Binder - BARC CD SA Bank Forecasting Valuation

Barclays
Bank forecasting and valuation
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Contents
Introduction to banks...................................................................................................... 1
Financial statement analysis for banks........................................................................... 47
Fundamentals of regulatory capital................................................................................. 87
Forecasting and modeling for banks............................................................................... 115
Bank valuation................................................................................................................ 147
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© Adkins Matchett & Toy 2008 - 2015 info@amttraining.com

Introduction to banks
© Adkins Matchett & Toy 2008 - 2015 1 info@amttraining.com

2
How a bank makes money

HOW A BANK MAKES MONEY – BALANCE

SHEET
ASSETS LIABILITIES
The bank then lends the A bank collects a deposit

funds to another customer from a customer
Customer Loans Customer Deposits

(LIBOR + margin) (LIBOR – margin)
• Credit risk – Customers • Liquidity risk – Deposits

may not repay loan, tend to be shorter term
leading to losses than loans, leading to risk
of a run-on-the-bank
Margins are to compensate the bank for risk and to make a profit
© Adkins Matchett & Toy 2008 - 2015 3

SHEET
ASSETS LIABILITIES
Customer Loans Customer Deposits

(LIBOR + margin) (LIBOR – margin)
Central Bank Deposits Long Term Funding
Capital
Long term funding, capital and liquid assets help make banks safer
…but reduce profitability


SHEET
ASSETS LIABILITIES
Central Bank Deposits Customer Deposits

(LIBOR – margin)
Customer Loans
(LIBOR + margin) Long Term Funding
Capital
Interbank Loans Interbank Deposits
Banks use the interbank market to fund/place any

shortage/surplus of funds

SHEET
ASSETS LIABILITIES
Central Bank Deposits Interbank Deposits
Interbank Loans Customer Deposits

(LIBOR – margin)
Customer Loans
Capital
Trading Assets Trading Liabilities

Reverse Repos Repos
Investment banks have a securities trading business which is often

funded using the repo market


SHEET
ASSETS LIABILITIES

(LIBOR – margin)
Interbank Loans
Interbank Deposits
Trading Assets
Trading Liabilities
Reverse Repos
Repos
Customer Loans
Capital
Derivative Assets Derivative Liabilities
Banks facilitate hedging for clients using derivatives and hedge
their exposure with other banks, this position is unfunded

SHEET
ASSETS LIABILITIES

(LIBOR – margin)
Interbank Loans
Interbank Deposits
Trading Assets
Trading Liabilities
Reverse Repos
Repos
Derivative Assets
Derivative Liabilities
Customer Loans
Investments
Goodwill Capital
Banks who have acquired shareholdings in other banks will have
investment in associates and goodwill on their balance sheet

HOW A BANK MAKES MONEY – INCOME

STATEMENT
Interest Income Net interest income comes Risks:
from the bank lending money •Credit; and
Interest Expense
at a higher interest rate than •Interest Rate
Net Interest Income the money is borrowed
Fee and Comm. Income

Trading Income
Other Income
Operating Income
Loan Loss Provisions
Non Interest Expense
Net Profit Before Tax

INCOME STATEMENT ITEMS
Interest Income
Interest Expense
Net Interest Income
Fee income from banking
Risks:
Fee and Comm. Income products and services e.g.
•Operational
money transfers and advisory
Trading Income
Can include income from Risks:
Other Income
associates, insurance or •Operational
Operating Income investment income



Interest Income
Interest Expense
Net Interest Income
The results of trading activities
Trading Income are in this line. Can be positive Risks:
or negative. •Market
Other Income
Operating Income
When loans go bad (IAS39, Risks:
IFRS9) •Credit

Interest Income
Interest Expense
Net Interest Income
Trading Income
Other Income
Operating Income
Key line for measuring bank
Non Interest Expense efficiency e.g. Cost/Income
ratio

Interest Income
Interest Expense
Net Interest Income
Trading Income
Other Income
The banking equivalent of Risks:
Operating Income gross profit, but is after interest •Operational
The banking equivalent of
Net Profit Before Tax operating profit, but is after
interest
Introduction to regulatory capital

INTRODUCTION TO BANK CAPITAL
 Banks need to hold capital to prevent bank failure

 Compared to other industries bank failure is more
economically complicated due to the:
 need to protect retail depositors
 liquidity that the banking sector supplies
 strong link between banks and the real economy
 systemic links between banks (e.g. one bank fails
they all fail)
 Bank’s are regulated under Basel regulations (currently
moving toward Basel 3)
INTRODUCTION TO BANK CAPITAL
 There are two sets of rules:

Required Capital (Demand) Available Capital (Supply)
• Based on the concept of risk • There are 3 levels of capital
weighted assets (“RWA”) at decreasing quality:
• The riskier the asset the • Common Equity Tier 1
more capital is required (CET1)
• Covers the following risks:
• Credit (and counterparty)
• Market;
< • Additional Tier 1 (AT1)
• Tier 2 (T2)
• Each has a minimum
• Operational requirement
• Minimum capital • CET1 is based on
requirements is a % of RWA shareholders equity less
• Basel 3 – 10.5% (B2 – 8%) adjustments

WHY DO BANKS MAKE LOSSES?

KEY BANKING RISKS
Credit risk comes primarily from lending
activities. Additional credit risk is off-balance
sheet exposures, including derivatives. There
Credit is a standard approach and advanced internal-
ratings based approach to measuring credit
risk.
Market risk comes from trading activities.

Market There is a standard approach and VaR
approach to measuring market risk.
Operational risk covers other losses that the

Operational bank can incur outside of lending and trading.
Liquidity risk comes from having funding that

Liquidity is short term, assets that are long term, or
offering liquidity facilities to clients.
BASEL III AVAILABLE CAPITAL
Key layers of capital Basel 2 Basel 3 new Basel 3 with

minimum minimum buffer
+ Equity
+ Non controlling interests
- Goodwill
+ Accounting adjustments
- Other deductions
= Common Equity Tier 1 2% 4.5% 7.0%
+ Additional Tier 1
= Tier 1 Capital 4% 6.0% 8.5%
+ Tier 2
+ Accounting adjustments
- Other deductions
= Total Capital 8% 8.0% 10.5%

RISK WEIGHTED ASSETS INTRODUCTION
 Using the standard approach to credit risk, assets are

risk weighted as follows:
ASSET X Risk Weight = Risk Weighted Asset
Consumer Loan
X 75% = $7,500
$10,000
Corporate Loan – A
X 50% = $100 million
$200 million
BASEL I AND BASEL II (& III): STANDARDISED

APPROACH COEFFICIENTS FOR CREDIT RISK
Basel I Basel II
AAA to BBB to BB to
Claim A to A B to B <B Unrated
OECD not OECD AA BBB BB
Sovereigns 0 100 0 20 50 100 100 150 100
Banks1 20 100 20 50 100 100 100 150 100
Banks2 20 100 20 50 50 100 100 150 50
Banks
20 100 20 20 20 50 50 150 20
Short Term
Corporates 100 100 20 50 100 100 150 150 100
Retail
50 50 35 35 35 35 35 35 35
Mortgages
Other Retail 100 100 75 75 75 75 75 75 75
ABS 1003 100 20 50 100 350 Deducted Deducted Deducted

1. Option 1 – based on risk weighting of sovereign
2. Option 2 – based on assessment of each bank individually
3. RMBS are 50% risk weighted and retained equity must be deducted

Financial statement analysis for banks
Introduction to IAS39/IFRS9

BANKING BOOK AND TRADING BOOK
 When a financial asset or liability is added to the

balance sheet the way it is accounting for is
based on its classification as either:
Book Strategy Accounting Risk
Banking Hold to maturity Amortised Cost Credit
Trading Make speculative profit Mark-to-market Market
OVERVIEW - ASSETS
Banking Book
Central Bank Deposits
Interbank Loans
Reverse Repos AMORTISED COST
Customer Loans*
(LIBOR + margin)
Trading Book
Trading Assets*
FAIR VALUE THROUGH P&L
Derivative Assets
* If Bonds are intended to be held to maturity they are part of the banking book, otherwise trading book

OVERVIEW - LIABILITIES
Banking Book
Customer Deposits
(LIBOR – margin)
Interbank Deposits AMORTISED COST
Repos
Long Term Funding*
Trading Book
Trading Liabilities*
FAIR VALUE THROUGH P&L
Derivative Liabilities
* Bonds issued for funding are banking book, otherwise trading book (Fair value of own credit)
LOAN LOSS PROVISIONS - IAS39 VS IFRS9
IAS39 – Incurred Loss IFRS9 – Expected Loss

• A loan loss provisions is • When loan is made,
made only after a loss event: expected losses are
• Covenant breach calculated
• Borrower in financial • Expected losses are
distress unwound over the life of the
• Bankruptcy is likely loan
• Incurred losses recognises • In reality this method is how
profits upfront and pushes banks price loans
losses out into the future • Expected losses match the
losses with when the income
is earned

Key performance indicators
INCOME STATEMENT – PROFITABILITY

RATIOS
Net Profit (after NCI)
Return on Equity =
Equity
Net Profit (before NCI)

Return on Assets =
Total Funded Assets

Return on RWA =
Risk Weighted Assets

INCOME STATEMENT – MARGIN RATIOS
Interest Income
Asset Yield = Average Earning Assets
Interest Expense
Liability Yield = Average Earning Liabs
Spread = Asset Yield - Liability Yield
Net Interest Income

Net Interest Margin = Average Earning Assets
INCOME STATEMENT – EFFICIENCY RATIOS

Cost / Income =
Operating Income

Cost / Net Income =
Operating Inc. (after prov)

INCOME STATEMENT – ASSET QUALITY
Non Performing Loans

NPL Ratio =
Gross Loans
Provision Expense
Provisions % =
Gross Loans
Provision Expense
NPL Coverage =
INCOME STATEMENT – LIQUIDITY RATIOS
Customer Loans
Loan Deposit % =
Customer Deposits
Bank Loans
Bank Loans/Deposits % =
Bank Deposits
Liquid Assets
Liquidity Ratio =
ST Wholesale Funding

INCOME STATEMENT – CAPITAL RATIOS
CET1
CET1 Ratio % =
RWAs
Total Capital
Total Capital Ratio % =
RWAs
Total Assets
Leverage Ratio =
Equity (incl. NCI)
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20
Bank fundamentals drill questions

ASTRA ZENECA AND STANDARD CHARTERED COMPARED
Compare the balance sheet and income statement extracts for Astra
Zeneca and Standard Chartered, and answer the following questions
ASTRA ZENECA
INCOME STATEMENT
BALANCE SHEET

STANDARD CHARTERED
INCOME STATEMENT
BALANCE SHEET

QUESTION 1
In the income statement does the operating profit or operating income
come before or after interest for Astra Zeneca and Standard Chartered?
QUESTION 2
What is EBIT (assume that there are no non-recurring items)?
QUESTION 3
What is the bottom line of the income statement?
QUESTION 4
Is there a “cost of sales” in the income statement?
QUESTION 5
Where are Astra Zeneca’s sales reported in the financial statements?
Where are Standard Chartered’s sales reported in the financial
statements?
QUESTION 6
What is the working capital for each company (working capital is defined
as current assets – current liabilities)?
QUESTION 7
What is the size of the total assets of each company?
QUESTION 8
What is the largest item on the balance sheet?
QUESTION 9
What percentage of assets is made up by PPE?
QUESTION 10
What is the ratio of Total Assets / Total Equity?

24
Regulatory capital fundamentals drill questions

QUESTION 1
Identify the key risk that caused major loss in each of the following
banking stories. Choose from:
 Operating risk
 Liquidity risk
 Market risk
 Credit risk
LEHMAN BROTHERS
Lehman Brothers filed for Chapter 11 bankruptcy protection on September
15, 2008. At the time this was the largest bankruptcy in US history, with
Lehman Brothers holding $600bn in assets.
JP MORGAN
In April and May 2012 very large trading losses occurred at JPMorgan's
Chief Investment Office, based on transactions booked through its London
branch. A series of derivative transactions involving credit default swaps
(CDS) were entered into, reportedly as part of the bank's "hedging"
strategy. The original estimated trading loss of $2 billion was announced,
with the final actual loss expected to be substantially larger.
CITIBANK
In April 2008, Citigroup reveals another $12bn in sub-prime losses,
bringing its total to $40bn, the most of any bank. It cuts 9000 jobs amid a
quarterly loss of $5bn, down from $9.8bn in the previous quarter.
UBS
In early September 2011, the Swiss bank UBS announced that it had lost
over $2bn dollars, as a result of unauthorized trading performed by a
director of the bank's Global Synthetic Equities Trading team in London.
On 24 September 2011, Oswald Gruebel, the CEO of UBS, resigned "to

assume responsibility for the recent unauthorized trading incident",
according to a memo to UBS staff. It later emerged that UBS had failed to
act on a warning issued by its computer system about the unauthorized
trading.

