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Methodology
March 2015
Note: this methodology replaces the earlier version published in February 2014
Contacts
Jacques-Henri Gaulard (author)
Executive Director
+44 (0)203 71449-83
j-h.gaulard@scoperatings.com
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Contents
Executive Summary ............................................................................................................................................................. 4
Forward-looking estimates in a rating context: why? .......................................................................................................................... 4
Forward-looking estimates in a rating context: which time frame should be used? ....................................................................... 5
Forward-looking estimates in a rating context: Lessons learned ...................................................................................................... 5
Choosing the appropriate metrics and the appropriate accounting system .................................................................. 6
Choosing the appropriate sources ..................................................................................................................................... 8
Forecasting the balance sheet ............................................................................................................................................ 8
Loans forecasts ........................................................................................................................................................................................ 8
Gross loans vs. net loans: introducing asset quality ......................................................................................................................... 10
Deposits forecasts ................................................................................................................................................................................. 10
Securities forecasts ............................................................................................................................................................................... 12
Changes triggered by IFRS 9 on the classification and measurement of Financial Instruments ............................................... 14
Wholesale funding forecasts ................................................................................................................................................................ 15
Putting this all together ......................................................................................................................................................................... 16
Derivatives or the unfunded balance sheet ........................................................................................................................................ 19
Other assets and liabilities.................................................................................................................................................................... 21
Shareholders equity .............................................................................................................................................................................. 22
Forecasting the profit & loss account .............................................................................................................................. 26
The revenue block ................................................................................................................................................................................. 26
Net interest income ........................................................................................................................................................... 26
Commissions & Fees ......................................................................................................................................................................... 28
Trading gains....................................................................................................................................................................................... 29
Net insurance income ........................................................................................................................................................................ 29
Other income ....................................................................................................................................................................................... 30
The cost block ........................................................................................................................................................................................ 30
The cost of risk block............................................................................................................................................................................. 32
Changes in impairment requirements triggered by IFRS 9 .............................................................................................................. 35
The below-the-line block .................................................................................................................................................................... 37
Non-recurring items ............................................................................................................................................................................ 37
Taxes and minority interest ............................................................................................................................................................... 39
Wrapping-up the forecasts: adjusting the balance sheet for earnings and distributions ........................................... 41
Forecasting the business lines ......................................................................................................................................... 44
Divisional balance sheet 1.0 ................................................................................................................................................................ 44
Divisional profitability forecasts ............................................................................................................................................................ 45
dRCB .................................................................................................................................................................................................... 45
fRCB ..................................................................................................................................................................................................... 46
WAM ..................................................................................................................................................................................................... 46
WIB ....................................................................................................................................................................................................... 49
Corporate centre ................................................................................................................................................................................. 54
Putting it all together: art and science again ...................................................................................................................................... 55
Regulatory forecasts ......................................................................................................................................................... 57
Basel 3-compliant risk-weighted capital ratios ................................................................................................................................... 57
Basel 3-compliant unweighted Leverage Ratio ................................................................................................................................. 59
Net Stable Funding Ratio (NSFR) ....................................................................................................................................................... 60
Computing the numerator: the available amount of stable funding ............................................................................................. 60
Computing the denominator: required stable funding for assets and on-balance sheet exposure ......................................... 61
Liquidity Coverage Ratio (LCR) ........................................................................................................................................................... 63
Calculation of the numerator and the denominator ........................................................................................................................ 63
Scopes Bank Rating Team ............................................................................................................................................... 69
Disclaimer ........................................................................................................................................................................... 69
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Executive Summary
This report looks at the determination and use of forward-looking estimates (or forecasts) in the ratings
assignments of Scope. As a measure of consistency, this report should be read in conjunction with Scopes
Bank Rating Methodology. As such, the objective of this methodology is twofold: first, give pointers on ways to
estimate the main metrics of the balance sheet and the P&L of a bank, and second, show how specific metrics
apply to the various business models identified by Scope in its methodology.
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This said, as a rating agency, Scope is not bound by the same short-term dynamics as other market
participants. Quarterly financials are important but much less so than half-yearly financials, which in turn are
less important than the annual balance sheet and profit and loss account. Forecasting has a better chance of
being useful if it sticks to annual metrics, amended by the quarterly reports in the course of the year.
Why rating analysis is different from equity analysis.
Even if the tools used by Scope in its forecasting work are similar in nature to the craftsmanship of the equity
analysis, the objectives are different. Credit rating analysis does not navigate quarterly per share numbers with
the idea of staying close to a daily market valuation so as to identify trading opportunities. Nor does it have to
take quick views on the back of a constantly evolving stock price. On the contrary, the credit rating analyst
builds a forecast so as to identify weaknesses or uncertainties which in turn will have a direct impact on the
banks ability to meet its contractual financial commitments on a timely basis and in full as a going concern. So
clearly the focus is not on the next quarter, not even on the next half year, but much more on the capacity of the
bank to improve or secure its credit quality over a long period of time. The forecasting work will also help the
credit rating analyst to identify at an early stage the seeds of what could turn into significant credit problems in
future.
Keeping it simple.
This report gives a relatively comprehensive view of the forecasting process. However, following this
methodology is by no means a guarantee that the bank will deliver balance sheet and P&L metrics that are in
line with forecasts. On the contrary, summarising the forecasts in 10-20 key metrics can be enough to have a
solid view of the institution being analysed. In a banking world that is getting ever more complex, it is tempting to
get lost in the detail. The European banking sector has been given for dead repeatedly over the last six to
seven years. Despite the financial crisis, macroeconomic problems, sovereign crises, material regulatory and
policy changes as well as public aid (at times), it is still here to tell the tale and in a much better financial
condition than before the crisis.
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Liabilities
Cash
20
Total Loans
100
Total Assets
120
Total Deposits
100
Total Liabilities
100
Shareholders' Equity
20
120
The core of the forecast work will be done on the loans and on the deposits. Scope aims to be realistic as well
as conservative in forecasting, so that our ratings can absorb a sufficient degree of volatility with respect to
profitability or balance sheet metrics.
