Banking in Crisis E-Book

Dr. oec. Fabian Brunner

• Herausgeber: tredition
• Kategorie: Wissenschaft und neue Technologien
• Sprache: Englisch

Seitenzahl: 296

Veröffentlichungsjahr: 2020

Beschreibung

In the foreseeable future, banks as we now know them will cease to exist. In view of the increasingly digital banking business, the pressure on costs and the reduction in vertical integration, the banking industry in the future will be characterized by technologization and specialization and threatened by the influence and capabilities of the BigTechs. There will need to be drastic changes in the competitive situation, the value creation structures and business models of the banking industry; despite the protection provided by banking supervisors and governance regulations, the core functions of banking - the handling of payment transactions and financing - are no longer the unique key functions that have made the banking industry indispensable within an economy to date. The perfect storm seems to be brewing; as Bill Gates already said in 1994 "banking is necessary, banks are not". Banks around the world are striving to find an adequate response. This book starts by providing a well-founded theoretical basis and then analyses the situation, identifies the present shortcomings and problem areas of the banks and outlines possible approaches to solutions.

Leseprobe

Dr. Fabian Brunner

Banking in Crisis

How strategic trends will change the banking business of the future

1st edition

Copyright: © 2020 Dr. Fabian Brunner

Editing: Erik Kinting – www.buchlektorat.net

Translation: Geoff Maddocks

Cover design and layout: Erik Kinting

Published and printed by:

tredition GmbH

Halenreie 40-44

22359 Hamburg

Germany

978-3-347-10201-9 (Paperback)

978-3-347-10202-6 (Hardcover)

978-3-347-10203-3 (e-Book)

This work, including any part thereof, is protected by copyright. This work and any part thereof shall not be used without the permission of the publisher and the author. This applies without limitation to electronic or other copying, translation, distribution and making available to the public.

Bibliographical information of Deutsche Nationalbibliothek (German National Library):

Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie (German National Bibliography); detailed bibliographical information is available on the Internet at http://dnb.d-nb.de.

Contents

Quo vadis banking?

Background

Approach

The valuation of banks – a special case

The valuation of a bank is not a simple corporate valuation

Consequences for valuation

Valuation approaches and their suitability

The challenge of forecasting

Capitalized earnings approach

Equity and return

The cost of equity

Forecasting future net cash flows

Market approaches

Price-to-earnings ratio

Price-to-book ratio

The valuation of banking business areas

Consumer banking

Investment banking

Summary and outlook

Banking business models

Value creation and business model

The banking value creation model

Trends in banking

Outsourcing of the banking value chain

The role of FinTechs in banking taking the example of the neo-banks

Acquisition of growth and know-how

The goal of achieving a competitive advantage

Attractiveness of sector

Excursion:

The relative competitive position

Excursion:

The evaluation of (bank) strategies

Evaluation criteria

Evaluation approaches

Summary and outlook

Strategy and competition

Market attractiveness taking the German banking market as an example

The transformation of banking business

German banks in competition

The opportunity and risk profile

The competitive situation – case studies

Commerzbank

The bank as a whole

Business areas

Deutsche Bank

The bank as a whole

Business areas (divisions)

Summary and outlook

Value creation analysis – case studies

Survey-based value creation analysis

Background and methodology

Empirical results

Part I. Intensity of competition – Threat to competitive position

Part II. The relationship between customers and banks – competitive advantage

Part III. Future prospects – with reference to the standard banking business case, branch business

Market-based value creation analysis

Market development

Commerzbank

Deutsche Bank

Earnings situation

Summary and outlook

Conclusion

Appendix: Questionnaire

End notes

Quo vadis banking?

Background

Banks now face a large number of previously unknown challenges. Apart from the fact that everyday business is becoming increasingly globalized and technologized, banking in the future will be characterized by increasingly intense regulatory provisions and a growing number of new entrants, driven by digitalization and specializing in individual aspects of the banking value stream, especially the BigTechs. All these developments will significantly change the competitive situation, value creation structures and existing business models of the banking industry.