QUESTION 2
Using the following assumptions calculate risk weighted assets of the
balance sheet information on the next page:
0% RISK WEIGHTING
Cash in vault and at central bank
Claims on or unconditionally guaranteed by OECD governments
20% RISK WEIGHTING

Claims on or guaranteed by OECD banks
Claims collateralized by OECD gov. securities or cash
50% RISK WEIGHTING

Performing mortgage loans secured by residential real estate
100% RISK WEIGHTING

All other claims
Use the following assumptions for off balance sheet items.
0% RISK WEIGHTING
Commitments up to one year
All unconditionally cancelable commitments
20% RISK WEIGHTING

Commercial letters of credit
50% RISK WEIGHTING

Commitments beyond one year
Performance related standby letters of credit
100% RISK WEIGHTING

Direct credit substitutes
Financial guarantees
Sales with recourse
Financial standby letters of credit

Balance sheet assets Balance Risk Adjusted

sheet weight
Cash 2
Reserves with central bank 38
Due from OECD banks 100
Due from non OECD banks 10
OECD government bonds 130

Corporate bonds 40
Unsecured loans 350

Loans secured by OECD govt 300
bonds
Commercial mortgages 10
Residential mortgages 20
Total 1,000
Commitments & letters of credit

Guarantees & direct credit 200
substitutes
Commitments more than one year 100
Commitments up to 1 year to 100
customers
Total risk weighted assets

Required capital RWAs x 8%

QUESTION 3
Using the extracts from Barclays’ results announcement, please calculate
the following capital ratios for Barclays at the end of 2014 and 2013
Key balance sheet figures 31.12.14 31.12.13

Total assets 1,357,906 1,343,628 From BS
Risk weighted assets 401,900 442,471 From note on
Key capital figures 31.12.14 31.12.13

Ordinary shareholders' equity 55,245 53,322 From BS
Total equity (including non-controlling interests) 65,958 63,949 From BS
PRA CET 1 40,870 40,207 From note on
PRA Tier 1 52,062 50,147 From note on
Total capital 66,343 66,447 From note on
Key capital ratios 31.12.14 31.12.13

CET 1 ratio calculate
Tier 1 ratio calculate
Total capital ratio calculate
QUESTION 4
Barclays has a minimum required CET1 of 9%. Does Barclays have a
surplus or a deficit versus this target at the end of 2014?
a) Please quantify Barclays’ surplus or deficit

b) Please comment on expected future capital initiatives
QUESTION 5
Based on the Basel I, II and III risk weights and capital requirements,
calculate the RWA and minimum Total Capital for the following loans:
1. Retail mortgage 250,000
2. A+ rated corporate loan 100m
3. B+ rated corporate loan 50m
4. Consumer loan 10,000

Bank analysis fundamentals drill questions

QUESTION 1
PTM Bank has loans outstanding of 100m, financed by deposits of 84m
and equity.
PMT Bank achieves the following performance:
Interest income on loan: 10%
Interest paid to deposit holder: 5%
Cost / Income ratio: 50%
Tax rate: 30%
Construct the opening balance sheet, income statement and RoE for PTM
Bank
BALANCE SHEET
Assets Liabilities and equity
Loans Deposits
Equity
Total Total
INCOME STATEMENT
Interest income
Interest expense
Net interest income
Operating expenses
Profit before tax
Tax
Net income
RoE = Net income / Equity

QUESTION 2
and equity.
Tax rate: 30%
Construct the opening balance sheet and income statement for PTM
bank. What is the ROE resulting from the improved C/I ratio?
BALANCE SHEET
Loans Deposits
Equity
Total Total
INCOME STATEMENT
Interest income
Interest expense
Net interest income
Operating expenses
Profit before tax
Tax
Net income

QUESTION 3
and equity.
Tax rate: 30%
Loan loss provision / Gross loan 2%
Bank.
BALANCE SHEET
Net Loans Deposits
Equity
Total Total
INCOME STATEMENT
Interest income
Interest expense
Net interest income
Operating expenses
Loan impairment expense
Profit before tax
Tax
Net income

QUESTION 4
and equity.
Tax rate: 30%
The bank also earns net fee income from its asset management division
of 2m per annum.
Bank.
BALANCE SHEET
Net Loans Deposits
Equity
Total Total
INCOME STATEMENT
Interest income
Interest expense
Net interest income
Non-interest income
Total banking income
Operating expenses
Loan impairment expense
Profit before tax
Tax
Net income

QUESTION 5
and equity.
The performance metrics are as set out in question 4.
Common Equity Tier 1 is equivalent to the Equity of PTM Bank.
Gross loans carry a risk weighting of 85%.
PTM targets a Common Equity Tier 1 ratio of 10%.
Calculate the maximum dividend that could be paid out whilst maintaining
the minimum capital ratio.
AVAILABLE CAPITAL
Common Equity Tier 1 capital
REQUIRED CAPITAL
Gross loans
Risk weighted assets
Required capital
CAPITAL SURPLUS / DEFICIT

Capital surplus (Available capital – Required capital)
Annual Profit
Maximum dividend payable

34
Bank fundamentals drill answers
Bank fundamentals drill answers

ASTRA ZENECA AND STANDARD CHARTERED COMPARED
ANSWER 1
Operating income is above interest for Astra Zeneca, and below interest
for Standard Chartered. This is because interest is an operating item for
Standard Chartered, but a financing item for Astra Zeneca.
ANSWER 2
EBIT is $12,795 m for Astra Zeneca, but does not exist for Standard
Chartered.
ANSWER 3
Profit for the period / Profit for the year; essentially the income statement
is doing the same thing for both companies. It shows the breakdown of
performance for shareholders, albeit, quite differently.
ANSWER 4
Astra Zeneca: yes.
Standard Chartered: no – the main costs are the staff costs.
ANSWER 5
Sales are reflected in the income statement for Astra Zeneca.
When Standard Chartered makes a sale, you would see the balance
sheet (loan or deposits) move first, before seeing the margin appear in the
income statement.
ANSWER 6
Astra Zeneca: CA (23,506) less CL (15,752) = $7,754m
Standard Chartered: the working capital is meaningless for a bank.
ANSWER 7
Astra Zeneca: $52,830m Standard Chartered: $599,070m
ANSWER 8
Astra Zeneca: Intangible assets ($10,980m)
Standard Chartered: Customer accounts ($342,701m)
ANSWER 9
Astra Zeneca: $6,425m / $52,830m = 12.2%
Standard Chartered: $5,078m / $599,070m = 0.8%
ANSWER 10
What is the ratio of Total Assets / Total Equity?
Astra Zeneca: $52,830m / $23,472 = 2.25x
Standard Chartered: $599,070m / $41,375m = 14.48x

36
Regulatory capital fundamentals drill answers

ANSWER 1
Identify the key risk that caused major loss in each of the following
banking stories. Choose from:
 Operating risk
 Liquidity risk
 Market risk
 Credit risk
LEHMAN BROTHERS
Liquidity risk
JP MORGAN
Market risk
CITIBANK
Credit risk
UBS
Operating risk

ANSWER 2
Using the following assumptions calculate risk weighted assets of the
balance sheet information on the next page:
Balance sheet assets Balance Risk Adjusted

sheet weight
Cash 2 0% 0
Reserves with central bank 38 0% 0
Due from OECD banks 100 20% 20
Due from non OECD banks 10 100% 10
OECD government bonds 130 0% 0

Corporate bonds 40 100% 40
Unsecured loans 350 100% 350

Loans secured by OECD govt 300 20% 60
bonds
Commercial mortgages 10 100% 10
Residential mortgages 20 50% 10
Total 1,000
Commitments & letters of credit

Guarantees & direct credit 200 100% 200
substitutes
Commitments more than one year 100 50% 50
Commitments up to 1 year to 100 0% 0
customers
Total risk weighted assets 750

Required capital 60
RWAs x 8%

ANSWER 3
Using the extracts from Barclays’ results announcement, please calculate
the following capital ratios for Barclays at the end of 2014 and 2013
Key balance sheet figures 31.12.14 31.12.13

Total assets 1,357,906 1,343,628 From BS
Risk weighted assets 401,900 442,471 From note on
Key capital figures 31.12.14 31.12.13

Ordinary shareholders' equity 55,245 53,322 From BS
Total equity (including non-controlling interests) 65,958 63,949 From BS
PRA CET 1 40,870 40,207 From note on
PRA Tier 1 52,062 50,147 From note on
Total capital 66,343 66,447 From note on
Key capital ratios 31.12.14 31.12.13

CET 1 ratio 10.2% 9.1% calculate
Tier 1 ratio 13.0% 11.3% calculate
Total capital ratio 16.5% 15.0% calculate

ANSWER 4
Barclays has surplus capital at the end of 2014 because its CET 1 ratio
(10.2%) is higher than the minimum 9% Core Tier 1 ratio.
Please quantify Barclays’ surplus or target
Surplus = 40,870m – 9% x 401,900m
= 4,699m
Please comment on expected future capital initiatives
The current surplus represents a reasonably strong capital position and is

the outcome of a successful plan of capital strengthening activities
including capital raisings and asset disposals. As long as there is no
additional exceptional losses, Barclays would be able to start paying full
dividends to shareholders to distribute the surplus.
ANSWER 5
Basel I Basel II Basel III

Retail Mortgage 250,000 250,000 250,000
Risk Weight 50% 35% 35%
RWA 125,000 87,500 87,500
Min. Total Capital % 8.0% 8.0% 10.5%
Min. Total Capital 10,000 7,000 9,187.50
A+ Corp Loan 100m 100m 100m

RWA 100m 50m 50m
Min. Total Capital 8.00m 4.00m 5.25m
B+ Corp Loan 50m 50m 50m

Risk Weight 100% 150% 150%
RWA 50m 75m 75m
Min. Total Capital 4.00m 6.00m 7.875m
Consumer Loan 10,000 10,000 10,000

RWA 10,000 7,500 7,500
Min. Total Capital 800 600 787.50

Bank analysis fundamentals drill answers

ANSWER 1
and equity.
Tax rate: 30%
Bank
BALANCE SHEET
Loans 100 Deposits 84
Equity 16
Total 100 Total 100
INCOME STATEMENT
Interest income 10.00
Interest expense 4.20
Net interest income 5.80
Operating expenses 2.90
Profit before tax 2.90
Tax 0.87
Net income 2.03
RoE = Net income / Equity 12.7%

ANSWER 2
and equity.
Tax rate: 30%
Construct the opening balance sheet and income statement for PTM
bank. What is the ROE resulting from the improved C/I ratio?
BALANCE SHEET
Equity 16
Total 100 Total 100
INCOME STATEMENT
Tax 0.96
Net income 2.23

ANSWER 3
and equity.
Tax rate: 30%
Bank.
BALANCE SHEET
Equity 16
Total 100 Total 100
INCOME STATEMENT
Loan impairment expense 2.00
Tax 0.36
Net income 0.83

ANSWER 4
and equity.
Tax rate: 30%
The bank also earns net fee income from its asset management division
of 2m per annum.
Construct the balance sheet, income statement and RoE for PTM Bank.
BALANCE SHEET
Equity 16
Total 100 Total 100
INCOME STATEMENT
Non-interest income 2.00
Operating Income 7.80
Loan impairment expense 2.00
Tax 0.69
Net income 1.60

ANSWER 5
and equity.
The performance metrics are as set out in question 4.
Common Equity Tier 1 is equivalent to the Equity of PTM Bank.
Gross loans carry a risk weighting of 85%.
PTM targets a CET1 ratio of 10%.
Calculate the maximum dividend that could be paid out whilst maintaining
the minimum capital ratio.
AVAILABLE CAPITAL
CET 1 capital 16
REQUIRED CAPITAL
Gross loans 100
Risk weighted assets 85
Required capital 8.5
CAPITAL SURPLUS / DEFICIT

Capital surplus (Available capital – Required capital) 7.5
Annual Profit 1.6
Maximum dividend payable 9.1

46
Financial statement
analysis for banks

48
Banks’ financial statements

Financial statements: BS and IS
LEARNING OUTCOMES
 A revision of the key lines

 balance sheet; and
 income statement
 A reminder of the key profit drivers within a bank

BALANCE SHEET – ASSETS
Held for liquidity

purposes Central Bank Deposits
Low risk-low yield
assets where banks Interbank Loans
place surplus funds Largest asset on a
bank’s balance sheet,
consists of:
Customer Loans • Mortgages
• Credit Cards
Low risk-low yield • Corporate Loans
secured assets
where banks place Reverse Repos
surplus funds Where banks look to
Trading Assets acquire undervalued
Positive mark-to- assets to make profits
market of derivative Derivative Assets Small shareholdings
positions
Investments (<50% of other
Price over fair value financial institutions
that a bank has paid Goodwill
for another bank
BALANCE SHEET – FUNDING
A source of stable
funding, split between Customer Deposits
retail and corporates
Cheap short term

funding used to fill
Interbank Deposits any liquidity
An inexpensive requirements
funding method using
high quality bonds as
Repos
Where banks look to
security
Trading Liabilities short overvalued
Negative mark-to- assets to make profits
market of derivative Derivative Liabilities
positions
Used to make the bank
Long Term Funding more secure against
Minimum requirements liquidity shocks
under Basel 3 to make
banks more secure
Capital
against failure

INCOME STATEMENT
Interest received from

customer and bank Interest Income
loans Interest paid on
Interest Expense customer deposits and
short and long term
The result of the
wholesale funding
excess pricing of Net Interest Income
loans over deposits
Fee and Comm. Income Income from providing
services to customers
Gains (or losses) on
trading activities Trading Income
Common sources of
Other Income other income include
dividend income and
Operating Income insurance premiums
The result of loans
going bad Loan Loss Provisions
Operating costs of the
Non Interest Expense business

Accounting for financial

instruments

FINANCIAL ASSETS: CATEGORIES &

MEASUREMENT
Asset
Available Held to Loans and

AFVTPL
For Sale Maturity receivables
Fair value
Fair value
through
through Amortised cost
profit or
equity
loss
FINANCIAL LIABILITIES: CATEGORIES &

MEASUREMENT
Liabilities
Others (deposits,
AFVTPL securities issued,
subordinated liabilities)
Fair value
through
Amortised cost
profit or
loss

ASSET CLASSIFICATION
Central Bank Deposits

Interbank Loans
Amortised
Cost Customer Loans
Reverse Repos
*Bonds will be classified Trading Assets*
as trading assets if held Fair Value
for speculative profit, Derivative Assets (through IS)
otherwise they will be held Investments
to maturity and accounted
for at amortised cost Goodwill
LIABILITY CLASSIFICATION
Customer Deposits
Amortised Interbank Deposits