Loans forecasts
Loan growth is strongly correlated with economic growth. So depending on this growth (which will be materially
different based on the geographic location of the bank) the growth rate of the loan book should be adjusted
accordingly. At times, it should be possible to break the loan book down in different sectors. The most common
split is the breakdown between retail and corporate lending. Another common split, within retail banking, is
between mortgage loans and consumer loans. Figure 2 puts this breakdown into perspective.
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O/W SECTOR 2
O/W
While it is possible to fine-tune this breakdown, particularly on the corporate side, we do not feel this is a level of
detail we need to go into to establish forecasts (even if the sectorial breakdown of the banks loan book itself is
an important component of the rating process itself). Experience shows that, except for mergers, acquisitions or
disposals, the sectorial loan breakdown of a bank tends to remain broadly stable, even if changes in tax
incentives can have an impact on the growth rate of a particular section of the loan book.
Another type of breakdown which is worth considering is the geographic breakdown as it shows the different
areas of growth. This breakdown can prove more useful than the sectorial breakdown to assess the potential
growth of the loan book but it is usually difficult to reconcile both.
Judgement is an important factor here: for a bank mostly present in one or at best two countries, the sectorial
breakdown will be the most useful to establish forecasts. For a multinational bank with a significant presence in
many markets, a forecast based on the weighted-average GDP growth of each country could be a better place
to start.
For a mono-country bank, a sectorial approach is indispensable, and the split between corporate and
consumer loans will be key. In particular, for mortgage specialists, a thorough assessment of property prices,
household debt and Loan-to-Value (LTVs) will be important to forecast the loan book.
Another key factor is the maturity of the loan book. As such, a loan book can really be broken down in three
components:
The new loans that have been granted in the course of the year (and commonly known as the front book);
The loan outstanding that are in the normal course of being serviced (and commonly known as the back
book);
The loans that, in the particular year under review, are on the verge of being repaid and/or refinanced (the
maturing loans).
Therefore at the end of one given year, the stock of loans at one given bank should be defined as follows:
Loan outstanding Year 1= Loan outstanding (or Back Book) Year Zero + Front Book Year 1 Maturing loans
Year 1.
Therefore one can see that the loan progression of a bank from one year to another can be really fine-tuned into
quite a bit of detail. Unfortunately, public disclosure to this degree of detail is rather infrequent unless a bank is
active in few markets and geographies, in which case such detailed forecasts are possible.
Another aspect to take into account is state specific sector support. At times, the state will encourage banks
to lend at a preferred rate to such and such industries: car loans or first-home buyer loans are typical areas
where the state will subsidise banks and retrocede to them the difference between the nominal rate paid by the
borrower and the cost of funding (plus a margin).
Last but not least, deleveraging can be an important consideration in forecasting. Due to banks necessity to
strengthen their balance sheet, some will either reduce their lending effort or sell whole portfolios of assets. In
some cases, banks will reduce lending growth because the activity is expensive in liquidity terms. This would be
typically the case for consumer loans, funded with short-term borrowings and therefore expensive for banks in
light of their Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) calculations.
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Deposits forecasts
Let us now switch to deposits: deposits are a more unified species than loans. Overall, there are three types of
deposits. The first is demand (or sight) deposits representing the current account of households, where money
is deposited and withdrawn at no notice. Second there are time deposits (where depositors can only withdraw
money after a certain time has elapsed). Third there are savings deposits (paying a higher interest of interest
because the maturity is longer or because the withdrawal conditions are more stringent).
Deposits can also be split by categories of holders: retail deposits are considered more sticky, more stable,
even in the eye of the regulators. Corporate deposits are treasury instruments for companies; therefore they can
be very volatile as corporate deposits are a very competitive market. Regulators add to the breakdown by
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distinguishing between covered deposits, non-covered preferred deposits and non-covered, non-preferred
deposits (please review our Bank Rating Methodology for more details).
Typically, because the retail/corporate breakdown of deposits can be difficult to obtain, deposits are forecast on the
basis of their maturity breakdown (which is also the accounting one): in other words demand, time and savings.
Four factors have a decisive impact on deposit forecasts:
Economic growth: even if less intuitive than for loans, the relationship between deposits and economic
growth is real: greater economic growth increases capital expenditures, partly achieved through lending. The
capex create new employment therefore new salaries and then new deposits.
Inflation: the relationship between inflation and interest rates is well-known and can be mutually self
sustained. In mature economies though, inflation rates have not been high enough so as to play an important
role in deposit pricing.
Interest rates levels are a key determinant of deposit pricing and most recently have been the key driver
behind deposit growth at banks. Indeed, the recent financial crisis exposed the excessive leverage level of
many banks with long-term loan books being funded by short-term, volatile market resources. The recent
strengthening of bank liquidity rules has encouraged banks to increase the use of deposits in their funding
(1) by shifting away from intragroup funding for their foreign subsidiaries and (2) by entering very intense and
sometimes unreasonable competition on interest rates to attract depositors. Regulators in some countries
have tried to mitigate this phenomenon. Overall though, banks have been successful in strengthening their
deposit base. Banks have also improved their loan to deposit ratios by reducing their loan books.
Lack of alternative for household savings. This last factor is more art than science but it reflects the
fact that despite the low economic growth most banks have experienced supernormal deposit growth driven
by customer reluctance to invest in equities.
Forecasting deposits is significantly more complicated than forecasting loans: management guidance or (even
better) a quick look at the banks commercial websites can provide information on the types of promotional
offers that are available on deposits. The analyst must therefore assess to which extent a bank can capture
market share and assess the impact of this commercial effort on the interest paid on deposits (a critical issue
but one we will address when we speak about the net interest margin forecasts later on). Management
guidance can take several forms and can take the shape of a Loan-to-Deposit ratio target for example. The
analyst must in turn assess whether this target is reasonable or not.
After this effort is done, it is critical then to allocate the growth in-between sub-categories (demand, term, and
savings). And here the expected level of future interest rates will be essential. As interest rates go down, it is
likely investors/depositors are less concerned about leaving some more money on their current accounts as the
opportunity cost gets less important. As interest rates go up, there will be more movement on the term and
savings side.