To date, the strategic trends faced by the classical banking value creation process, which are mentioned in this book, have chiefly been innovations, which have largely been followed by banks throughout the world. It therefore seemed that the traditional value creation model of the banks had survived unchanged over the course of time. As long as the author can remember, the basic configuration of core banking industry operations, the smooth processing of payment transactions and financing operations, has remained unchanged. These core operations lay the foundations for the key functions of banking within any economy. Payment and financing transactions are simply indispensable for the proper functioning of an economy. Of course, the world has not stood still – the establishment of online banking is one example – but the basic logic of the banking industry has scarcely changed at all over the past decades.

Nevertheless, there are now signs that the perfect storm is now brewing, at least for the European banking industry. On the one hand, banks face an economic stress scenario as a result of COVID-19 in conjunction with the currently low levels of profitability of Europe’s banks. Despite the progress achieved since the financial crisis, the global financial system is vulnerable to a poor economic situation with a significant duration. Over the past few years, the share of relatively high-risk borrowers in banks’ loan portfolios has grown steadily. Impairment losses and bad debts will therefore grow even faster and more strongly in the impending global recession than would have been the case with a balanced distribution of credit risks.

This scenario is exacerbated by increasingly evident negative side-effects of the European Central Bank’s monetary policy. Inevitably, the low interest environment that has prevailed for many years has led to investment decisions with more pronounced risk exposure than would have been the case in a normal interest rate situation at least among professional market players such as insurers, pension funds and banks who are under pressure to earn returns themselves.

Not only the economic situation, the strong growth in nonperforming loans and the poor earnings situation but also persisting cost inefficiencies and overcapacities will mean that the returns on equity of banks in the Eurozone, which are already relatively low, will face further pressure. In the event that returns on equity fall below the cost of capital for a significant period, there is a risk that the capital market will no longer be prepared to finance banks as only banks which are sustainably profitable are also stable banks.

And what about supervision? International financial markets and banking regulatory authorities have already made significant preparations for this situation. Examples include the developments outlined below:

1. Through efforts including the completion of the Banking Union, the European Central Bank is attempting to establish a supervisory institution covering the entire market with a joint deposit guarantee system. The idea behind this approach is to control cross-border systemic risks especially faced by system-relevant banks via a uniform European supervisory system, the Single Supervisory Mechanism (SSM) and to avoid risk clusters which would pose hazards in the event of a financial crisis.1

2. The German supervisory authority (Federal Financial Supervisory Authority, BaFin) already identified the hazard of cyclical systemic risks in 2019. In order to avoid excessive restrictions on the provision of loans in economic stress phases and to reduce a possible procyclical effect of the banking system on the real economy, BaFin called upon German banks to activate a countercyclical capital buffer and to raise this buffer to 0.25 percent of risk-weighted exposure to domestic loans.2

However, the regulations issued by international financial market and banking regulatory authorities have not been harmonized to date. In this context, a key challenge is regulatory arbitrage, which not only includes avoiding regulatory requirements by interpreting the scope of regulations but also the activities of the private credit funds, hedge funds and various special-purpose financing vehicles grouped together under the heading of shadow banking. These shadow banks avoid the stringent capital and liquidity requirements that apply to banks, operate outside the close monitoring of supervisory authorities and still perform functions similar to banks.3

The review initiated by the Trump administration of the Dodd Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), a key element in US banking regulation, shows how influential banking regulation can be. The Dodd-Frank Act overhauled financial regulation following the financial crisis of 2008/2009 and subjected it to stricter rules.4 However, the position of the Trump administration was that the Dodd-Frank Act was connected with over-regulation as lending by banks was (allegedly) restricted and the associated goal of avoiding future crises in the financial sector could only be achieved by accepting massive sacrifices in terms of economic growth. The regulatory measure as a whole was therefore regarded as too restrictive and was eased.5

The amendments adopted in 2018 raised the threshold at which a bank was deemed too important to fail, and was therefore subject to stricter supervision, from a balance sheet total of $50 billion to $250 billion. In addition, the rules on trading, lending and capital for banks with total assets of less than $10 billion were relaxed. An assessment of these changes would be beyond the scope of this book but it is clear that the amendment of the Dodd-Frank Act can be seen as a deregulation of US banking supervision with the political motivation of creating significantly better competitive conditions for American banks.6