Cost
Repos
Trading Liabilities Fair Value
Derivative Liabilities (through IS)
*Funding will be at
amortised cost if
issued to maturity Long Term Funding* *Funding will be at fair
value if issued with
Capital the intention of buying
back if rates move

COST VS FAIR VALUE DISCUSSION
 Both amortized cost and fair value accounting have

benefits and limitations
 Amortized cost  Fair value

 Less volatility  More volatility
 Relies on management  Faster in recognizing
discretion losses
 Slower in recognizing  More reliable if price is
losses available
 Disclosure of NPLs and  If price is not available
NPL coverage ratios fair value might be
not easily comparable unreliable
FAIR VALUE HIERARCHY
 Level I instrument
Fair value = Market price
 Level II instrument
Fair value = Reasonable estimate
 Measured according to accepted methods and observable inputs
 (say – comparable prices, indexes)
 Level III instrument
Fair value = Subjective opinion camouflaged in complex models
 Estimated with models using unobservable inputs
 (say – black box models)
 By implication, banks results can be not only volatile but also of

disputably quality

Accounting for bonds
ACCOUNTING FOR BONDS
 Bonds will be accounted for depending on the intention

of the bank when the bonds are acquired:
 If the intention is to hold the bond to maturity then it will be
accounted for as amortised cost
 If the intention is to make a speculative profit then it should be
accounted for as fair value and the bond should be marked-to-
market

ACCOUNTING FOR BONDS: AMORTISED COST
 The amortised cost method values an instrument at the

amount that it is acquired for
 The interest on instrument is imputed based on the yield
of the bond, based on the IRR of the price and
contractual cash flows
 The interest revenue is based on the carrying value of
the instrument times the yield
Interest Revenue = Carrying Value x Yield
 Where the bond price is different from the par value, the
interest will differ from the coupon
USEFUL EXCEL FORMULAS
To calculate effective yield of an instrument

 Yield = IRR(range of all cash flows) including
 For example, initial
yield =IRR(B14:F14) investment
To calculate present value of future cash flows

 Value=NPV(IRR,range of future cash flows)
 For example,
Value=NPV(B15,C14:F14)
Yield

USEFUL EXCEL FORMULAS
Formulas that can be used specifically for bonds are:

To calculate effective yield of an instrument
 Yield = RATE(nper, pmt, pv, fv)
 For example, Should be
Yield =RATE(5, 4, -102, 100) negative
=3.56%
To calculate present value of future cash flows
 Price=-PV(rate, nper, pmt, fv)
 For example,
Value =-PV(3.5%, 5, 6, 100)
=111.29
AMORTISED COST: BOND ILLUSTRATION
 Eg. ABC bank buys a bond for 105

 Coupon = 3.5%
 Maturity = 3 years
 Effective yield = 1.77% (=RATE( 3 , 100 x 3.5% , -105 , 100))
Eg. Bond trading at a premium
Time 0 1 2 3
Cash flows -105.00 3.50 3.50 103.50

Effective yield (IRR) 1.77%
BS (amortised cost) 105.00 103.36 101.70 100.00
IS (accrued interest) 1.86 1.83 1.80
For a bond purchased at a premium, the yield will be lower than the coupon.
The difference between the IS and cash flow decreases the balance sheet
amount each year as the premium unwinds

FAIR VALUE (AFVTPL): DEFINITION
 The fair value method marks the value of the instrument

to its market price i.e. what the bank can sell it for (or
buy it back at if it is a liability)
 The income statement reflects both movement in price
and any accrued interest
FAIR VALUE (AFVTPL): ILLUSTRATION
 Eg. ABC bank buys same 3.5%, 3 year bond (asset)

 The bond is classified as trading, accounted at fair value
through profit and loss
 Interest rates increase, and the value of the bond …
Bond at fair value through income statement
Time 0 1 2 3
Cash flows -105.00 3.50 3.50 103.50
Market yield 1.77% 2.00% 2.25%
Opening Bond Valuation 105.00 102.91 101.22
Less cash payment (3.50) (3.50) (3.50)
Accrued interest 1.86 2.06 2.28
Capital gain/(loss) (0.45) (0.25) 0.00
Ending Bond Valuation 105.00 102.91 101.22 100.00
IS (trading gain) 1.41 1.81 2.28

FAIR VALUE OF OWN CREDIT
 If a bank issues a bond to take advantage of the current

market environment, with the intention of buying back if
market conditions deteriorate then the bond will be held
for trading purposes
 If bond yields increase, leading to a reduction in the
value of the bond, then this will lead to a trading gain
 This is refered to as fair value of own credit and has
been a controversial issue for banks as banks have
been able to account for gains in their trading book as
their bond values have dropped
FAIR VALUE OF OWN CREDIT
 Fair value of own credit should be treated as an

exceptional item
 New accounting standards are being developed to deal
with this anomaly
 Any fair value of own credit gains/(losses) will be treated
as follows:
-2 Reduction due to an increase in rates – through IS
-3 Reduction due to rating downgrade
– directly through equity
Bond Value
100
95

Accounting for loans
ACCOUNTING FOR LOANS
 Loans are measured at amortized cost (unless

they are held for sale)
 At each reporting date, the carrying value of the
loan is lower of the historic cost (less any
repayments made) and the present value of the
expected future cash flows at the loan’s initial
yield
 The loans are reported at cost at inception, but
the cost amortizes toward the principal value to
be repaid at maturity

AMORTISED COST: LOAN ILLUSTRATION
 Eg. AMT bank makes a loan for 100

 Interest rate = 6.5%
Eg. Simple loan
Time 0 1 2 3
Cash flows -100.00 6.50 6.50 106.50

With no fees, for a loan issued at par, the cash interest will be the
same as the accrued interest
AMORTISED COST: LOAN ILLUSTRATION
 Eg. AMT bank makes a loan for 100

 Interest rate = 4.5%
 Origination fee = 100bp
 Effective yield = 4.87% (=RATE( 3 , 100 x 4.5% , -100 x (1-1%) , 100))
Eg. Loan with origination fee
Time 0 1 2 3
Cash flows -99.00 4.50 4.50 104.50

For a loan with fees, the yield will be higher than the interest rate. The
difference between the IS and cash flow increases the balance sheet
amount each year

Accounting for loan losses
LOANS AND CREDIT RISK – INCURRED LOSS

APPROACH
 Banks expect some loans to go bad and generate loan losses
 However, loans will only be impaired once there is sufficient
evidence that a loss has taken place (ie >90 days overdue)
Neither past due nor Past due but not Individually Written-
individually impaired individually impaired impaired off
30 60 90
days days Days
Impairment Foreclosure
Missed
procedure procedure
payment
= overdue
= delinquent =default
Non-performing, bad and

doubtful or credit risk loans

LOANS AND CREDIT RISK – EXPECTED LOSS

APPROACH
 Banks expect some loans to go bad and
generate loan losses
 These expected losses are built into the loan
pricing
 Total expected losses are calculated on the
origination of the loan and the provisions accrue
over the life of the loan
 If the loan repays with no actual loss to the bank
the accumulated provision is reversed
PROVISIONING EXAMPLE – INCURRED

VERSUS EXPECTED LOSS (NO DEFAULT)
 A bank makes a loan with the following terms:
 Amount 100
 Term (years) 4
 Interest rate 5.0%
 Initial Expected loss 4.0%
 Actual default None
 Actual recovery 40%
 How do you account for the loan on an incurred
and expected loss basis

INCURRED LOSS APPROACH
 Based on the incurred loss approach, if there is no

default event there is no provisioning
1-Jan-21 31-Dec-21 31-Dec-22 31-Dec-23 31-Dec-24 Total
Contractual cash
(100.0) 5.0 5.0 5.0 105.0 20.0
flows
IRR 5.00%
P&L 5.0 5.0 5.0 5.0 20.0
Actual cash flows (100.0) 5.0 5.0 5.0 105.0
EXPECTED LOSS APPROACH
 Based on the expected loss approach the loan is

provisioned over the life of the loan
 If no default occurs the provision is reversed
Contractual cash
(100.0) 5.0 5.0 5.0 105.0 20.0
flows
IRR 5.00%
Provision (1.2) (1.2) (1.2) 3.6*
P&L 3.8 3.8 3.8 8.6 20.0

* (-1.2 + 4.8)

PROVISIONING EXAMPLE – INCURRED

VERSUS EXPECTED LOSS (WITH DEFAULT)
 A bank makes a loan with the following terms:
 Amount 100
 Term (years) 4
 Interest rate 5.0%
 Initial Expected loss 4.0%
 Actual default Year 3
 Actual recovery 40
 How do you account for the loan on an incurred
and expected loss basis
INCURRED LOSS APPROACH
 When the default event occurs you stop accruing

interest and an estimate of recovery and timing is
made
Contractual cash
(100.0) 5.0 5.0 5.0 105.0
flows
IRR 5.00%
P&L 5.0 5.0 0.0 0.0
Default Recovery
value

IMPAIRMENTS – INCURRED LOSS
 Upon default, the loan is impaired and recorded at

net realisable value, i.e.
Net loan = gross loan - impairment allowance
Gross Loan 100.0 100.0 100.0 100.0 Provision

Impairment allowance (0.0) (0.0) (0.0) (61.9) Amount
Net Loan* 100.0 100.0 100.0 38.1*
*Net loan = PV of recovery amount
IMPAIRMENTS – EXPECTED LOSS
 Upon default, the loan is impaired and recorded at net

realisable value, i.e.
Net loan = gross loan - impairment allowance
Gross Loan 100.0 100.0 100.0 100.0 Provision

Impairment allowance (0.0) (1.2) (2.4) (61.9) Amount
Net Loan* 100.0 98.8 97.6 38.1* 59.5
(61.9 – 2.4)
 The provision expense on default is lower under this
approach as some provision had previously been
expensed
*Net loan = PV of recovery amount

KEY DEFINITIONS: GROSS, NET LOANS
+ Gross loans - Allowance for loan losses = Net loans
Contra-asset
Allowance account
for loan
losses
Gross Carrying
loans value
Net
loans
DISCLOSURE: EXAMPLE
20X2
2012 20X1
2011
20X1
20X2
20X2
2012 2011
20X1

CREDIT QUALITY – ACCOUNTING RATIOS
 We can analyze the risk of the loan book by evaluating

the percentage of loans that are non-performing
NPL ratio % = Non-performing loans (NPLs)

total loans
 Even for a bank that has a high proportion of NPLs, they may have
these adequately covered by provisions. Check the adequacy of
loan loss reserves by calculating the NPL coverage ratio
 Some emerging markets may over provide for loans making the
potential for increased profits as the loans are recovered
NPL coverage % = Loan impairment allowance

NPLs
2012 2011
NPLs
NPAs
NPL %
NPA %
NPL coverage
NPA coverage

LOAN LOSS PROVISIONS – BASE ANALYSIS
Beginning Provisions
Additions Provision Expense
Subtractions Loan Write-Offs
Ending Provisions
 We can evaluate the cost of loan losses on a bank be calculating

loan impairment provision (basis points lost to credit losses)
Loan impairment = Loan impairment charge

margin % Average loans
 Over time impairment charges and write-offs should converge,

although write-offs (actual ultimate losses) are more volatile than
impairments
Net charge-off ratio % = Net charge-offs (write-offs)

Average loans

EU banks focus on yearly

IS loan losses as % of
average gross loans
US banks focus on
yearly write-offs
(charge-offs) as % of
average gross loans
2012 2011
Accounting for derivatives

EXAMPLE: HEDGING INTEREST RATE RISK
Example
 A bank holds a 10m loan which pays a 6% fixed interest.
 The bank funds itself by borrowing at LIBOR, variable
rate
 With a fixed rate loan if interest rates rise margins will be
eroded as the funding cost increases and the interest
income remains the same
 To hedge interest risk, the bank enters into a SWAP
where they pay fixed (say 3%) and receive floating
INTEREST RATE SWAP
Pay FIXED (x%)
10million
Receive FIX
SWAP
Loan Bank SWAP counterparty
6% =
600k
Receive floating
(LIBOR)

INTEREST RATE SWAP KEY DATA
 Notional amount: 10 million

 Expected cash flows: the bank and swap
counterparty will settle only the difference
between the fix rate (3%) and the variable rate
(LIBOR).
 For example:
 If LIBOR is 2% the SWAP counterparty will
receive from the bank 1% x notional = 100,000
 The bank has achieved its purpose to turn the
loan’s interest from fixed into variable
INTEREST RATE SWAP VALUE
 At inception the swap fair value is zero

 Thereafter, the fair value is measured as the
present value of expected future cash
settlements
 If the fair value is positive, the derivative is
recorded as an asset
 If the fair value is negative, it’s a liability
 The same contract can change from being an asset to
liability throughout its life

INTEREST RATE SWAP VALUE
 SWAP value will be positive (asset) if LIBOR

increases
 SWAP value negative (liability) if LIBOR
decreases
 Eg. With a flat $LIBOR curve at 2%, the SWAP
gives the bank right to $10,000 net settlement
over – say – 3 years
 SWAP value (at 3% discount rate =
10,000/1.03+10,000/1.032+10,000/1.033 =
28,286 recorded as an asset on balance sheet
WHY DO BANKS AND CLIENTS USE

DERIVATIVES?
1. Risk management
 Banks and clients use derivatives to mitigate or transform
exposure to risk (interest rate swaps, CDS, FX forwards)
2. Defensive investing
 Investor clients use derivatives to protect investments from
downside
3. Leveraged investing
 Hedge funds, asset managers and prop traders use derivatives
to provide leverage and increase their investment returns
(options, swaps, binary payouts, etc.)
4. Liquidity
 Broker dealers and market makers use derivatives to distribute
risk to the market (so called ‘flow products’)

CLASSIFICATION CRITERIA
Derivative  Derivatives expose users to

instrument market risk and – therefore –
they have to be marked-to-
Is it part of No
a cash flow or market through income
FX hedge? statement (as trading products)
Yes
 However, when they are used
for hedging purposes, US
GAAP and IFRS apply hedge
accounting rules which link the
accounting of the hedged item
and the hedging instrument to
avoid accounting mismatch
Changes through
AFVTPL
equity
DERIVATIVES NETTING
 This is an area where US GAAP and IFRS differ!