Life insurance products can be forecast at the same time as deposits but they will enter the very specific
bucket of technical provisions of insurance companies. The rationale for the forecast is exactly the same as for
deposits, but the accounting line is distinct, way down the balance sheet presentation reflecting the less
liquid aspect of this particular liability. Technical provisions in insurance terminology are intended to represent
the current amount the insurance company would have to pay for an immediate transfer of its obligations to a
third party. In a way, the technical provisions are the counter-value of the total insurance benefits and therefore
are a good proxy for the life insurance product itself.
Mutual funds and assets under management (for institutional, retail and private clients) are all off-balance sheet
products and are not liabilities of the bank itself. As such they can only be forecast at the business line levels of
asset management, wealth management, and sometimes retail banking.
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We are now in a situation where we can forecast the deposit base of Bank XYZ for the Current Year and the two
years after that. In light of the willingness of the bank to increase its liquidity, it has offered an exceptional 4.25%
yield on current accounts for new clients. This promotional offer is only valid for the first six months of the year.
XYZs management knows that this will have a negative impact on profitability, but is interested by the stock of
deposits first and foremost. We expect more muted growth in the two years after that, slightly below loan
growth. So we apply deposit growth of 5%, 2% and 3% for the Current Year, Year 1 and Year 2 respectively.
We can now forecast Bank XYZs initial balance sheet for a three-year period.
Figure 3: Balance sheet Bank XYZ Current Year
Assets
Liabilities
Cash
25
Customer deposits
105
Total Loans
100
Total Liabilities
105
Shareholders' Equity
20
Total Assets
125
125
Liabilities
Cash
24.6
Customer deposits
107
Total Loans
103
Total Liabilities
107
Shareholders' Equity
20
Total Assets
127
127
Liabilities
Cash
24.2
Customer deposits
110
Total Loans
106
Total Liabilities
110
Shareholders' Equity
20
Total Assets
130
130
It is important to note that, as loans and deposits do not grow at the same rate, the assets and liabilities should
not be balanced. However, since the towering principle of double-entry accounting lies in the equality of assets
and liabilities, we have assumed so far that the excess deposits generated by what we believe will be Bank
XYZs strategy will be reinvested in cash. This is not as simplistic as it sounds. When XYZs balance sheet gets
much more complex, a good way to match assets and liabilities that are not equal is to consider an increase or
a decrease of cash: a decrease of cash reflects the fact that the bank needs to allocate more money in granting
new loans, buying securities, contracting repo operations. Conversely an increase in cash means that so far the
bank has not really managed to find an appropriate use for its excess resources be it capital, debt or deposits.
So basically the available cash of the bank is paradoxically a metric that never gets to be forecast but that tends
to be an outcome of the forward-looking strategy of the bank, as expressed by the analysts forecast even if
regulatory constraints have recently turned cash balances into more important and less predictable components
of the balance sheet.
Securities forecasts
In the area of markets and securities, the accounting norms are not very helpful. Indeed, securities, under IFRS
or US GAAP, are part of an item labelled financial instruments. Financial instruments are split between cash
instruments and derivatives instruments.
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Financial instruments are not split by product, as would intuitively make sense but by intention and relative
liquidity. So for example,
Trading assets are instruments where the variation in value (either by sale or revaluation of the asset) is
channelled through the P&L.
Available-for-sale (AFS) assets are instruments where the change in value is channelled through
shareholders equity.
Held-to-Maturity (HTM) assets are instruments which the bank commits to keep in its books until maturity at
historical costs.
To do a proper forecasting job, the analyst has to retrieve debt instruments and equity instruments from the
three components and apply some growth rates accordingly.
Within the debt securities category, it will be helpful to split government bonds from other bonds. Even if in
many instances the sovereign component of banks balance sheets is nowhere nearly as risk free as it used
to be considered, it is still a vital component to assess the carry-trade activities of a bank, i.e. the use of shortterm market/interbank resources to fund sovereign debt.
These activities present two risks and one opportunity for the bank. The opportunity is to secure a strong spread
reflecting the difference between the yield on the government bond and the interest paid on the shortterm/interbank resource.
The first risk is the counterparty risk of some sovereigns, which could lead to depressed bond prices if the credit
risk of these sovereigns was perceived by the market to deteriorate. The second risk is over-dependency on
short-term Central Bank resources, preventing an institution from funding itself properly through diversified
market and customer funding.
In this context, the role of the credit analysts forecast is to assess the timeframe from which the bank will have
made enough progress in its liquidity and its balance sheet management to significantly reduce its dependency
on Central Bank funding.
The good news is that sovereign exposure is now much more transparent than it used to be thanks to the
various stress tests that have been coordinated by the EBA. Stress-test disclosure enables the analyst to
benefit from the reporting of the sovereign exposure of individual banks by maturity and by country, enabling in
turn to draw reliable conclusions on sovereign bonds forecasting. .
Typically, forecasting equities and bonds reflect a relationship between volumes and prices.
For equities, a quick look at overall stock price performances in the major countries in which a bank operates
can give a good idea of the buoyancy of the equities market and therefore of the relative situation of the equities
portfolio. The analyst will have to assume that the bank may well have sold some equities into a strong market
so that the performance may not be fully reflected in the balance sheet growth of the equities portfolio. Going
forward, it is necessary to take a view on the future performance of equities markets.
The stock of corporate bonds will be essentially triggered by interest rates levels and by credit risk since they
will have a direct impact on the valuation of the bond portfolio both government and corporate. Regulation
around proprietary trading and the capital cost of holding too many bonds in inventory are also factors that credit
analysts have to keep in mind when forecasting bond holdings of banks.
As for government bonds, the perception of any given sovereign, its rating and the level of interest rates will be
key drivers to the forecasts.
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Yes
No
Yes
Yes
No
Fair value through other
comprehensive income
*Presentation option for equity investments to present fair value changes in OCI
The concept of business model under IFRS 9 refers to how a financial asset is managed: either collecting
contractual cash flows; selling the asset; or both. As we can see on Figure 6, the classification will be largely
based on the effective management of the financial instrument. In effect:
Financial Assets at amortised costs correspond to a business model where the objective is to hold assets to
collect contractual cash flows.
