houses regularly calculate valuation sheets with key market data and multiples. The sheet in the example below shows:

7

A. Damodaran, Investment valuation, Chap. 14. FCFE Valuation versus Dividend Discount Model Valuation. 8 Forward and trailing PE—see Glossary for definitions.

Year (eur mn) Earnings Amortisation & depreciation Goodwill write-downs Cash flow Risk weighted assets CET1 capital(@ 12% CET1 ratio) Increase in CET1 capital Free cash flow to equity (FCFE) DIvidends paid out Payout ratio Dividends as % of FCFE Discount factor NPV of FCFE Risk-free rate Beta Risk premium Cost of equity Perpetual growth rate Terminal PE Terminal value Total value Terminal value as % of total value Shares outstanding (mn) Value per share

4% 1.3 4.5% 10% 2.0% 12.7 50,707 85,979 59% 3000 28.7

2022A 7000 200 400 7600 4,12,000 49,440 0

Table 5 DCFE valuation of Bank XYZ—example 1 2023E 7177 200 401 7778 4,19,828 50,379 939 6839 4103 57% 60% 0.910 6226

2 2024E 7359 200 402 7961 4,27,805 51,337 957 7004 4342 59% 62% 0.829 5804

3 2025E 7433 200 402 8035 4,35,933 52,312 975 7059 4518 61% 64% 0.754 5326

4 2026E 7508 200 402 8110 4,44,216 53,306 994 7116 4696 63% 66% 0.687 4887

5 2027E 7583 200 402 8185 4,49,546 53,946 640 7545 4980 66% 66% 0.625 4717

6 2028E 7659 200 402 8261 4,54,941 54,593 647 7614 4873 64% 64% 0.569 4333

7 2029E 7736 200 402 8338 4,60,400 55,248 655 7683 4764 62% 62% 0.518 3980

24 Valuing a Bank in Going Concern

Source: Authors

Current share price Upside potential Implied PE (2024) Implied P/TE (2023)

6.0 378% 11.7 1.71

Market Multiples 25

26

Valuing a Bank in Going Concern

• • • •

Market capitalization PE stated and adjusted Book value (BV) Adjusted book value, corresponding to tangible equity (TE), or adjusted net asset value • Price to BV and price to TE(P/TE) • Return on stated equity (ROE) and return on tangible equity (ROTE) (Table 6) As implied by finance theory, there is normally a strong correlation between the return on capital generated by a (listed) business and the price to capital multiple that investors are willing to pay for its shares. Based on such a correlation, it is possible to build a “value map” for a peer group of comparable banks belonging to the same market. Incidentally, we point out that the “correct” correlation is between the P/Capital and value added, i.e. the spread between the return on capital and the institution’s cost of equity. We can, however, make the simplifying assumption that that the cost of equity for banks belonging to the same market is very similar, which allows us to focus on returns only. The value map shown in the example below is a linear regression of P/TE against return on tangible equity (Table 7).

PE Valuation: An Example PE valuation is the ratio between the Price of a stock versus the earning per share (EPS). EPS is calculated on 2 or 3 years forward-looking perspective. To estimate the forward-looking EPS, the analyst should start from latest announced balance sheet and P&L figures. The key metrics of the relative valuation are listed in Table 8. To obtain the forward-looking estimates, we suggest the following steps: Step 1 Forecast balance sheet growth. The support materials for the analysis are: (1) macro estimates (as GDP, industrial production, consumer confidence, and other macroeconomic indicators). In many cases, it is possible to find a statistical correlation between macro indicator growth and the potential loans growth. The multiplication factor is also very much correlated with the loan’s penetration in the country (lower the penetration of loan over GDP and higher is the multiplication factor). Remaining asset growth can be forecasted based on the bank’s management business plan, bank’s expectation on possible market trends and marketing strategy. Step 2 Determine required equity by forecasting the required CET1 equity it is necessary to meet the capital requirements. Step 3 Forecast required funding mix by possibly matching estimated asset growth and liability plus equity. The financing of asset expansion, partially done via capital requirement, would come from a mix of liabilities that varies between banks and may be linked to factors such as the strength of the depositor base,

Source: Authors

Bank 1 Bank 2 Bank 3 Bank 4 Bank 5 Bank 6 Bank 7 Bank 8 Bank 9 Bank 10 Bank 11 Bank 12 Bank 13 Bank 14 Bank 15

Price Eur 25 49 27 20 22 23 34 18 6 46 25 20 28 19 29

Shares outst (m) m 1234 2015 260 2126 1982 871 1914 1907 900 1512 333 1924 1583 955 1526

Mkt cap EUR m 30,850 98,735 7020 42,520 43,604 20,033 65,076 34,326 5400 69,552 8325 38,480 44,324 18,145 44,254

Table 6 Banking sector valuation sheet—example

2.08 4.45 3.38 1.11 3.14 7.67 1.89 4.50 0.67 2.09 1.32 1.00 9.33 2.11 2.42

EpS

EpS adj. Eur 1.9 4.0 3.0 1.0 2.8 6.9 1.7 4.1 0.6 2.3 1.2 0.9 8.4 1.9 2.2

BVpS Eur 12.5 24.5 13.5 10.0 11.0 11.5 17.0 9.0 3.0 23.0 12.5 10.0 14.0 9.5 14.5 8.9 16.9 12.9 8.0 9.2 19.0 37.8 7.2 2.4 18.4 10.0 8.0 11.2 7.6 11.6

adj.BVpS 12.0 11.0 8.0 18.0 7.0 3.0 18.0 4.0 9.0 22.0 19.0 20.0 3.0 9.0 12.0

PE 13.3 12.2 8.9 20.0 7.8 3.3 20.0 4.4 10.0 20.0 21.1 22.2 3.3 10.0 13.3

PE adj. 2.80 2.90 2.10 2.50 2.40 1.21 0.90 2.50 2.50 2.50 2.50 2.50 2.50 2.50 2.50

P/TE

16.7% 18.2% 25.0% 11.1% 28.6% 66.7% 11.1% 50.0% 22.2% 9.1% 10.5% 10.0% 66.7% 22.2% 16.7%

ROE

ROTE Eur 8.0% 10.0% 25.0% 5.0% 7.0% 12.0% 18.0% 24.0% 4.0% 11.0% 20.0% 15.0% 8.0% 7.0% 2.0%

PE Valuation: An Example 27

28

Valuing a Bank in Going Concern

Table 7 Value map

Source: Authors Table 8 Valuation metrics Valuation metric Net income EPS Book value Tangible book Book value per share (BVPS) ROE ROTE Return on assets (ROA) Dividend per share (DPS) Valuation multiple P/E P/BV P/TBV Source: Authors

Formula Profits Earnings per share = Net income/# shares Shareholder equity Shareholder equity-intangibles (e.g. goodwill) Book value/# shares Net income/book Net income/tangible book Net income/assets Dividend/# shares Formula Current price/EPS Current price/BVPS Current price/tangible BVPS

PE Valuation: An Example

29

access to wholesale markets and access to bond markets. Banks would need to comply with certain requirement as Liquidity Coverage Ratios (LCR),9 Net Stable Funding ratio (NSFR)10 or less technical requirement as loan to deposit ratios. Using this metrics can help to calculate the required funding mix. Step 4 Forecast future profit and loss. Once calculated the new balance sheet it would be time to calculate the P&L impact derived from the additional assets and the new liability mix. In addition to the new balance sheet mix, it would be necessary to factor the expected interest rate trend and the factors influencing margin. Commission trend would be influenced by banks’ commercial policies, competition, and asset growth. When a bancassurance agreement is in place, the bank normally receives distribution fees based on agreed sales targets. Additionally, it is not uncommon for a bank to manage the funds backing insurance reserves. This is especially common for unit-linked reserves, which are normally invested in funds run by the bank’s asset management arm. Fees from this activity might be reported both under the umbrella of insurance commissions and asset management. The analyst should identify if overlapping exist and remove the double-counting from the valuation. Trading income would be impacted by the market trends and volatility. Operating expenses can be forecast using, ceteris paribus, the inflation rate or investments decision (e.g.: branches opening, hiring, bonuses decisions, depreciation, and amortization expected). Losses on loans are linked to PDs, LGDs, etc., like loan portfolio valuation methodology (see chapter “Loan Valuation”). Macro trends are crucial to calculate losses on loans. In many cases, it is possible to find a statistical correlation between macro indicator (e.g.: unemployment, GDP) and the potential losses. • The starting level of credit quality might be low after years in which a bank has posted above-average growth rates in its loan book and market share gains. • The expected evolution of default rates. In turn, this will largely be driven by GDP growth and changes in the level of interest rates, with the latter being positively correlated with default rates (higher interest rates increase the probability of default on mortgages and corporate loans as well as consumer credit) and the former negatively (better GDP growth should lead to lower default rates thanks to lower unemployment and higher average corporate profits). A decline in property prices can exacerbate issues of credit quality in that: (a) privates are more inclined to default on their mortgage obligations if they fall 9

BIS: LCR is designed to ensure that banks hold a sufficient reserve of high-quality liquid assets (HQLA) to allow them to survive a period of significant liquidity stress lasting 30 calendar days. HQLA are cash or assets that can be converted into cash quickly through sales (or by being pledged as collateral) with no significant loss of value. 10 BIS: NSFR is defined as the amount of available stable funding relative to the amount of required stable funding. This ratio should be equal to at least 100% on an ongoing basis.

30

Valuing a Bank in Going Concern

into negative equity; (b) a decline in house prices could lead to lower recovery rates for banks. Bank-specific issues also matter too, of course. For example, a strengthening of the risk management function may be beneficial for credit quality and so could the disposal of a portfolio of bad loans. For a European portfolio composed mainly of mortgages and loans to SMEs, we would argue that the average loan loss rate (i.e. loan loss provisions/net loans) should be, for EU Banks, on the base of the 1990–2020 average, circa 60 bps with peaks as high as 180 in the worst years of the credit cycle and lows at 20–30 bps in the best ones. Assuming a loss given default (LGD) of 50%, this implies a default rate just below 2%. Observing historical data on default rates as provided by rating agency S&P, such a number corresponds to the probability of default of a speculative-grade corporate (See graph below on historical default rates). The analyst should attempt to isolate the positive effect of recoveries on loan loss provisions since recoveries tend to appear near the peak of the credit cycle and usually do not last very many quarters. Lastly, we point out that LLPs should not be seen in isolation: an institution might exhibit higher than average LLPs, but this could be offset by lower fixed costs and/or better revenue margins. What matters at the end of the day is return on capital, or, better, its spread over the cost of equity (Table 9). Business plans can help the analyst form an idea about normalized earnings and so can interactions with the bank’s management. The results of the model should provide the forward EPS. The 2–3 years forward EPS would be the denominator of our PE valuation methodology. Differently from DDM, DCF, and WEV, the price earning valuation is a relative valuation methodology. We show, below, an example of a valuation using with peers’ multiples, in this case PE ratios. Five peers are selected, and an average PE calculated. This is applied to forward earnings, year 3 in our example, to obtain a valuation (Table 10).