 US GAAP gives greater recognition for netting (positive
and negative fair values with same counterparty) and
collateral mitigation
 US GAAP recognises on the balance sheet net
derivative exposures to the same counterparty
 IFRS recognises on the balance sheet the sum of
positive fair values (as an asset) and the sum of
negative fair values on all contracts (as a liability)

DERIVATIVES AND COUNTERPARTY RISK –

IFRS APPROACH
Gross amount is shown

on the balance sheet
DERIVATIVES AND COUNTERPARTY RISK – US

GAAP APPROACH
Net amount is shown

on the balance sheet

Cleaning the numbers
ANALYZE EARNINGS –
NORMALIZING OR CLEANING
 It is the future value of the business that is being
assessed, so items which are “one-offs” need to be
cleaned out to reflect the normal earnings
 “One offs” are removed or “cleaned” from the
historic data on the basis that they are not expected
to occur in the future
 Common non-recurring items include:
 Restructuring charges
 Large gains and losses on the sale of businesses
or assets
 Impairments of non-current assets
 Regulatory fines
 Fair value of own credit

 To “clean” or normalize the company’s
earnings to reflect ongoing performance:
1. Find the non-recurring items in the financials
 Use the main statements
 The footnotes and
 Any management discussion and analysis
2. Find / calculate the impact of the non-recurring items
on taxes
3. Clean up / normalize the data
NORMALIZED NET INCOME – THE CONCEPT
 Normalized net income should include both

core and non-core businesses regardless of
whether they are controlled or not
 Therefore we are looking at net income
which is:
 Continuing

Non-recurring items
pre-tax. Adjust for tax
when cleaning net
income
Above tax
Below tax
Non-recurring
items post-tax
 Multiply the non-recurring item by (1 – MTR)
 In this example, the marginal tax rate is 30%
 Add back expenses, and deduct gains or income
Non-recurring
Year 1 Cleaned year 1
item
Net interest income 1,000 1,000

Non-recurring item
Net fee and commissions 600 600
Trading income 300 300

Fair value of own credit 100 (100) 0
Gross Income 2,000 1,900
Tax impact of non-
recurring item:
Non-interest expense (1,200) (1,200) =100*30%
Income before tax 800 700
Post tax non-

Provision for income taxes (240) 30 (210)
recurring:
Net income 560 (70) 490 =100*(1-30%)

Banks’ ratio analysis
LEARNING OUTCOMES
 Banks ratios can be split into three areas:

 Performance ratios:
 Returns
 Margins
 Efficiency
 Risk ratios:
 Liquidity
 Asset quality
 Capital
 Growth rates:
 Assets
 Liabilities
 Revenue
 Costs

BANK RATIOS
Ratios
Growth Profitability Risk
Loans, deposits Yields, spreads Asset quality

Total assets, RWAs Margins Capital
Revenues, Cots Returns Funding
Profits Efficiency Liquidity

RATIOS
Net Profit (after NCI)
Return on Equity =
Equity

Return on Assets =
Total Funded Assets

Return on RWA =

PROFITABILITY RATIOS: RETURNS
Net income attrib. to ordinary shareholders

Return on average assets 
Average assets

Return on average equity 
Average ordinary shareholders equity
Note :
Averages during the year  either disclosed or calculated as
Start value (1 Jan)  Closing value (31 Dec)

2
VARIATIONS OF RETURNS

Return on average RWAs 
Average RWAs

Return on average tangible equity 
Average tangible equity
Note :
RWAs  risk weighted assets
Tangible equity  Equity - goodwill & intangibles

Interest Income
Interest Expense
Net Interest Income


Cost / Income =
Operating Income

Cost / Net Income =


NPL Ratio =
Gross Loans
Provision Expense
Provisions % =
Gross Loans
Provision Expense
NPL Coverage =
Customer Loans
Loan Deposit % =
Customer Deposits
Bank Loans
Bank Deposits
Liquid Assets
Liquidity Ratio =

CET1
CET1 Ratio % =
RWAs
Total Capital
RWAs
Total Assets
Leverage Ratio =
Equity (incl. NCI)
BANK RATIOS & DRIVERS OF PROFITABILITY
Asset composition & funding mix

Yield on interest earning assets
Yield on interest bearing liabilities
Net interest margin
Non interest margin
Loan loss expense %
Efficiency ratio %
Tax rate %
Other
(NCI)
RoA x Leverage = RoE

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Please note:

Fundamentals of
regulatory capital

88
Fundamentals of regulatory capital
CONTENTS
 Overview of bank regulation

 Components of capital
 Minimum capital requirements
 Risk weighted assets (RWAs)
 Liquidity and funding ratios
 Key capital ratios

Overview of bank regulation
TIMELINE OF BANK REGULATION
 Traditionally bank regulation was a national issue

 Globalisation has driven the need for a unified system
 Bank for International Settlements’ (BIS)
Basel Committee on Banking Supervision (BCBS)
has established the Basel Capital Accords
 The Basel Capital Accords set a voluntary, international
regulatory framework for banks and continue to evolve
 1988 Basel I Credit risk / Market risk
 2006 Basel II Operational risk / Credit risk
 2009 Basel 2.5 Market risk
 2010 / 11 Basel III Liquidity risk / Market risk
 2013 – 2019 Phased implementation of Basel III

BASEL ACCORDS ARE IMPLEMENTED

THROUGH LOCAL LAW
Basel I, II, 2.5 and III – Set global standard, implemented by local law
Country Status Regulatory bodies
EU Basel II, 2.5 adopted Financial Conduct Authority (UK)
Basel III approved BaFin (Germany)
USA Basel I, II running in parallel OCC, FED, SEC
Basel 2.5 largely approved
Basel III approved
China Basel II, 2.5 adopted China Banking Regulatory Commission
Basel III approved
Hong Kong Basel II, 2.5 adopted HK Monetary Authority
Basel III largely approved
Australia Basel II, 2.5 adopted Australian Prudential Regulation Auth.
Basel III approved
Japan Basel II, 2.5 adopted Financial Services Agency
Basel III largely approved
Source: BIS, BCBS, Seventh progress report on adoption of the Basel regulatory framework, October 2014
BASEL II AND III SUMMARY
 Capital requirements
 3 Pillars of banking supervision
1. Minimum capital requirements
2. Risk management and supervision
3. Market discipline – Pillar 3 disclosure
 Additional capital requirements for systemically
important financial institutions (SIFIs)
 Liquidity requirements
 Global liquidity standard and supervisory monitoring
Source: BIS, BCBS, Basel III summary

CAPITAL REQUIREMENTS FOR BANKS
 Banks are required to meet or exceed a

minimum level of capital
 What is capital?
 A buffer to absorb unexpected losses
 Why do banks have to hold capital?
 To absorb losses
 To protect creditors
 To ensure credit rating
 To support future growth
CAPITAL REQUIREMENTS FOR BANKS
 Two simple concepts in relation to capital:
Minimum capital
>
Actual capital
requirements
The capital that a bank
actually has The capital that a bank
is required to have

LIQUIDITY REQUIREMENTS FOR BANKS
 Basel III introduced two new ratios to monitor

the liquidity of banks
Liquidity coverage ratio Net stable funding ratio

Requires banks to have A long term structural ratio
sufficient high-quality liquid designed to address
assets to withstand a 30- liquidity mismatches
day stressed funding
scenario
Actual capital
Components of capital

COMPONENTS OF CAPITAL
 Under Basel III capital is organised into different

tiers
To prevent
Tier 1 Capital insolvency and allow an
Going-concern capital institution to continue its
activities
To ensure that depositors

Tier 2 Capital and senior creditors can
be repaid if an institution
Gone-concern capital fails
ACTUAL CAPITAL BASEL II
• Equity
• Non controlling interests
• Less deductions, examples:
Core
• Intangibles and goodwill
Tier 1 • Shortfall in provisions
• Gains on change in own credit risk
• 50% investments in other financial institutions
Tier 1
Capital • Hybrid Tier 1 instruments
• Subordinate to Subordinate debt of bank
Hybrid
• Callable
Tier 1 • Discretionary dividend
• No step ups
Innovative
• Hybrid Tier 1 instruments as above, but with step ups
Tier 1
• General provisions
• Tier 2 instruments examples
Tier 2 • Cumulative preference shares
Capital Tier 2 • Subordinate debt of bank
• Less deduction
• 50% Investments in other financial institutions
Note that under Basel II, Tier 3 capital also existed

CHANGES TO ACTUAL CAPITAL UNDER

BASEL III
 The financial crisis revealed that:
 Insufficient capital was held by many institutions
 The capital that was being held was sometimes
ineffective at absorbing losses
 Basel III addressed these issues by:
 Increasing the quality and quantity of Tier 1 capital
required
 Simplifying and reducing Tier 2 capital
 Eliminating Tier 3 capital
ACTUAL CAPITAL BASEL III
• Equity
• Non controlling interests
• Limited to amount required for subsidiary
Common
• Less deductions, examples:
Equity • Intangibles and goodwill
Tier 1 • Shortfall in provisions
(CET1) • Gains on change in own credit risk
Tier 1 • 100% Investments in other financial institutions
• Net deferred tax
Capital
• Hybrid Tier 1 instruments
• Subordinate to Subordinate debt of bank
Additional • Perpetual
Tier 1 • Callable
• Discretionary dividend
• No step ups
• Loss absorbing through write off or conversion
• General provisions
Tier 2 • Tier 2 instruments
Tier 2
(T2) • Subordinate debt of bank
Capital • Maturity >5 years
• No accelerated repayment

Minimum capital requirements
MINIMUM CAPITAL REQUIREMENTS

OVERVIEW
 Banks are required to maintain a minimum capital ratio,
to ensure that they have sufficient capital to absorb
unexpected losses
 Unexpected losses arise from the key risks that banks
are exposed to
 The capital ratio is calculated as:
Capital is the capital that
the bank has. Minimum
capital ratios exist for
CET1, T1 and Total capital Capital
Risk weighted assets Exposure to risk is
quantified using the
concept of risk weighted
assets (RWAs)

KEY BANKING RISKS THAT DRIVE RWAs
Credit risk is the risk of

Credit risk
Credit risk unexpected credit loss in the
banking book RWAs
Market risk is the risk of Market risk

Market risk unexpected losses due to changes
in market prices RWAs
Total
Operational risk is the risk of loss
RWAs
Operational from a failure of internal
Operational
risk processes, or systems risk RWAs
Counterparty risk is equivalent to

Counterparty credit risk for derivative contracts
Counterparty
risk and secured financing transactions risk RWAs
Liquidity risk is the risk that a bank

Liquidity risk may be unable to meet its daily No RWAs
payment obligations
MINIMUM CAPITAL RATIOS

PHASE-IN OF BASEL III REQUIREMENTS
16%
Basel III introduces a capital Capital

14% surcharge for systemically important surcharge for
banks, to be met with CET1 G-SIBs
Counter-
12% 2.5% cyclical
Basel III introduces two capital
capital buffer
buffers in addition to the total capital 1.875%
10% requirements, each to be met with 1.250% Capital
CET1 2.5% conservation
0.625% 1.875% buffer
1.250%
0.625%
8%
2.0% 2.0% 2.0% 2.0% 2.0% T2
2.5%
6% 4.0% 3.5%
1.5% 1.5% 1.5% 1.5% 1.5% Additional T1
1.5%
4% 1.0%
2.0%
4.5% 4.5% 4.5% 4.5% 4.5% CET1
2% 3.5% 4.0%
2.0%
0%
Until 2012 2013 2014 2015 2016 2017 2018 From 2019
Source: New proposals on capital requirements, European Commission

CAPITAL CONSERVATION BUFFER

2.5% RWA MET WITH CET1
 Issue
 Banks struggle to raise capital in times of stress
 Basel III solution
 Banks are required to build up a capital conservation
buffer in good economic times
 Banks under stress are allowed to reduce this
conservation buffer without being in breach of their
minimum capital requirements
 Banks that do reduce this buffer will face constraints
on their ability to return funds to their CET1 investors
until the conservation buffer is restored
COUNTER-CYCLICAL CAPITAL BUFFER

UP TO 2.5% RWA MET WITH CET1
 Issue
 Periods of excessive credit growth increase the risk of
future credit losses
 Extra capital should be built up in such periods
 National regulators can require a counter cyclical
buffer of up to 2.5% RWA in periods of excessive
credit growth
 This buffer is released in an economic downturn
 The release of the buffer helps to avoid credit supply
constraints

CAPITAL SURCHARGE FOR G-SIBS

 Issue
 The failure of a global systemically important bank (G-
SIB) has the potential to send shocks through the
financial system which could harm the real economy
 Additional measures are needed to reduce the
likelihood and impact of such a failure
 G-SIBs are subject to a capital surcharge to provide
additional loss absorbency
 This additional capital requirement (met by CET1) will
vary by institution, with a maximum of 3.5% RWA
CAPITAL SURCHARGE FOR G-SIBS

G-SIB Capital
G-SIBs in alphabetical order
Bucket surcharge
5 3.5% No banks are currently in this bucket
4 2.5% HSBC, JP Morgan Chase
3 2.0% Barclays, BNP Paribas , Citigroup, Deutsche Bank
Bank of America, Credit Suisse, Goldman Sachs,
2 1.5%
Mitsubishi UFJ FG, Morgan Stanley, Royal Bank of Scotland
Agricultural Bank of China, Bank of China,
Bank of New York Mellon, BBVA Groupe, BCPE Group,
Crédit Agricole, ICBC, ING Bank, Mizuho FG, Nordea,
1 1.0%
Santander, Société Générale, Standard Chartered,
State Street, Sumitomo Mitsui FG, UBS, Unicredit Group,
Wells Fargo
Source: BIS, G-SIBs as of November 2014, updated annually