Financial Assets held at Fair Value through Other Comprehensive Income (FVOCI) correspond to a
business model where the objective is achieved by both collecting contractual cash flows and selling financial
assets.
Any other Financial Assets that are not held in one of these two business models are measured at fair
value through profit and loss. As such, fair value through profit and loss represents a residual category.
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Financial assets that are held for trading and those managed on a fair value basis are also included in this
category.
It is interesting to note that versus IAS 39, the concept of AFS financial instruments has disappeared. Only two
classifications remain: amortised costs and at fair value (the latter whether through P&L or through OCI). We
note that FVOCI is close to the former AFS though since movements in the carrying value are taken through
OCI while the recognition of impairment gains or losses, interest revenue and foreign exchange gains and
losses are recognized in profit and loss.
As far as the forecasting effort is concerned, we do not believe that the difference in classification and
measurement will materially alter our forecasts it will be interesting to know the status of the financial
instruments that had been recognized as loans and receivables in the course of the crisis to avoid fair value
adjustments through P&L. However, the bigger issue is to make sure that a breakdown of every financial
instrument by product (equities, sovereign bonds, other bonds) remains available under the new accounting
regime.
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proved to be very liquid up to the point when the crisis occurred. Indeed, a lot CDs were bought by money
market funds, meaning than in many ways banks were keeping the control of this product since banks were
sponsoring the funds themselves. With the development of capital markets, banks started to issue CDs in nondomestic currencies which enabled them to find funding beyond their traditional domestic market. The flipside is
that they became dependent on foreign funding sources and there have been cases where institutional CD
buyers decided to brutally withdraw from certain currencies or certain countries. This has forced banks to find
alternative funding in a hurry. With signs of economic recovery in the Euro area (EA), US money market mutual
funds are now re-investing in European banks CDs.
Long-term debt:
Following the crisis and increased efforts by the regulator to match-fund assets and liabilities (through the
introduction of new metrics such as the NSFR Net Stable Funding Ratio), banks have given more and more
importance to long-term funding. The recent initiatives on recovery and resolution are also forcing banks to
increase their level of bailinable debt as a percentage of their total liabilities, in particular through the TLAC
(Total Loss-Absorbing Capacity) and MREL (Minimum Requirements for Own Funds and Eligible Liabilities)
concepts that are both defined in greater detail in our Bank Rating Methodology. Once the levels of TLAC and
MREL are finalised (probably towards the end of 2015), it is Scopes intention to forecast these metrics. The
difficulty of the exercise will be assessing how much net new issuance of TLAC and/or MREL will be necessary
after existing debt (senior or subordinated) matures. This new issuance is likely to increase funding costs.
Capital instruments:
Capital instruments, in theory, should not be part of the wholesale funds. But as the new recovery and resolution
regimes are increasing the type and number of instruments that are effectively loss-absorbing, the line between
debt and equity is more and more blurred.
Regulatory capital instruments such as Tier 2 capital and Additional Tier 1 (AT1) instruments will have a growing
importance as the regulators force banks to raise more bailinable/loss-absorbing debt, through TLAC and MREL
in particular.
We believe that there are two drivers to wholesale funding forecasts:
1. Economic and market activity, that will somewhat dictate the size of the loan book to be funded;
2. Regulatory trends that will encourage greater allocation to long-term debt and capital instruments rather than
more short-term and volatile resources.
While CDs and CP used to fill the gap between loans and deposits, and while repos will always be important,
banks will have to increase the weight of long-term funding (through secured and unsecured debt) to fulfil the
need of the NSFR ratio and to abide by the new recovery and resolution regimes.
Therefore, these constraints will influence forecasts in addition to markets and lending activities occurring on the
asset side.
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Figure 7: Balance sheet Bank XYZ Year Zero
Assets
Liabilities
Cash
20
Customer deposits
100
20
80
Government Bonds
85
CDs
95
Other Bonds
65
15
Equities
30
subordinated debt
10
Total Loans
100
Total Liabilities
300
Shareholders' Equity
20
320
Total Assets
320
Liabilities
Cash
25.0
Customer deposits
105.0
20.0
72.0
Government Bonds
72.3
CDs
80.8
Other Bonds
58.5
18.0
Equities
30.0
subordinated debt
10.0
Total Loans
100.0
Total Liabilities
285.8
Shareholders' Equity
20.0
Total Assets
Liabilities
Cash
22.5
Customer deposits
107.1
20.0
70.4
Government Bonds
72.3
CDs
80.8
Other Bonds
58.5
21.6
Equities
32.1
subordinated debt
8.0
Total Loans
102.5
Total Liabilities
287.9
Shareholders' Equity
20.0
Total Assets
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Figure 10: Balance sheet Bank XYZ Year 2
Assets
Liabilities
Cash
8.9
Customer deposits
110.3
20.0
71.0
Government Bonds
75.0
CDs
75.0
Other Bonds
60.0
23.0
Equities
35.3
subordinated debt
6.0
Total Loans
106.1
Total Liabilities
285.3
Shareholders' Equity
20.0
305.3
Total Assets
305.3
As we can see in the figures above, we have added the different securities on the asset side, and the wholesale
funds on the liability side. The interbank deposits (including repos and reverse repos) appear as Due from
banks on the asset side and Due to banks on the liability side.
With the growth imposed on XYZ, the bank is now much more leveraged than previously, and the loan book is
not the most important component of the balance sheet anymore.
As Figure 7 demonstrates, the bank has a heavily negative net interbank position (meaning that XYZ has more
interbank liabilities than interbank assets). XYZ also posts an important securities portfolio (180 in total as of
Year Zero, so about 56% of the banks total assets) representing the sum of government bonds, other bonds
and equities.
We also note that the dependency of the bank on short term funding is quite important (close to 60% of total
liabilities).
As far as forecasts are concerned, the Current Year is showing that XYZ is trying to reduce its bond portfolio
due to interest rate pressures so we are expecting a 15% decrease in government bonds for the Current Year,
and a 10% decrease in the other bond portfolio. We assumed that equities are unchanged.