Table 9 Global default rates—S&P Global Default Rates: Investment Grade Versus Speculative Grade 12 10

Investment grade Overall Speculative grade

%

8 6 4 2

19 81 19 83 19 85 19 87 19 89 19 91 19 93 19 95 19 97 19 99 20 01 20 03 20 05 20 07 20 09 20 11 20 13 20 15 20 17 20 19

0

Source: S&P

PE Valuation: An Example Table 10 PE valuation

31

Multiples PE Bank 1 Bank 2 Bank 3 Bank 4 Bank 5 Average Earnings (FY3) Valuation

9.8 8.5 15.7 12.8 8.9 11.14 7433 82,802

Source: Authors

PE analysis is a relative analysis. Analyst should be careful in comparing Banks in different countries using the same PE multiple. Various factors explain the generally higher multiples of US banks relative to their European counterparts. The key factor is arguably represented by differences in the business model. In particular.: 1. The different structure of the mortgage market. In US it is controlled by two GSEs (Government Sponsored Enterprises) Fannie Mae and Freddie Mac consolidating c. half of outstanding mortgages.11 On the contrary, most mortgages are retained on balance sheet by European banks, which, therefore leads to a higher capital absorption and lowers free cash flow. 2. A higher reliance by US banks on fee business in the capital markets business lines. Again, this implies a lower capital absorption. Both factors contribute to US banks operating with lower levels of required capital and, hence, higher cash flow and better returns, which, in turn, justify higher multiples, both on earnings (PE) and capital (P/BV P/TE). Additional factors are represented by the fact that the US banking market is ampler and more concentrated and by macro factors such as the higher GDP growth as well as a less depressed level of interest rates over the past several years.

11

J. A. Soler Martin, S. Carbo Valverde: market value of banks, an international comparison, Madrid, April 2020. https://biblioteca.cunef.edu/files/documentos/TFG_Jose_Antonio_Soler_Mar tin.pdf

32

Valuing a Bank in Going Concern

Banks and Inflation As concerns a bank’s balance sheet, inflation should largely be a “wash” in that neither loans on the asset side, nor deposits or the value of issued debt on the liabilities side, stand to be affected, as such.12 As regards the P&L, things may, on the contrary, look rather different in that several second-order effects kick in: a context of high inflation might compel the Central Bank to act, rising interest rates. A context of higher rates should benefit the net interest margin if, as it typically happens, banks can re-price their asset side faster and more decidedly than competitive pressures force them to pass higher rates to their depositors. Additionally, if the increase in rates leads to a steepening yield curve, banks should profit by engaging in more aggressive maturity transformation. However, a context of high inflation coupled with a depreciating domestic currency might create a difficult environment for certain products. We point out, for example, that volatile and rapidly rising domestic interest rates, particularly after the September 2022 minibudget, forced UK lenders to pull many existing fixed-rate mortgages from the market as these products had suddenly become very difficult to hedge. Fixed-rate mortgages are typically hedged with interest-rate swaps.13

Building a Value Map A “value map” is created by regressing a price over capital multiple (price to tangible equity—P/TE in our example) against a profitability indicator (ROTE in our example) having the same denominator. The regression allows the analyst to understand, briefly, which listed shares are undervalued: those sitting below the regression line, ceteris paribus, these should trade at a higher price to tangible equity, given their returns, i.e., sit on the regression line. Conversely, shares of banks depicted above the regression line are, ceteris paribus, overvalued. We point out, however, that: 1. The “ceteris paribus” qualification is arguably a strong one: various companyspecific factors can justify a discount to fair value. This is something that requires fundamental analysis. 2. As mentioned above, P/capital multiples should be regressed against riskadjusted returns rather than simple returns. The value map is a purely statistical tool and, no matter the strength of the correlation, (high, in our example, as exemplified by 90% R squared), should not be relied upon to make investment decisions, in our opinion. Nevertheless, the value

12 See T. Koller, M. Goodhart, D. Wessels (Mc Kinsey & co.): Valuation: measuring and managing the value of companies, Chap. 26 (inflation). 13 ECB working paper series (September 2018): Who bears interest rate risk?

Building a Value Map

33

Table 11 Value map

Source: Authors Table 12 Valuation of Bank XYZ with regression

EUR 0.000 Alpha Beta ROTE 3YE Fair P/TE TE 2025E Valuation

0.25 9.91 0.15 1.76 52,312 91,845

Source: Authors

map can support the analyst as an intuitive guide to identify stocks that may be undervalued or overvalued and hence help the analyst identify a smaller group of banks on which it may be worth carrying out additional and time-consuming fundamental research (Table 11). Inserting our bank’s ROTE (independent variable) in the regression formula, we obtain a fair P/TE (the dependent variable), hence a valuation for the equity of our bank. Since the key driver for value creation is the spread of returns over the cost of equity, a theoretically more correct version of the value map would use the spread (ROTE-COE) as the explanatory variable. Alternatively, the analyst could riskadjust returns by subtracting the value of credit default swaps from the ROTE. This method, however, fails to consider a properly calculated cost of equity (Table 12).14

14

HSBC Global Research, Greek banks, July 2020

34

Valuing a Bank in Going Concern

The Warranted Equity Value (WEV) Method Ensuing from the same principle of high correlation between returns and price to capital returns, we introduce the warranted equity value (WEV) as a commonly used valuation tool for banks. Indeed, the warranted equity value approach makes perfect sense if we want to value a capital-driven business model such as that of a bank. The WEV can be applied to the institution as a whole or to the entity’s individual business areas in a sum-of-the-parts approach (see below). The WEV is an extension of the economic value-added valuation method (EVA) in that: • It uses the normalized (sustainable) return on capital as its main input • Compare this to the hurdle rate (cost of equity). For our approach to derive the cost of equity, see below The WEV applies a “fair” P/capital multiple to divisional capital or to the bank’s overall equity. The fair P/capital is, driven by value added, i.e., the spread of the (sustainable) returns on capital over and above the cost of equity (COE). The higher the sustainable return and the lower the volatility of returns (and hence the COE), the higher the valuation, consistently with finance theory. To estimate a sustainable return on capital (ROE), the analyst should use a process like the EPS-PE methodology. He/she should look for normalized earnings, i.e. remove the effect of one-off factors from earnings and project earnings some years into the future. To obtain the Return on Tangible Equity (ROTE) analyst should divide the forward-looking estimated EPS with the Capital (less goodwill). As for the estimation of the cost of equity, factor models such as the CAPM or Fama–French can be used (See chapter below). The formula for the WEV is represented by a perpetuity of the value (V) created by the business, i.e. the return on capital (tangible equity for a bank) over and above the cost of equity (k). where g represents the sustainable LT growth in economic value, (i.e. the time during which the current spread of ROTE-COE can be sustained), while TE is constituted by capital (tangible equity). The size of the spread of ROTE-G over COE-g creates a “fair” P/TE multiple, which is applied to tangible equity. V=

ROTE - g × TE: K -g

Alternatively, V can be derived as the perpetuity of sustainable value added, i.e., by first calculating the difference between return on TE and COE in numerical terms (e.g. in EUR m) and then dividing by (k-g).15

15 For Economic Value added, see: A. Damodaran, Investment valuation, Chap. 32; And T. Koller, M. Goedhart, D. Wessels (McKinsey): Valuation (1990), Chap. 38. The authors define value added in the banking sector in an interesting way: value added on loans, for instance, is defined as (a) net interest margin less (b) MOR (matched opportunity rate), i.e. the return that the bank could have

Capital—How to Treat It Table 13 WEV valuation of Bank XYZ—an example

35

ROTE Cost of equity Perpetual g Fair P/TE TE Valuation

15% 10% 2% 1.7 52,312 88,121

Source: Authors

The following is an example of a valuation carried out with a warranted equity value. The key inputs are represented by: • The bank’s sustainable return on tangible equity (14%) • A CAPM-derived cost of equity (10%) • A perpetual growth of 2%. This should refer to the growth in capital which can be deployed at the assumed ROTE, though the growth rate in earnings is sometimes used as a proxy The WEV formula returns a fair P/tangible equity of 1.5×, well above 1×. Since the spread between returns and cost of equity is largely positive, this makes sense (Table 13).

Excess Return Models Excess return models constitute a generalization of the WEV: it sums the PV of excess returns (economic value added) to equity holders to existing capital, to obtain an equity valuation. Unlike in the WEV, which is based on a perpetuity, implicitly if the inputs to the valuation will stay the same, in the excess return models, EVAs estimated year-by-year analytically.16 The valuation in the example below has the beginning of 2023 as a reference date. We have used the same inputs as in our DDM and DCFE examples above, wherever possible, e.g. our CAPM-derived cost of equity of 10% (Table 14).

Capital—How to Treat It Firstly, the analyst should allocate capital by division, generally using 8–12% of divisional RWA17 as a driver. This is in line with somewhat above regulatory minimums. It is important not to penalize riskier business areas such as investment

earned on investments with a similar duration and risk profile less (c) a tax penalty on required equity capital and on the portion of loans funded by equity. 16 see: A. Damodaran, Investment valuation, Chap. 21; excess return models. 17 RWA: https://www.investopedia.com/terms/r/riskweightedassets.asp.

36

Valuing a Bank in Going Concern

Table 14 Excess return valuation of Bank XYZ—example Year (eur mn) Earnings Tangible equity ROTE COE Excess return EVA Discount factor NPV Invested capital Sum of discounted EVAS 2023–2028 Terminal value Total value Shares outstanding (mn) Value per share

2022A 7500 49,440 15.2% 10%

1 2023E 7690 50,379

2 2024E 7885 51,337

3 2025E 7964 52,312

4 2026E 8044 53,306

5 2027E 8125 53,946

6 2028E 8206 54,593

7 2029E 8289 55,248

15.3% 10% 5.4%

15.4% 10% 5.5%

15.2% 10% 5.4%

15.1% 10% 5.2%

15.1% 10% 5.2%

15.0% 10% 5.2%

15.0% 10% 5.2%

2727 0.91

2828 0.83

2811 0.75

2793 0.69

2811 0.63

2829 0.57

2847 0.52

2483

2343

2121

1918

1757

1610

1475

49,440 12,233

18,789 80,461 3000

26.8

Source: Authors

banking by allocating too much capital to them. This might happen, for example, if the analyst chooses to allocate more capital than average (e.g. 12% of RWA versus 8% for other divisions to a business area which is already more RWA-intensive than the rest of the group). Secondly, analysts can derive the value of each division on the basis of different valuation methods: e.g. a WEV for capital-intensive business areas, a DCF for cashgenerating businesses such as asset management. Market multiples when a significant number of listed peers exists for a division or business area. Third, we can derive a figure for excess capital/capital shortfall. This is given by the difference between available shareholders’ capital, and the sum of divisional allocated capital. Other sources of capital such as minorities, subordinated debt, super-subordinated notes included in shareholders’ equity and preferred shares, which are usually included within minorities, should all be removed from available capital for valuation purposes in that they are not supplied by common equity holders. Regarding the definition of available capital, to be prudent, we recommend taking the lower of tangible net asset value and common equity Tier One capital.