TOTAL LOSS-ABSORBING CAPACITY
 BIS Financial Stability Board has concluded that is still

needs to act to remove the systemic and moral hazard
risks associated with G-SIBs
 Additional loss absorbing capital is required to avoid the
future cost to taxpayers in resolving a failed G-SIB.
Effectively ends “Too big to fail”
 The FSB envisages that the TLAC should consist of
instruments that can be legally, feasibly, effectively and
operationally written down or converted into equity
 Emerging market G-SIBs exempt
 Draft principals issued in November 2014, Proposals
muted for implementation from 2019
TOTAL LOSS-ABSORBING CAPACITY
 Global minimum basic “Total loss-absorbing capacity”

proposed at 16% - 20% RWAs, with national regulators
able to increase this minimum
 Adding in capital buffers pushes the ratios to 23.5% -
27.5% RWAs

Risk weighted assets
Credit risk
Market risk
Operational risk
Counterparty risk
CREDIT RISK RWA

OVERVIEW
 Credit risk is the risk of unexpected credit loss in
the banking and trading book
 Credit risk RWAs are calculated as:
Asset value Credit risk
Ʃ (On or Off BS) X Risk weight = RWAs
 There are 2 approaches to calculate the risk

weights A standard risk
 Standardised approach weighting is used
 Internal ratings based approach (IRB) The risk weighting

is based on internal
bank estimates

CREDIT RISK RWA

STANDARDISED APPROACH
 Under the standardised approach, credit risk weights are based on
an external credit assessment of the claims that the bank has
 The credit risk weights under this approach were updated, to
become more sensitive to credit risk, on the introduction of Basel II
Basel I Basel II onwards
Non Un-
Claim OECD AAA AA A BBB BB B C
OECD rated
Sovereigns 0% 100% 0% 0% 20% 50% 100% 100% 150% 100%
Banks(1) 20% 100% 20% 20% 50% 100% 100% 100% 150% 100%
Banks(2) 20% 100% 20% 20% 50% 50% 100% 100% 150% 50%
Banks(3) 20% 100% 20% 20% 20% 20% 50% 50% 150% 20%
Corporates 100% 100% 20% 20% 20% 100% 100% 150% 150% 100%
Retail mortgages(4) 50% 50% 35% 35% 35% 35% 35% 35% 35% 35%
Other retail(4) 100% 100% 75% 75% 75% 75% 75% 75% 75% 75%
(1) Option 1 – based on credit assessment of sovereign
(2) Option 2 – based on credit assessment of bank
(3) Option 2 – based on credit assessment of bank and short term claim (original maturity <3 months)
(4) Risk weights increase for past due loans
Source: BIS Basel II, Part 2.II
CREDIT RISK RWA

IRB APPROACH
 Under the IRB approach banks may rely on their own internal
estimates of risk components in determining credit risk weights
 Use of the IRB approach is subject to regulatory approval, certain
minimum conditions and additional disclosure requirements
 The risk components include the probability of default, loss given
default, the exposure at default, and maturity
What is the % risk What is the % of
Probability of Loss given
of default in the the claim that
default (PD) next 12 months? default (LGD) could be lost?
How long are we

Exposure at What is the overall
Maturity (M) exposed to this
$ exposure?
risk? default (EAD)
Credit risk
RWA ($)

CREDIT RISK RWA

IRB APPROACH MATH SCHEMATIC
Probability of
default (PD)
Adjusted
Math (1)(2) probability of
default (%)
Capital
Maturity (M) X required
(K%)
Credit risk
Loss given
weighs
default (LGD) X 12.5 (RW%)
Credit risk
X RWA ($)
(1) The math used to calculate the adjusted probability of default is
complex, relies on other coefficients and varies by asset type
Exposure at
(2) Basel III increased the risk weights (RW%) on exposures to default (EAD)
financial institutions relative to the nonfinancial corporate sector.
In effect, a multiplier of 1.25 was introduced
Source: BIS,Basel II, Annex 3
CREDIT RISK RWA

IRB APPROACH ILLUSTRATIVE RISK WEIGHTS
Maturity Corporate Residential Other Qualifying revolving
(M) 2.5yrs exposures (1) mortgages retail retail
LGD = 45% LGD = 45%
PD LGD = 45% LGD = 25% LGD = 45% LGD = 85% LGD = 45% LGD = 85%
Large corp. Small corp.
0.03% 14.4 % 11.3 % 4.2 % 2.3 % 4.5 % 8.4 % 1.0 % 1.9 %
0.05% 19.7 % 15.4 % 6.2 % 3.5 % 6.6 % 12.5 % 1.5 % 2.9 %
0.10% 29.7 % 23.3 % 10.7 % 5.9 % 11.2 % 21.1 % 2.7 % 5.1 %
0.25% 49.5 % 39.0 % 21.3 % 11.8 % 21.2 % 40.0 % 5.8 % 10.9 %
0.40% 62.7 % 49.5 % 29.9 % 16.6 % 28.4 % 53.7 % 8.4 % 15.9 %
0.50% 69.6 % 54.9 % 35.1 % 19.5 % 32.4 % 61.1 % 10.0 % 19.0 %
0.75% 82.8 % 65.1 % 46.5 % 25.8 % 40.1 % 75.7 % 13.8 % 26.1 %
1.00% 92.3 % 72.4 % 56.4 % 31.3 % 45.8 % 86.5 % 17.2 % 32.5 %
1.30% 101.0 % 78.8 % 67.0 % 37.2 % 50.8 % 96.0 % 21.0 % 39.7 %
1.50% 105.6 % 82.1 % 73.5 % 40.8 % 53.4 % 100.8 % 23.4 % 44.2 %
2.00% 114.9 % 88.6 % 87.9 % 48.9 % 58.0 % 109.5 % 28.9 % 54.6 %
2.50% 122.2 % 93.4 % 100.6 % 55.9 % 60.9 % 115.0 % 34.0 % 64.2 %
3.00% 128.4 % 97.6 % 112.0 % 62.2 % 62.8 % 118.6 % 38.7 % 73.0 %
4.00% 139.6 % 105.0 % 131.6 % 73.1 % 65.0 % 122.8 % 47.2 % 89.1 %
5.00% 149.9 % 112.3 % 148.2 % 82.4 % 66.4 % 125.5 % 54.8 % 103.4 %
6.00% 159.6 % 119.5 % 162.5 % 90.3 % 67.7 % 127.9 % 61.6 % 116.4 %
10.00% 193.1 % 146.5 % 204.4 % 113.6 % 75.5 % 142.7 % 83.9 % 158.5 %
15.00% 221.5 % 171.9 % 235.7 % 131.0 % 88.6 % 167.4 % 103.9 % 196.2 %
20.00% 238.2 % 188.4 % 253.1 % 140.6 % 100.3 % 189.4 % 118.0 % 222.9 %
(1) Large corporate exposure example for companies with a turnover of €50m
Small corporate exposure example for companies with a turnover of €5m Risk weights
Source: BIS Basel II, Annex 5

MARKET RISK RWA

OVERVIEW
 Market risk is the risk of unexpected losses arising from
adverse price movements on traded instruments:
 Interest rate
 Foreign exchange
 Equity prices
 Commodity prices
 Market risk capital requirement (and therefore the
RWAs) is calculated using VaR (Value at risk)
 Under Basel II, a standardised approach and an internal
models based approach were allowed
 Under Basel 2.5 these approaches to the calculation of
the market risk capital requirements have been updated
MARKET RISK RWA

VALUE AT RISK
 Value at risk (VaR) is the
Normal
best possible loss for a distribution of
given portfolio or position, daily profits
within a specific time
frame and known 95% confidence
confidence level
 For a normal distribution
VaR (95% confidence) =
1.645 x Standard 1.645
deviations (σ) from the xσ
mean Value at risk

(Unexpected loss)
Expected profit
(Mean)
VaR (99% confidence) =
2.326 x σ from the mean

MARKET RISK RWA

BASEL 2.5
 Basel 2.5 increased the capital requirements (and therefore RWAs)
for market risk following the financial crisis
 Overall the market risk capital requirements for banks with a large
trading book have more than doubled
Basel II Basel 2.5

 Standardised approach, or  Standardised approach
 Internal models based approach  New capital for securitisation
using VaR positions based on credit risk
 Internal models based approach
using VaR
 General VaR charge
 Stressed VaR charge
 Incremental risk capital charge
 Improved risk factor coverage
MARKET RISK RWA

INTERNAL MODELS APPROACH USING VaR
 Banks calculate VaR for various portfolios in their trading
book; this is the basis for the market risk capital
requirement
 VaR should be based on a 99% confidence over a 10
day time period(1)
 Depending on back testing, VaR should be multiplied by
a factor of 3 – 4
 The total capital requirement is multiplied by 12.5 to
calculate the market risk RWAs
(1) A 10 day VaR can be calculated by multiplying a 1 day VaR by √10

OPERATIONAL RISK RWA

OVERVIEW
 Operational risk is defined as the risk of loss resulting
from inadequate or failed internal processes, people and
systems or from external events
 Operational risk RWAs are generally calculated as:
Gross A fixed Operational risk
income(1) X percentage X 12.5 = RWAs
 There are 3 approaches to calculating operational risk

RWAs
 Basic indicator approach
 The standardised approach
 Advanced measurement approach
(1) Gross Income is the average of last three years net interest and net non-interest income
(excluding realised gains/losses on held-to-maturity and available-for-sale securities)
OPERATIONAL RISK: CALCULATION
Basic Indicator Approach The Standardised Advanced Measurement

(BIA) Approach (TSA) Approaches (AMA)
GI  
 Corporate Finance 18%
Gross Trading & Sales 18% KAMA = Expected +
KBIA = Income  15% Unexpected loss
Retail Banking 12%
(GI)
Commercial Banking 15%
 Internal models subject
Payment & Settlement 18% to qualifying criteria
Agency Services 15%  ‘Severe tail losses’
Asset Management 12%
Retail Brokerage 12%
KTSA = Total
 Gross Income is the average of last three years net interest and net non-interest income
(excl. realised gains/losses on held-to-maturity and available-for-sale securities)

COUNTERPARTY RISK
 Counterparty risk is the credit risk equivalent for

derivative contracts and secured financing
transactions, such as repurchase agreements
BASEL 2.5 / III

OVERALL IMPACT ON CAPITAL RATIOS
Increased quality of Tier 1 capital
Simplified and reduced Tier 2 capital
Eliminated Tier 3 capital
Actual capital
Minimum
> capital ratios
RWAs
Increased CET1 ratio
Reduced T2 component
Added capital buffers and G-SIB surcharge
Increased credit risk RWAs
Increased market risk RWAs
Introduced counterparty risk RWAs

Liquidity and funding ratios
LIQUIDITY RISK (BASEL III)
Liquidity
LCR coverage Income
ratio
Net stable NSFR Expense

funding ratio
Assets
Earnings
Equity
RWA No impact
on RWAs

LIQUIDITY RATIOS (BASEL III)
 Liquidity coverage ratio

 Liquid assets / Cash requirements over 30 day period
 Net stable funding ratio
 Amount of stable funding / Required stable funding
 Required stable funding = Assets * requirement %
 Leverage ratio
 Tangible common equity / Total assets
NEW QUANTITATIVE LIQUIDITY AND FUNDING

REQUIREMENTS
Available Stable
Funding
NSFR = Required Stable
> 100%
Funding
Liquid assets
LCR = > 100%
Net cash outflow

BASEL III LIQUIDITY FRAMEWORK
Funding & Liquidity

 Balance sheet analysis: AL mismatches and
potential cash outflows
 Two complementary inter-related rules
NSFR LCR
 Focus: medium-long-term  Focus: short-term liquidity

liquidity  Balance sheet & cash flow
 Balance sheet analysis
 Resilience to 1 year stress  Resilience to 30 days stress
BASEL III: STABLE FUNDING RATIO
Available stable funding

NSFR = ≥ 100%
Required stable funding
 Banks, analysts and rating agencies have already developed

similar methodologies to assess how solid is a bank’s funding
structure
 Let’s imagine a persistent stress situation: say over one year
 How reliable would be the bank’s funding be reliable over one
year?
 Which assets would require funding?
 Would off-balance sheet commitments require further funding?

BASEL III: STABLE FUNDING RATIO
Carrying value of
liabilities and equity
Available
stable funding =Σ x
AFS factors
NSFR =
Carrying value of assets
and OBS commitments
Required
stable funding =Σ x
RSF factors
BASEL III: LIQUIDITY COVERAGE RATIO
High Quality Liquid Assets

LCR = ≥ 100%
Net Cash Outflows
 Let’s imagine a liquidity stress scenario: 30 days

without access to external liquidity
 Would the bank survive with its own means?
 Would it have enough liquid assets to sell/convert
into cash to cover the upcoming cash outflows?

