Abstract
In this chapter, we discuss the implementation of an asset-side approach in order to overcome the problems of the equity-side models. Unlike non-financial firms, bank deposits generate value. Such an effect is explored by several empirical studies concerning the relation between capital requirements and the weighted average cost of capital (WACC) and, consequently, on a bank’s value. Moreover, in this chapter, we use such empirical evidence to highlight the problems related to the applicability of Modigliani and Miller propositions to the banking industry. Specifically, the main concern of this chapter is to build a new corporate finance theoretical framework for bank valuation, exploring a new issue that represents a relevant gap in the literature. Using the theoretical framework, we elaborate the AMM to highlight the value generated from the unlevered assets, deposits and tax-shields. To do this, we formalize the link between the cost of assets and the WACC, and propose a restatement of the Modigliani and Miller propositions using bank-specific adjustments. Additionally, we compare and reconcile the AMM to excess returns models.
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Notes
- 1.
The non-riskiness of deposits is questioned in the case of bail-in mechanisms, where customers share private losses of banks.
- 2.
Miller describes two other types of core deposit valuation methods: the Historical Development Cost Approach and the Future Income Approach. The first establishes the value of deposits, determining the costs actually incurred to attract those deposits (i.e. the amount spent for advertising). The second establishes that the value depends on the difference between the cost of deposits and the income generated by deposits (fees) or income obtained using those deposits to invest in loans and other assets. The quantification of attracting cost to obtain deposits is very difficult to implement; the first method is therefore difficult to realize in practice. The second approach can bring about a double-counting of value, due to the use of income from loans and other assets on the evaluation of both core deposits and assets. For this reason, in the present work we have only made use of the Cost Saving Approach.
- 3.
Even if, in practice, mark-down is calculated by taking into account interbank rates such as Euribor or Libor, in the theoretical discussion we use the term “risk-free” as commonly found in corporate finance contributions.
- 4.
The steady-state hypotheses determine that the cash flows are constant, equal to earnings and perpetual. More precisely, for a bank this implies that: (1) there are no changes in assets and liabilities; and (2) depreciation and LLPs correspond to cash outflow to ensure the same firm value.
- 5.
We assume that the non-deposit interest rate of return is equal to the cost of debt.
- 6.
Refer to Chap.4 for the determination of the After taxes Operating Profit.
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Beltrame, F., Previtali, D. (2016). Value, Capital Structure and Cost of Capital: A Theoretical Framework. In: Valuing Banks. Palgrave Macmillan Studies in Banking and Financial Institutions. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-137-56142-8_3
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