For Years 1 and 2, we appreciate the fact that XYZ does not need to alter the composition of its bond portfolio
(or only at the margin). Considering likely buoyant equity markets and considering that the performance of
equity markets should go beyond its historical averages, we assume that XYZ would grow the level of its equity
portfolio by 7% in Year 1 and +10% in Year 2.
On the funding side, XYZ is aware that it needs to rebalance its funding structure towards more long-term
products. Therefore we have assumed that for the Current Year, XYZ would decrease its interbank liabilities by
10%, and its CDs outstanding by 15%. We assume a 20% increase in senior debt: this seems a lot (and the
forecasts have to take into account the capacity for the market to absorb XYZs long term debt issues) but
considering the low initial level of senior debt in Year Zero, we do not believe that this amount is too demanding.
For debt forecasts, it is always interesting to refer to the debt maturity of a given bank. It enables the analyst to
calibrate more precisely the amount of debt that has to be refinanced. For long-term debt maturing within the
next twelve months, XYZ may choose to refinance it with LT debt or use more short-term instruments,
depending on the level of activity.
As for subordinated debt, we assume that these are products that will not be eligible as AT1 or Tier 2 capital
under the new regulatory regimes, and that the bank will exchange or call them (even if these products can be
used as bailinable debt). Therefore we have assumed that XYZ would reduce them by -20% and -25% in Year 1
and Year 2 respectively.
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Following this process a reality check will be performed. Comparing the Year Zero balance sheet with the
forecast Year 2 balance sheet, our forecasts look reasonable. Deposits increase from 31% to 36% of total
assets; short-term funding (interbank, repos and CDs) decline from 55% to 48%, and long-term funding
increases from 4.7% to 7.5%.
These forecasts seem realistic enough and reflect reasonable efforts by XYZ management to restructure the
balance sheet while demonstrating at the same time that banks balance sheet structures are quite static and
difficult to adjust in a short time period. We will introduce capital instruments forecasts once MREL and TLAC
levels are properly defined.
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Figure 11: Balance sheet Bank XYZ Year Zero
Assets
Liabilities
Cash
25
Customer deposits
100
20
80
Government Bonds
85
CDs
95
Other Bonds
65
15
Equities
30
subordinated debt
10
Total Loans
100
Derivatives (obligations)
85
Derivatives (rights)
80
Total Assets
405
Total Liabilities
385
Shareholders' Equity
20
405
Liabilities
Cash
29.7
Customer deposits
105.0
20.0
72.0
Government Bonds
72.3
CDs
80.8
Other Bonds
58.5
18.0
Equities
30.0
subordinated debt
10.0
Total Loans
100.0
Derivatives (obligations)
79.2
Derivatives (rights)
74.5
Total Assets
384.9
Total Liabilities
364.9
Shareholders' Equity
20.0
384.9
Liabilities
Cash
27.2
Customer deposits
107.1
20.0
70.4
Government Bonds
72.3
CDs
80.8
Other Bonds
58.5
21.6
Equities
32.1
subordinated debt
8.0
Total Loans
102.5
Derivatives (obligations)
80.6
Derivatives (rights)
75.8
Total Assets
388.4
Total Liabilities
368.4
Shareholders' Equity
20.0
388.4
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Figure 14: Balance sheet Bank XYZ Year 2
Assets
Liabilities
Cash
13.8
Customer deposits
110.3
20.0
71.0
Government Bonds
75.0
CDs
75.0
Other Bonds
60.0
23.0
Equities
35.3
subordinated debt
6.0
Total Loans
106.1
Derivatives (obligations)
83.9
Derivatives (rights)
79.0
Total Assets
389.2
Total Liabilities
369.2
Shareholders' Equity
20.0
389.2
So if the derivatives book of XYZ follows its asset composition more closely, then the weighted average growth
of the book (based on the assumed growth rates of loans and securities) should be -6.875% in the Current Year
(versus Year Zero), +1.8% in Year 1 and +4.2% in Year 2.
We have assumed that the net derivatives position of XYZ was negative (i.e. the bank has more obligations than
rights).
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litigation cases, a proper assessment of potential outcomes and their financial impact are an increasingly
important part of banks financial analysis and forecasting.
Equity-accounted investments:
This line reflects minority equity stakes in which the bank has a significant influence. This is presumed to be
the case when the ownership is 20% or more. The investment is initially recorded at cost and is subsequently
adjusted to reflect the investors share of the net profit or loss of the associate. This line will usually be fairly
stable over time (safe for the annual adjustment in the associates net profits) except when a fully-consolidated
equity stake gets partly sold, meaning that a bank ends up with a minority stake rather than a majority stake, for
example. This factor is likely to boost the associate line. Conversely a bank can decide to reduce a stake that
was previously equity-accounted - the idea being to avoid too important a capital deduction of that stake under
Basel 3. If enough of the stake is sold, the shares are deconsolidated and reclassified as AFS assets, triggering
a fall in the equity-accounted accounting line. This type of reclassification is likely to change with the introduction
of IFRS 9.
Intangible assets & Goodwill:
Operating intangibles (such as software expenses) are to be amortized and they should be distinct from
goodwill. The portion of goodwill that is not identifiable as PPA (or Purchase Price Allocation) is not to be
amortized but submitted to yearly impairment tests, validating or invalidating its valuation. Goodwill is generally
assumed stable except if the fair values of comparable companies tend to go down consistently, in which case
the analyst has to consider an impairment. We come back to PPA later in this methodology.
Fixed assets:
These are lands, buildings, equipment and furniture, which sometimes are depreciated. Ageing equipment has
to be replaced; therefore the forecast insight is pretty limited.
Other assets & liabilities:
At any given time, banks hold vast amounts of prepaid expenses and accrued income that are of no particular
analytical importance. As a result, this inventory of various metrics is sometimes used as a balancing item for
the balance sheet even if the cash balance is our preferred item for such a purpose. To be thorough, the
overall balance sheet growth averages could be applied to these items but we do not view this as being
critical.
Shareholders equity
The main challenge will be a proper identification of the components of shareholders equity. Under IFRS, the
own funds line can include a vast proportion of subordinated debt, preferred shares and other old style
capital instruments that have nothing to do with the proper loss-absorbing common equity that forms the last
line of defence of a banks credit position.
