Bank valuation with a terminal value
V = SUM E(CFt) / (1 + k)^t
CF(n+1) = CF(n) x (1 + g)
TV at year n = CF(n+1) / (k - g)
PV(TV) = TV / (1 + k)^n
V = PV(forecast years) + PV(TV)
Any bank valuation question. Discount each year separately, grow the last forecast year once to get the terminal numerator, and discount the terminal value by (1+k)^n where n is the last forecast year.
- E(CFt)
- Expected free cash flow to equity in period t
- k
- Required rate of return, that is the cost of equity
- g
- Stable terminal growth rate, which must be less than k
Profitability ratios
NII = interest earned - interest expended
NIM = NII / earning assets
Earning assets = gross advances + all investments + balances with banks
Cost-to-income = operating expenses / (NII + other income)
ROA = PAT / total assets
ROE = PAT / (share capital + reserves)
Loan-to-assets = gross advances / total assets
ICR = EBIT / interest expense
ROE = ROA x leverage
Reading a bank's P&L. Watch three denominators: earning assets exclude cash and fixed assets, total income is NII plus other income, and ROA uses total assets while NIM uses earning assets only.
- gross advances
- Net advances plus closing provisions
- leverage
- Total assets divided by equity
Liquidity ratios
CD ratio = gross advances / total deposits
LCR = HQLA / net cash outflows over 30 days (min 100%)
HQLA = cash with RBI + HFT + 70% of AFS
Net outflows = 10% of deposits + 15% of borrowings
SLR = government securities / NDTL (req ~18%)
CRR = cash with RBI / NDTL (req ~4.5%)
Scoring a bank on liquidity. NDTL is approximated by deposits in the professor's problem. Government securities for the SLR are HTM plus 70% of AFS.
- HQLA
- High-quality liquid assets, convertible into cash easily and quickly
- run-off rate
- Fraction of a funding source assumed to leave in a 30-day stress
Capital adequacy
CET1 = share capital + reserves and surplus - deductions
Total RWA = credit RWA + market RWA + operational RWA
Credit RWA = SUM (exposure x risk weight)
CET1 ratio = CET1 / total RWA (min 8%)
CAR = (Tier I + Tier II) / RWA
Capital questions. Deduct the deferred tax asset before dividing, and add all three RWA categories. Risk weights: government bonds 0%, corporate loans 100%, retail and SME 75%, mortgages about 35% to 50%.
- deductions
- Items that cannot absorb loss, notably the deferred tax asset
- risk weight
- Regulatory multiplier reflecting the riskiness of the counterparty