Capital and a Word of Caution on the Danish Compromise: A Numerical Example

37

Lastly, we discount the face value of excess capital by 25%, to consider agency costs. The discount is, however, subjective: the analyst could very well use a zero discount if he/she believes that management is going to deploy excess capital at a rate that is in line with the institution’s cost of equity or is likely to return excess capital to shareholders in full and reasonably quickly. Some banks might show a capital shortfall under this definition. We discount this at 15%, to reflect the fact that part of the shortfall could be covered by subordinated debt, whose face value is reduced by the tax shield. On the contrary, the analyst might choose to apply a higher discount if management has a poor track record as per value creation via M&A and/or the distribution of excess capital is penalized from a tax standpoint.

Capital and a Word of Caution on the Danish Compromise: A Numerical Example Special caution should be used when assessing the existence of a capital surplus for financial conglomerates using the Danish compromise. We cite (Intesa Sanpaolo Pillar III 2019, pg 13 re: own funds) for the definition of the “Danish compromise” (DC): Article 49 of Regulation (EU) No 575/2013 (CRR) grants financial conglomerates the option to activate (with the prior permission of the competent authorities) the so-called Danish Compromise, which permits banks that hold own funds instruments in insurance companies not to deduct those significant investments from Common Equity Tier 1 Capital (CET 118), weighing them at 370% for the purposes of RWA, reducing capital absorption. As a “financial conglomerate” with a Parent Company of a banking group—Intesa Sanpaolo Spa—which controls the Intesa Sanpaolo Vita Insurance Group, on 9 May 2019, the Intesa Sanpaolo Group submitted the request for authorization to the competent supervisory authorities and received permission from the ECB on 9 September 2019 to calculate the Group’s consolidated capital ratios by risk weighing the insurance investment instead of deducting it, with effect from the report as at 30 September 2019. The amount of T2 subordinated instruments issued by the Group’s insurance companies and held by (Intesa Sanpaolo Pillar III 2019, pg 13 re: own funds). Ceteris paribus, the DC allows a conglomerate to free up a substantial amount of equity capital. If the analyst expects that, for whatever reason, that supervisors might restrict the use of the DC, therefore, he/she should apply a discount to the capital freed-up by the DC, in our view. Let us assume that a bank with EUR 82 m in common equity Tier One (CET1) capital and EUR 1000 m RWA owns 95% in an insurance company having an equity capital of EUR 40 m. The bank’s CET1 ratio would be EUR 82/1000 = 12%.

18

CET1 capital: https://www.investopedia.com/terms/c/common-equity-tier-1-cet1.asp

38

Valuing a Bank in Going Concern

Table 15 Capital relief from the Danish compromise—a numerical example Bank CET1 capital RWA CET1 ratio Insurance capital Stake owned

Base 120 1000 12% 40 95%

Ordinary regime 82 1000 8%

Danish C. 120 1140.6 11%

370%

14%

Source: Authors Table 16 Summary of valuation methods Method DDM DCFE PE EVA WEV Statistical Average

Value EUR mn 57,671 85,979 82,802 80,461 88,121 91,845 81,147

Per share Eur/share 19.2 28.7 27.6 26.8 29.4 30.6 27.0

Upside -20% 19% 15% 12% 22% 28% 13%

Implied PE 7.2 10.8 10.4 10.1 11.1 11.5 10.2

Implied P/TE 1.10 1.64 1.58 1.54 1.68 1.76 1.55

Source: Authors

Under the ordinary regime, the bank would have to deduct from its CET1, its stake (95%) in the insurance company’s capital, or 95% of EUR 40 m. If RWA remains unchanged, this would lead to the CET1 ratio declining a hefty 4PP to 8%. Under the DC, on the contrary, the amount of CET1 capital is almost unchanged. The stake held in the insurance company is risk weighted at 370%, which increases total RWA by 14%. The new CET1 ratio is 11%, down only 1 pp versus 4 pp under the CRR’s general regime. The application of the DC allows the institution to reap a sizeable 3 pp higher CET One (Table 15). Assuming a target CET1 is, e.g., 10%, the conglomerate will have excess capital in the base case and a shortfall in the other cases, especially with no DC. We show, below, a recap of the valuation methods used in our examples, along with a theoretical upside potential, implied PE, and implied P/TE (Table 16). The statistical method values bank XYZ at EUR 30.6/share, with an implied PE of 11.5x and a P/TE of 1.76x. It is the most generous valuation methodology. Of the four fundamental “absolute” valuation methodologies (DDM, DCFE, EVA, and WEV), the latter appears to be somewhat more generous than the others. We point out, however, that the WEV valuation of EUR 29.4/share is not too distant from the others and, in fact, rather close to the EUR 28.7/share of the DCFE. Given the theoretical formulaic identity of EVA and DCF, we find this reassuring.19 Unsurprisingly, the DDM valuation is the most conservative, valuing Bank X at a modest 19 See T. Koller, M. Goedhart, D. Wessels (McKinsey & co.): Valuation: measuring and managing the value of companies, appendix A (discounted economic profit equals discounted free cash flow)

Market Multiples as a “Control” Method

39

7x PE and only marginally above its tangible equity. In general, we take comfort from the fact that values are rather concentrated around the mean value of EUR 27/share: the standard deviation of the distribution is less than EUR 3.5 and the coefficient of variation (standard deviation divided by the mean) is a modest 16%. Our relative valuation methodology (peers’ PE) returns a value of EUR 27.6/share, not far from the average.

A Sum-of-the-Part Valuation: A Practical Example In the previous examples, we have valued our hypothetical bank’s equity in its entirety. We will now discuss a sum-of-the-parts approach, where each business area is allocated its own slice of tangible equity and valued independently. A WEV can thus be used for most banking businesses (retail, investment banking), a DCF for highly cash-generating businesses such as asset management, embedded value for insurance operations. As mentioned, we then discount the face value of excess capital by 25%, to consider agency costs. The discount is, however, subjective: the discount could very well be zero if the analyst believes that management is going to deploy excess capital at a rate which is in line with the institution’s cost of equity or is likely to return excess capital to shareholders in full and reasonably soon. On the contrary, the analyst might choose to apply a higher discount if management has a poor track record as per value creation via M&A and/or the distribution of excess capital is penalized from a tax standpoint. In the opposite case, a bank might show a capital shortfall. We discount this at 15%, to consider the fact that part or all of the shortfalls could be covered by subordinated debt, whose negative value for shareholders is reduced by the tax shield (Table 17). The first two columns on the left-hand side contain essential economic information pertaining to each of the bank’s division or business area, i.e. earnings and riskweighted assets (RWA). The analyst should use normalized earnings, removing the effect of one-off factors and projecting earnings 2–3 years into the future, if possible. Business plans can help the analyst form an idea about normalized earnings and so can interactions with the bank’s management. The loan loss rate (LLP/net loans) should be normalized to reflect the risk of the loan portfolio. It is a warranted equity value approach (WEV) that we apply to most banking divisions/business areas. However, as mentioned above, this need not necessarily be the case: a DCF can be used to value low capital-intensity, high cash flow businesses such as asset management, embedded value for insurance operations.

Market Multiples as a “Control” Method We also use PE as a “sanity check” for our divisional values. This helps the analyst ensure that the values of the institution’s business areas are consistent:

Source: Authors

Rf Beta Risk premium (d) CoE (e)c/(d) fair P/BV (b)x (d) = (f) valuation PE (X) Notes

Division EUR m (a) Earnings RWA Capital/RWA (b) Capital (c)(a/(b) ROC

Retail banking 150 15,000 9% 1350 11.1% 11.1% 5% 1.1 4% 9% 1.2 1596 10.6

Table 17 SOTP valuation of Bank XYZ Investment banking 130 8667 12% 1040 12.5% 12.5% 5% 1.3 4% 10% 1.2 1275 9.8 2565 18.3% 18.3% 5%

175 Nm 108.6% 5% 3 4% 17% Na 2850 15.0 DCF for AM 0.0

5%

Total-operations 470 23,667

Asset management 190 0

Excess capital 20 8000 11% 5130 Nm 0.4% 5% 0.8 4% 5% 0.75 3848 192.4 25%discount

9568

4% 5%

Total-bank 490 55,333 Nm 10,260 4.8% 4.8% 5%

40 Valuing a Bank in Going Concern

ROE Dupont Decomposition for Banks

41

• With those of listed peers in the same or similar markets, if available • With the multiples paid in recent M&A transactions. To ensure this, the analyst should extend the comparison to other suitable multiples such as those based on AuM for asset management or embedded value for insurance operations For banks having a defined-benefit pension fund, a shortfall (usually disclosed in the notes to the annual Report) should be subtracted from the valuation in that it is shareholders that are responsible for plugging in the shortfall.

ROE Dupont Decomposition for Banks The classic Dupont ROE decomposition can be extended to banks, with only minor variations (Table 18). Relative to an analysis valid for an industrial entity, we have added only a few, mainly P&L-related, ratios: Table 18 Bank-ROE decomposition P&L Net revenues Expenses Gross operating profit Llp EBT Taxes Minority interests Net income Balance sheet Net loans Total assets Deposits Shareholders’ equity Ratio Net income/EBT EBT/GOP GOP/net revenues Asset turnover Leverage Loan loss rate (basis points) ROE Source: Authors

(EUR mn) 1000 -561 439 -129 310 -30 -6 274 (EUR mn) 21,500 46,500 36,500 10,000 88% 71% 44% 2% 4.65 60 2.7% 2.7%

Comment Share of income not absorbed by taxes & minorities Loss absorption capacity 1—cost-income ratio Not much sense for a bank RE: LLP/net loans

42

Valuing a Bank in Going Concern

• Net income/EBT, which represents the share of pre-tax profits not lost to taxes and minority interests. • Gross operation profit (EBT/GOP), a measure of loss absorption capability. The complement to 1 of these ratios is indeed the share of profits lost to loan loss provisions (including write-offs, known in Europe as the main component of the cost of risk).

Cost of Equity While its power to predict equity returns is too low according to part of the doctrine, the single-factor capital asset pricing model continues to be widely used by practitioners, including bank analysts. Its main advantage is its simplicity: betas can be obtained from several data providers such as Bloomberg and DataStream while the market risk premium is derived from historical data series and conventionally set at 3–6%. Given the fact that debt is part and parcel of a financial institution’s business, levered betas are of little significance and little used by practitioners. For non-listed institutions, the analyst may resort to using the cost of equity of peers listed in the same or similar markets.

