Economic Spread Valuation of Banks

The text discusses the challenges and methods involved in valuing financial institutions, particularly banks, compared to corporations. Here’s an English translation:

Valuing Banks:

It is considered that evaluating financial institutions, including banks, is a more complex task than evaluating corporations. Banks are characterized by high and variable financial leverage. Their published reports do not truly reflect the created value, and due to complicated regulations, the industry is becoming increasingly cyclical.

Valuation Methodology:

Banks are typically valued using the Equity Cash Flow (ECF) method because interest expenses and revenues form a major part of their operations, making it inappropriate to separate them.

Problems with ECF Method:

1. Timing Mismatch: The deposits taken by banks and the loans given do not usually match in time. Thus, the difference between interest income and interest expenses (Net Interest Income) does not accurately describe real value. For instance, this difference might increase due to taking on additional risks, potentially reducing the actual value.
2. Capital Cost Variability: The cost of bank capital depends on the beta of loans and deposits, meaning significant changes in the duration or ratio of assets and liabilities can alter the cost of capital (unlike in corporations where WACC is stable).
3. Tax Penalty on Equity: Due to high leverage, banking regulations require banks to maintain a minimum amount of capital. Issuing additional loans may force a bank to raise its equity, resulting in a tax penalty since equity does not provide a tax shield (dividends are taxable).

Alternative Method – Economic Spread:

Due to the above issues, the Economic Spread method is used in practice. This method allows for the separate evaluation of value created in relation to both loans and deposits.

The logic is straightforward: loan interest income is not compared with deposit interest expenses, but rather with alternative income in the financial market (e.g., buying bonds of the same duration and risk). This alternative income is called the Matched Opportunity Rate (MOR), which essentially represents the Cost of Debt.

For deposits, the comparison is made against what the interest expenses would be if bonds of the same duration were issued in the financial market.

Additionally, the method considers tax components arising from the forced increase in equity (Tax Penalty on Equity – TPE) and from mismatches in the maturity of liabilities (Tax on Maturity Mismatch – TMM). For specific formulas, refer to the Excel file linked at the end of the text.

An example from the book shows that while Net Interest Income might be 20.2 million, the Economic Spread, or the actual value created, is 10.3 million. The difference is attributed to two components: the adjusted cost of capital (4.2 million, which represents the cost of capital the bank would have without the mismatch in the duration of deposits and loans) and the additional risk-related increase in capital cost (5.2 million).

Excel Model

Additional Considerations:

1. Interest Rate Forecasting: Long-term interest rates depend on expectations of short-term interest rates, which eventually converge. Therefore, forecasting a bank’s interest income should align with this phenomenon.
2. Loan Loss Provisions: It is crucial to estimate the portion of loans that will default and the losses the bank will incur. This requires evaluating the quality of the current loan portfolio and reviewing historical statistics.
3. Forecasting Required Capital: The amount of required capital is determined by Risk-Weighted Assets (RWA), complicated by Basel III directives post-2007 crisis. Banks publish RWA, but the calculation models are diverse and not transparent, necessitating external evaluation techniques.

RWA reflects three types of risks: credit, market, and operational. The calculation of credit risks is based on Basel II, allowing the determination of RWA by various banking products. Market risk is assessed using VaR (Value at Risk) data, which banks publish, describing the maximum probable loss in the worst-case scenario. The ratio of RWA to VaR can be derived from historical statistics. Operational risk encompasses all other risks not covered under credit or market risks, focusing on net income (net interest income and other revenues). Statistical methods can establish the ratio between net income and RWA.

Source: Valuation, Measuring and Managing the Value of Companies – by McKinsey & Co, T. Koller, M. Goedhart, D. Wessels