In summary, it can be stated that the global recession as a result of the COVID-19 pandemic and the zombification of the economy pose a tremendous risk, at least for the European financial system. The dramatic economic slump and the attendant abrupt rise in risk premiums will hit the global financial system hard despite the international improvement in minimum regulatory standards and equity requirements. In the worst case, this could lead to a run on the banks and/or far-reaching market consolidation.7

These developments are combined with a disruption, the contours of which are becoming increasingly clear, which will call the banking sector as a whole into question. This is a change with far-reaching structural consequences, the threat to the banking value stream posed by the BigTechs. Major international technology groups such as Google (USA) or Alibaba (China) are now targeting the heart of value creation in banking with their online payment services. BigTechs are increasingly gaining a foothold in the financial services market and are offering their gigantic user base more and more financial services, with the traditional banks assuming the role of service providers.

Even though the financial services business is not a core activity of the BigTechs, it is only a matter of time before a major technology company launches a scalable banking offering individualized for millions of customers in all the major banking segments with a cost base which is dramatically below the average in the sector. Customers will rapidly use the platforms of the BigTechs as a starting point for all their banking services instead of going to their traditional bank in order to purchase these services. When the direct connection with the customer is cut, some banks will become white label platforms while others will no longer be needed at all.

As yet, banks are still protected against this disruption by a) the regulations governing banking, which are rather complex, b) the extremely pronounced consumer and data protection requirements of many countries and finally c) the fact that the financial services sector is still strongly dependent on national regulatory frameworks, which pose extremely high obstacles and apparently insurmountable barriers to market entry. However, it is only a question of time before consumers, with their convenient everyday relations with the BigTechs, generate the necessary demand, especially since the customer acquisition costs of the BigTech platforms are low as a result of digitalization and big data analyses and they can relatively easily meet the banking requirements of these customers.8

Customers are highly familiar with and also rather trusting towards the major technology companies. As yet, severe data protection infringements, such as the disclosure by Facebook of large quantities of customer data to the data analysis company Cambridge Analytica, have not adversely affected their popularity with customers, at least not permanently.9 The sheer market dominance of the big technology companies must also be considered. Almost every modern mobile phone is equipped with software either from Google (Android) or from Apple (iOS). This means that almost every mobile device can be reached by Google and Apple as a platform. With the establishment of a mobile payment application and the integration of this function in their own operating systems, Apple and Google could directly target their own gigantic customer base with a banking service.

The margin pool that can be tapped by them is certainly not the decisive criterion for the development of services of this type by the BigTechs. More important for them is the fact that they would gain almost complete control over their customers’ data. Companies who are familiar with the regular payments of their customers also have information on interdependencies and contract conditions and can target these relationships in a tailor-made, individualized way. There is virtually no limit to the possibilities.

A direct consequence of this development would be a massive loss of customers by the banks; small banks would practically become superfluous,10 as the number of technology-averse customers who appreciate the vicinity of their local savings bank or cooperative bank branch will continue to fall and will become insignificant at some time in the future. There are many indications that the breakthrough of this disruption is becoming increasingly probable: Goldman Sachs is cooperating with Apple for credit card business11, and Facebook has announced the introduction of a cryptocurrency (Libra) in partnership with a number of major banks and other organizations.

However, this disruption has progressed furthest in the People’s Republic of China. The leading Chinese Internet giants Alibaba and Tencent dominate Chinese payment traffic with their online payment services Alipay and WeChatPay. They play an equally leading role in product categories such as consumer credit. The main catalyst for this development is the ubiquity of mobile devices in everyday life in China. In 2018, Chinese customers already used their mobile devices for 83 percent of their payment transactions.12 Many people no longer even carry any physical currency. In the processing of payment transactions, the Chinese market has largely bypassed the age of the credit card and moved from a cash-based economy to a digital economy dominated by mobile phones.