BASEL III: LIQUIDITY COVERAGE RATIO
Carrying value of
cash & liquid assets
HQLA = +Σ x
Factor
LCR =
Maturing liabilities &
Net Cash cash outflows
Outflows = +Σ x
Factors %
Maturing assets &

cash inflows
-Σ x
Factors%
LEVERAGE RATIO
 Leverage ratios are

crude and simple
indicators of risk
within banks
 Prior to the crisis
leverage ratios
increase whereas
regulatory capital
ratios were stable
 Banks have gone
through
deleveraging

Key regulatory ratios
BANK REGULATION – KEY RATIOS
 Capital
 CET1 ratio CET1 / RWAs
 Tier 1 ratio Tier 1 / RWAs
 Total capital ratio Total capital / RWAs
 RWAs / Total assets RWAs / Total assets
 Liquidity
 Leverage ratio
 Liquidity coverage ratio
 Net stable funding ratio

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Please note:

Forecasting and modeling
for banks

116
Financial modeling fundamentals
Modeling fundamentals for banks
EXCEL SHORTCUTS
 Many of the most fundamental shortcuts used by

Excel 2003 are the same in Excel 2007, 2010
and 2013
 Please note that unless otherwise stated, all
shortcuts throughout this presentation work in
both versions

OPTIMAL SETTINGS – EXCEL 2003
Open the Excel options dialog box (ALT + t o):

Tab Setting
View Formula bar on
Status bar on
Comment indicator only
Calculation Iterations off
Automatic calculation on
Error checking Background error checking off
Edit Edit directly in cells off
Move selection after enter off
Enable AutoComplete for cell values off
Go to Tools, Options, Customize:

Also open Tools, Customize from the menu. Click the Options tab and select
the Always show full menus check box
OPTIMAL SETTINGS – EXCEL 2007, 2010, 2013
Open the Excel options dialog box

(ALT + f i) 2007, (ALT + f t) 2010, 2013:
Category Setting
Formulas Enable iterative calculation: off
Enable background error checking: off
Advanced Editing options
After pressing enter, move selection: off
Allow editing directly in cell: off
Zoom on roll with IntelliMouse: off
Extend data range formats and formulas: off
Enable automatic percent entry: on
Enable AutoComplete for cell values: off
Cut, copy and paste
Show paste options buttons: off
Show insert options buttons: off

ESSENTIAL NAVIGATION COMMANDS
ARROW One cell up / down / left / right

CTRL + ARROW Edge of block of cells
CTRL + PAGE UP / DOWN One worksheet left / right
CTRL + END To last cell formatted or
occupied on the sheet
CTRL + HOME Move to cell A1
COMPONENTS OF A BANK FORECAST MODEL
The following components will always exist:

 Historical data
 Historical ratios (to show trends)
 Forecast assumptions
 Forecast financials
 Ratios based on forecast financials

MODEL STRUCTURE & DESIGN
Assume
B/S
I/S I/S
Assume
B/S
TOWER: MATRIX:
All on one sheet Spread across multiple sheets
MODEL STRUCTURE & DESIGN
POSITIVE POSITIVE / NEGATIVE

PRESENTATION PRESENTATION

MODELING STEPS FOR BANKS
2 3
Calculate Create
ratios assumptions
1 4
a. Balance sheet (balancing line)
Input Build b. Income statement
c. Regulatory capital
historicals projections d. Link up equity
MODEL DESIGN
 Tower or matrix model?

 Positive presentation or positive / negative
presentation?
 Decide on the layout
 Assumptions in a block or threaded throughout
the model?

MODELING STEPS REVIEW
1. Input balance sheet and income statement

historicals
2. Calculate ratios
3. Build assumptions
4. Balance sheet
 Use balancing line, flat line equity
5. Average balance sheet
6. Income statement
7. Regulatory capital
8. Wire in equity, derive dividends payable
STEP 1: INPUT BALANCE SHEET AND INCOME

STATEMENT HISTORICALS
1. Calculate subtotals in the balance sheet
2. Do a balance sheet check to ensure it balances
3. Calculate subtotals in the income statement
4. Check that net income matches source data
5. Do not move on until steps 2 and 4 are good
USE THE SUM function if possible:

ALT + =
to calculate historical subtotals

STEP 2: CALCULATE RATIOS
 Calculate ratios using the income statement and

balance sheet historical numbers
 The ratios calculated should correspond to the
assumption being used
 If forecasting loans using a growth rate, calculate a
historical growth rate ratio; or
 If forecasting interest income as a % of average
loans, calculate the interest income / average loans
historical ratio
 Historical ratios will identify trends which will
help you form a view on your assumptions
SHORTCUTS TO HELP YOU COPY FORMULAS
CTRL + C Copy
Enter Paste (once only)
CTRL + R Copy (or fill) right

STEP 3: BUILD ASSUMPTIONS
 Assumptions are given in this model

 Historical ratios will identify trends which will
help determine assumptions about the future
STEP 4: BALANCE SHEET
 Place the assumption first when writing a

formula if possible
 Check thoroughly
 Copy across section by section and not line by
line
 Copy historical subtotals across – do not
recalculate them
 Perform secondary calculations as necessary
and link into balance sheet

STEP 4: BALANCE SHEET
 The balance sheet line items for a bank are generally

forecast using growth rates
 Some items are forecast using assumptions other than
growth rates
 Deposits are often forecast using the loan to deposit ratio
 Goodwill will only change if there is an acquisition
 Non controlling interests can be forecast using BASE analysis
 Keep equity constant for now
 Update once regulatory capital requirements are known
 All bank models require a balancing line
 Often interbank funding is used
CHECKING TECHNIQUES
These checks should be used together:

 Sanity or sense check
 Matrix check
 Stress check

USE EXCEL TO HELP YOU - THE JUMP TOOL
CTRL + [
Jump out
F5 + ENTER
Jump back
STEP 5: AVERAGE BALANCE SHEET
 Only the balance sheet lines that drive the

income statement performance need to be
averaged
 This is due to the underlying assumptions about
the timing of the issuance and repayment of
debt

TIMING AND INTEREST
SCENARIO 1 : Repayment on FY day 1
100 million note at 10%

FY beginning balance FY ending balance
100
(50)
50 50
What is the interest expense?
TIMING AND INTEREST
SCENARIO 2 : Repayment on FY day 365

100 100
(50)
50

TIMING AND INTEREST
COMPROMISE: Average debt

100 50
Average debt over year: 75 = (100 + 50) / 2

MIDYEAR AVERAGING
Interest expense: use midyear averaging if date of

payment is unknown
= AVERAGE(C14:D14) * D15
or
= AVERAGE(C14,D14) * D15
Average dangers!
YES: = AVERAGE(C14:D14) * D15 NO: = AVERAGE(C14 + D14) * D15
= AVERAGE(C14,D14) * D15 = AVERAGE(C14) + D14 * D15

=AVERAGE DANGERS
No number, no average:
Zero History Year 1
Revolver balance 0.0 20.0

Interest rate 10.0% 10.0%
10% * (0.0 + 20.0) / 2
Interest expense 1.0 1.0
No Zero History Year 1
Revolver balance 20.0

Interest rate 10.0% 10.0%
10% * 20.0
Interest expense 1.0 2.0
STEP 6: INCOME STATEMENT

formula if possible
line
recalculate them
and link into income statement

STEP 6: INCOME STATEMENT

COMPONENTS
 Net interest income
 Non interest income
 Cost income ratio
 Loan loss provisions
 Taxes and others
FORECAST NII: APPROACHES
Approaches to forecasting
net interest income
Simple Detailed
Forecast separately
Forecast directly
interest income,
net interest income =
interest expense
net interest margin
x average interest
Check net interest
earning assets
margin at the end

NET INTEREST MARGIN
 There are two approaches to forecasting interest

margins:
Interest Rate Method Treasury Method

• Forecast each interest rate • Assets and liabilities each
for each type of: have a margin to an internal
• Asset: treasury curve
• customer loans; • Both assets and liabilities can
• inter-bank loans; be profit centers when
• other interest earning compared to the internal
assets; curve
• Liability:
• customer deposits;
• inter-bank deposits;
• bonds outstanding
NET INTEREST MARGIN

Interest Interest
Rate Rate
6.0% 6.0%
Asset Margin
4.2%
Total Margin Treasury Margin
3.6%
Liability Margin
2.5% 2.5%
Time (Years) Time (Years)

INTEREST RATE VERSUS TREASURY METHOD

 Interest rates are forecast for  Each asset and liability is
each asset and liability modeled as having a margin to
 Method is flexible to model treasury
trends in interest rates (e.g.  Assumption that any liquidity
changes in yield curve) shortfall or surplus is
 Method is very sensitive to funded/placed at a zero margin,
implied asset and liability mix in e.g. LIBOR in the interbank
forecasts market
 WARNING: Additional focus is  Funding structure is not
needed to make sure the explicitly modelled
liquidity position of the balance  WARNING: Funding
sheet is realistic shortfalls/surpluses need to be
evaluated
UNDERSTANDING HISTORICAL INTEREST

RATES AND NET INTEREST MARGINS
 The reported average balance sheet can be used to
understand historical net interest margins
 Calculate historical interest rates:
 Interest income rate =
Interest income / average interest earning assets
 Interest expense rate =
Interest expense / average interest bearing liabilities
 Calculate historical net interest margin:
 Net interest margin =
Net interest income / average interest earning assets
 The net interest margin should be understood with reference to
the asset and liability mix of the bank

DETAILED FORECAST FOR NET INTEREST

INCOME
1. Forecast future interest rates = base rate +/- spread
 Link future interest rates to LIBOR
 Banks borrow on the interbank market at LIBOR +/- a spread
 Banks lend at LIBOR + a spread
 Customer deposits attract low interest
2. Forecast future absolute interest income
 Interest income =
Average interest earning assets x interest income rate
 Interest expense =
Average interest bearing liabilities x interest expense rate
3. Check forecast net interest margin (NIM)
 Small movements in NIM impacts performance significantly
 Banks manage their NIM very tightly with the use of derivatives
NON INTEREST INCOME
 Net fee and commission income comes from a variety of

different sources
 Use a driver relevant to the source of net fee income to forecast
the future performance of this line item, e.g.:
 Commercial banking fees: linked to customer loans and deposits
 Asset management fees: linked to funds under management
 Investment banking fees: linked to capital markets’ volumes,
market share and margins
 Trading income
 In the short term, trading gains/losses reflect capital market
volatility. Interim results announcements can b used to capture
trends
 In the long term, trends should revert to normalised capital gains

FORECASTING LOAN LOSSES: APPROACHES
Approaches to forecasting
loan loss charges
Simple Detailed
a. Forecast separately:
Forecast directly 1. Loan loss allowance
loan loss charge = 2. Non-performing loans
loan loss margin 3. Write-offs
x average loans 4. Loan loss charges
b. Check NPL coverage ratio
UNDERSTANDING HISTORICAL LOAN LOSSES
 A key driver of losses for commercial banks

 Historical loan losses are very cyclical
 Asset quality is cyclical: NPL % can increase by
multiples during phases of economic recession
 NPL ratio =
Non-performing loans (NPLs) / Total loans
 To understand history
 Reviewing loan book quality: NPL and coverage
ratios
© Adkins Matchett & Toy 2008 - 2015

 Banks focus on managing their NPL coverage

ratio
 NPL coverage =
Loan impairment allowance/ NPL
 The NPL coverage can be used as a modeling
assumption or as a check that the projections of
provisions, write-offs and NPLs are realistic
DETAILED MODELING OF LOAN LOSS

CHARGES
 Build-up BS loan loss allowance:
 Opening loan loss allowance (BS)
 Net loan loss impairments (P&L)
 Write-offs net of recoveries
+/ Other movements
 Closing loan loss allowance
 Drivers:
 NPL ratio = NPLs/total loans, write-offs/NPLs
 Write-offs rates and provisioning rates
 Write-offs lag behind provisions and are often more volatile

COMPLETING THE INCOME STATEMENT
 Modeling operating costs for banks:

two options
 Cost income ratio (CIR): defining a desirable level
given cyclicality
 Cost inflation rate
 Other items are modeled in the same way as for
industrial companies:
 Taxes
 Associates
 Non controlling interests
STEP 7: REGULATORY CAPITAL

formula if possible
line
recalculate them
and link into regulatory capital

STEP 7: REGULATORY CAPITAL

COMPONENTS
 Risk weighted assets
 Minimum capital required
 Common equity Tier 1 ratio
 Total capital ratio
 Derive minimum equity required
FORECASTING RISK WEIGHTED ASSETS
Approaches to risk
weighted assets
Simple Detailed
Forecast separately:
Forecast directly
+ Credit RWAs
RWAs ($ m) =
+ Market RWAs
Total assets ($ m)
+ Counterparty RWAs
x RWAs ratio
+ Operational RWAs
Assets
= Total RWAs

MODELING CAPITAL AVAILABLE
 Maintain all accounting adjustments constant

 Accrue earnings generated during the year
 Deduct dividends
 Hybrid securities: generally keep constant
FORECASTING RISK WEIGHTED ASSETS
 Benchmark each RWA against a driver of that risk:
Customer Loans Credit Risk
Derivative Assets Counterparty Risk
Trading Assets (& Liab) Market Risk
Gross Income Operational Risk
 As for any modeling, benchmark historicals, extrapolate

and then forecast

MODELING RWAs
 Credit and counterparty risk RWAs

 RWAs = Exposure x relevant risk weighing
 Take into account credit risk in off balance sheet
commitments and guarantees
 Market risk RWAs are driven by value at risk
(VAR)
 Operational risk capital is driven by banking
income
STEP 8: WIRE IN EQUITY, DERIVE DIVIDENDS
 The minimum equity requirements are known

from the regulatory capital analysis and
forecasting
 This can now be linked into the balance sheet
 The net income is known from the income
statement
 Dividends payable (or any capital injection) can
be derived using BASE analysis

EQUITY – BASE ANALYSIS
Beginning amount
Additions What makes equity go up?
Subtractions What makes equity go down?
Ending amount
EQUITY – BASE ANALYSIS
Beginning amount
Additions Net income / profit after tax
Subtractions Dividends
Ending amount

RATIOS ANALYSIS FOR BANKS
Ratios
Growth Profitability Risk
Loans Margins Asset quality

Risk-weighted assets Asset yield Funding / liquidity
Deposits Returns Solvency
Net banking revenues DuPont analysis
Attributable profits

RATIOS
Net Income (after NCI)
Return on Equity =
Equity
Net Income (before NCI)

Return on Assets =
Total Funded Assets
Net Income (before NCI)