Factor Models for COE ECB researchers have used the CAPM as well as other factor models (e.g.: Fama– French) to estimate the cost of equity of Euro area banks (See: ECB Occasional paper series, January 2021. Measuring the cost of equity of Euro area banks). The mean cost of equity is estimated at 7.33% with the CAPM and 12.45% with the Fama–French factor model. Results are consistent with Coco (contingent convertible debt) yields.

Bottom-Up Approach to the COE for the SOTP Cost of equity based on division/geography/leverage: Our WEV model compares normalized returns on (divisional) capital with divisional costs of equity. These are obtained by summing up country risk-free rates and division-specific betas times a market risk premium20

20

It should be borne in mind that the analyst should use perspective betas for valuation. Historical betas should be seen as a useful starting point but not necessarily accepted and used as God’s immutable will, as some analysts seem want to do.

Consistency Between COCO Yields and Cost of Equity

43

1. Country risk-free rates correspond to rates on long-term (10Y) sovereign debt. We recommend using the risk-free rate of the country where the business is based. 2. Division betas can be derived by listed pure play businesses. While the analyst is allowed a degree of discretion in imputing the divisional betas, these should be consistent: divisions with more volatile returns, e.g., investment banking, should receive a higher beta than businesses with more defensive profiles, e.g. asset management or retail banking. 3. We use a 4% risk premium across the board.21 The bank’s cost of equity is then derived “bottom up” as the weighted average of divisional cost of equity, with the weighting driven by the amount of capital allocated to each division. Excess capital can be assumed to have a cost of equity equal to the risk-free rate. This bottom-up approach leads to different estimates for the cost of equity, depending on each bank’s business composition, geographic diversification, and leverage, given by the size of the excess capital or capital shortfall. This is entirely consistent with finance theory, in our view.

Consistency Between Capital, Liquidity, and Cost of Equity An important sanity check consists in making sure that institutions with riskier business models are, ceteris paribus, valued using a higher cost of equity than less risky ones. The analyst should consider, in particular: 1. A bank’s capitalization (common equity tier one, total capital ratios), leverage (leverage ratio) 2. Liquidity and funding (LCR, NSFR, loan to deposit ratio)

Consistency Between COCO Yields and Cost of Equity If a bank has issued COCO bonds (contingent convertible debt), then the yield on Cocos should be considered as a floor for the cost of equity: Cocos combine elements of fixed-income and equity investments and are, therefore, less risky than pure common equity. Hence, the required return on Cocos must logically be lower

21 See T. Koller, M. Goedhart, D. Wessels (McKinsey & co.): Valuation: measuring and managing the value of companies, Appendix G, where the (historical)global risk premium is calculated to be 4.5% for the years 1967–2016 and 4.2% for 1900–2016. T bills are used as the risk-free asset. On the cost of equity, see also: A Damodaran, Investment valuation, Chap. 4 (estimating risk parameters and cost of financing), Chap. 7 (riskless rates and risk premiums), & Chap. 8 (the cost of equity and capital).

44

Valuing a Bank in Going Concern

than that of equity instruments, consistently with the principle of investors’ risk aversion.

Reference Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation: Measuring and managing the value of companies. McKinsey & Co..

Banks M&A: Strategy and Valuation

Abstract

Valuing a Bank in an M&A scenario can be challenging, and several factors and points of views would need to be considered. The starting point of an M&A valuation can be the traditional methodologies used for valuing a Bank in a normal scenario. In this chapter, we investigate some of the critical aspects of a Banking M&A and the valuation implications from two points of view: the shareholders’ point of view and the supervisors’ point of view. From the shareholders’ point of view, the key aspects to be considered are the calculation of the synergies arising from the M&A and the potential earning accretion/ dilution. On the other side, Banks M&A are always assessed by supervisors on a case-by-case basis. The main objectives from their point of view will be to ascertain, to the extent possible, the sustainability of the business model of the combined entity. In this sense, the analysis of the potential goodwill impairment represents a key component of the consideration.

Rationale for Banking M&A In the past 20 years, the two main drivers for Banking M&A were cost reduction in mature markets and expansion into higher growth markets. Acquisition of smaller companies, usually in the same line of business, that presents strategic value was often regarded as the best way to get scale and critical mass in niche products and selected geographies. At the same time, where critical mass is seen as unobtainable or where the underlying profitability of the operation is seen as inferior companies proceeded to selected disposals. There are however other several factors that could incite a company’s management to launch a takeover bid. This could involve: 1. Deploying a capital surplus 2. Expand product and service offering # The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 A. Santoni, F. Salerno, How to Value a Bank, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-031-43872-1_4

45

46

Banks M&A: Strategy and Valuation

3. 4. 5. 6. 7.

Expand customer base Desire to find new sources of top line growth by entering new regions Access the target’s complementary products or regional coverage A need to reach economies of scale Exploit a valuation premium (i.e. a Bank is trading at premium multiples relative to the sector average providing it with a strong currency for a payment in shares) 8. Funding synergies: it may be beneficial for a bank whose funding is mainly institutional and, perhaps, concentrated towards a small number of providers, to purchase a bank with more diversified funding sources and a lower loan to deposit ratio 9. Tax efficiency Valuation considerations are very important to allow management to justify an offer to acquire a competitor. In the event of a hostile bid, the management of the buyer might argue that the two companies are complementary and that the merger, thanks to the synergies, would create shareholder value. The price paid for the target would be crucial for the determination of the positive shareholder value for the buyers as we will see in the example. A key metric to judge a merger or an acquisition are the synergies that the deal would be able to produce. Synergies can be defined as the value that the combination of two entities is able to produce following their merger. Synergies can be defined revenue synergies when they are the results of top line value creation (eg: they could come from cross selling, share of wallet increases thanks to new products, new market access). On the other side, synergies deriving from cost cutting are defined as cost synergies. They usually are generated from economies of scale and scope. There is also a third source of synergy that can be defined as pure financial synergies that could be generated by RWA optimization, tax benefit, reduction in cost of funding, reduction in cost of capital among others. Deutsche Bank analysts analysed1 the merger and acquisition track record of European Banks in the period 1999–2015. They found that cost synergies represented 33% of the target cost base on average in the in-market M&A of the European Banks. For the cross-border M&A, they found that the cost synergies represented 17% of the target cost base. The difference derives from lower complementarities reducing the cost cutting opportunities (Table 1). For US Banks, expected in-market cost savings for transactions reached 35% (of the seller’s non-interest expenses) versus 25% in 2010.2 There could be some easy hanging fruits synergies in case the target presents features as: 1. Governance issues that create incoherent or unconvincing strategies 2. Distrust by the market as results of bad investor communication strategy

1 2

Deutsche Bank (2015). Olsen and Palmer (2019).

M&A Transaction from the Supervisor’s Point of View Table 1 Costs synergies from Banks M&A (1999–2015)

In-market M&A Italy Iberia Greece Nordic Germany France UK and Irish Average EU cross-border transaction

47

Synergies % target costs 25% 44% 8% 27% 57% 22% 29% 30% 17%

Source: Author, DB, Reuters, Bloomberg

3. Weak revenue generation as a result of lack of product cross selling or ownership of a limited clients’ share of wallet. This means to be easier for the buyer to rectify if the weakness is the result of managerial or marketing mistakes rather than issues affecting the base, e.g. product overpenetration 4. High-cost base as a result of inefficiencies From a pure valuation point of view, the most common characteristics observed for the search of the ideal target for an M&A deal would include: – Attractive valuation—a discount valuation versus the sector characterized by a 12 m or 24 m forward P/E below sector median. – Low expected growth—with analyst estimating EPS growth below sector median. – Low dividend yield expectation characterized by low earning generation or by lack of capital. Once the deal has been agreed in the case of a friendly M&A or the deal has been decided in the case of a hostile take-over is decided or agreed there are however two main points of view to consider: the supervisor point of view and the market point of view.

M&A Transaction from the Supervisor’s Point of View Once a deal has been decided by the buyer, one of the most important next steps would be to obtain the green light from the Supervisors (Central Bank). Supervisors’ assess M&A deals on a case-by-case basis. The main objectives from its point of view will be to ascertain, to the extent possible, the sustainability of the business model of the combined entity. Key criteria for the assessment would be from one side the managerial capacity to execute the deal and from the financial point of view, capital, liquidity, business model, and risk profile (including quality of assets and operational risk) of the combined entity.

48

Banks M&A: Strategy and Valuation

For this purpose, Supervisors3 will investigate the business plan presented by the management mainly focusing on: • Business plan assumptions. These are expected to be conservative and appropriately justified and documented by solid microeconomic and macroeconomic assumptions that form the baseline scenario • Company is expected to provide tangible signs of capacity of turnaround capacity based on experience and truck record • The targets are expected to comply with applicable regulatory requirements and supervisory measures at each year of the plan • Targets should avoid any reliance to optimistic revenue targets based on unproved sale or marketing capacity or excessive risk taking • Cost synergies should not rely on layoffs plan that is difficult to obtain unions green light thus creating frictions or higher than expected layoffs costs • A liquidity and funding structure, consistent with macro and micro business developments assumptions and the company risk appetite • A detailed IT integration plan • Provide a detailed and credible roadmap and timeline to achieve the targets announced Among the criteria particularly important for the Supervisor, two of them have relevance: governance and risk management. The governance and organizational structure of the business combination is expected4 at the level of the management body to have a clear decision-making capacity and an adequate composition with a clear allocation of responsibilities and decision-making processes as governance arrangements of the business combination. The merger should be managed by a strong leadership team with a proven track record while the consolidation plan includes the timely integration of the risk management and internal control framework, in particular the mitigation of execution risk.

M&A Transaction from the Market’s Point of View: Key Criteria on Top of Regulators From a shareholder’s point of view, the criteria that a manager would need to consider when decides to launch a deal would include the following:

3 https://www.bankingsupervision.europa.eu/legalframework/publiccons/pdf/consolidation/ssm. guideconsolidation_draft.en.pdf. 4 Section 2 of ECB Banking Supervision: SSM Supervisory Priorities 2020, the SSM supervisory statement on governance and risk appetite, and Section 5 Element 2: Internal governance and risk management of the SSM SREP Methodology.

M&A Transaction from the Market’s Point of View: Key Criteria on Top. . .

49

1. Will the deal be EPS accretive or dilutive (these aspects need to be explained to shareholders after allowing for a possible a) capital increase and/or share swap b) synergies)? 2. How are the synergies calculated? Management would need to consider the following potential sources of synergies: Costs synergies • • • • • •

Branches overlap and the cost to close Headquarters (HQs) to reduce Product companies to merge Number of employees per branch to optimize the distribution IT to integrate or not One-off costs (usually ca 5% of combined cost base) Revenue synergies

• • • • • • • •

Market share pre and post Product company’s diversification Funding gap (e.g. cost of funding difference between the two Banks) Liquidity mismatch (e.g. Mismatch in maturity to cover) Customer spread gap in general Products penetration AUM penetration per branch Quality of the revenue line of the target (% of trading income)

Management should verify if due diligence has been performed on asset quality and other legacy. On asset quality, the buyer might want to pay special attention to the NPL coverage gap, under various standpoints: • Split NPL secured/unsecured portfolio • NPL vintage gap. The longer an NPL (with similar collateral) stays in the balance sheet of a Bank, the lower the probability to be recovered • Other risks such as legal and money laundering risks Capital impacts from the deal could concern: • RWA density. The buyer could have acquired expertise in calculating RWA with internal models, which the target may be lacking, thus having to rely on standardized models for the calculation of RWA. The acquiror might, therefore, be able to re-calibrate the target’s RWA based on its more sophisticated and efficient models. This could lead to lower capital requirements for the combined entity. The benefit might as well stem from the acquiror’s getting hold and leveraging better expertise in the target entity.

