Mario Massari (Milan, Italy) is Full Professor of Corporate Finance, Head of the Finance Department, Director of the Institute of Accounting, Finance and Control from 2003 to 2007 at Bocconi University. Formerly full professor of Financial Management at Università Cattolica di Milano and Ca' Foscari of Venice.

Gianfranco Gianfrate (Milan, Italy) is Assistant Professor of Finance, Bocconi University. He is Visiting Scholar, Boston College (2003) and Cass Business School (2006), Visiting Fellow, Harvard University (2007-2008) and Deputy Director, Clefin-Finance MSc.

Laura Zanetti (Milan, Italy) is Associate Professor of Finance at Bocconi and Visiting Professor at the HKUST Business School.

Preface vii

Acknowledgments ix

1 Bank Business Models 1

1.1 Economics of banking 1

1.2 Commercial banks 3

1.2.1 Structure of the industry in the US 3

1.2.2 Overview of the US regulation 5

1.2.3 Commercial banks’ balance sheets 6

1.3 Investment banks 7

1.3.1 Structure of the US banking industry 9

1.3.2 Typical balance sheet for an investment bank 10

1.3.3 The banking industry outside the US 12

2 Financial Statements Analysis for Banks 15

2.1 Balance sheet 15

2.1.1 Assets 16

2.1.2 Investment property 17

2.1.3 Intangibles 18

2.1.4 Research and development 20

2.1.5 Goodwill 20

2.1.6 Securities 21

2.1.7 Equity stakes 25

2.1.8 Loans and receivables 27

2.1.9 Impairment test 30

2.1.10 Financial liabilities 32

2.1.11 Hedging 35

2.1.12 De-recognition of financial assets and liabilities 37

2.2 The US GAAP for banks 44

2.2.1 Reversal of impairment 49

2.2.2 Transfer among different categories 49

2.3 Profit & loss statement 49

2.4 Major differences between IAS/IFRS and US GAAP 51

2.5 Example of IAS/IFRS application 54

3 The Regulatory Capital for Banks 61

3.1 Regulatory capital requirements 61

3.1.1 Definition of capital according to basel I and II 62

3.1.2 The risk-weighted assets 64

3.2 Basel II 68

3.2.1 Does Basel II work? 70

3.3 The reform of Basel III 73

3.3.1 New definition of capital 73

3.3.2 Change in RWA computation 75

3.3.3 New coefficients 75

3.3.4 Leverage ratio 77

3.3.5 Liquidity ratios 78

3.4 Managing the regulatory capital 78

4 Assessing and Preparing the Business Plan for a Bank 81

4.1 Status quo analysis 82

4.1.1 Asset quality 82

4.1.2 Toxic and illiquid assets 83

4.1.3 Goodwill 84

4.1.4 Capitalization 84

4.2 Internal consistency 85

4.2.1 Historical versus projected performance 86

4.2.2 ROE framework 86

4.2.3 P&L and balance sheet drivers 87

4.2.4 P&L versus balance sheet 88

4.2.5 Asset side versus liability side 89

4.2.6 Financial versus operating forecasts 92

4.3 External consistency 92

4.3.1 Macroeconomic outlook 93

4.3.2 Competitive dynamics 94

4.3.3 Business plan versus market consensus 96

4.4 The forecasting model of a bank 96

4.4.1 Balance sheet 97

4.4.2 P&L 99

4.4.3 Checking forecasts 101

5 Bank Valuation 105

5.1 Why bank valuation is different 105

5.2 Discounted returns model 108

5.2.1 The cost of capital for financial institutions 108

5.2.2 The dividend discount model 111

5.2.3 The cash flow to equity model 118

5.2.4 The excess return model 120

5.3 Relative valuation 123

5.3.1 Market multiples 126

5.3.2 Deal multiples 129

5.3.3 Multiples from fundamentals 131

5.3.4 Value maps and other regressions 134

5.4 Asset/liability-based valuation 137

5.5 The sum of the parts framework 143

5.6 Bank valuation in M&A 144

5.7 The valuation of Wells Bank 148

6 Insurance Business Models and Financial Statements 159

6.1 The business model of insurance companies 159

6.2 Segmentation by products 160

6.2.1 Life and health 160

6.2.2 Property and casualty 161

6.2.3 Reinsurance 161

6.3 Distribution channels 162

6.4 Insurance balance sheet under US GAAP 162

6.4.1 Reserves and separate accounts 162

6.4.2 Deferred policy acquisition costs 167

6.5 Insurance contracts under IAS/IFRS 167

6.5.1 Recognition of insurance contracts 168

6.5.2 Adequacy of insurance liabilities 169

6.5.3 Unbundling 170

6.5.4 Reinsurance 171

6.5.5 Discretionary participation features 171

6.6 Case study 172

7 Regulatory Capital for Insurance Companies 177

7.1 Insurance industry regulation in the US 177

7.2 Current US system 178

7.2.1 Risk-based capital 178

7.3 Solvency II – European-based regulation 181

7.3.1 Valuation of assets and liabilities 182

7.3.2 Best estimate and risk margin 184

7.3.3 Own funds 184

7.3.4 SCR and MCR 187

7.4 Main differences between solvency II and US regulation 190

8 Assessing the Business Plan for an Insurance Company 193

8.1 Status quo analysis 193

8.1.1 Asset valuation 194

8.1.2 Reserve adequacy 194

8.1.3 Solvency 195

8.2 Internal consistency 195

8.2.1 Historical versus projected performance 196

8.2.2 P&L versus balance sheet 197

8.2.3 Asset side versus liability side 198

8.2.4 Financial versus operating forecasts 199

8.3 External consistency 200

8.3.1 Macroeconomic outlook 201

8.3.2 Competitive dynamics 202

8.3.3 Business plan versus market consensus 203

8.4 The forecasting model 204

8.4.1 Non-life business 204

8.4.2 Life 206

8.4.3 Checking forecasts 208

9 Insurance Companies Valuation 209

9.1 Appraisal value 209

9.1.1 The value-in-force 210

9.1.2 The ANAV 212

9.1.3 The business goodwill 213

9.2 Relative valuation 215

9.3 The case of “general insurance” 216

9.3.1 Step 1 217

9.3.2 Step 2 217

10 The Valuation of Other Financial Companies 227

10.1 The valuation of finance companies 227

10.2 The valuation of funds 229

References 233

Index 235

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