Valuing Banks: A New Corporate Finance Approach PDF
Preview Valuing Banks: A New Corporate Finance Approach
PALGRAVE MACMILLAN STUDIES IN BANKING AND FINANCIAL INSTITUTIONS SERIES EDITOR: PHILIP MOLYNEUX Valuing Banks A New Corporate Finance Approach Federico Beltrame Daniele Previtali Palgrave Macmillan Studies in Banking and Financial Institutions Series Editor: Philip Molyneux Bangor Business School Bangor University UK Th e Palgrave Macmillan Studies in Banking and Financial Institutions series is international in orientation and includes studies of banking systems in particular countries or regions as well as contemporary themes such as Islamic Banking, Financial Exclusion, Mergers and Acquisitions, Risk Management, and IT in Banking. Th e books focus on research and practice and include up to date and innovative studies that cover issues which impact banking systems globally. More information about this series at http://www.springer.com/series/14678 Federico Beltrame • D aniele Previtali Valuing Banks A New Corporate Finance Approach Federico Beltrame Daniele Previtali University of Udine Luiss Guido Carli University Italy Rome , Italy Palgrave Macmillan Studies in Banking and Financial Institutions ISBN 978-1-137-56141-1 ISBN 978-1-137-56142-8 (eBook) DOI 10.1057/978-1-137-56142-8 Library of Congress Control Number: 2016938714 © Th e Editor(s) (if applicable) and Th e Author(s) 2016 Th e author(s) has/have asserted their right(s) to be identifi ed as the author(s) of this work in accordance with the Copyright, Design and Patents Act 1988. Th is 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, specifi cally the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfi lms 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. Th e use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specifi c statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. Th e 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, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made. Cover image © RPStudio / Alamy Stock Photo Cover design by Oscar Spigolon Printed on acid-free paper Th is Palgrave Macmillan imprint is published by Springer Nature Th e registered company is Macmillan Publishers Ltd. London To Giorgio, Silva and Ivana (Federico Beltrame) To Virginia, Daniela and Antonio (Daniele Previtali) for their love and support Fore word W hy a new book on bank valuation? And why not a new book on fi rm valuation? Maybe the answer is in the question itself, as sometimes h appens, and, according to Beltrame and Previtali, this is the case. Of course, there are many relevant issues in company valuation that are worth discussing, from the general approach to more specifi c operational techniques, such as cash fl ow identifi cation, discount rate setting, asset appraisal, and so on. But this book focuses on the application of the generally accepted valuation approaches to fi nancial institutions, not just taking into consideration the general theory of fi rm valuation, but also trying to ascertain whether such a theory works when it comes to banks. Th e issue is not new or, if you prefer, it is rather an old one. So, why are we still interested in it? From my point of view, the reason is that we have not yet solved all the problems, so a generally accepted approach to bank valuation is still some way off . As a matter of fact, both practitioners and scholars have their own framework for bank valuation, even though they often admit to a certain lack of accuracy when general v aluation techniques are applied to fi nancial institutions. If we seek a concrete demonstration of such inaccuracy, it is suffi cient to look at the huge fl uctuations of bank share prices during the fi nancial crisis. One must admit that the word “inaccuracy” is an understatement. But what really diff ers between banks and other companies? What makes fi nancial institutions so special as opposed to all other kinds of vii viii Foreword fi rm? Most practitioners and scholars share the idea that banks are diff er- ent from other fi rms in two main ways: the role and the nature of their regulation—namely, capital requirements; and the role of debt—which is not merely a funding instrument but, rather, is part of the products that a bank sells. If we put these roles together, we conclude that the right side of a bank’s balance sheet is so peculiar that, in order to evaluate a fi nancial institution, we cannot simply apply the generally accepted methodolo- gies. By the way, I would like to stress that, in turn, the diff erences in the funding structure of banks refl ect the special nature of these fi rms. Th e crucial point is that bank debt is the most common means of payment; bank debt is money, not just a funding source, and this is also the reason why regulation is so tough. Th e central role of banks in the modern economy is of such great importance that governments and authorities worry about banks’ soundness in order to protect deposits and to preserve the stability of the overall economic system. Such a deep macroeconomic peculiarity is relevant also from the microeconomic point of view, and this is why the evaluation of banks remains an issue for practitioners and academics. Th e starting point of the authors is these diff erences, which they try to overcome by attributing a specifi c value to the liabilities side. More generally, the proposed methodology gives many diff erent answers to the issue concerning bank valuation that the existing literature has consis- tently stressed. Th e authors achieve this by using a new corporate fi nance approach. I do not wish to anticipate the solutions they see, but I would like to say something about it. F irst, I share their technical approach with regard both to the capital requirements issue and to the instrumental nature of debt. Th e aim of the proposed model is to better quantify the cash fl ow that is to be put in the classical discounted cash fl ow (DCF) models. Needless to say, the a ccurate defi nition of the cash fl ows is crucial in order to obtain a correct measure of a fi rm’s value. In this respect, the qualifi cation of bank debt not merely as a funding instrument, but rather as an operating tool in the produc- tion process of intermediation opens diff erent perspectives in the construction of the model. It should be emphasized that the model is coherent with all the prudential and accountancy rules usually adopted in the banking sector, so the application of the model does not require any Foreword ix steps other than the ordinary reclassifi cation of the balance sheet and the income statement. Th is is important because it allows the proposed model to be compared with traditional techniques. Th e book also off ers an interesting literature review that gives readers the chance to refl ect on the various approaches usually applied in bank valuation. It suggests that it may be useful to devote more studies to the analysis of the eff ect of regulation on banks’ value. I refer particularly to the eff ects of capital requirements on the appraisal exercise, where the common praxis is to include in the free cash fl ow to equity only the excess capital or, more generally speaking, only the amount of resources that could be distributed to shareholders without notching the minimum requirements set by the regulations. Th e assumption is easily understand- able in the light of the fi nancial approach, which states that the value of a fi rm, and even of a bank, is simply the present value of the future cash fl ows from the investment. If, therefore, a bank is not able to distribute any cash fl ow due to the necessity to maintain the required gearing ratio, does it mean that it is worth zero or even below zero? In other words, does it mean that the required equity of a bank is valueless? Of course, if we adopt, for a while, a gone approach, it is evident that such equity is worth the diff erence between the value of assets and liabilities. In an ongoing approach, this value seems to disappear, even if it is the fundamental engine of the banking activity. I feel further analysis and refl ection are needed on this subject. A nother intriguing point is the role of the interest rate in bank valuation. As everybody knows, the discount rate is crucial even in the valuation of other types of company, but its eff ect is limited to the area of the determination of the present value of the expected cash fl ow. Every change in the general level of the interest rate aff ects only the discount factor and not future cash fl ows, at least directly. As far as banks are concerned, interest rate fl uctuation infl uences both the returns and the discount factor; signifi cantly, these two eff ects are in opposition to each other. Here, we can see another positive aspect of the proposed model because it makes possible the isolation of the eff ect of interest rate changes on both the operating profi t and on the debt. Th is demonstrates that banks’ goodwill depends heavily on their debts and, in turn, it underlies the very nature of commercial banks (and not necessarily of every kind of
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