Banks represent a crucial element of the modern economy. Often we read about bank specifics. What exactly is it about? How do banks operate and what kind of risks and regulation are they facing? Do the risks and regulation impact the value creation?
Generally speaking we divide banks into four groups according to the source of the bank’s income:
- Net interest income is income generated as a difference between funds attracted in the form of customer deposits and debt and funds provided to customers in the form of loans such as mortgages, credit card loans, and corporate loans.
- Fee and commission income is income charged for services such as transaction advisory, underwriting and placement of securities, managing investment assets, securities brokerage, and many others.
- Trading income is income generated from trading financial instruments such as equity stocks, bonds, foreign exchange and exotic financial products.
- Other income is income generated from wide variety of nonbanking activities, including real estate development, minority investments in industrial companies, and distribution of investment, insurance, and pension products and services for third parties.
Ideally, any activity involving financial advisory service should consider businesses and dependent value drivers separately according to the source of income.
Besides value drivers, a very good understanding of the business activities and value creation is required. In contrast to non-banks institutions, most of banks create value on both sides of the balance sheets – on the equity and liabilities side, due to the customer deposits costs that are below the market interest rate, and on the asset side, due to the value added to financial products. By definition, financial obligations carry operational meaning for banks and are not meant only as a source of financing as for non-financial companies.
One should also account for risks related. In last decade the volatility of profitability of the banking industry has increased, causing the impact on market-to-book ratios. Banks deal with interest rate risks, due to the mismatched maturities of loans and deposits. High leverage causes a bank to be highly vulnerable to even small changes in interest rates. Besides that, banks take on significant risks inherent in balance sheet items (such as proprietary trading activities) and also risks related to off-balance sheet positions (such as swaps, forward deals and options on foreign currencies or securities).
Furthermore, the way modern banks operate in the financial markets result in a general dependency on exogenous factors such as the economic cycle or trends in money, capital or real estate markets, showing up through changes in a bank’s credit losses. Financial planning and other financial advisory services thus require a thorough analysis of several parameters and forecasting future trends.
Last but not least, law and regulation is also crucial. Banks are subject to various bank-specific rules. High regulation is necessary due to specific role within the financial system, risks they face and dependency on economic cycles. Regulation is imposed at the state level and occasionally at the international level, as in the case of bank capital requirements. Six types of regulation seek to enhance the net social welfare benefits of financial intermediaries’ services: (1) safety and soundness regulation, (2) monetary policy regulation, (3) credit allocation regulation, (4) consumer protection regulation, (5) investor protection regulation, and (6) entry and chartering regulation. The regulation that significantly influences the value of a bank is capital adequacy.