50

Banks M&A: Strategy and Valuation

Table 2 M&A valuation, value created Market value (day announcement) Bank buyer Bank target Combined pre deal value Pre-tax synergies Post tax synergies Value of synergies based on 10× 2Y FW PE After-tax one-off costs Combined post deal value % Market value created

US $ bn 80 50 130 3 2

A B C=A+B D E

20 -5 145 12%

E*10 G H=C+E+G H/C-1

Source: Authors

• Goodwill/badwill: A business combination transaction may result in the generation of goodwill or badwill. If the market valuation of a bank is below book value, badwill will be generated. In principle, Banking Supervisors recognize duly verified accounting badwill as capital from a prudential perspective. However, Supervisor expects it to be used to increase the sustainability of the business model of the combined entity. This happens when the bank uses badwill to increase provisions for non-performing loans, to cover transaction, integration costs, or other investments. Or simply retains it to boost capital ratios. On the contrary, supervisors’ frown upon badwill being distributed to shareholders as dividends or buybacks. Once the deal has been approved by the Supervisors and the synergies properly calculated by the management, then the most important step would be to convince equity analysts and the shareholders on the value creation capacity of the deal. One of the most common and easy techniques to evaluate the value added from an M&A relies on a PE valuation methodology. The steps are the following: Step 1: Consider the market cap pre-announcement of the two company (a) Step 2: Consider the synergies announced by the banks ($bn) net of tax and net of one-off costs and apply the average PE multiple of the banks under consideration to obtain the total net synergies created by the deal (b) Step 3: Sum (a) and (b) to get the expected new market cap of the new bank created from the deal Below is an example of a friendly full shares’ merger between two Banks (Table 2). Several caveat to this calculation should be made:

Accretive Versus Dilutive Deal

51

• Synergies should be discounted for their expected feasibility and credibility. Usually cost synergies are considered credible because more tangible. On the contrary, the credibility of revenue synergies is lower due to the higher execution risks as such are usually heavily discounted. • Time of execution. Synergies should be discounted for the expected timing of execution. If the PE valuation is 2 years forward, then the synergies that can be added to the valuation are the 2 years announced while the remaining should be subject to a special valuation assumption.

Accretive Versus Dilutive Deal Acquisitions sometimes involve a capital increase. This is because the buyer must finance the deal while maintaining the regulatory capital required by the Supervisor and other market stakeholders as rating agencies and equity analysts. To evaluate the possible accretive or dilutive impact on the buyer’s earnings per share it is important to compare the buyer EPS pre-acquisition with the EPS post-acquisition. The EPS post-acquisition can be calculated assuming the earnings estimated for the target bank are summed up to the synergies excepted. The new future earnings will be divided by the new number of shares (post capital increase). In the example below, the acquisition represented an accretive deal for the buyer with a positive impact (EPS accretion) of 22% already from year 3. This matrix is usually used by analysts and traders to evaluate in the short term an M&A deal. For the value creation of a deal in the long term, a valuation methodology as DCF analysis should be used (Table 3).

Table 3 Bank acquisition simulation A

B C D E = A/C F=B/D F/E Source: Authors

EUR millions Net profits (NP) Bank acquirer NP bank target Post tax one-off charges Post tax synergies Pro forma Bank acquirer NP # Shares Bank acquirer Pro forma # shares Bank acquirer EPS New Bank acquirer EPS Accretion/dilution

Year 1 1000 500 -400 60 1160 1500 2000 0.667 0.580 -13%

Year 2 1050 540

Year 3 1100 550

80 1670 1500 2000 0.700 0.835 19%

140 1790 1500 2000 0.733 0.895 22%

52

Banks M&A: Strategy and Valuation

NPV Valuation in M&A Below we provide a simplification of a Net Present Value valuation methodology for an M&A transaction mainly focusing on capital deficit versus the target CET 1. The process foresees the following steps (Table 4): 1. Identification of the cost of equity for the calculation of the discount rate for the terminal value, long-term growth (in line with long-term GDP growth of the country where the Bank operates), and the common equity target in line with the Supervisors’ expectations. 2. Estimates of the RWA growth and the common equity excess/deficit of capital versus the Supervisors’ expectations. In case of capital deficit, the model should include the potential impact. 3. Estimates of net profits and dividend for the full period. 4. Calculation of the TV on the base of adjusted terminal value net profits and final RWA versus target CET1. Terminal value = ðAdjusted Net Profit TVÞ ð1 þ gÞ=ðcoe - gÞ - ½RWA final 2028 CET target g 0:33=ðcoe - gÞ 5. Calculation of the Core Equity Value as: Core Equity value = Sum FCF 2024–2028 þ Excess=deficit initial capital þ NPV TV

Premium over Deposits According to the S&P Global Market Intelligence data5 the median M&A tangible book premium to core deposits during the period 2017–2022 in US ranged from over 9% in the period 2017–2018 to 6.9% in 2022 and an average 1.5× PBV. Range varies depending on how Banks are looking to M&A to solve funding pressures, making targets with low-cost core deposit bases more valuable. Premium to core deposits is a valuable “sanity check” valuation method (Table 5). An additional step to a more granular valuation metric would be to add to core deposits valuation a clean book analysis. This analysis would involve a valuation of the loan book portfolio, with a special focus on NPL, and compare the current coverage versus peers’ comparison. This would allow us to discount the possible

5 https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/fundingarms-race-drives-up-m-a-pricing-for-banks-with-low-cost-deposits-73457534.

Premium over Deposits

53

Table 4 NPV valuation (example with fictitious numbers) i ii iii

iv v a) b) c) d) e)

f)

g)

h) i) j) k) l)

n) o) p) q) r) s)

NPV valuation Risk-free rate TV Beta TV Equity risk premium Cost of equity (I + ii*iii) Long-term growth net profits Long-term growth RWA Target CET 1 2025 Capital buffer CET 1 2025 (iv + v) RWA initial RWA final CET 1 initial CET 1 final ROE Excess/deficit capital initial (c-target CET1%) * a Remuneration excess/deficit e*(riskfree rate) * (1-tax rate) Excess/deficit capital final (d-target CET1%) * b Net profits Dividends Capital increases Net profits adjusted (net of f). i-f Delta BV due to distribution excess cap/rec = g-e-j Free cash flow distributable = k + l Discount factor = 1/ (1 + i t)t-0.5 NPV free cash flow = n*o Sum FCF 2024–2028 Excess/deficit initial capital Net profits TV

2023 4.02% 1.17 4.00% 8.70%

2024

2025

2026

2027

2028

120,829 121,762 8.18% 8.66% 10.87% -987

121,762 125,041 8.66% 9.12% 11.42% -408

125,041 128,449 9.12% 9.60% 11.90% 147

128,449 144,706 9.60% 9.10% 11.13% 772

144,706 148,709 9.10% 9.53% 11.52% 151

-26.5

-11.0

4.0

20.8

4.0

-408

147

772

151

791

1172 586 0 1199

1316 658

1467 733

1452 726

1603 802

1327

1463

1431

1599

578

556

625

-622

641

1777

1882

2088

809

2240

0.96

0.88

0.81

0.75

0.69

1705

1661

1695

604

1539

1.00% 1.00% 9.00% 0.12% 9.12%

7203 -987 1619 (continued)

54

Banks M&A: Strategy and Valuation

Table 4 (continued) t)

u)

v) w) x) y) z)

NPV valuation Remuneration excess/deficit capital in TV Terminal value (s-t) (1 + g)/(coe-g)[RWA final 2028*CET target*g*0.33/ (coe-g)] Discount factor TV NPV TV = u*v Core equity value = q + r + w Tangible book 2023 P/TBV implicit x/y Current PBV Upside

2023

2024 6.05

2025

2026

2027

2028

20,587

0.69 14,144 20,360 10,550 1.93 1.16 66.8%

Source: Authors Table 5 Example M&A tangible book premium to core deposits

EUR mln Book value Intangibles Tangible book value Core deposits % Premium Total value

2022 1000 200 800 20,000 6.90%

Value

800 1380 2180

Source: Authors

hidden losses derived from under-collateralization of the portfolio or overvaluation of the collateral. The analysis would involve the haircut of the book value for the hidden NPL losses.

Capital Increase and TERP An important practical consideration in the analysis of an M&A deal would derive from the calculation of the Theoretical Ex-Rights price or the so-called TERP. Investors , in order to decide to acquire the new shares issued, would likely compare the TERP to the spot share price share and, as a consequence, the current valuation with the implied valuation of the new shares. The steps to calculate the TERP are:

Goodwill Valuation

55

Table 6 Simulation TERP A B C D E F = A*(1-E) G = D/F H=G+C (B + D)/H

EUR Old price Market cap # Shares Bank acquirer P/E old Bank Capital increase Assumed discount to current price Right price issue New shares issued New outstanding shares TERP

10 15,000 1500 15.00 3000 30% 7 429 1929 9.33

Source: Authors

A. Market capitalization of the Bank buyer before the capital increase B. Total number of new shares issued multiplied by the price of issuance (cash raised) C. New number of shares as the sum of the old shares issued plus the new shares issued The formula for the calculation of the TERP is: ðA þ BÞ=C Theoretical Ex-Rights Price (TERP) can so be defined as the “theoretical” price of a single share of a company immediately after a rights issue. Usually, TERP would be set lower than the market value of a share prior to the rights issue. This is because, to attract new investors, new shares issued will be sold at a price below the prevailing market price. Keeping the same example of Table 1, we can investigate the TERP (Table 6).

