High-Level Questions Flashcards
How does a commercial bank make money?
First, the bank gets money (Deposits) from customers because customers need a place to keep their money and earn a small amount of interest on it.
Then, the bank pools this money together and loans it out in larger quantities, at higher interest rates, to businesses and individuals that need to borrow money.
A bank makes money based on the interest rate spread: For example, if it pays 1% interest on Deposits but charges 4% interest on Loans, the spread is 3%.
Additionally, most banks earn significant non-interest revenue, such as service charges, credit card fees, asset management fees, mortgage servicing fees, and principal investing (trading).
How does an insurance firm make money?
Insurance firms collect Premiums upfront from customers who pay to be protected in the case of an accident (car, house, business, health) or death (Life Insurance).
They pay out Claims to customers if the accident happens.
In the meantime, they collect a lot of money upfront (similar to commercial banks), and they use this
money (“the float”) to make investments and earn interest and investment income.
Many insurance companies are unprofitable based on their Underwriting activities and only become profitable due to their Investing activities
How are commercial banks different from normal companies?
1) Balance Sheet First – The Balance Sheet drives banks’ performance, and you start the financial
statements by projecting the Balance Sheet first.
2) Equity Value Only – You cannot separate a bank’s operating and financing activities as you can separate those of a traditional company. So, the concept of Enterprise Value does not apply, and you use Equity Value and Equity Value-based multiples instead.
3) Dividend Discount Models in Place of DCFs – “Free Cash Flow” doesn’t mean anything for banks because the Change in Working Capital and CapEx do not represent reinvestment in the business. So, you use Dividends as a proxy for FCF, Cost of Equity instead of WACC, and the Dividend Discount Model instead of the Discounted Cash Flow analysis.
4) Regulations and Capital – Banks are highly regulated, and they must maintain minimum amounts of “capital” (Tangible Common Equity with a few modifications) at all times. These requirements constrain their growth.
5) Different Valuation Multiples – The Price / Book Value (P / BV), Price / Tangible Book Value (P / TBV), and Price / Earnings (P / E) multiples are all important because these firms are Balance Sheet-driven, and Interest is a huge part of their revenue.
What about asset management firms, broker-dealers, and financial technology firms? Are they different as well?
The points above (difference between commercial and banks and normal companies) apply to commercial banks and insurance firms (though not quite as much to certain insurance firms).
Companies such as asset management firms, broker-dealers, and fin-tech firms operate more like normal companies.
So, you can still use multiples such as EV / Revenue and EV / EBITDA to value them, and the traditional Unlevered DCF still works.
If the firm invests the upfront Cash it receives from customers and earns interest and investment income on it, the differences above apply. If not, they do not.
How are insurance companies different from normal companies?
Most of the key differences above (Equity Value only, Dividend Discount Models, different valuation multiples, regulations, etc.) also apply to insurance firms, but you do not start the financial projections with the Balance Sheet.
That’s because Premiums, which appear on the Income Statement, act as the key driver rather than Loans and Deposits.
A few other differences include:
- Non-Interest Revenue tends to be a higher percentage of revenue than it is for banks because of the Premiums that insurance firms collect.
- They use Statutory Accounting, a different system from IFRS / U.S. GAAP that is closer to cash accounting.
- Valuation is similar to commercial bank valuation, but Embedded Value is an important methodology for Life Insurance (see the Valuation section).
- The Regulatory Capital requirements differ because it’s harder to define and calculate risk in the insurance industry. The basic idea is the same – firms must maintain enough Tangible Common Equity relative to their Assets – but the ratios and calculations are different.
How are the financial statements different for a commercial bank?
- Balance Sheet: Loans on the Assets side and Deposits on the L&E side are the key drivers; there are new items, like the Allowance for Loan Losses (a contra-asset), and more categories for Investments and Securities; items common for normal companies, such as Inventory, may not be present.
- Income Statement: Revenue is divided into Net Interest Income and Non-Interest Income; COGS do not exist; the Provision for Credit Losses is a major new expense; operating expenses are labeled Non-Interest Expenses.