To properly identify this line, we refer to the statement of changes in shareholders equity. There we make the
difference between:
Shareholders equity, group share;
Other Comprehensive income;
And Minority interests.
Shareholders equity should be understood in its strictest sense i.e. the sum of:
Share capital + issue premium + accumulated retained earnings + non-distributed income for the year.
Other comprehensive income (OCI) is really the accumulation of changes in the value of assets and liabilities
recognised directly in equity. Typically, this is where the variations of value on AFS assets will be recognized.
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Another big line in this category is the change in value of assets and liabilities triggered by foreign exchange
movements. This can be quite big for companies who do not hedge their foreign exchange risk.
Overall, the OCI is extremely difficult to forecast as it is a balance sheet reflection of all the market movements
that have affected a bank in the course of one given period.
As a result, the main difference in equity forecasts from one year to another is the net profit, minus the planned
distribution for the year. The forecasts will also reflect, as and when needed, capital increases and capital
reductions.
Assume a banks capital is divided in 1,000 shares with a nominal of 20. The bank decides to raise a sum of
2,000, at a price of 100 (that happens to be close to the share price). The way to reflect this in the forecasts is
to:
1/ Raise share capital by 400: nominal of 20 x number of new shares issued (2000/100, so 20);
2/ Raise issue premium by 1,600: issue premium of 80 (issue price of 100 - nominal of 20) x number of new
shares issued (20).
Lastly, convertibles and warrants may be included in equity depending on the conversion feature (mandatory
convertible bonds for example).
Figure 15: Balance sheet Bank XYZ Year Zero
Assets
Liabilities
Cash
25
Customer deposits
100
20
80
Government Bonds
85
CDs
95
Other Bonds
65
15
Equities
30
subordinated debt
10
Total Loans
100
Derivatives (obligations)
85
Derivatives (rights)
80
20
Technical provisions
20
Other assets
Other provisions
10
Equity-accounted investments
Other liabilities
Intangible assets
Total Liabilities
423
Goodw ill
Shareholders' Equity
20
Fixed assets
Total Assets
443
443
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Figure 16: Balance sheet Bank XYZ Current Year
Assets
Liabilities
Cash
31.1
Customer deposits
105.0
20.0
72.0
Government Bonds
72.3
CDs
80.8
Other Bonds
58.5
18.0
Equities
30.0
subordinated debt
10.0
Total Loans
100.0
Derivatives (obligations)
79.2
Derivatives (rights)
74.5
3.0
16.0
Technical provisions
17.4
Other assets
5.0
Other provisions
10.0
Equity-accounted investments
2.0
Other liabilities
5.0
Intangible assets
2.0
Total Liabilities
400.3
Goodw ill
7.0
Shareholders' Equity
20.0
Fixed assets
2.0
Total Assets
420.3
420.3
Liabilities
Cash
32.6
Customer deposits
107.1
20.0
70.4
Government Bonds
72.3
CDs
80.8
Other Bonds
58.5
21.6
Equities
32.1
subordinated debt
8.0
80.6
Total Loans
102.5
Derivatives (obligations)
Derivatives (rights)
75.8
3.0
12.0
Technical provisions
17.4
10.0
Other assets
5.0
Other provisions
Equity-accounted investments
2.0
Other liabilities
5.0
Intangible assets
2.0
Total Liabilities
403.8
Goodw ill
7.0
Shareholders' Equity
20.0
Fixed assets
2.0
Total Assets
423.8
423.8
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Figure 18: Balance sheet Bank XYZ Year 2
Assets
Liabilities
Cash
23.3
Customer deposits
110.3
20.0
71.0
Government Bonds
75.0
CDs
75.0
Other Bonds
60.0
23.0
Equities
35.3
subordinated debt
6.0
Total Loans
106.1
Derivatives (obligations)
83.9
Derivatives (rights)
79.0
3.0
8.0
Technical provisions
17.4
Other assets
5.0
Other provisions
10.0
Equity-accounted investments
2.0
Other liabilities
5.0
Intangible assets
2.0
Total Liabilities
404.7
Shareholders' Equity
20.0
424.7
Goodw ill
7.0
Fixed assets
2.0
Total Assets
424.7
We can now disclose a reasonably detailed balance sheet forecast for Bank XYZ, in Figures 15 to 18.
The balance sheet of XYZ in Year Zero is now complete.
We have assumed that XYZ had a small insurance operation (justifying technical provisions of 20), some
contingent liabilities for a legal case (provisioned up to 10).
Following past losses, XYZ also recognizes tax loss carry-forwards of 20. A recent acquisition results in goodwill
of 7.
With regards to forecasts for the Current Year, Year 1 and Year 2 (Figures 16 to 18), a lot of these items are
likely to remain flat (except if an impairment is recognized on the goodwill), and in regards to:
DTAs related to Tax Loss Carry Forwards (TLCFs), that are subject to deduction under Basel 3 in XYZs
country, and that XYZ decides to use aggressively to ensure that these deferred tax assets are gone within
five years we have decided to depreciate the amount on a straight line basis accordingly;
And the technical provisions, where we have proxied the trends we forecast for the bond portfolio of XYZ
(both government and other). In this context, we expect XYZs stock of technical provisions to decrease by
12.8% in the Current Year, before stabilising in Year 1 and Year 2.
We have assumed flat legal provisions, knowing that these can go up and down depending on the outcome of
some legal cases and the reassessment of claims on others.
Please note that we did not forecast the shareholders equity of XYZ. This is due to the fact that this allimportant line can only be estimated when net profit and net distribution for the year have been forecast. This is
the next section of this methodology.
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As for the cost of interest-bearing liabilities, we know that XYZs management made a significant effort to gather
deposits in the Current Year, which would warrant a significant increase from 2% to 2.25%. As this marketing
effort subsides, we would not expect XYZ to reprice its deposit base significantly. We would therefore maintain
the cost of interest-bearing liabilities to 2.25% in Year 1 and in Year 2 in the context of rising interest rates.