Return on RWA =

Interest Income
Interest Expense
Net Interest Income


Cost / Income =
Operating Income

Cost / Net Income =

Cost / Net Income =


NPL Ratio =
Gross Loans
Provision Expense
Provisions % =
Gross Loans
Provision Expense
NPL Coverage =
Customer Loans
Loan Deposit % =
Customer Deposits
Bank Loans
Bank Deposits
Liquid Assets
Liquidity Ratio =

CET1
CET1 Ratio % =
RWAs
Total Capital
RWAs
Total Assets
Leverage Ratio =
Equity (incl. NCI)
MODELING RULES
 Always build the model with ITERATIONS OFF 

 Ensure the model has MATRIX INTEGRITY – Always check formulas for MATRIX
INTEGRITY 
 Keep formulas ‘tight’ (only include cells needed in the formula) 
 Put ASSUMPTIONS first if possible
 COPY totals across from historicals 
 COPY ACROSS section by section 
 Check for ‘HOCKEY STICKS’ 
 Stress test 
 Ensure only ONE ENTRY POINT for a number 
 Never ‘HARD CODE’ in a formula 

 Leave AUDIT TRAILS and INSERT COMMENTS 

PREPARE FOR HANDOFF
1. Prepare a cover page 

2. Check work for accuracy 
3. “Beauty save” with cursor homed on each sheet and
placed on opening sheet 
Please visit us on:

www.amttraining.com
Please note:

146
Bank valuation

148
Bank valuation
Bank valuation
CONTENTS
 Corporate and bank valuation compared

 Free cash flow to equity model
 Bank trading multiples
 Sum of the parts valuation
 Key drivers by segment

Bank valuation
Corporate and bank valuation compared
© Adkins
3 Matchett & Toy 2008 - 2015 info@amttraining.com
COMPARABLE COMPANIES ANALYSIS
 Takes traded values of comparable banks

 Implies value by reference to the benchmark for
the industry set being used
 Is very dependent on the “comps set” being
used
 Is a market based valuation tool
 Is a relative valuation tool

Bank valuation
CASH FLOW VALUATION
 Forecasts the cash flows into the future and

 Values them
 Gives the forecast builder’s view of value
 Is an intrinsic or fundamental valuation tool
BANK VALUATION IS AN EQUITY VALUATION
 For a corporate the operating business can be

treated separately from the financing of the
business
 The operating business can be valued using
Enterprise Value
 For a bank it is not possible to separate the
operating business from its financing, so
Enterprise Value can not be used
 All bank valuation is focused on equity value
irrespective of which valuation method used

Bank valuation
CORPORATE COMPS VS BANK COMPS
Comparable Comparable
companies for companies for
a corporate a bank
Enterprise value Equity value

often focus always focus
EV / EBIT
P/E
EV / EBITDA
P/B
P/E
CORPORATE DCF VS BANK DCF
DCF for DCF for

a corporate a bank
Enterprise value Equity value

technique technique
Free cash flow

Free cash flow to equity =
Potential dividends
Discount rate Discount rate

WACC Ke

Bank valuation
Free cash flow to equity model
Bank DCF valuation
© Adkins
STEPS OF A BANK DCF VALUATION
Step 1: Forecast a
Step 2: Calculate Ke
bank’s BS, IS and
Step 3: Calculate a
capital requirements
terminal value for
then calculate the
the bank at the end
free cash flows to
of the forecast
equity
period; either use a
growing perpetuity
method (using a LT
growth rate and
Ke), or the multiple
Step 5: The PV of method
the free cash
flows to equity =
equity value. Step 4: Discount the
Calculate the free cash flows to
implied share equity and TV to
price and present value using
sensitize to get a Ke
range of values

Bank valuation
STEPS OF A BANK DCF VALUATION

CHECKS
1. Forecast the free cash flows to equity
 Use an existing model if one is already built
 Check the forecast for consistency with consensus forecast for the first few years
2. Calculate Ke
 Use assumptions reflecting the long term
 There is no “correct” answer here as this is just an estimate
3. Calculate the terminal value (TV)
 Typically between 60% and 80% of the valuation is contained in the TV
 The result is very sensitive to assumptions, so be careful
4. Discount the free cash flows to equity and terminal value
5. Calculated the implied share price
 Sensitize the results to get a range of share prices
 Establish a reasonable share price range
 Always sanity check the results
STEP 1: FORECAST THE FREE CASH FLOWS

TO EQUITY – WHAT ARE THEY?
 Dividends will only paid by a bank once its regulatory
capital requirements are met
 Market expectations for capital normally exceed the
regulatory minimums
 A target common equity tier 1 capital ratio should be
estimated, based on market expectations
 BASE analysis is used to derive the maximum potential
dividends (or required capital injections) the bank can
make while maintaining this target common equity tier 1
ratio
 The maximum potential dividends (or required capital
injections) are the free cash flows to equity

Bank valuation
STEP 2: CALCULATE THE COST OF EQUITY
 Ideally the Ke would be measured by asking all investors

what expected return they anticipate for investing in the
company’s shares
 Difficult in practice to ask all the investors! So estimate
the expected return
 Several methods exist but the most commonly used is
the Capital Asset Pricing Model (CAPM)
 Calculates equity returns using building blocks
+ “Get out of bed return”
+ Premium required for taking general equity risk
+/- Adjustment for the risk profile of the company
= Cost of equity (Ke)
STEP 2: CALCULATE THE COST OF EQUITY
The minimum expected

return investors require
for investing their money. Significant controversy over the
Similar to the opportunity exact number for the market risk
cost of money. premium - usually
between 5% and 8%
Ke = risk free rate + (market risk premium * beta)

Measures the volatility of returns
(the risk) from the specific stock against the
volatility of returns (the risk) of the market
β Retail banks 1 to 1.5
β Investment banks 1.5 to 2.0

Bank valuation
STEP 3: CALCULATE THE TERMINAL VALUE
 The bank has value after the forecast period

 The terminal value estimates the continuing
value after the projected period
 Captures the value of all future cash flows to equity
from the end of the forecast period
 Typically represents a significant proportion of the
bank’s overall value
 Small changes in assumptions result in big changes
to the terminal value
 Terminal value calculations assume the business has
reached a steady state
STEP 3: CALCULATE THE TERMINAL VALUE ─

POSSIBLE APPROACHES
1 Exit multiple 2 Growing perpetuity
 Use an equity multiple  Assumes the free cash
in the final year to derive a flow to equity in the last
terminal value forecast year grows into
 A short cut method drawing perpetuity at a constant
upon experience rate
 Choose the multiple  Ensure you normalize your
carefully - the number assumptions in the final
reflects steady state growth forecast year
and returns  Easy to make timing
 Exit multiple should mistakes when discounting
normally be lower than
today’s LTM multiple

Bank valuation

EXIT MULTIPLE METHOD
 Only use equity value multiples (P/E or P/B)
 Both the exit multiple and earnings should reflect
the steady state
 Use trading comparables, since deal
comparables will reflect a change of control
premium
 Take multiples of companies reflecting the
growth and margins of a bank in its steady state
 Often the current multiples don’t reflect steady
state

GROWING PERPETUITY METHOD
 Another way to calculate the terminal value is to
assume the final cash flow continues to grow at
a constant growth rate into perpetuity
 The method is very sensitive to changes in Ke
and growth rate used
Steady state FCFEN * (1 + LT growth rate)
Terminal valueN =
(Ke ─ LT growth rate)
Terminal value in the LT growth rate is the
last forecast year growth rate into
perpetuity so don’t
Steady state cash use a larger growth
flow rate than nominal
GDP

Bank valuation

TERMINAL VALUE CHECKS
Whichever way you calculate the terminal value, a cross check against
the other method is useful
Implied Terminal Value multiple Implied LT growth rate
TVGP Ke* TVMM - FCFN

P/B multipleN =
Book valueN LT growth rate =
FCFN + TVMM
Terminal value
from growing Terminal value
perpetuity from multiple
method method
STEP 5: CALCULATE IMPLIED SHARE PRICE

AND SENSITIVITY ANALYSIS
 Divide equity valuation by the number of shares outstanding to
derive the share price
 The two biggest areas of uncertainty are the Ke and the long term
growth rate
 Using either the growing perpetuity and exit multiple methods, we
build a “data table” of implied share prices for different combinations
of assumptions
Five different Three different

assumptions assumptions for the
for the LT growth rate
discount rate
(Ke)
Table of
15 (= 3 * 5) answers
for different
combinations of Ke
and LT growth

Bank valuation
Bank trading multiples
© Adkins
TWO TYPES OF MULTIPLES ANALYSIS
 Trading comparables  Transaction comparables

 Uses market’s perception  Key for controlling stake
of bank’s value relative to acquisitions
peers traded in the market  Used to help decide how
 No premium for control – much to offer for a
only a minority stake business or asset
 Difficult to get comparable  Difficult to find recent
companies in some cases comparable transactions
 Used mainly for
negotiations

Bank valuation
TRADING COMPARABLES
 Advantages  Disadvantages
 Useful for understanding of  Finding direct comparables
the bank’s strengths and is often challenging
weaknesses against the  Comparison is often affected
peer group by
 Limited liquidity
 Helpful for identification of
 Limited earnings forecasts
the most highly valued
 M&A activity (impacts both
strategy by the markets share prices and earnings
 Usually based on forward numbers)
looking earnings  Only uses forecast earnings
in near future
 Reliant on equity research
quality
TRADING COMPARABLES – CALCULATING

MULTIPLES
 Trading comparables multiples analysis is a ratio
analysis where a valuation measure (numerator)
is compared to the company’s performance
measure (denominator)
Market valuation Equity value
Performance Earnings or
measure Book value

Bank valuation
4 MAIN COMPONENTS
 Decide on the comparable set

 Calculate equity value
 Analyze earnings
 Check that the output makes sense
THE COMPARABLE SET
 Review all the  Faster-growing

comparables in the set; companies have higher
which are the most multiples
comparable?  The growth is already priced
 Competitive advantage: into the value number
margins  Earnings will catch up
as time goes on, and the
 Earnings growth:
multiple will fall
LT EPS growth
 Potential downside:
Venture Growth Maturity
business risks
P/E
Multiple
EPS

Bank valuation
PRICE EARNINGS MULTIPLE OR P/E
Share price = 7.40 = 18.5x

Diluted EPS 0.40
Net income available to equity holders

Weighted average diluted shares outstanding
Profit after tax 600.0

Noncontrolling interest (100.0)
Net income 500.0
Less: preferred dividend (120.0)
Net income attributable to equity holders 380.0
Weighted average diluted shares outstanding 950.0
Diluted EPS 0.40
PRICE TO BOOK MULTIPLE OR P/B
Equity value = 750.0 = 1.5x

Book value 500.0
of equity
Market value of shareholder’s equity

Book value of shareholder’s equity
Shareholder’s equity 500.0

Noncontrolling interest 100.0
Total equity 600.0

Bank valuation
CALCULATE EQUITY VALUE – SHARE DATA
 Use latest number available for shares outstanding

 If not provided, calculate shares outstanding from the
footnotes: (issued shares – shares bought back)
 Some companies have two or more share classes: add them
both together. Do not include Depository Receipts
 Check for corporate actions - stock splits, issuances or
repurchases
CALCULATE EQUITY VALUE – OPTIONS
 In addition to the shares already issued, companies

often commit to making future issuances to employees
via share options
 Options allow the holders to buy a share at a fixed price in the
future known as the exercise or strike price
 Include the potential impact of these items to get the diluted
shares outstanding
 Do not use numbers from the company EPS calculations as
these are average diluted shares outstanding
 Only include options which are in the money. In other words
they are profitable for the holder to convert – where the current
share price is above the strike price

Bank valuation
 Check the company’s current share price against the table disclosing
options in the notes to the financial statements (the 10K / annual reports
may contain more detail than 10Q / interims)
 Look at the outstanding options below (exercisable options are options
which are not “locked out”)
 Where the strike price of the options is lower than the stock price, it is profitable
to convert
 If any options have a strike price above the share price, it would be unprofitable
to convert
 For in the money options assume conversion into new shares

 Assume any proceeds from the conversion of the options are used to
repurchase shares at the current price
 Here’s an example:
Total outstanding shares 1,000

Number of options 100
Strike price 5
Current share price 12
Cash from options 100 * 5 = 500

Shares repurchased 500÷ 12 = 42
Net new shares 100 – 42 = 58
Equity value (1,000 + 58) * 12 = 12,700

Bank valuation
NORMALIZED EARNINGS – THE CONCEPT
 Normalized net income is conceptually different

than EBIT / EBITDA
 It should include both core and non-core
businesses regardless of whether they are
controlled or not
 Therefore we are looking at net income which is:
 Continuing
ANALYZE EARNINGS – LAST TWELVE MONTHS
 Using the quarterly data and the 10-K produce a more

up to date historical year – known as last twelve months
or LTM
 Not all countries report quarterly (particularly outside the
U.S.), so you cannot do this for all companies
 Quarterly reports are organized so this is easily done
Q1 Q2 Q3 Q4 Q1 Q2
Subtract the oldest quarters Add the newest quarters

- +

Bank valuation
ANALYZE EARNINGS – CALENDARIZING
 Earnings period
 Compare companies earnings over the same period
 Companies can have different year-ends
 You can “create” a comparable year by calendarizing
companies’ earnings
 Most comps models will do this automatically for you
31-Dec-28 Target - actual 31-Dec-29
Comparable - actual 31-Mar-29 Comparable - forecast 31-Mar-30
ANALYZE EARNINGS – CALENDARIZING
Actual to 31-Mar-29 Forecast to 31-Mar-30
3 months 9 months
“Calendarized” year
31-Dec-28 31-Dec-29
Months Net income

Net income % to include
to include to include
Year to
31 March 29 – 100.0 3 25% 25.0
Actual
Year to
31 March 30 – 150.0 9 75% 112.5
forecast
Net income
calendarized to 137.5
31 December 29