It is easy to predict what that could mean in specific terms for the banking sector in other economies. In China, customers now simply scan a QR code (Quick Response code) with their mobile phone in shops, hotels, restaurants and taxis, even at roadside stalls, in general everywhere where goods and services are sold in the country.13 It is merely a matter of time before this technology is replicated and established as a standard application, especially in view of the fact that the technology companies already provide what many customers expect, that is speed, accessibility and seamless service.14 Customers just take for granted the ethical principles of the banking business, security and reliability.

This development is reinforced by a further effect. For some time now, a small but extremely vocal group of customers and shareholders in the mature economies have been calling vehemently for companies to act with greater social and environmental responsibility. Irrespective of the fact that the significance and limits of responsible action are extremely difficult to define and possible side-effects of certain specific changes in behavior have not yet been investigated using scientific methods, this message has been further reinforced by the media and has become a significant issue on the political agenda.

Although this may seem harmless at first glance, this development may lead to self-limitation on the part of banks, which would then gradually change their image, their services and their products as well as their business model. It is true that a bank, like any other company, bears economic and social responsibility. It is also correct that the demands and expectations of the various stakeholders or society as a whole may change over the course of time. To this extent, it is legitimate for the changing expectations faced by banks to be reflected by their corporate decisions.

Nevertheless, however important topics such as climate change may be, banks face a real dilemma if these small groups in society pose quite specific demands, such as calls for banks to discontinue financing for coal-fired power plants.15 The banks which react fastest to such calls may gain a genuine edge while other banks may find it difficult to follow their example. With respect to such issues, the generation Z has become even more sensitive than the millennials were. Going forward, especially those banks which project a modern media and social profile and the implementation of socially aware business practices via good corporate communications will benefit from this development. Technology companies like Amazon, Apple, Alibaba or Google are already working intensively to earn this reputation and therefore enjoy a high degree of brand loyalty and trust throughout the world. The overall business model of the big technology companies (BigTechs) is based on communications tailored for specific target groups. For this reason, it is highly probable that small and medium-sized banks will have problems in this area compared with their new competitors.

It is difficult to predict the timing of this disruption. However, there is no doubt that banks will need to adjust to this scenario and to develop appropriate reactions as a matter of urgency. It is also clear that this development will have an impact on the economic value of banks. To put it simply, banks will probably no longer reach such high valuations. However, there is a far more serious consequence; in this context, the raison d’être of commercial banks will increasingly be called into question. The abolition of cash is being seriously discussed, which would lead to the “glass citizen” that politicians want. Crypto-currencies would no longer be exotic.16 Changed expectations of customers as regards service levels and corporate responsibility are among the developments that affect the basic monetary policy functions of banks – batch sizes and maturity and risk transformation.

It is therefore hardly surprising that the global banking industry is frantically attempting to adapt its own strategic profile to the changed conditions. This is associated with the need for continuous transformation and innovation in all facets of the sector. FinTechs, which were seen by many banks as a genuine threat for some time, have now become pacemakers for banking business thanks to their innovative power and technological openness. Although they originally set out to revolutionize banking, many FinTechs are now attempting to gain a banking license or access to such a license. They are therefore cooperating rather than competing with established banks.

Nevertheless, banking in its present form will disappear in the future. The next two years will show how correct Bill Gates was in the statement he made in 1994: Banking is necessary, banks are not. This assertion, which was probably intended to be provocative at the time, is now truer than ever before.17

Approach

This is the starting point for this book, which is divided into two parts:

The first part establishes a theoretical basis in order to make well-founded predictions for the future. The detailed presentation of banking issues in the first part of the book paves the way for the conclusions presented in the second part. The chapter The valuation of banks – a special case (Part 1) outlines the special features of valuation for banks and the main factors that have an impact as well as outlining a number of different valuation methods.

Starting from the impending far-reaching changes in banks’ strategies and business models, the chapter Banking business models (Part 1) explores the effects of strategy and regulation on the economic value of a bank. Various possibilities of making strategies clear for corporate valuations are highlighted.