- Cash Flow Statement: The classifications are murkier; all changes in Balance Sheet items are still reflected here, and Net Income still flows in as the first item. New items include the add- back for the Provision for Credit Losses and the Changes in Gross Loans and Deposits.
How are the financial statements different for an insurance firm?
- Balance Sheet: Assets are split into Investment Assets and Non-Investment Assets (Cash, Premiums Receivable, Reinsurance Recoverables, Ceded Unearned Premiums, Deferred Acquisition Costs, etc.). The L&E side has Reserves for Claim Expenses and Unearned Premiums (similar to Deferred Revenue).
- Income Statement: Revenue is divided into Premiums, Net Investment and Interest Income, Gains / (Losses), and Other; COGS do not exist; Claims are the major expense, and other expenses include G&A, Acquisition Costs, and Interest Expense.
- Cash Flow Statement: It’s similar, but you must reflect changes in the insurance-specific Balance Sheet line items as well. Also, most insurance companies spend a significant amount on Investments, and that could be considered a recurring item within Investing Activities.
How do you value a commercial bank?
You use Public Comps, Precedent Transactions, and the Dividend Discount Model in place of the traditional Discounted Cash Flow analysis. Key differences include:
- Public Comps and Precedent Transactions: Screen based on Total Assets, Loans, or Deposits rather than Revenue or EBITDA; focus on metrics like ROE, ROA, Book Value, and Tangible Book Value; use multiples such as P / E, P / BV, and P / TBV.
- Dividend Discount Model: Project the bank’s future Dividends based on its Regulatory Capital requirements, Total Assets, and Net Income, discount them to Present Value using the Cost of Equity, and add them up. Then, calculate the bank’s Terminal Value with a P / BV or P / TBV multiple or the Gordon Growth Method, discount it to Present value, and add it to the Sum of PV of Dividends to determine the bank’s Implied Equity Value.
You cannot separate a bank’s operational and financial activities, so you use only Equity Value-based metrics and multiples, and you use Dividends as a proxy for Free Cash Flow since CapEx and the Change in Working Capital do not represent reinvestment for banks.
How do you interpret Public Comps for a bank? What’s the relationship between the key metrics
and multiples?
Banks with higher ROEs should have higher P / BV multiples, and banks with higher ROTCEs should have higher P / TBV multiples. If a bank’s financial metrics have stabilized, you can calculate these multiples with:
P / BV = (ROE – Net Income Growth Rate) / (Cost of Equity – Net Income Growth Rate)
P / TBV = (ROTCE – Net Income to Common Growth Rate) / (Cost of Equity – Net Income to Common Growth Rate)
If a bank has not yet stabilized, these formulas won’t work, but there will still be some correlation.
There may be some correlation between P / E multiples and Net Income Growth, but it’s weaker than
the other pairings.
A bank might be undervalued if its ROTCE is on par with the median from the set, but it trades at a much lower P / TBV multiple.
How do you value an insurance firm?
The same way you value a commercial bank: With P / E, P / BV, and P / TBV multiples for Public Comps and Precedent Transactions, and with a Dividend Discount Model (DDM) instead of the traditional DCF analysis.
You might screen for comparable companies and deals based on Total Assets or Premiums Earned. You could also create a Net Asset Value (NAV) model where you mark everything on the firm’s Balance
Sheet to market value (if it has not already done so), and then you could create a P / NAV multiple by dividing Equity Value by Net Asset Value.
For a Life Insurance firm, you could also use the Embedded Value methodology, which takes a firm’s Net Asset Value (via the method described above) and adds it to the Present Value of future cash profits from the insurance firm’s current policies to determine the firm’s Implied Equity value.
Embedded Value represents the Cumulative, After-Tax Cash Flows from Policies in Past Years + the Present Value of Expected After-Tax Cash Flows in Future Years.
You could then create a P / EV multiple and alternate metrics such as ROEV based on this concept.
