Integrated Bank Analysis and Valuation

A Practical Guide to the ROIC Methodology

S. Chen

• Publisher: Palgrave Macmillan
• Year: 2013
• ISBN:
  9781137307460
• Topic: Business
• Subtopic: Corporate Finance
• Index: Business

Leading analyst Sandy Chen provides a thorough guide to the analysis and valuation of banks. Unlike other businesses and institutions, banks have a number of unique characteristics that need to be taken into account when performing a valuation and as such traditional valuation methodologies are unsuitable and more specialized techniques required.

1

Other Approaches to Bank Analysis and Valuation

In this chapter, we will look at several other tools for bank analysis and valuation that are used in practice. These include operating performance ratios like the cost-income ratio, regulatory ratios like the Core Equity Tier 1 ratio and leverage ratio, and valuation ratios like P/E and Price-to-Tangible Book multiples.

At the end of the chapter, we’ll give an example (using HSBC’s 2012 annual results) of how bank analysts knit these ratios together for a bank’s investment ‘story’ – as if we were analysing the results on the morning that they were published.

Firstly, we’ll run through several key ratios that most bank analysts use when evaluating a bank’s results:

Operating performance ratios

These ratios are used to compare a bank’s operating performance versus its peers and/or track the changes in a bank’s operating performance over time.

Cost-income ratio

This is calculated by dividing a bank’s operating expenses by its net operating income over a period. The formula is as follows:

Cost-income ratio = Operating expenses/Net operating income

Note that the operating expenses do not include impairment charges; the cost-income ratio is mainly used to track whether or not a bank’s operating efficiency is improving or deteriorating over time, and/or to compare a bank’s operating efficiency versus its peers.

The cost-income ratio is often mentioned in a bank’s management comments at the beginning of its results announcement; it also often appears in the summary table in a results announcement. Historically, retail and commercial banks have tended to have cost-income ratios in the 30–50% range, whereas investment banks have tended to have cost-income ratios in the 60–80% range. We think this is largely because of the higher compensation packages that investment bankers, as compared to retail/commercial bankers, have tended to get.

Compensation ratio

The compensation ratio (or ‘comp ratio’) is a sub-category of the cost-income ratio; it is calculated by dividing the personnel expenses – wages, salaries, and other employee compensation including bonuses – by net operating income. The formula is as follows:

Comp ratio =

Personnel expenses (including wages, bonuses and related personnel expenses)/Net operating income

The comp ratio is often used when analysing investment banks. For many investment bankers, bonuses have often been linked to the revenue that they have generated in the period (for example, bonuses could be defined as 20% of an investment banker’s revenues), so the comp ratio is basically used as a management tool. During the recent financial crisis, some investment banks used this performance-linked compensation structure to ratchet bonuses down as well as up.

Note that some EU countries have been tinkering with compensation structures for senior bankers and investment bankers; for example, in the UK, there are proposals to defer bonuses for up to ten years and to claw back compensation if there has been financial misconduct. This could add to volatility and uncertainty in comp ratios.

Net interest margin

Net interest margin is calculated by taking net interest income (from the income statement) and dividing it by average interest-earning assets (from the balance sheet). The formula is as follows:

Net interest margin = Net interest income/Average interest-earning assets

We generally take net interest income directly from the income statement; for interest-earning assets, we include cash, customer loans, debt assets, and anything else that could be a source of interest income.

For the past several years, quantitative easing and other unconventional monetary policies have caused net interest margins to decline at many banks; indeed, one of the stated aims of quantitative easing was to bring down interest rates in general (and borrowing rates in particular) – this has put downward pressure on net interest margins. If these unconventional monetary policies begin to be unwound, it could be expected that net interest margins would increase again as interest rates increased.

Net interest spread analysis

Net interest spread is another way of looking at how banks generate net interest income; it compares the average rates on lending and other interest-earning assets with the average rate on deposits and other interest-bearing liabilities. The formula is as follows:

Net interest spread =

(Gross interest income/Average interest-earning assets) – (Interest expense/Average interest-bearing liabilities)

Or in other words, the net interest spread is calculated by subtracting the liability spread from the asset spread in a period. The asset spread is calculated by taking gross interest income and dividing by average interest-earning assets; the liability spread is calculated by taking interest expense and dividing it by average interest-bearing liabilities. As with interest-earning assets, we include customer deposits, deposits held with other banks (including central banks), debt liabilities and any other liability where interest expense is recognised.

Net interest spread analysis is often used to distinguish between the competitive environments on each side of balance sheet. For example, if the liability spread for a bank has remained relatively stable whilst its asset spreads have fallen, we can guess that competition on the asset side (e.g. in lending) is tougher than on the deposit or wholesale markets funding side of the balance sheet.

Derivatives hedging structures

Some banks disclose how their derivatives positions affect their net interest margins and/or spreads. For example, a structural hedge, whereby a bank holds a position in interest-rate swaps that are designed to offset swings in the interest rate environment, could be used to smooth out some of the volatility in net interest margins.

However, we have found the disclosure on derivatives to be relatively minimal for most banks, thus it is often difficult to analyse or predict the performance of derivatives hedging structures as an external analyst.

