Contents:

Preface Module 1:Starting the Process of Valuing A Bank Introduction Factors affecting bank valuation How mergers add value What makes a merger unattractive Three-step valuation process Market value approach Equity value approach Bank risks Data gathering Summary Module 2: IAS/IFRS Disclosure for Banks Accounting policies under IAS 30 Preparation and Presentation of Banks' Financial Statements Cash Flow Statement for Banks Disclosure Requirements for Banks and Similar Institutions Maturities of Assets and Liabilities IAS 39 and hedging asset/liability mismatch Concentration of Assets, Liabilities and Off-Balance Sheet Items Losses on Loans and Advances Related party transactions and other disclosures Deficiencies of IAS 30 Proposed IFRS to Replace IAS 30—Preliminary Recommendations Merger Accounting for Banks Summary Module 3: Book to Market Value Current market values versus historical costs FMV and a Bank’s Assets and Liabilities: book to market implications Determining the quality of the loan portfolio: a framework Market value of fixed assets Sales value of investment portfolio Goodwill and other adjustments Derivative financial instruments Off-balance sheet items Hedging issues Case study example of book value to fair market value Annex: Example of cash flow hedge Module 4: Market Valuation Models Model Basis Appropriate discount rate Model usage for assets Model usage for liabilities Model equations and formulas Summary of valuation concepts Module 5: Cash Flow Valuation for Banks Cash flow and the equity approach Free cash flow to shareholders Discounted cash flow Application to a bank Estimating free cash flow Step 1: Identifying the relevant components of free cash flow Step 2: Developing an integrated historical perspective Step 3: Forecasting changes in net interest income (NII) and developing the forecast assumptions Step 4: Calculating and evaluating the resulting free cash flow forecast Case study application Module 6: GAP Value Drivers Static GAP Dynamic GAP Determinants of rate sensitivity Factors affecting net interest income Changes in the Level of Interest Rates Changes in the Relationship Between Short-Term Asset Yields and Liability Costs Rate Sensitivity Reports Strengths and Weaknesses: Gap Analysis Managing the GAP Link Between Gap and Net Interest Margin Sensitivity and Simulation Analysis The Duration Gap: Managing the Market Value of Equity A Duration Application for Banks An Immunized Portfolio GAP versus Duration Gap: Which Model is Better? Macrohedging and the GAP Hedging and Duration Gap Module 7: Equity Value Application Free cash flow valuation: Capital asset pricing model (CAPM), Dividend valuation model, and Targeted return on equity model. Case applications Premium to book value Premium to adjusted book value Price to earnings per share Price to prevailing share price Return on investment approach EPS dilution constraints Historical performance analysis Case study implications Nonfinancial considerations that affect mergers and acquisitions Summary Module 8: Enhancing Bank Value with Credit Derivatives Definition of credit derivatives Types of credit derivatives: Credit options Credit swaps Credit-linked notes The credit default swap Protection sellers Settlement risk Correlation Protection buyers Optimizing returns on regulatory capital The total return swap Credit risk Maturity Value advantage The principal-protected structure Summary Module 9: Basel II and Bank Value Definitions of capital Background to Basel I Basel II: Pillar 1 – capital adequacy requirement Credit risk Market risk Operational risk Pillar 2 – supervisory review Pillar 3 – market discipline Internal growth rate of capital (IGRC): a measure of the link between profitability and capital Supplementary traditional capital ratios Can shareholder value be added under Basel II? Factors motivating regulatory capital arbitrage Capital arbitrage in practice Summary Appendices: Time value of money Embedded options and applications Description of bond ratings Regulatory capital arbitrage: examples Selected notes to case study financial statements Glossary Answers to Exercises References

Summary:

Valuing a commercial bank is an increasingly important enterprise for a number of reasons. The merger wave is now an impregnable force within the banking industry. Both acquiring and target banks need a thorough assessment of market value in order to negotiate reasonable terms of the business combination. Experience has taught analysts and market observers that a positive capital base, according to published financial statements, does not necessarily mean a solvent institution. Commercial banks are unique, compared to other financial institutions and corporates, in that they play a pivotal role in the payments system, enjoy tremendous leverage in balance sheet structure, and are supervised more intensely than any other business entity. Further, financial and regulatory accounting standards now require a disclosure of the fair value of financial assets and liabilities. Commercial banks, as deposit-taking entities, are no exception. The purpose of this Workbook is to provide objective guidance to anyone who may be involved in determining the value of a commercial bank. The intended audience includes: - Shareholders, owners and prospective owners of commercial banks subject to regulatory supervision. - Financial and security analysts. - Credit Analysts. - Bank managers. - Financial consultants. - Accounting professionals. - Solicitors and lawyers. - Business appraisers. It is a hands-on tutorial designed to unravel the complexities of valuation in general and the application of valuation models in particular. The Workbook is not intended to make the reader an expert in the field but at least equip the reader with the working tools and applications used by valuation experts for banks and business entities. To facilitate the reader¡¦s progress, the Workbook is replete with practical, real-life examples, exercises and self-test questions to enhance understanding of the subject matter. Answers to exercise and test questions are to be found at the back of the book. Module 1, ¡§Starting the Process of Valuing a Bank¡¨, provides the setting and rationale for valuing a bank. Based on the premise that merger activity is here to stay, there is a pressing need for bank managers and analysts to appreciated the major forces driving the urge to merge among banks worldwide. These forces include