Basically the net interest margin will be a function of the growth rate of loans (and other interest-earning assets)
and deposits (and other interest-bearing liabilities), as well as interest rates expectations. Consequently, we can
infer the net interest margin of XYZ on a three-year period.
Figure 19: Inferred net interest margin of Bank XYZ (%)
1.50%
1.47%
1.45%
1.44%
1.40%
1.35%
1.32%
1.30%
1.25%
1.22%
1.20%
Year 0
Current
Year 1
Year 2
As shown in the chart above, market share gains on deposits imply a sharp fall in XYZs net interest margin
between Year Zero and the Current Year. A faster repricing of the loan book in a rapidly rising interest-rates
environment help XYZ restore its NIM by Year 2, almost back to where it was in Year Zero.
Commissions & Fees
The second part of the revenue block is made of fees & commissions. As for interest income, fees &
commissions are the product of a difference between commissions received and commissions paid.
However as a significant part of commissions are not asset-based, it is infrequent for an analyst to forecast both
commissions received and commissions paid. The forecast work in the P&L is limited to net commissions only
(i.e. commissions received minus commissions paid). Commissions paid reflect monies paid by the bank to
advisors on its debt and equity issues, for example. Under IFRS, commissions paid also include monies paid to
third-parties for business introductions (even if this particular item is recognized as an expense under US
GAAP).
Commissions are received on means of payment and on loans, but also from asset management and private
banking activities, capital markets operations and advisory business. Commissions also include brokerage fees,
etc.
In terms of forecasts and versus the net interest income, commissions have to be expressed as a growth
percentage versus the prior year. Because fees and commissions cover a multiplicity of businesses (there is
nothing in common between a processing fee on a mortgage loan and a management fee on a mutual fund) it is
difficult to forecast them with a reasonable degree of confidence. In this respect, business line revenue
forecasts will give a greater degree of comfort than the commission line itself, which is linked to a vast array of
businesses.
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While we do forecast commission and fee income, this line will inherently be more nebulous. For example, from
a reasonably depressed level of fees & commissions in Year Zero, XYZ is not experiencing client business to
grow significantly. Only in Year 2 does XYZ expect a modest recovery in commission income of 5% p.a.
Trading gains
Capital market revenues (or trading gains) are even more volatile and unpredictable than commissions. In this
domain, more detailed inputs from the business lines will be a much better base for forecasting than just using
the reported P&L number which, as we pointed out in the section on net interest income, is not economically
representative of the effective trading gains, as the cost of funding the trading portfolio appears at interest
expense level.
Trading gains is the commonly-accepted term used to refer to trading-related income. However, we have seen
that quite a chunk of capital markets income can be included in commissions as well.
As a result, trading gains really refers to capital gains, on two categories of products:
Realised and unrealised capital gains on assets held for trading (fixed income instruments, equity
instruments, F/X instruments, commodities instruments, and derivatives). Because these assets are held for
trading, they need to be valued on a mark-to-market basis, so the gains will go through the P&L even if they
are not realised;
Realised gains only on AFS securities. Unrealised gains on AFS are recorded as Other Comprehensive
Income (OCI). Once the AFS instruments are sold, the capital gain is transferred from OCI to P&L. This is
likely to change once IFRS 9 is introduced.
Overall, there is a significant volatility that is attached to trading gains making them, as such, very difficult to
predict. The task is made easier at business line level, when the bank discloses the breakdown of capital
markets revenues. We therefore feel more comfortable using the level of the business line to make forecasts on
capital markets activities.
However, determining the direction of trading gains can be informed by major market indices, credit spreads,
and any daily market information. Overall though, it is necessary for the analyst to take a view on market
conditions for future time periods a process which is easier to implement at divisional level (and not at
accounting level). Indeed, the trading gains line gives little to no detail about the specific business model of a
bank in investment banking.
Using XYZ as an example, from a rather elevated level in Year Zero, we expect trading gains to remain flat in
the Current Year (the good performance in the course of the first half being negated by less favourable H2
market conditions). Year 1 should look more like the second half of the Current Year so we are expecting a 20%
decline in trading gains, followed by a muted 5% recovery in Year 2, driven by recovering equity markets.
Net insurance income
For some banks, insurance operations can represent an important portion of their business. The net insurance
income represents the difference between income from insurance activities minus claims and benefits
expenses.
Net insurance income includes gross premium written (on the income side), movements in technical provisions
(on the income or expense side), claims & benefits paid (on the expense side), surrenders and maturities (on
the expense side).
As is the case for trading gains, the presentation of insurance activities under traditional bank accounting is far
from ideal. We will tend to rely again mostly on business line disclosure to make forecasts.
Insurance is a complex business, whose full assessment may go beyond the competence of a bank analyst, but as
a way to proxy the revenue trends in insurance, applying a return on the technical reserves is a good way to start.
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For the purpose of this exercise, and from a starting point of 2.5%, we assume a flat return for the insurance
business in the Current Year, increasing to 2.6% in Year 1 and 2.7% in Year 2, to proxy a mild rise in interest
rates.
Other income
A lot of what banks call other income should be restated below the line as not being very representative of
regular operating business. Earnings from equity-accounted companies (or associates) even if they can be
considered as recurring, should be segregated as they have already been taxed and therefore are not included
in taxable income. The same way, capital gains on the sale of properties should be transferred below the line
as they are not part of the recurring operations of a bank. Once netted from insurance income, associates, and
other non-recurring capital gains, the Other income position should mostly be flat from one year to another.
Figure 20: P&L XYZ revenue block
Year Zero Current Year
Year 1
Year 2
Interest income
10.33
10.09
10.22
10.55
Interest expense
-6.00
-6.59
-6.45
-6.45
4.33
3.50
3.77
4.10
1.50
1.50
1.50
1.58
Trading gains
1.00
1.00
0.80
0.84
Insurance income
0.50
0.44
0.45
0.48
Other income
0.25
0.25
0.25
0.25
7.58
6.69
6.77
7.25
Wrapping up all the forecast work above, we can see that XYZ posts revenues going down 11.7% in the Current
Year, followed by a mild recovery of 1.2% in Year 1 and a more sustainable +7% in Year 2.