Credit quality: non-performing/impaired loans ratios

On a bank’s income statement, the impairment charge (and before that the loan-loss provisioning charge) tended to be one of the most volatile line items. This is partly because of the way it is calculated: a bank will add up its bad loans, estimate the provisions that are required to cover those bad loans (taking into account the likely realisable value of the collateral backing those loans and the cost of foreclosure etc.), and then adjust those numbers by the amount of actual loan write-offs and recoveries in that period, with the net change in these factors being the impairment charge. All of these factors can be relatively big, moving parts – especially if the credit environment has suddenly changed – and thus the impairment charge number can swing around quite widely and unpredictably.

It is important to note that the terminology of bad debts has not been unified yet. Definitions of what constitutes a non-performing loan, or an impaired loan have yet to be agreed globally, and for banks reporting under IFRS there was a big transition from, say, UK GAAP to IFRS that led to the non-performing loans item being replaced by an impaired loans line item that was calculated in a different manner. We expect that over the next few years, these definitions will be standardised – making cross-bank comparisons much easier.

One key indicator of the impairment charge is the level of non-performing (or, in the IFRS parlance, impaired) loans. The formula for the NPL ratio is as follows:

Non-performing loans (NPL) ratio =

Non-performing (or impaired) loans/Gross customer loans

An increase in the NPL ratio is often a sign that impairment charges will rise (and a fall in the NPL ratio often presages falling impairment charges). It is also a useful measure of the extent to which a bank’s bad debts have been addressed.

Note that the standards for what constitutes a non-performing loan, or an impaired loan, can vary from country to country, and even from bank to bank within a country, so although we do compare NPL ratios across banks, these comparisons should not be regarded as entirely apples-to-apples.

Provisioning adequacy: provisioning coverage ratio

One related measure is provisioning adequacy, which measures the extent to which a bank’s loan-loss provisions (or, under IFRS, impairment allowances) cover that bank’s non-performing (or impaired) loans. The formula is as follows:

Provisioning coverage = Loan-loss provisions (or impairment allowances)/Non-performing (or impaired) loans

As with the NPL ratio above, it should be noted that apples-to-apples comparisons across banks may not be wholly accurate because of different recognition policies being used. We tend to look for changes in provisioning coverage over time in a single bank.

Regulatory ratios

The recent financial crisis triggered a wave of new regulations on capital and liquidity, commonly referred to as Basel III. These new regulations aim to both improve the transparency and consistency of bank regulatory disclosures as well as strengthen capital and liquidity requirements. Although the Basel III requirements are being phased in over several years (mostly to 2019), many of the Basel III disclosures are already becoming available.

For analysts, these Basel III disclosures are extremely helpful in giving a clearer picture of a bank’s robustness and enabling it to be compared with other banks. In this book we will focus on how the published regulatory ratios can be used in bank analysis; trying to build up those ratios according to the regulatory formulas would require data that are not available to external analysts.

Capital adequacy ratios

Under Basel III, a bank’s capital is divided into two buckets: Tier 1 capital, which is described as ‘going-concern’ capital (i.e. capital that can be used when a bank is operating), and Tier 2 capital, which is described as ‘gone-concern’ capital (i.e. capital that can be drawn upon if the bank is no longer operating).

Tier 1 capital is further divided into two components, Common Equity Tier 1, which is regarded as the highest quality capital in a bank, and Additional Tier 1 capital, which is other capital that is available to a bank to cover losses.

For all banks under Basel III, the Common Equity Tier 1 ratio will be required to be at least 4.5% of risk-weighted assets, the Tier 1 capital ratio will be required to be at least 6.0% of RWAs, and the Total Capital (Tier 1 capital plus Tier 2 capital) ratio will be required to be at least 8.0% of RWAs. Larger banks that are deemed to be systemically important will be subject to higher capital requirements.

Common Equity Tier 1 ratio

Over the next few years, the Basel III Common Equity Tier 1 ratio will replace the Basel II Core Equity Tier 1 ratio in bank reporting. Somewhat confusingly, both are abbreviated as the ‘CET1 ratio’ (although they are calculated quite differently). Because it is the measure of a bank’s highest quality capital (or in other words, this layer will be the first to absorb any losses), we focus on a bank’s Common Equity Tier 1 ratio as the core measure of its capital strength.

The ratio is calculated as follows:

Common Equity Tier 1 ratio =

Common Equity Tier 1 capital/Risk-weighted assets

Common Equity Tier 1 capital consists of:

a bank’s common shares

plus additional paid-in capital (share premium)

plus retained earnings

plus minority interests

minus goodwill and other intangible assets

minus deferred tax assets

minus cash-flow hedging reserves

minus expected losses over existing provisions

minus gains (plus losses) on sale related to securitisation transactions

minus gains (plus losses) on changes in the fair value of own debt

minus defined benefit pension assets net liabilities

minus treasury shares

minus reciprocal cross-shareholdings in financial institutions

minus financial investments outside the scope of regulatory consolidation accounting for more than 10% of a bank’s common equity in aggregate.

The Basel III regulations go into far greater detail on the recognition policies for all of the above items, but as w...

Table of contents

• Cover
• Title
• Introduction: Fundamentals of Bank Analysis and Valuation
• 1 Other Approaches to Bank Analysis and Valuation
• 2 ROIC for Banks Methodology
• 3 Case Studies
• Index