Goodwill Valuation One of the most important items to be valued post M&A is goodwill, that is the intangible asset that is created when one company acquires another company for a price greater than its net asset. The International Accounting Standards (IAS 36) establishes that the recoverable amount of goodwill acquired in a business combination must be assessed each year. IAS 36 states that an asset must not be carried in the financial statements at more than the highest amount to be recovered through its use or sale. If the carrying amount exceeds the recoverable amount, the asset is described as impaired. The entity must reduce the carrying amount of the asset to its recoverable amount and recognize an impairment loss. IAS 36 establishes that the recoverable value is the higher between the market value/transfer net of costs to sell and the value in use:

56

Banks M&A: Strategy and Valuation

• The market value/transfer net of costs to sell represents the price at which the asset could be sold net of directly attributable charges. • The value in use, on the other hand, represents the present value of the expected future income flows attributable to the asset being valued. From a methodological point of view, the different valuation approaches can be traced back to the following fundamental categories: • Analytical criteria (to determine the value in use) • Market criteria (to determine the fair value) As regards the analytical methods, the valuation of the value in use as a criterion for determining the recoverable value implies the application of methodologies based on the estimate of the dividends that the cash-generating units (CGUs) can produce in the future (discounted dividend method or Dividend Discount Model— DDM, in the meaning of “Excess Capital”). The Dividend Discount Model is a variant of the cash flow method. This method, in the “Excess Capital” variant, establishes that the economic value of a financial company is given by the discounting of a flow of dividends determined on the basis of the minimum capital constraints imposed by the Supervisory Authority. Among the market criteria, the two main methods are: • The method of stock prices/market multiples • The method of comparable transactions The method of stock prices/market multiples is based on the analysis of listed companies as a company being valued. Due to the high volatility of the multiples themselves and the fact that they do not reflect control, they have not been used in recent years. The method of comparable transactions is based on an analysis like that of market multiples and on the relationship between the prices expressed in the context of company/company branch transactions and the assets and income figures relating to these companies. The assessments carried out with the analytical criterion (value in use) of the DDM foresee the identification of the key parameters to use in the valuation of the value in use: 1) The Cost of Equity (Ke), 2) the long-term growth rate (g), 3) the last published CET 1 ratio, and 4) the Supervisory target of CET 1. The differences between the CET 1 estimated and the Supervisor target will determine the maximum dividend that can be distributed. The analysis of the distributable dividend can be based on a three-stage model:

References

57

1. On the last historical financial account published by the Group 2. On the 4 year forward-looking projections of the individual banks/companies of the Group based on company budget 3. On the further extrapolation for the fifth year which was constructed according to the following assumptions: • Annual growth rate of risk-weighted assets (RWA) in line with the long-term growth rate • Maintenance of the Intermediation Margin/RWA ratio constant at the levels of the last projected year • Value adjustments on loans estimated assuming constant (versus latest estimated the cost of risk) • Operating costs: growth rate equal to the annual growth rate expected for the latest estimated year The Terminal Value is therefore constructed assuming as a reference the final year net profit (last year of explicit projection) increased by long-term growth. In summary, the DDM method to estimate the value in use of the Banking Assets makes it possible to estimate the equity value (EV) by discounting: • Future cash flows represented by dividends (Divi) in the period covered by the explicit projections and • A closing cash flow (Terminal Value, TV) which represents the discounting of perpetual cash flows (with a view to the companys going concern) after the explicit projections which are calculated by multiplying the net profit in the last year of the projections by a long-term coefficient (coefficient g). The Excess Capital variant provides that future cash flows are determined considering the minimum capital constraints imposed by the Supervisory Authority. EV =

n i=1

Divi þ TV ð1 þ KeÞðiÞ

References Deutsche Bank. (2015). M&A: Poor track record, rich opportunities. Olsen and Palmer. (2019). Bank Director. MA Monitor.

Valuation in Resolution

Abstract

In April 2014, following the early 2000 financial crisis, European Authorities published the Bank Recovery and Resolution Directive (BRRD). The Bank Recovery and Resolution Directive was adopted to provide authorities with comprehensive and effective tools to deal with failing banks at national level and provide cooperation arrangements to tackle cross-border banking failures. The overarching objective of the BRRD resolution regime is to make sure a bank can be resolved swiftly with minimal risk to financial stability. Banks’ valuation methodologies, which are used by Supervisors and Resolution Authority to trigger the failure of a bank and the best resolution tool to utilize, constitute the key aspects of the BRRD. In this chapter, we will revise the key principles of these valuation methodologies.

Resolution and Valuation Methodologies Resolution Authorities should ensure that a fair, prudent, and realistic valuation of the Bank’s assets and liabilities is carried out before deciding to write down or convert relevant capital instruments. The accuracy of the valuation is essential to limit litigation risk from creditors. If the valuation is inaccurate, valuing assets above a fair value might require additional capital injections in the future. Alternatively, if assets are valued below their fair value, it might require the Resolution Authority to compensate creditors. Valuation has been formalized by different Resolution Authorities, as for example the SRB and the PRA (Bank of England), into three types of valuations (Table 1). Valuation 1 is based on the standard financial reporting obligations using normal accounting practice for going concern banks. The Valuation is intended to determine whether the bank is in a position that justifies entering resolution. As such it introduces a higher degree of prudence in the value of the assets. # The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 A. Santoni, F. Salerno, How to Value a Bank, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-031-43872-1_5

59

60

Valuation in Resolution

Table 1 Valuation pre- and post-resolution

Valuation 1

Selection of resolution tools

Trigger resolution

Valuation 3

Valuation 2

NCWO

Source: Authors

Valuation 2 is a forward-looking exercise. It is intended to provide an accurate economic value of the assets to confirm that all losses are properly and fully recognized. This kind of valuation goes beyond the accounting recognition of the losses since it aims to identify all the losses which might materialize in the resolution process. This process envisages a range of potential resolution actions with the valuer that may submit several valuations for each resolution action. In the case of capital injections, Valuation 2 shall also provide an estimate of the post-conversion equity value of new shares issued. In the case of bail-in tool, Valuation 2 should quantify the extent of the eligible liabilities written down. If the chosen resolution tool is the Bridge Bank, then Valuation 2 should provide information on the value of assets, liabilities, or other instruments to be transferred. Very similarly in the case of sale of business tool, Valuation 2 should provide an estimate of the value of the assets on sale. Valuation 3 comes after resolution, and it provides an estimate of the potential valuation gaps between the resolution tool adopted and liquidation scenario. If the creditors had been better off under normal insolvency proceedings, then the “no creditor worse off” rule would not have been respected as such they would reserve a compensation by the Resolution Authority (Articles 20(16)–(18) SRMR). To avoid any conflicts of interest, this kind of valuation would need to be carried out by an independent person assessor in a timely manner after the resolution actions have taken effect.

A Practical Example A practical example will facilitate the understanding of the different steps of the valuation methodologies. Assuming financial institutions reporting a loss that triggers resolution actions by the local Resolution Authority. Being a significant institution for the country and

A Practical Example

61

Table 2 Valuation 1 Assets (EUR m) Cash Securities Loans Investments Real estate & equipment Intangibles Other assets Total assets Liabilities Deposits Subordinated debt Pension liabilities Accrued expenses Other liabilities Total liabilities P&L Equity Total liabilities and equity

Opening value

Valuation 1-FOLTF

Adjustments

100 50 650 90 110 50 25 1075

100 50 600 80 100 50 20 1000

0 0 -50 -10 -10 0 -5 -75

700 280 5 11 10 1006

700 280 5 10 10 1005

0 0 0 -1 0 -1

69 1075

-5 1000

-74 -75

Source: Authors

having critical services the Authority decided to apply a resolution instead of liquidation. The first step, Valuation 1, was based on the assessment of the failing or likely failing of the Bank. The Authority assesses the capital position, the liquidity position, and other requirements for continuing authorization. EBA Guidelines (EBA-CP-2014-22 (CP on GL on failing or likely to fail)) provide guidance on the objective elements that should guide competent authorities and resolution authorities in determining that: – An institution infringes, or is likely to infringe in the near future, requirements for continuing authorization in a way that would justify the withdrawal of its banking license by the competent authority, including but not limited to because it has incurred or is likely to incur losses that will deplete all or a significant amount of its own funds. – An institution’s assets are, or there are objective elements to support the determination that its assets will be, in the near future, less than its liabilities. – An institution is, or is likely to be in the near future, unable to pay its debts or other liabilities as they fall due. In our example, the institution has incurred losses that depleted all or a significant amount of its own funds. Since no private solution was available then the Bank was judged failing or likely to fail (FOLTF), resolution was triggered (Table 2).

62

Valuation in Resolution

Table 3 Valuation 2 Assets (EUR m) Cash Securities Loans Investments Real estate & equipment Intangibles Other assets Total assets Liabilities Deposits Subordinated debt Pension liabilities Accrued expenses Other liabilities Total liabilities P&L Equity Total liabilities and equity

Valuation 1-FOLTF

Economic value

Valuation adjustment

100 50 600 80 100 50 20 1000

100 40 500 70 90 45 18 863

0 -10 -100 -10 -10 -5 -2 -137

700 280 5 10 10 1005

700 280 8 10 12 1010

0 0 3 0 2 5

-5 1000

-147 863

-142 -137

Source: Authors

To determine the full amount of possible losses and the amount of equity potentially necessary to recapitalize the Bank, an independent valuer would be appointed by the Resolution Authority to determine the economic value of the assets and the liabilities. The valuer would request access to the IT systems of the Bank as well as to the numbers to conduct a fair valuation of the balance sheet of the Bank. The analysis conducted by the independent valuer (Valuation 2) will bring certain valuation adjustments. The adjustments would be justified by the valuer, in our case, by the unrecognized losses of the loan portfolio, market value on property and equipment, disposal value for the investments and other valuation adjustments, based on conservative assumptions for the other assets (Table 3). The Resolution Authority would need at this stage to choose a resolution tool based on the valuation adjustments provided by the independent valuer. We assume that the Resolution Authority adopts a bail-in strategy. Give the valuation adjustments and the losses incurred by the Bank, some subordinated liabilities and other liabilities that are part of the loss absorption capacity of the Bank would need to be written off to cover the losses not covered by the equity while the rest would be converted into equity (Table 4). Following the restructuring decision to sell assets or restructure loan portfolio, a new business plan would be set up by the independent valuer to evaluate the new bank. This exercise (called equity valuation) would start with a new opening balance sheet that considers the actions stated above. In particular, the restructuring actions

A Practical Example Table 4 Balance sheet post bail-in

63

Assets (EUR m) Cash Securities Loans Investments Real estate & equipment Intangibles Other assets Total assets Liabilities Deposits Subordinated debt Pension liabilities Accrued expenses Other liabilities Total liabilities P&L Equity Total liabilities and equity

Economic value

Bail-in

100 40 500 70 90 45 18 863

100 40 500 70 90 45 18 863

700 280 8 10 12 1010

700

-147 863

160 863

3

703

Source: Authors Table 5 Equity valuation Balance sheet after restructuring and bail-in Cash Securities Loans Real estate & equipment Total assets Liabilities Deposits Total liabilities P&L Equity Total liabilities and equity

Opening balance business plan 300 50 185 50 585

E FY1 315 51 204 50 620

E FY2 331 52 224 50 657

E FY3 347 53 246 50 697

E FY4 365 54 271 50 740

E FY5 383 55 298 50 786

335 335

355 355

376 376

399 399

423 423

448 448

50 385

264 620

280 657

298 697

317 740

338 786

Source: Authors

and the bail-in resolution tool. During this exercise, the economic value would need to be rebased to accounting value allowing the independent valuer to assess the compensation due to the bailed-in creditors. The objective of the equity valuation is to calculate the value that would be redistributed to the creditors affected by the bailin (Table 5).