heightened competition caused by deregulation, the need to hold on to customers as the latter become more sophisticated in their financial expectations, and a call for greater transparency from markets and regulatory authorities alike. These are discussed as factors affecting bank valuation. The Module proceeds to answer the question: How do mergers add value? With an overview of some of the ways this is done and the benefits a merger might produce for acquiring and target banks. What makes a merger unattractive is also worthwhile knowing, so the Module introduces the first of many quantitative tools for measuring value¡Xdilutive concerns by bank buyers. The Module recommends a top-down, three-stage approach to valuing a bank whereby a bank manager or analyst reviews the broad macroeconomic picture, the industry characteristics, and the profile of the bank itself. This is akin to applying the Porter competitive analysis method and a summary framework is presented. Finally, a market value/equity value approach is discussed which will be illustrated in more detail in modules appropriately titled. Market value is defended despite opposition by many nonbelievers in fair value accounting. The benefits of the market and equity valuation approaches are shown to be extraordinary, but not without a review of bank risks in general. Module 2, ¡§IAS/IFRS Disclosure for Banks¡¨, makes the transition from initial discussion of market value (also called fair value) to the accounting standards that emphasize the relevant principles. The more than 7,000 firms quoted on European stock exchanges will be required to published their financial statements in accordance with IAS/IFRS norms beginning January 1, 2005 and banks are no exception. Banks enjoy the particularity of having their own standards of reporting under IAS 30 and, along with other bank-related standards, facilitates the conversion of book value assets and liabilities to market value relevancy. The Module introduces a case study bank whose financial statements have been prepared in accordance with IFRS norms early in its fiscal reporting year of 2004. Without going into the mechanics of accounting, the Module recommends familiarity with the various standards applicable to the preparation of financial statements by banks. These include the IAS 30 specific standard and IAS 32 and 39 which concern presentation, disclosure, and measurement of financial instruments. It also includes merger accounting procedures as put forward by IFRS 3 Business Combinations which replaced IAS 22 by the same name. In general, the reader should appreciate the overall objective of IAS/IFRS norms which is consistency and transparency through very precise disclosure guideline rules. Disclosure is an effective mechanism to expose banks to market discipline. It should be sufficiently comprehensive to meet the information needs of market participants within the constraints of what can reasonably be required. This Module is, therefore, basic and casual in its discussion of presentation characteristics of a bank that adheres to IAS/IFRS norms. Module 3, Book to Market Value, is transitional. It takes the basic discussion of IFRS accounting presentation for banks in the previous module to a higher level with a more detailed discussion of the most important financial statement accounts. Using the case study bank, ABC, focus is on book value versus market value presentation and the implication on bank valuation as a whole. Due to the disclosure requirements under IFRS norms, book to market value disclosure is practically a nonissue but the differences, account by account, are worthwhile noting. Therefore, the purpose of Module 3 is - to highlight the complexities of book to market value conversion; - to emphasize the importance of market values for bank valuation; - to reflect on the determinants of value more carefully; - to understand the factors that give rise to differences in book and market values; and - to achieve an enhanced knowledge of bank accounting categories that are important for valuation purposes. For simplicity, the Module underscores the value impact of book to market disclosure for almost every financial statement category with an arrow symbol (ƒÏ). On the other hand, Module 4, ¡§Market Valuation Models , is almost a quantum leap from a review of the financial statement accounts to their conversion to market value through a series of market valuation models. The purpose of the Module is to present actual book to market conversion examples. The Module presents a significant number of mathematical formulae to assist the bank manager or analyst in the conversion of a bank¡¦s most important asset and liability items to their market values. The Module provides a specific model for virtually every line item of the balance sheet with examples of the model¡¦s implementation. This is important for analysts when inadequate or unavailable market price information did not permit the bank to report fair values in the balance sheet or note disclosures. The complete mastery of the conversion formulae is not essential to grasping the general techniques for placing a bid price on a bank. This should be amply understood in the modules which treat the market and equity valuation approaches as initially introduced in Module 1. For those readers who take flight, like the Author, when they see complex mathematical formulae, the Module can be skirted¡Xif not skipped altogether. This will not hamper the grasp of the more important market and equity approaches to valuing a bank which use familiar mathematical models fundamental to finance and investing. Module 5, ¡§Cash Flow Valuation for Bank¡¨, introduces a sometimes controversial topic. Why attempt cash flow analysis of a bank when its stock in trade is cash itself? The Module sides with IAS 7 ¡V Cash Flow Statements which argues that user¡¦s of financial statements are interested in how the entity generates and uses cash and cash equivalents¡Xirrespective of whether cash can be viewed as the product of the entity, as may be the case with a financial institution. The Module reintroduces a discussion of the equity approach to valuing a bank because that approach relies heavily on cash flow from operations and especially an adjusted ¡§free cash flow¡¨ as input to the well-known discounted cash flow (DCF) model for entity valuation. The components of the DCF model are explained along with their assumptions and complexities. The