The second part focuses on the assessment and context of the theoretical results obtained in the two preceding chapters. For this purpose, the chapter Strategy and competition (Part 2) investigates the attractiveness of the German banking market, which is taken as an example, and develops an opportunity/risk profile. In addition, the competitive position and structure of the two banks taken as case studies, Commerzbank and Deutsche Bank, are presented at the levels of the entire bank and of divisions.

The chapter Value creation analysis – case studies (Part 2) then analyses the relationship between the individual strategy selected by a bank and its economic value. The effects of strategy and regulation on the intensity of competition and the competitive advantage that can be gained are demonstrated on the basis of a survey conducted by the author.

Finally, the results obtained in the course of the book are summarized in the Conclusion (Part 2).

The valuation of banks – a special case

What really distinguishes a bank from a perfectly ordinary company? As this chapter will show, there are quite a number of differences. Of course, these differences are not only important in the context of the valuation but the valuation of a bank says quite a lot about the significance of these differences within the individual market or within an economy. For example, if we look at capital market valuation, the absolute market value of a bank reveals a great deal about the expectations and significance of the industry concerned. This chapter, which is divided into four sections, therefore focuses on the question of how the value of a bank is to be determined.

Starting from the general distinction between banks and industrial companies, the first section explains why the valuation of banks requires special treatment and what conclusions are to be drawn. In addition, the basic approaches which could be considered are presented and the problem of forecasting, which applies to all the methods, is discussed.

Sections two and three consider selected valuation approaches and their special features. The main focus of the second section is on the income approach while the third section deals with market approaches.

Finally, the fourth section of the chapter considers certain classical business areas of banking as examples in order to highlight the differences between them, to identify the value drivers and to demonstrate the special features of bank valuation using a specific example.

The valuation of a bank is not a simple corporate valuation

What are the fundamental differences between banks and industrial companies that justify the special treatment of banks in the context of corporate valuation?

One of these special features is the nature of the banking service itself. It is frequently characterized by intangibility and normally has a time component. In contrast to industrial production, the business relations between a bank and its customers often do not end with the sale of a product or service.18 Furthermore, there is little scope for product differentiation within the sector as a result of the lack of patent protection for banking services.19

Not least for this reason, individual banks attempt to position themselves and distinguish themselves from their competitors by focusing on individual aspects of the banking value chain such as investment banking or wealth management. However, the consequence of these attempts is that there may be considerable differences between the business models of banks, which makes banking a very non-homogeneous sector.20

The individual configuration of a bank’s basic orientation also results in the formation of a bank-specific risk profile with links to the statement of income and the key performance indicators relevant for valuation. Depending on the bank’s business model, the effect of the risk profile may be evident in pronounced sensitivity to credit cycles and borrowers’ creditworthiness or in dependence on the development of certain market prices such as stock market prices.21

For an external observer, it is almost impossible to assess the adequacy of the measures adopted by a bank with respect to its own risk profile. For this purpose, it would be necessary to have comprehensive detailed information on individual bank-specific risks. Frequently, this information is confidential and cannot be published by the banks.

However, bank-specific risks are especially relevant both from the economic perspective and from the point of view of the investor. The more effectively a bank is able to defend itself against the specific risks it faces, the more willing will investors be to pay a valuation premium for that bank. The relevance of the risks undertaken by financial intermediaries in terms of banking regulation and therefore the economy as a whole must also be considered. In contrast to an industrial company, the insolvency of an individual bank normally poses a risk to the entire banking system and therefore to the economy as a whole.22 The determination of a bank’s risk profile is therefore important not only for the valuation of the bank.23

In view of the special sensitivity of banking business to fluctuations in confidence and the fact that the quantification and also the identification of the risks entered into are in some cases inadequate, the stringent supervisory framework (which is by no means normal practice for industrial companies in this form) and the internal risk management systems of the banks derived from this framework have become increasingly important over the past few years. The objective is to anticipate risks to an appropriate extent so that they can be accommodated adequately and effectively in the event of occurrence. In conjunction with this development, banks often include regulatory indicators such as the BIS tier I ratio, which is a measure of a bank’s core capital, in the list of targets for their corporate strategy as an expression and an external manifestation of their soundness in terms of risk policy.