What is “Regulatory Capital”? Why do banks and insurance firms need it?
Both banks and insurance firms expect to lose money from customers defaulting or customers getting in accidents.
They handle expected losses with specific items on their Balance Sheets: The Allowance for Loan Losses for banks and the Claims Reserve for insurance companies.
But there are also unexpected losses, and Regulatory Capital exists to cover those. It consists mostly of Tangible Common Equity (with adjustments and variations), which serves as a “buffer” against potential, unexpected losses.
If a bank has to write down a Loan, something must decrease on the L&E side to balance the change. If the bank has enough Regulatory Capital, that “something” will be its Equity rather than customer Deposits (i.e., the money in your checking account).
Banks must keep their Regulatory Capital / Some Type of Assets above certain percentages, such as 3% or 8%, at all times.
Banks must also maintain enough Liquid Assets to cover cash outflows and enough Stable Funding to meet their “Required Stable Funding” (Assets multiplied by various adjustment factors).
What is Common Equity Tier 1 (CET 1), and why do banks need to maintain a certain level?
CET 1 equals Common Shareholders’ Equity – Goodwill – Other Intangibles +/- Other Adjustments. It’s
similar to Tangible Common Equity, but not the same due to the adjustments. CET 1 is the most basic and important type of Regulatory Capital.
The CET 1 Ratio equals CET 1 / Risk-Weighted Assets. To calculate Risk-Weighted Assets, a bank multiplies “risk weights” such as 50%, 75%, or 150% by all its on-BS and off-BS Assets and adds up everything.
The minimum CET 1 Ratio under Basel III is 4.5%, but that climbs to 9.5% when you include various
buffers, and it’s even higher for large, systemically important banks.
Banks must maintain this capital to cover unexpected losses.
Why are banks so heavily regulated? What are the main requirements?
Banks are heavily regulated because they’re central to the economy and all other businesses. One large bank failure could result in an apocalyptic recession, which governments prefer to avoid.
Here are the main requirements under Basel III:
- The CET 1 Ratio must be greater than or equal to 4.5% at all times;
- The Tier 1 Ratio must be greater than or equal to 6.0% at all times;
- The Total Capital Ratio must be greater than or equal to 8.0% at all times;
- A Conservation Buffer of 2.5% gets added to all these ratios;
- A Countercyclical Buffer of 2.5% gets added to all these ratios if economic growth is strong;
- Tier 2 Capital cannot exceed Tier 1 Capital;
- The Leverage Ratio must be greater than or equal to 3% at all times.
- Liquidity Coverage Ratio (LCR): The bank must maintain enough “high-quality Assets” to cover
100% of net cash outflows over a 30-day “stress period.” - Net Stable Funding Ratio (NSFR): The bank’s “Available Stable Funding” must meet or exceed its “Required Stable Funding” over a 1-year period.
What are the Regulatory Capital requirements for insurance firms?
The key ratio is the “Solvency Capital Requirement Coverage Ratio,” or SCR Coverage Ratio, which is defined as Available Capital / Required Capital.
Insurance companies must keep that ratio above 100% at all times, but most firms stay comfortably above it, with median percentages frequently in the 200-300% range.
“Available Capital” is similar to Total Capital for commercial banks: It’s mostly Tangible Common Equity along with some longer-term Liabilities and funding sources.
Required Capital equals “the expected negative impact on Own Funds of a 1-in-200-year event,” so you cannot calculate it with a simple formula. However, it is related to the firm’s Total Assets and its risk from cumulative Written Premiums.
There’s also a “Minimum Capital Requirement” (MCR) ratio for insurance firms, which is similar to the
SCR Coverage Ratio but set to a 25-45% minimum threshold rather than 100%.
Insurance companies also pay attention to the Solvency Ratio (Statutory Cap & Surplus, a variation of Shareholders’ Equity, divided by Net Written Premiums) and the Reserves Ratio (Net Technical Reserves divided by Net Written Premiums).
