A Bottom-Up Approach To Value Financial Institutions And Their Business Units
o the extent that the capital becomes such a determinant factor in a bank´s capacity to grow. It is clear that it also determines its economic value. The current economic crisis has shown the importance of calculating accurate capital estimates. As a consequence, it may be logical to determine a bank´s intrinsic value by first estimating the economic value of the resources it must own to meet the minimum level of solvency required by the investor.
Usually Investment Bank´s valuations use a top down approach to calculate bank’s capital. Most of them consider only regulatory capital (BIS I, II or III). Those calculations do not address completely key issues like portfolio and risk type diversification, solvency level desired by the bank (target rating) or capital aggregation methodology used.
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In a recent paper, we address the valuation of Financial Institutions from a bottom-up approach to valuate banks showing the differences between capital aggregation methods, diversification and target rating.
Our approach is presented in a complete bank valuation and in the valuation of the different business units. The approach used is particularly relevant when doing the due diligence valuation in M&A transactions or in internal capital requirements in the Capital Management Unit as it will provide a range of risks adjusted values of the bank.
A financial entity may be defined as a risk manager that plays an intermediating role by taking resources from clients (e.g., deposits) or in the market and investing them in other financial assets (e.g. mortgages), earning a spread or margin in the process, i.e., the difference between the cost of deposits/cost of carry and return on the assets.
In this context, it is important to understand clearly what role the borrowed resources, i.e., deposits or money market, plays in a financial entity or bank. In short, borrowed resources are for a bank something similar to what steel may be for a manufacturer of ball bearings for example, i.e. a basic raw material. Accordingly, capital then becomes a central component for leveraging the total resources of the bank. In this way, the solvency and profitability of a bank can be monitored by a financial regulator and investors by keeping tabs on the minimum level of the bank´s Equity required, through capital by means of solvency ratios. The level of required resources is defined by a domestic regulator (e.g. The Federal Reserve), an international organization (e.g. The Bank for International Settlements) or internally presenting bottom up internal capital estimates in annual reports. Given the crucial role of a bank´s capital, it then becomes a scarce and valuable component whose level determines the capacity that a bank has to grow its assets and investments.
To the extent that the capital becomes such a determinant factor in a bank´s capacity to grow, it is clear that it also determines its economic value. Undoubtedly, it may be logical to determine a bank´s intrinsic value by first estimating the economic value of the resources it must own to meet the minimum level of solvency required by the investor/regulator.
Banks are significantly more leveraged than other firms in different industries and that’s one of the reasons why diversification of the risk portfolio is a key determinant of fair value of the bank (i.e. the lower the diversification the higher amount of capital needed). There are different sources of diversification such as:
1. within portfolio: for example what are the chances that a significant amount of credit cards will default simultaneously
2. within business unit: what are the chances that the retail business unit will default?
3. within business units: what is the correlation between retail and wholesale business untis?
4. within risks: how diversified are credit, market, ALM, operational and reputational risk?
5. Geographical diversification: includes the benefits of having business in countries with different economic cycle
The economic value of a financial entity may be obtained in a similar way that it is obtained in case of any firm that operates in the real economy (i.e., the non-financial sector) by using references given by markets (extrinsic value) or by internal indicators (intrinsic value). The former may be given by the market capitalization of the financial entity while the latter may be provided by the value of the discounted cash flows it generates and the implicit economic capital requirements.
Both of these approaches present advantages as well as limitations. The overriding advantage of using the intrinsic or fundamental value is that it allows measuring the impact of specific value-drivers in the overall value of the entity. By using this approach the source of the entity´s value being generated can be isolated and understood.
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