model is then applied to a bank with further discussion of the significant of free cash flow to shareholders. A transition is made within the Module from a review of the importance of the historical cash flow statement to an exercise in forecasting free cash flows. Thus, forecasting free cash flow becomes topical with a step-by-step illustration of 1) the components; 2) the historical performance of the bank through return on assets and return on equity perspective; 3) the future net interest income (NII); and 4) the forecast outcome. A bold example of forecast financial statements and resulting operating and free cash flow is presented with the case study bank, ABC. Module 6, GAP Value Driver, is an interlude. Forecasting net interest margin (NIM) is so essential to arriving at forecast cash flows that a discussion of the NIM¡¦s principal driver¡XGAP analysis¡Xwarrants its own module. GAP analysis focuses on the impact of interest rate changes on net interest income, the bank¡¦s most important income statement line item. The Module illustrates the various GAP strategies such as static versus dynamic GAP analysis and the determinants or interest rate sensitivity. Several practical examples are given under changing interest rate scenarios. GAP has to be managed. The Module proposes some tools and strategies in that respect. This is topped off with a discussion of duration gap analysis which makes up for some of the shortcomings of traditional GAP analysis. Duration gap analysis is a key driver to equity market value determination. Although duration gap models involve mathematical computations, their basis is well-founded in bank liquidity risk analysis (i.e., the Macaulay and modified duration models) and should not be intimidating. Numerous practical examples are illustrated along with the strategy of immunizing and hedging assets and liabilities against unexpected or undesirable changes in interest rates. Module 7, Equity Value Application, uses previous modules as a springboard to determining the value of a bank, including the case study example, ABC Banking Group. Although the DCF model using free cash flow is the linchpin valuation method other methods help provide a range of values which can be used in buy-sell negotiations. The methods covered are - Free cash flow valuation - Premium to book value - Premium to adjusted book value - Price to earnings per share - Price to prevailing share price - Return on investment approach. Ample guidance is provided so that the reader does not get lost in this myriad realm of valuation models. Preliminary discussion revolves around the well-know Capital Asset Pricing Model (CAPM) as one method to come up with the investor¡¦s required rate of return. Most valuation models need a required rate of return in order to be functional. A highlight to the Module is a tabular summary of the values for ABC using the models illustrated. No valuation exercise which uses these models produces the same result and no two analysts working independently will achieve identical results¡Xunless accidentally. Why? It is all in the assumptions used. Besides the final price paid to acquire the bank may have nothing to do with the model use. Premiums (or discounts) are paid for all sorts of hard-to-quantify reasons as the Module points out. Module 8, Enhancing Bank Value with Credit Derivatives, walks the reader through the esoteric world of credit derivatives with a hands-on guide of what how important they have become, what they are, and how a bank can benefit from there use. This Module focuses on the three most commonly used structures that a bank can apply to unbundle credit risk and increase returns, thereby enhancing shareholder value. These three structures are credit default swaps, total return swaps, and credit-linked notes. Credit default swaps are the most popular of the credit derivatives family and enable a bank to transfer credit risk as though it bought an insurance policy. Total return swaps provide diversification of the loan portfolio and an assured source of income. Credit-linked notes facilitates asset securitization while providing credit default protection. The Module uses ample graphics to illustrate these structures, their risks, and benefits. Although regulatory oversight is strong in the derivatives markets as a whole, credit derivatives offer opportunities for capital arbitrage. Working examples are provided which show value enhancement implications. Module 9, Basel II and Bank Valuation, is designed to underscore the impact of regulatory capital requirements on a bank¡¦s balance sheet structure and operating activities. Financial markets have changed considerably since the Basel Capital Accord of 1988, so this Module brings the reader up-to-date with emphasis on the compatibility of adhering to regulatory capital and increasing shareholder value. Understanding the ramifications of Basel II, however, is important. The new Accord hinges on three pillars¡Xcapital adequacy requirement, supervisory review, and market discipline. Each is intended to encourage commercial banks to better manage and control their primary risks: credit, market, and operational risks in particular. Oversight is provided by bank regulators (supervisors) and the financial markets. Since most banks around the world will trend towards a common capital adequacy base, allowing for local conditions, competitive advantage must be sought in other areas to enhance value. The Module guides the Workbook user through that challenge and the ways a bank can improve returns by reintroducing targeted return on equity discussed in previous modules and a new measure. This new measure is called internal growth rate of capital (IGRC) and serves as a link between profitability and capital. Several appendices appear at the end of the Workbook as reference material but also to add to the readers knowledge. These include a time value of money concepts refresher and an overview of embedded options and options pricing. Bank capital and enhancing shareholder value serve as the unifying them to this Workbook on bank risk and valuation. As such the book demonstrates how bank managers and analysts can develop and implement strategies to maximize shareholder value by balancing the trade-off between banking risks and returns. Above all, the Workbooks primary purpose is to help the reader determine a price to pay for a bank in todays environment of new accounting and regulatory procedures.