What's a bank worth?
Realistic valuationsof the finance industry

 This book provides a theoretical model for bank valuation, but also highlights the challenges in times of economic uncertainty. It consists of two parts: the first part outlines a theoretical model for bank valuation, and the second part looks into associated subjects such as behavioural aspects, responses to crisis and the prohibition of interest.

This book starts with a brief review of the theoretical framework surrounding the valuation of companies, and which model appears to be most suitable for firm valuation, and then guides the reader through the application of the residual income model to value a financial institution. Subsequently, it outlines a number of practical challenges faced when applying the model. We will. The question that then arises is how banks differ and the impact of these exact differences on the valuation model. Is it possible to use the same model to value a bank?

This book is based on the author’s earlier work “Valuing Banks in Uncertain Times”. There are, however, a number of differences. The most substantial change is that this book does not have a specific section for Islamic financial institutions. Instead, it has a number of additional sections dealing with asset bubbles, financial regulations, risk management, and interest.

The data used for the study that forms the basis of this book predates the global financial crisis of 2007/2008. Although current events do not by definition invalidate the results, they do raise a number of related questions such as how the model presented might hold up throughout an economic cycle and whether or not the asset bubble and subsequent bust could have been predicted.

The remainder of this book is divided into two main sections. The first part explores different types of valuation models and how the selected “residual income model” can be applied to the valuation of banks as well as to Islamic banks. The second part focuses on challenges which are not necessarily only applicable to banks and will consider issues such as the impact of the media on share prices, valuation in uncertain times and market sentiment.

Contents. iii

Acknowledgments. vii

Why Value?. ix

1        Valuation of Firms. 3

1.1     Valuation Components. 3

1.1.1      Growth. 3

1.1.2      Risk. 4

1.1.3      Returns. 5

1.1.4      Capital 7

1.1.5      Cost of Capital 8

1.2     The Models. 9

1.2.1      Discounted Cash Flow.. 10

1.2.2      Economic Profit. 12

1.2.3      Which Model?. 15

2        Why is Bank Valuation so Difficult?. 19

2.1     Bank Valuation Model 20

2.2     The Parameters. 21

2.2.1      Return. 21

2.2.2      Capital 22

2.2.3      Cost of Capital 23

2.2.4      Risk. 27

2.3     The Proof 29

2.3.1      Data. 30

2.3.2      Statistical Method. 34

2.3.3      Sample Details. 35

2.3.4      Test Results. 38

2.4     Valuing Banks – The Conclusion. 39

3        Further Observations. 41

4        Valuing in Uncertain Times. 45

4.1     What Recent Data Tells Us. 45

4.1.1      The Data. 46

4.1.2      The Statistics. 47

5        The Challenge with Value at Risk. 57

5.1     The Beauty of VaR. 58

5.2     How VaR has Fared. 59

5.3     Is VaR all bad?. 63

6        The Impact of News and Behavioural Finance. 65

6.1     Efficient Market Hypothesis. 65

6.2     Behavioural Finance. 67

6.3     Is the Market Efficient?. 71

7        Asset Bubbles, Regulations, and Politics. 75

7.1     Asset Bubbles and Financial Crises. 76

7.1.1      The Stock Market Crash – 1929. 77

7.1.2      The Credit Crunch – 2008. 79

7.1.3      Common underlying causes. 81

7.2     The Responses. 82

7.2.1      The Public. 83

7.2.2      The Politicians. 86

7.2.3      The Regulators. 88

7.3     Lessons Learned. 92

8        The History of the Prohibition of Interest 96

9        Concluding Remarks. 109

9.1     The Model and Parameters. 109

9.2     VaR, Behaviour, Asset Bubbles, and Interest. 110

9.2.1      Value at Risk. 110

9.3     Behavioural Finance. 112

9.3.1      Asset Bubbles. 112

9.3.2      The Prohibition on Interest. 113

9.4     Capturing Bank Fundamental Value. 113

Glossary. 117

Bibliography. 119

Index    125