64

Valuation in Resolution

This exercise would be compared with the value that would have been distributed in case of insolvency (Valuation 3-non-creditor worse off). This exercise would be informative for the Resolution Authority. It would estimate the amount of the potential compensation risk. The insolvency case (liquidation value) is derived by the valuer assuming a hypothetical scenario to estimate recoveries for creditors and shareholders in a counterfactual (hypothetical) insolvency scenario, i.e. liquidation (Table 6).

Bridge Bank Operationalization One of the most used resolution plans focused on the transfer of assets and liabilities of the failing institution to a new bridge entity with a new full license to banking activities and investment services. The new Bank would likely be financed in terms of capital and liquidity by a Resolution fund or a Deposit Insurance. The asset separation would likely be operated by the resolution authority through an Asset Management Vehicle (AMV). The AMV is usually owned and controlled by the resolution fund and designed to take over non-performing assets from banks in resolution. The AMV would be capitalized by the resolution fund. Resolution authority, during this process, would need to carry out a provisional valuation with a view to 1) determining the resolution measures, 2) revealing further losses that could lead to a capital shortfall and, in case subordinated debt would be insufficient to cover losses then 3) recapitalize the bank. In our example below, we see the potential operationalization of the Bridge bank. We assume: • Overall balance sheet losses quantified in E15.04mn of which E12.25 from loan. • Subordinated liabilities eligible for write-down were fully written down. • The remaining subordinated debt of EUR 1.8 million left in this residual entity to be liquidated. • In return for making up the negative net value of the bridge bank, the resolution fund will retain a senior claim of EUR ten million in the residual entity, as illustrated in the tables below. The resolution authority proceeds to transfer the NPL to the AMV. In return for those NPL, the bridge bank received debt securities from the AMV. The resolution fund guaranteed these debt securities in the full amount. Finally, a further EUR ten million was injected by the resolution fund into the bridge bank in cash resulting in own funds of EUR 10.4 for the bridge bank, corresponding to a CET1 value of around 9% of RWA (Table 7).

Source: Authors

Assets (EUR m) Cash Securities Loans Investments Real estate & equipment Intangibles Other assets Total assets Liabilities Deposits Subordinated debt Pension liabilities Accrued expenses Other liabilities Total liabilities P&L Equity Total liabilities and equity 700 280 8 10 12 1010 -147 863

700 280 5 10 10 1005

-5 1000

700 280 5 11 10 1006

69 1075

45 18 863

50 20 1000

50 25 1075

100 40 500 70 90

Economic value

100 50 600 80 100

Valuation 1-FOLTF

100 50 650 90 110

Opening value

Table 6 Summary valuation pre- and post-resolution

-142 -137

160 863

703

3

700

45 18 863

-5 -2 -137 0 0 3 0 2 5

100 40 500 70 90

Bailin

0 -10 -100 -10 -10

Valuation adjustment

0 389

335 44 5 2.5 2.5 389

0 10 389

100 30 139 60 50

Insolvency (Ins) valuation

100% 16% 100% 25% 25%

0% 50%

100% 60% 75% 75% 50%

Realization in Ins.

Bridge Bank Operationalization 65

66

Valuation in Resolution

Table 7 Operationalization of a Bridge bank Assets Bank pre clean up Loans Other assets Total Residual entity (to be liquidated)

Bridge bank (at set up) Assets transferred NPL Cash RF Total Bridge bank (after) Assets transferred AMV debt securities Cash from resolution fund Other assets Total

E mln

Liabilities

E mln

106.2

Deposits Sub. Own funds Total

135.3 4.3 0.1 147.1

Loans from RA Sub debt Own funds

10.1 1.8 -11.8

123.5 9.2 10.1 142.7

Deposits

142.7

Own funds Total

0.0 142.7

123.5 9.2 10.1 10.4 153.1

Deposits

142.7

Own funds Total

10.4 153.1

40.9 147.1

Source: Authors

Purchasing and Assumption Operationalization A P&A is the most utilized instrument to solve banking crisis under liquidation and resolution regime. It involves a transaction in which good, going concern bank, acquires some or all the assets of a failed bank and assumes the insured deposits. The main characteristics of the P&A transaction involves the acceleration of key growth opportunities for the acquirer, the lowest cost and most efficient option for the Deposit Insurance Fund, branches and offices of the failed bank would open as normal the day after the announcement. Usually, the acquirer would implement a comprehensive due diligence plan to support transaction assumptions and integration plan. This would include the possibility that the Deposit Insurance Fund would guarantee up-front a part of the asset acquired. The transferred price of part of assets and insured deposits of the failed bank are at book value. However, the deal usually is structured in a way to facilitate the acquirer from the liquidity and capital point of view. In an example below, taken from a real case an acquirer Bank (we will call it Bank A) purchased a failed bank (Bank F) with the support intervention of the local Deposit Insurance Fund (DIF). In particular: Bank A acquires substantial majority of assets and assumed certain liabilities of Bank F from the DIF

Purchasing and Assumption Operationalization

67

Table 8 P&A example. Bank failed balance sheet pre- and post-P&A US$ Assets Cash Securities Loan Intangibles Other assets Total Liabilities Deposits DIFA Term financing Other liabilities Total

Pre-P&A

Post-P&A

Comments

0 29.6 172.9 0 5 207.5

0 29.6 150.3 1.1 4.8 185.8

Loss share agreements From Core deposits

92.4 28.1 0 1.4 121.9

87.4 28.1 50 2.3 167.8

Eliminate Bank A dep on consolidation DIF provides 5-year financing

Source: Author elaboration of Auditor Y data

• $173B of loans and $30B of securities • Approximately $92B of deposits and $28B of Deposit Insurance Advances. • Bank A did not assume Bank F’s corporate debt or preferred stock. Bank A makes a payment of $10.6B to the DIF while DIF will provide loss share agreements with respect to most acquired loans. In particular: • Single family residential mortgages: 80% loss coverage for 7 years • Commercial loans, including CRE: 80% loss coverage for 5 years DIF provides a new $50B 5-year fixed-rate term financing, the funding would be need to the buyer to fund receivership operations until asset liquidation generates enough working capital (Table 8).

Valuation in Liquidation

Abstract

Liquidation value is the value of the assets that remain if the company goes from a going concern to a gone concern status. In the liquidation process, creditors, lenders, and shareholders based on seniority of their claims will receive the proceeds from the liquidation of the company’s assets. Banking assets included in liquidation value usually include loans, financial assets, tangible assets like real estate, equipment, investment. Liquidation procedures differentiates from resolution measures and presents several valuation methodologies peculiarities.

Liquidation Versus Resolution Normal insolvency or liquidation proceedings are the default procedure when a bank is failing. However, as BRRD art 45 states, “liquidation under normal insolvency proceedings might jeopardize financial stability, interrupt the provision of critical functions, and affect the protection of depositors. In such a case it is highly likely that there would be a public interest in placing the institution under resolution and applying resolution tools rather than resorting to normal insolvency proceedings”. The practical difference between resolution and liquidation is that in resolution a resolution strategy will be chose and executed by the Resolution Authority trying to minimize the costs and protect the financial stability. On the other side, as of 14 Article 2(47) of BRRD states, “‘normal insolvency proceedings’ means collective insolvency proceedings which entail the partial or total divestment of a debtor and the appointment of a liquidator or an administrator normally applicable to institutions under national law and either specific to those institutions”. Another key difference between the two procedures is that under Resolution scheme “no creditor shall incur greater loss than would have been incurred if the entity had been wound up (...) under normal insolvency proceedings (no creditor worse off principle)” (Article 74 of the BRRD and Article 15(1) of the SRMR). # The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 A. Santoni, F. Salerno, How to Value a Bank, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-031-43872-1_6

69

70

Valuation in Liquidation

Historical Liquidation Value One of the most complete databases to analyse liquidation value is the Federal Deposit Insurance Corporation (FDIC) website. This is a US insurance deposit agency with the mandate to maintain stability and public confidence in the nation’s financial system. An analysis provided by Bennet and Hulan1 in 2014 assessed the average value in liquidation for USA Banks which failed in the period 1986–2007. Their sample was significant and constitutes 1213 of the 1244 banks that failed during the 1986–2007 period. Their results revealed that: 1. The average discounted loss on the disposition of assets as a percent of total assets was 23.38%. 2. The mean ratio of discounted receivership expenses to assets was 12.02%, of which 3.49% is the average ratio of discounted direct receivership expenses to assets. 3. As a result, the average discounted total resolution cost to asset ratio was 33.18%. The main conclusion was that an average failed bank during 1986–2007 has a negative market value of equity that is about one-third of the book value of its assets. Another interesting result highlighted by their research was that the average time of bankruptcy process lasted 5 years, which was roughly twice that of a typical non-financial bankruptcy.

High-Level Liquidation Valuation In this example, we provide a back of the envelope simulation of what there could be the main hypothesis underlining a liquidation valuation. A liquidator will be appointed following the failure of the Institution and Resolution Authority deciding that the Bank will be liquidated. Among the first tasks, there will be the assessment of the company’s financial position. During this period, depositors will not have access to their deposits and no distributions to them will be made prior to the completion of a full assessment of the Bank’s assets and liabilities. Below we provide an overview of the main liquidation valuation drivers based on a real-case liquidation report2 and industry practices.

