The Valuation of Financial Companies: Tools and Techniques to Measure the Value of Banks, Insurance Companies and Other Financial Institutions

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The Regulatory Capital for Banks

One of the key aspects that sets the valuation of financial firms apart from the valuation of non-financial companies is the heavy regulation of the capital structure. The presence of specific and detailed capital requirements − defined at international level and enacted by the national banking authorities − affects not only the way banks manage their operations but also how much equity they should retain to meet the relevant requirements. This means that compliance with capital regulations − more than managerial discretion − defines how much income or cash is actually “freely” distributable to bank shareholders. Therefore, when applying valuation approaches like the DDM or the DCF, income, dividends, and cash flow forecasts should take into account how regulatory capital will evolve. Analogously, adjustments to multiple valuations of banks may be appropriate when the capital is significantly distant – either in excess or in deficit − from the level that regulators and investors consider adequate. This is why the regulation of capital is paramount for bank value and valuation.

This chapter begins by examining the main features of the relevant capital requirement regulation, and of the capital structure and asset base definitions according to the Basel II framework. It then looks at how management can actively work towards a capital structure assumed to be adequate by both regulators and investors. The last part presents the main changes expected ...