Another special feature of banks is balance sheet accounting or the significance of the balance sheet structure. As acquiring customers’ deposits is normally an integral component of the banking business, the liabilities side of the balance sheet assumes a financing function in contrast to industrial companies. In addition, the business activities of a bank not only affect its balance sheet structure but also the information value of the cash flow statement.24

The significance of the cash flow statement is limited as the classical distinction between cash flow from operating activities, investing activities and financing activities only applies to banking business to a limited extent. In comparison with industrial companies, this not only means that banks have their own key performance indicators but also leads to special difficulties with forecasting the future business success of a bank.25

The stringent statutory requirements concerning equity that apply to banks are also a special feature of the banking business. In contrast to industrial companies, banks must meet minimum equity requirements under banking supervision law in order to carry out banking business.26 Equity therefore plays a key role in banking activities. All basic strategic orientations, all (new) business areas and all growth targets must be oriented towards the limiting factor of equity.27

Moving from individual analysis to a macroeconomic perspective, further differences between banks and industrial companies become apparent. For example, the credit policy environment in the form of decisions on financial, monetary and currency policy has a decisive influence on the operational success and therefore also the value of a bank.28 Furthermore, as financial intermediaries, banks provide a buffer between savings and investment decisions in an economy and therefore perform both a maturity transformation and a risk transfer function.

Finally, the declining importance of national financial markets compared with internationally networked global capital markets leads to a tremendous increase in pressure on banks and financial market regulators to adapt to international standards.29

As a result of these effects, the banking industry is subject to a regulatory and supervisory density that is unmatched in virtually any other sector. Nowadays, the world’s major financial centers are generally subject to regulatory standards that are largely uniform or similar. However, national supervisory authorities (such as BaFin in Germany) differ, in some cases quite considerably, as regards the interpretation and implementation of the banking supervision standards that have been defined. This may lead to quite substantial competitive advantages for banks from individual countries. This is an extremely important aspect of the banking industry which has a crucial impact on the future viability of banks in specific countries.

Consequences for valuation

With respect to the institutional differences between banks and industrial companies outlined above, three main aspects are relevant for valuation: firstly, for the valuation of banks, it is generally beneficial to use the equity approach, rather than the entity approach; secondly, bank-specific problems arise in connection with the definition and forecasting of suitable future net cash flows for bank valuation; thirdly, the growth strategy of a bank must be oriented towards ensuring adequate equity.

For a corporate valuation, it is possible to use either the entity approach or the equity approach. If the equity approach is used, the value of the company, as the market value of its equity, is calculated from the cash flow (following interest and taxes) to shareholders discounted to the valuation date using the cost of equity.30

With the entity approach, the value of the company’s total capital is also determined by discounting future cash flow to the valuation date. However, the cash flow to all sources of capital, i.e. also to providers of debt capital, is taken into account. In addition, future cash flows are discounted using the WACC (Weighted Average Cost of Capital).31 In the entity approach, the market value of the company’s equity capital is then calculated by subtracting the net financial debt from the total value of the company.

Two evident problems arise in connection with the use of the entity approach to the valuation of a bank:

1. Firstly, in order to use the entity approach, the market value of the debt capital must be determined. However, the classical business model of banks is to earn money through the margin between borrowing and lending. Debt capital is therefore not only used for financing and it is considerably more problematical to determine the market value of debt capital than in the case of industrial companies.32

2. Secondly, the determination of the cost of debt capital plays a key role in the calculation of the overall cost of capital (equity plus debt capital) in view of the double function of debt capital in banking. It is especially relevant as inaccuracy in determining the overall cost of capital may result in substantial fluctuations in the value of the company.33

The equity approach avoids both problems as debt capital plays no role whatsoever in this approach. The valuation process is therefore considerably simplified. As a result, the equity approach is normally preferred for the valuation of banks .34 However, a number of problems arise in connection with the demarcation of (future) net cash flows suitable for bank valuation and the determination of these cash flows, which should be as accurate as possible.