1

Bennet and Unal (2014). SRB. Deloitte Valuation of difference in treatment. Banco Popular. https://www.srb.europa.eu/ system/files/media/document/valuation_report_non_confidential_version_en.pdf. 2

A Practical Example

71

A Practical Example In this paragraph, we will describe the Resolution scheme adopted for a real case in 2017. We will use fictitious names to identify the parties involved. Banco X normal valuation proceeding was opened in June 2017. Auditor Y was hired by the Resolution Authority to provide a valuation on the difference between the Resolution and the Liquidation scenario. Auditor Y conclusion was that, under the most optimist scenario, the total assets realization would have been equals to 82% of the balance sheet of the day before the failing declaration. The total estimated losses would have been at best 18% of assets up to a maximum 27% in the worst-case scenario. In the following paragraph, we provide the key metrics utilized by Auditor Y to perform the analysis, most of them are common industry practices. The valuator founded the analysis assessing three different timing scenarios. An unrealistic scenario of an 18-month recovery horizon that was the maximum prescribed by the National Insolvency Act. A 3-year scenario, with 50% of the portfolio maturing, and a more conservative scenario of 7 years where 75% of the portfolio maturing. Below is a table that summarizes the key findings of the three scenarios (Table 1). The main assumptions utilized by the valuator were: • Financial assets: Fair value methodology has been used as a proxy. The main differences between the book value and the amount estimated in liquidation was mainly due to Level 3 different valuation methodology. In the case of the worstcase scenarios, it has been included 0.1% adjustments of the financial assets to reflect the uncertainty in the market price. This uncertainty is linked to the valuation model uncertainty for the asset classified as Level 3 while for the other asset class level the uncertainty derived from future administrative costs and operational risk associated to the management. • Joint ventures, associates: A mix of valuation methodologies has been utilized, as for example: market multiples comparable, adjusted book value, market capitalization. • Real estate and foreclosed assets: Liquidator applied a valuation methodology that considered the latest appraisal value adjusted for some regional macroeconomic indicators such as unemployment, consumer price index (CPI). The value obtained at the expected time of sale was discounted considering maintenance costs (0.3% of the value per annum) and sale cost (approximal 5%). • Deferred tax assets (DTAs): Only protected tax (tax for which recoverability does not depend on future profits) was considered. • Intangible assets: Goodwill, computers software, trademarks were all considered having zero value following the license withdrawal of the Bank. • Loans: One of the main assumptions applied in the valuation was the discount rate applied to the rump. The rump is the remaining part of the portfolio at the end of the considered period (e.g.: after 18 months for the first scenario). The remaining part of the portfolio is assumed to be discounted by a range of 7.9% in the worst case for the 18 months scenario up to 5.1% for the best case of 7 years scenario

72

Valuation in Liquidation

Table 1 Banco X liquidation realization scenario

Assets % realization Equity, fixed income, and derivatives portfolio Loans and receivables Joint ventures, associates, and subsidiaries Real estate assets Intangible assets Tax assets Other assets Total assets Total insolvency realization Liquidation costs % Total assets Total realization for shareholders and creditors

% Realization in different scenarios 18 months 3 years scenario scenario

7 years scenario

Best case

Worst case

Best case

Worst case

Best case

Worst case

21,543

94.7%

94.7%

94.7%

94.7%

94.7%

94.7%

83,330

79.8%

76.1%

82.2%

78.8%

85.3%

82.3%

9908

84.6%

75.7%

84.6%

75.7%

84.6%

75.7%

3728 1198 5692 1045 126,444

67.4% 0.0% 41.0% 15.9% 79.3%

60.4% 0.0% 41.0% 15.9% 76.0%

76.0% 0.0% 41.0% 15.9% 81.2%

70.4% 0.0% 41.0% 15.9% 78.0%

79.0% 0.0% 41.0% 15.9% 83.3%

74.0% 0.0% 41.0% 15.9% 80.5%

NBV E mln 6th June 2017

0.78%

78.6%

0.78%

73.6%

0.85%

80.3%

0.85%

77.2%

0.94%

82.3%

0.94%

79.5%

Source: Author elaboration of Auditor Y data

the different discount derives from the evolving mix of the different mix of asset class with the evolution of the portfolio. Loans and receivables contained a significant portfolio of NPL in the case of Banco X (EUR 11.7 bn GBV). Important assumptions have been made on the recovery process and the NPL pricing. In particular: • Recovery costs – Legal costs: an average 7%–10% of the assets – Asset disposal costs (agency fee, taxation): an average 5% – Asset management costs: depending on the year assumed. On average 10 bps. • NPL pricing: – An average pricing in line with the market pricing at the time. A range between 20% and 29.8% P/GBV (Gross Book value).

Reference

73

For the liquidation costs representing up to 0.94% of total assets, the main components were: • Remuneration costs (18% of total): it is represented by – The liquidator remuneration paid an amount equal to the lower between 4% of the assets and an absolute EUR 1.5 mln. – The lawyers (based on the scale of the Bar Association) and the court (up to EUR 300 K). • Employee-related costs (47% of total): unpaid salaries for the last 30 days plus 20 days compensation for each year worked up to maximum 12 months’ salary. • Termination costs (23% of total): Mainly related to rental, IT termination contracts, and others. • Operating costs (12% of total): Costs related to the operation costs of the liquidation process as IT costs, branches to maintain operational activities, headquarters. Overall, we can say that the key drivers for calculating the impact in the liquidation scenario are: • The haircut to the loan portfolio comes from the discount estimated needed to dispose NPL and the discount assumption on the performing rump sale • Reduction in value for the assets as equity, intangibles, real estates, and tax assets. • The costs associated with the liquidation procedure

Reference Bennet, R., & Unal, H. (2014). Understanding the components of bank failure resolution costs. FDIC.

Loan Valuation

Abstract

During a period of recession or following period of economic financial turbulences, one of the main tasks to proper value a Bank is calculating the possible hidden losses arising from non-performing or illiquid assets. The two most important asset categories on Banks’ balance sheet that will be hit by severe losses during crisis are loans and financial assets. In this chapter, we will concentrate on the methodology used to value loans while in the next chapter we will focus on financial assets.

Literature Review There is plenty of academic literature available on the topics of bank valuation and accounting discrepancy and the market implication for this. We analysed the most relevant academic articles on the topics of banks valuation during severe economic downturn period. We found evidence that banks’ balance sheets in some cases offer a distorted view of the financial health of the banks. Harry Huizinga and Luc Laeven in Bank valuation and accounting discretion during a financial crisis,1 analysing quarterly accounting data on US bank holding companies for the period 2001–2008 found that the stock market implicitly discounted a 17% on banks’ real estate loans. Robert C. Pozen for the Harvard Business Review,2 tried to answer to the dilemma if it is fair to blame Fair Value Accounting for the Financial Crisis. A lack of market-to-market valuation for loans and financial assets is usually treated with prudence since it could bring, in period of financial distress, high earnings and capital volatility. On the other side, investors incorrectly assume that most bank assets are valued at market prices, as bond prices were nose-diving. Other investors 1 2

https://www.sciencedirect.com/science/article/pii/S0304405X12001341. https://hbr.org/2009/11/is-it-fair-to-blame-fair-value-accounting-for-the-financial-crisis.

# The Author(s), under exclusive license to Springer Nature Switzerland AG 2023 A. Santoni, F. Salerno, How to Value a Bank, Springer Texts in Business and Economics, https://doi.org/10.1007/978-3-031-43872-1_7

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Loan Valuation

failed to realize that notwithstanding the sharp markdowns of bonds available for sale would not put banks in violation of regulatory capital requirements. The dilemma is between transparency and correct asset valuation and too much volatility and risk of self-fulfillment prophecy. A suggestion put forward by Pozen is to have a double reporting that could match both sides. On the one side, a reporting earnings per share (EPS) and a CET 1 and on the other side an adjustement for the unrealized losses in the market value of its bond portfolio. Yi Zheng and Da Wu studied the impact of opacity on bank valuation during the global financial crisis.3 They demonstrated the relationship between in-transparency and bank value discount during a global recession. The most interesting aspect of their research was the analysis of the channel of transmission through which opacity negatively affects bank valuation. From one side, they found that the relationship between opacity and cost of equity during the financial crisis is positive and statistically significant. On the other side, they found that opacity is negatively associated with bank valuation during the financial crisis.

Loans Valuation: Cash Flow Adjustment Techniques Differently from financial assets, most loans are not traded as such it is difficult to value them at fair value. An additional difficulty derives from the fact that loans can have very specific conditions mostly depending on borrower’s credit quality. Lacking an objective market price, it is mostly important to leverage on a valuation methodology that would take into consideration the different loans specificality. The most used valuation methodology to value a loan is the cash flow adjustment technique that can be divided into two approaches: (a) a bottom-up approach and (b) a top-down approach. The main difference is that the first approach is very granular and analyses individual position while the second approach is most useful for wider portfolios.

Bottom-Up Approach Loan Valuation The bottom-up approach is mainly used for simple structure loans. The initial estimate envisages the calculation of the unadjusted cash flows assuming all payments are made as per contractual terms. Once the projected unadjusted cash flow has been calculated, then we should calculate the potential adjustments. For the second phase, the most important considerations would be: Risk profile of the loan portfolio: concentration risks per product and geography and credit risk collateralized or not are the most important aspects to consider. Time frame of the portfolio: the maturity horizon of the portfolio and the cash flows expectations. 3

https://www.sciencedirect.com/science/article/abs/pii/S1057521923000960.

Bottom-Up Approach Loan Valuation

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Table 1 Bottom-up approach loan valuation

Source: Author elaboration

Current market interest rate and expected future ones. The next steps would be to segment the loan portfolio between performing, sub-performing, and non-performing. On the Performing part, the second steps would be to highlight 1) the amortizing part, 2) the interest only part, and 3) the loan to value versus specific triggers (e.g.: 100%). The purpose of segmenting the loans is to derive key pricing assumptions for specific segments. After this segmentation process, the loans, groups can be finally valued collectively. Once segmented then the loans can be finally valued using specific inputs that are part of the portfolio inputs and market inputs. The most important market inputs are the probability of default, the loss given default, the discount rate (dependent from the current interest rate), and the pre-payment rates (Table 1). The calculation of the real economic value (REV) of the loans is so obtained from the bottom-up estimation of the future cash flows related to the loans. All future cash flows (net of workout costs) should be discounted using a sufficiently prudent credit spread (“a risk premium”) over and above the risk-free rate: REV = i

E ðCF i Þ=ð1 þ Rrisk - free,i þ Credit Spreadi Þ

The applicable credit spread premia depend on the default probability of the asset and its maturity. Losses on loans are linked to PDs, LGDs, etc., like loan portfolio valuation methodology. Macro trends are crucial to calculate losses on loans. In many cases, it is possible to find a statistical correlation between macro indicators (e.g. unemployment, GDP) and the potential losses. The Expected Losses can be calculated by the following formula:

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EL = EAD PD LGD EAD is the exposure at default. PD (probability of default) can be estimated using: • Historical portfolio performance: This can be calculated relying on the performances of similar portfolios in similar situations in the past. Considering the vast statistical data available to the Bank, this exercise can be very significant and precise. • Market data: There are several market sources (e.g. Rating Agencies, Central Banks, Central Bureau) that publish data that can be used to get the historical PD of a similar portfolio or forecast performance of portfolios (e.g. RMBS-Residential mortgage-backed security) or markets. A simplified way to calculate the PD is using the Altman Z-score.4 The original formula was based on five basic financial ratios to help determine the financial health of a company. It is a probabilistic model to screen for bankruptcy risk of a company. According to studies, the model showed an accuracy of 72% in predicting bankruptcy 2 years before it occurred, and it returned a false positive of 6%. The original formula was created for publicly traded manufacturing companies: Z - score = 1:2ðAÞ þ 1:4ðBÞ þ 3:3ðCÞ þ 0:6ðDÞ þ 1:0ðEÞ Where: A = Working Capital (Current Assets – Current Liabilities)/Total Assets (Measures liquidity of firm) B = Retained Earnings / Total Assets (measures accumulated profits compared to assets) C = Earnings Before Interest & Taxes (EBIT)/Total Assets (measures how much profit the firm’s assets are producing) D = Market Value of Equity (Mkt. Cap. + Preferred Stock)/Total Liabilities (compares the company’s value versus its liabilities) E = Sales/Total Assets (efficiency ratio – measures how much the company’s assets are producing in sales). Z-score results: Z-score of