Bank valuation
ANALYZE EARNINGS – PRO FORMA

ADJUSTMENTS
 Companies should be Transaction BS LTM IS
analysed on a pro forma basis closes adjustment adjustment
for significant corporate Prior to start None None
actions such as of LTM
 Acquisitions
 Disposals During LTM None Proportional
to period
 Stock issuances, buybacks before close
and stock splits
Post LTM 100% 100%
 Details are often contained
within the subsequent events
footnotes
 Also check public merger Pro forma adjustments required for
companies undertaking acquisitions
filings to obtain data to pro
and disposals
forma adjust for a transaction
(8-K, S-4, etc.)
ANALYZE EARNINGS – THE FUTURE
 The value of the company is driven by expectations

of future earnings
 The market will have a consensus about future earnings (average of equity
research estimates)
 Consensus is collated by I/B/E/S and others
 In many cases getting consensus estimates for net income is difficult, so choose
a research report in line with the consensus EPS estimates
 Choosing an equity research report
 Use a reputable firm and a report that is detailed
 Compare historical data disclosed in the report with your calculations. Do they
match? If not why not?
 Increasingly data is downloaded
 Earnings projections from internal data sources
 Share prices from Factset and Datastream

Bank valuation
CHECK THE OUTPUT

REGRESSION ANALYSIS
 Regression analysis can be used for estimating
the relationships between variables
 Regression analysis is performed by plotting (on
a scatter chart) a trading multiple (such as P/B)
against a performance metric (such as ROE)
 A trend line can then be derived and the
correlation between the variables measured
(using R2)
CHECK THE OUTPUT
 Check output thoroughly

 Always scan the output pages for errors
 Vertical and horizontal checks
 Cross reference other sources
 Look for unusual trends in the numbers: earnings and book
values usually go up
 Run a spell check
 Check footnotes for every assumption
and references in both Excel and the PIB. Include
page references so the data can be easily found
 Ask a colleague to check as well

Bank valuation
CHECK THE OUTPUT
 General company data  Book Value of Equity

 Putting the share price in cents/pence  Not using the latest balance sheet
rather than $/₤ (often the interim or 10-Q)
 General errors in numbers  Not adjusting for recent acquisitions
 Using share prices at different dates since the latest audited numbers
for the same set of comps  Using numbers from a secondary rather than
 Share data a primary source
 Not using all classes of shares where  Earnings
appropriate  Miscalculating the numbers
 Not picking up stock splits and new share when you are “reverse-engineering”
issuances/repurchases since the latest  Missing non-recurring items embedded
audited data in the MD&A section of the annual report
 Using weighted average shares and not  Missing non-recurring items in the interims
outstanding shares and 10-Qs
 Not using the number of shares outstanding  Acquisitions and divestitures that happen
at valuation date mid-year
 Using options that are out of the money  Accepting the company’s presentation of their
 Missing out or miscalculating share based numbers without checking
compensation plans
 Using numbers from a secondary rather than
a primary source
Sum of the parts valuation
© Adkins

Bank valuation
DERIVING EQUITY MULTIPLES FOR BANKS
 The equity multiples P/E and P/B can be derived using

some fundamental inputs, namely:
 Return on equity, Growth, Cost of equity
 Together these inputs are known as value drivers
 To value a bank or the division of a bank, assumptions
can be made about these value drivers, in order to
estimate its P/E or P/B multiple
 These estimated multiples can be applied to the bank or
division of the bank in order to derive a value
 The same methodology can be used with steady state
assumptions to derive a terminal value P/E or P/B
multiple
THE VALUE DRIVERS AND P/E MULTIPLES
 P/E multiples are driven by the value drivers, namely:

return on equity, growth, and cost of equity
Gordon growth model and P/E multiples Legend

Prospective
D1 D1
dividend
P =
Ke - g Ke
Expected return or
cost of equity
Divide both sides of the equation by earnings in year 1 (E1) Long term growth
g
rate
P D1/ E1
= ROE Return on equity
E1 Ke - g
Retention rate,
RR
Furthermore, per definition of retention rate: where RR= g / ROE
g = ROE * RR
P (1 – g/ROE) P/E multiple depends
= on growth, ROE and
E1 (Ke - g) cost of equity

Bank valuation
THE VALUE DRIVERS AND P/E MULTIPLES
 P/B multiples are driven by the value drivers, namely:

return on equity, growth, and cost of equity
Gordon growth model and P/E multiples Legend

Prospective
D1 D1
dividend
P =
Ke - g Ke
Expected return or
cost of equity
Divide both sides of the equation by the current book value
of equity (B0) Long term growth
g
rate
P D1/ Bo E1/ Bo * (1 – RR)
= = ROE Return on equity
B0 Ke - g Ke - g Retention rate,
RR
Furthermore, per definition of retention rate: where RR= g / ROE
g = ROE * RR
P (ROE - g) P/B multiple depends
= on growth, ROE and
B0 (Ke - g) cost of equity
SUM OF THE PARTS VALUATION

VALUE DRIVER METHOD
 A sum of the parts valuation can be performed by
making assumptions about the value drivers for each
division within a bank
 The corporate overheads are valued using a P/E
multiple based on trading comparables
Division RoE Ke g P/E P/B Earnings Valuation
Investment banking 11.0% 11.0% 2.0% 9.09x 1.00x 1,000.0 9,090.9
Private banking 12.0% 10.0% 3.0% 10.71x 1.29x 500.0 5,357.1
Business banking 13.0% 10.0% 2.0% 10.58x 1.38x 750.0 7,932.7
Retail banking 15.0% 9.0% 2.0% 12.38x 1.86x 250.0 3,095.2
Emerging markets 16.0% 14.0% 6.0% 7.81x 1.25x 600.0 4,687.5
Corporate overheads 10.00x (900.0) (9,000.0)
Total 2,200.0 21,163.5
Number of shares outstanding 10,000.0
Share price 2.12

Bank valuation

TRADING COMPARABLES METHOD
 A sum of the parts valuation can also be performed by
using the P/E or P/B multiples of comparable companies
for each division within a bank
 The corporate overheads are valued using a P/E
multiple based on trading comparables
Division P/E Earnings Valuation P/B BV Equity Valuation
Investment banking 9.00x 1,000.0 9,000.0 0.90x 9,500.0 8,550.0
Private banking 11.00x 500.0 5,500.0 1.30x 5,000.0 6,500.0
Business banking 12.00x 750.0 9,000.0 1.40x 6,000.0 8,400.0
Retail banking 12.00x 250.0 3,000.0 1.50x 2,200.0 3,300.0
Emerging markets 9.00x 600.0 5,400.0 1.40x 4,000.0 5,600.0
Corporate overheads 10.00x (900.0) (9,000.0) (9,000.0)
Total 2,200.0 22,900.0 26,700.0 23,350.0
Number of shares outstanding 10,000.0 10,000.0
Share price 2.29 2.34

CHECKS
 Ensure that all divisions and all portions of the
“value pie” are included, and not double counted
 Divisions and value that are often overlooked:
 Corporate centre and overheads
 Regulatory capital surplus or shortfall
 Run off portfolios
Financial assets whose value has fallen significantly
 Toxic assets and for which there is no longer a functioning market
 Bad bank division A structure created by a troubled bank to isolate illiquid

 Treasury and high risk securities within a segregated entity
Sometimes embedded within investment banking or transaction services

(because Treasury raises any capital shortfall from the capital markets)

Bank valuation
Key drivers by segment
© Adkins
UNIVERSAL BANKS: SEGMENTS
 Universal banking groups feature a wide range of

businesses
 Retail bank
 Wholesale bank
 Treasury
 Investment bank
 Asset management
 Insurance
 Each business has specific key drivers and ratios

Bank valuation
LENDING DIVISIONS
 Some divisions are just variations of the core lending

activity
 Home lending (mortgages)
 Credit cards
 Corporate lending
 Factoring and leasing
 Standard ratios and drivers apply
 Net interest margins, impairment charge margins
 Capital allocated based on credit risk weighted assets
 In addition, each sector might respond to drivers and
trends captured by specific indicators
HOME LENDING
 Long term lending secured by residential property

 Key ratios
 Delinquency rates: % customers overdue by 30+, 60+ days
 Customer loan to value ratio (CLTV) and migration to higher
CLTV bands
 FICO scores: a US measure of individual borrowers’ ability to
repay
 Net charge off rates: % write-offs net of recoveries
 Breakdown by vintages: year of sale

Bank valuation
CREDIT CARDS
 Consumer finance business

 Typically high margin high risk form of lending
 Key ratios
 Credit card loans are also called credit card receivables
 Migration to lower buckets: from current, to 30+ days overdue, to
60+ to 90+ to charge-off
 Non-performing loans % and coverage
 FICO scores
 Key drivers
 Link to unemployment rates and consumer confidence
 Exposure to off-balance sheet commitments
INVESTMENT BANKING
 Investment banks assist customers access to capital

markets and facilitate the flow of funds from investors to
issuers
 Underwriting and placing securities
 Market making and dealing
 Key sub-segments
 Fixed income
 Equities
 Credit
 Commodities
 FX
 Derivatives
 M&A

Bank valuation
INVESTMENT BANKING: UNDERWRITING
 Underwriting is just a form of intermediation

 Instead of borrowing and lending,
 Buying securities and selling them to investors
 Underwriting fees can be explained by 3 factors
 Volumes: overall capital markets’ activity (issuance
and secondary trading)
 Market share: linked to investment bank’s ranking in
league tables
 Margins: underwriting fees and bid-offer spreads
INVESTMENT BANKING: TRADING
 Trading
 Banks engage in large volumes of transactions.
 Most are ‘flow’ activities: Underwriting and
distributing, structuring derivatives and then passing
the risk to the markets for example
 A few are net trading positions: these are difficult to
identify and pose a market risk to the investment bank
 Trading can be risky and volatile
 Maximum potential losses are measured by
Value at Risk

Bank valuation
INVESTMENT BANKING: RATIOS AND DRIVERS
 Key drivers and ratios

 Growth in revenues, split by products
 Market share and league table rank
 Compensation ratio: to capture high bonus levels
 Value at risk: to capture volatility
 Asset quality and analysis of outstanding exposure to
toxic assets
 Toxic assets write-downs: recorded either as trading
losses or loan loss impairment charges
ASSET MANAGEMENT
 Asset management is a service business

 Limited capital requirements arising from operational risk
 High RoE, due to limited capital requirements
 However, it is a scale business and it requires
substantial investment in human capital
 Key drivers and ratios
 Funds under management (FuM): it is an additional off-balance
sheet disclosure
 Fees / funds under management
 Types of funds under management: retail vs. institutional, active
vs. passive
 Costs

Bank valuation
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Barclays

Bank forecasting and valuation

Financial statement analysis for banks........................................................................... 47

Fundamentals of regulatory capital................................................................................. 87

Forecasting and modeling for banks............................................................................... 115

Bank valuation................................................................................................................ 147

© Adkins Matchett & Toy info@amttraining.com

No decisions should be taken on the basis of

© Adkins Matchett & Toy 2008 - 2015 info@amttraining.com

© Adkins Matchett & Toy 2008 - 2015 1 info@amttraining.com

© Adkins Matchett & Toy 2008 - 2015 info@amttraining.com

How a bank makes money

© Adkins Matchett & Toy 2008 - 2015 info@amttraining.com

© Adkins Matchett & Toy 2008 - 2015 3 info@amttraining.com

HOW A BANK MAKES MONEY – BALANCE

The bank then lends the A bank collects a deposit

Customer Loans Customer Deposits

• Credit risk – Customers • Liquidity risk – Deposits

© Adkins Matchett & Toy 2008 - 2015 3

HOW A BANK MAKES MONEY – BALANCE

Customer Loans Customer Deposits

Central Bank Deposits Long Term Funding

© Adkins Matchett & Toy 2008 - 2015 4

© Adkins Matchett & Toy 2008 - 2015 4 info@amttraining.com

HOW A BANK MAKES MONEY – BALANCE

Central Bank Deposits Customer Deposits

Interbank Loans Interbank Deposits

Banks use the interbank market to fund/place any

© Adkins Matchett & Toy 2008 - 2015 5

HOW A BANK MAKES MONEY – BALANCE

Central Bank Deposits Interbank Deposits

Interbank Loans Customer Deposits

Trading Assets Trading Liabilities

Investment banks have a securities trading business which is often

© Adkins Matchett & Toy 2008 - 2015 6

© Adkins Matchett & Toy 2008 - 2015 5 info@amttraining.com

HOW A BANK MAKES MONEY – BALANCE

Central Bank Deposits Customer Deposits

HOW A BANK MAKES MONEY – BALANCE

Central Bank Deposits Customer Deposits

© Adkins Matchett & Toy 2008 - 2015 6 info@amttraining.com

HOW A BANK MAKES MONEY – INCOME

Fee and Comm. Income

Net Profit Before Tax

INCOME STATEMENT ITEMS

Loan Loss Provisions

Net Profit Before Tax

© Adkins Matchett & Toy 2008 - 2015 7 info@amttraining.com

INCOME STATEMENT ITEMS

Net Profit Before Tax

INCOME STATEMENT ITEMS

© Adkins Matchett & Toy 2008 - 2015 8 info@amttraining.com

INCOME STATEMENT ITEMS

Introduction to regulatory capital

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© Adkins Matchett & Toy 2008 - 2015 9 info@amttraining.com

INTRODUCTION TO BANK CAPITAL

 Banks need to hold capital to prevent bank failure

© Adkins Matchett & Toy 2008 - 2015 15

INTRODUCTION TO BANK CAPITAL

 There are two sets of rules:

© Adkins Matchett & Toy 2008 - 2015 16

© Adkins Matchett & Toy 2008 - 2015 10 info@amttraining.com