1. The first problem which should be mentioned in this context is the limited information content of the cash flow statements prepared by banks and the cash flows from operating, investing and financing activities presented in these statements. In general, the purpose of a cash flow statement is to present liquid funds and indicate the development of these liquid funds over a certain period of time. In banking on the other hand, most business transactions have an effect on payments and the key information on capital flows normally shown in a cash flow statement is already disclosed in the balance sheet and the statement of income. In addition, operating, investing and financing activities are difficult to distinguish from each other as a result of the nature of banking business.35

2. The question of the operational level to be used for the valuation of a bank or the determination of cash flows is closely connected with the first problem. In general, cash flows may be determined either for the bank as a whole or for individual divisions or segments. For example, the international financial reporting standard IAS 7.50(d) for the assessment of a diversified group recommends that cash flows should be disclosed for each business area and region in addition to the mandatory disclosure requirements for reportable segments. In view of the first problem outlined above with respect to the information content of a cash flow statement at the level of the bank as a whole, a cash flow statement drilled down to the level of the individual segments is even more difficult to accomplish for an external consultant.36

3. Banks are subject to regulatory requirements calling for adequate equity capital with reference to the risks undertaken, measured by the bank’s risk-weighted assets (RWA).37 As a result, the free cash flow can no longer be regarded as a measure of success in the context of a bank valuation. Instead, orientation must be taken from the dividends potentially available for distribution.38

In the final resort, the capital adequacy requirements of banking supervision law limit a bank’s possibilities of following a specific strategic concept. Unlike a classical industrial company, a bank which has reached its capital adequacy limits cannot finance the implementation of a strategy such as the expansion of lending using debt capital for reasons connected with banking supervision law. The growth targets for the business volume of a bank must therefore always be considered in connection with the question of whether capital adequacy is ensured.

In European banking regulation, the SREP decision (Supervisory Review and Evaluation Process) plays a key role. In itself, the SREP is not new as it was previously the responsibility of national supervisory authorities. What is new is the fact that a uniform supervisory mechanism has been created for the Eurozone. As a result, a uniform method and standard time frame apply to systemically important European banks. The bank concerned must remedy any deficiencies identified within a defined time limit .39

The retention of earnings or capital increases frequently resorted to by banks in this context as a means of raising capital are normally only accepted by investors if this approach would create recognizable additional earnings potential in the medium to long term. Depending on their organizational form, banks pursue different dividend policies; in an extreme case, for example that of a bank which is not operated for profit, these policies could involve the transfer of the bank’s entire profit to its reserves.40

The effects of the capital adequacy requirements of banking supervision law on the strategy of a bank can be illustrated by the example of risk-weighted assets. If a bank needs to increase its own core capital ratio, the reduction of risk-weighted assets is a tried and tested approach. As a result, the risk-weighted assets of the bank are improved but there is also a negative impact on its operating base and the bank’s leeway for action especially with respect to new business is significantly limited.41 for example, in the 2003 financial year, HypoVereinsbank was able to reduce its risk-weighted assets by about one third compared with the previous year (especially as a result of the spin-off of Hypo Real Estate Group). However, this step also led to a reduction of more than 40 percent in interest income.42

Valuation approaches and their suitability

Not every corporate valuation approach is equally well-suited for the valuation of a bank. The valuation of a bank or a banking segment must not only be in accordance with the generally accepted requirements and principles of valuation but must also take into consideration the special features of banks discussed above.

However, from the point of view of the external valuer, the selection of an appropriate valuation approach is limited by a number of factors. These include the availability of certain data as well as the listing or non-listing of the bank on the stock exchange. The following paragraphs distinguish appropriate approaches from approaches that are not well-suited for the valuation of banks.

In valuation theory and practice, a variety of approaches have been developed for the valuation of companies. It would be beyond the scope of this work to investigate these approaches in depth. Nevertheless, various approaches to corporate valuation are outlined below before the approaches which could be used for the valuation of a bank and the associated problem areas are presented.

In general, it is possible to distinguish between individual and overall valuation approaches, which can be subdivided into43

1. asset approaches (net asset value and liquidation value approaches),

2. market value approaches,

3. income approaches.