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The principle variables to look at when one forecasts the cost base of a bank are as follows:
Cost income ratio (CIR): sometimes the bank has a CIR target, and therefore the analyst can position the
forecasts as a function of the CIR target, depending how realistic management targets are;
Compensation costs % total costs and its opposite, non-compensation costs % total costs: sometimes a
bank can give targets with regards to the proportion of administrative expenses versus total costs. A bank will try
to optimize its non-compensation expenses versus the totality of its cost base. A good
analytical indicator is
also to monitor the proportion of compensation expenses to revenues. In banks where the compensation of
employees depends on revenues, the sensitivity of costs to revenues will be higher;
Inflation rate: for retail-based banks, the yearly inflation rate is an important indicator for mandatory
increases in salaries, for example.
Litigation costs: a large component of bank costs post-crisis is the litigation line. Usually, the banks give
guidance on the trends underlying that line, as companies seem to consider these costs as somewhat
exceptional. However, since the crisis and over the last seven years, litigation costs have become more
frequent, and therefore we include them as part of the regular cash non-compensation costs (even if these
costs are most of the time provisions for litigation).
Cost-cutting: in these post-crisis years, a lot of banks have given to the markets cost-cutting targets.
Usually they take the form of multi-year objectives adding to a total of x after a period of, say, five years. This
usually never means (unless it is specifically spelled out by the company) that the cost base in Year 1 will go
do down by x in absolute terms in five years time. Usually the bank either (a) increases the salary of its
remaining employees; and/or (b) re-invests parts (or all) of the cost savings into the business. This means
that absolute declines in cost bases are actually pretty rare, except in investment banking where variable
compensation can be slashed at will if revenues are too low. Unsurprisingly, in the latter cases, decreases in
compensation costs are usually lower than decreases in revenues, showing that cost flexibility at
investment banks is only relative.
Figure 21: P&L XYZ cost block static
Year Zero Current Year
Year 1
Year 2
Personnel expense
-4.10
-3.90
-3.79
-3.49
-1.80
-1.70
-1.64
-1.48
-0.30
-0.30
-0.30
-0.30
-6.20
-5.89
-5.74
-5.27
XYZ has a poor cost control in Year Zero, as its cost-income ratio is close to 82%. The management has
therefore decided to lower the cost base by 15% by Year 2, through a series of branch closures, which should
ease the cost burden of the company. The balance of cost savings will be reached through a control of the non
compensation to income ratio, which the company would like to bring closer to industry standards (20%-25%).
Figure 21 presents the cost base of XYZ on a static basis following the successful completion of the cost
savings program. A 15% cost savings program implies net decrease in costs of 15% x 6.20, so 0.93.
We have assumed that the cost savings program would be implemented by around 33% in the Current Year,
66% in Year 1 and 100% in Year 2. We have also assumed that two thirds of the cost savings program applies
to compensation expenses while the remaining third is taken off the cash non-compensation expense line.
We assume amortization and depreciation are unchanged.
Figure 21 gives a useful sanity check about the cost block of XYZ. Considering all the above assumptions, the
total costs of XYZ in Year 2 amount to -5.27 (versus -6.20 in Year Zero). This corresponds to savings of -0.93.
Our forecasts therefore reflect the program quite accurately.
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Figure 22: P&L XYZ cost block dynamic
Year Zero Current Year
Year 1
Year 2
Personnel expense
-4.10
-3.90
-3.87
-3.66
-1.80
-1.70
-1.67
-1.56
-0.30
-0.30
-0.30
-0.30
-6.20
-5.89
-5.84
-5.52
Banks frequently use the opportunity of a cost savings program to re-invest in the business. In the case of XYZ,
the revenue situation is way too dire for comfort so we have assumed that all the cost savings were retained in
the Current Year. In Year 1 and Year 2, we assume cost growth (from the static cost base) of 2% and 5%
respectively, as illustrated in Figure 22.
With this dynamic cost block forecast, we now have our final cost forecasts for XYZ.
Figure 23: Pre-provision P&L Bank XYZ
Year Zero
Current Year
Year 1
Year 2
Interest income
10.33
10.09
10.22
10.55
Interest expense
-6.00
-6.59
-6.45
-6.45
4.33
3.50
3.77
4.10
1.50
1.50
1.50
1.58
Trading gains
1.00
1.00
0.80
0.84
Insurance income
0.50
0.44
0.45
0.48
Other income
0.25
0.25
0.25
0.25
7.58
6.69
6.77
7.25
Personnel expense
-4.10
-3.90
-3.87
-3.66
-1.80
-1.70
-1.67
-1.56
-0.30
-0.30
-0.30
-0.30
-6.20
-5.89
-5.84
-5.52
1.38
0.80
0.92
1.73
Obviously, not every bank runs a cost savings program (although a lot of them do currently). In normal
circumstances, there is an increase in costs reflecting the inflation rate and/or the expected revenue growth plus
some capital expenditures to replace/upgrade some fixed assets.
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As we have shown before, goodwill impairment reflects the fall in the value of a past acquisition. As well, an
impairment can impact a loan, but also a security or any financial instrument where the credit quality of a
counterparty has changed due to financial stress. The provisions that a lot of European banks had to write
against specific sovereign debt in 2011 were the result of the restructuring plan decided upon by European
countries and bondholders, and would definitely belong to that category.
However, some impairments (goodwill or specific sovereign impairment) can be restated below the line if the
analyst considers them as exceptional/non-recurring.
The cost of risk is a function of:
The loan growth;
And the temporal position of the bank in the credit cycle, in other words what is the history of the banks cost
of risk ratio (as defined as loan loss charges % Total average gross loans);
The loan growth has been forecasted in the balance sheet section.
As for the cost of risk, lets assume that the past five years of Bank XYZ look like this
Figure 24: Past cost of risk of XYZ Bank
2.50%
2%
2.00%
1.50%
1.25%
1.00%
0.75%
0.50%
0.50%
0.25%
0.02%
0.00%
Y-5
Y-4
Y-3
Y-2
Y-1
Year Zero
Cost-of-risk ratios can be very volatile and their variation can be quite brutal from one bank to another.
There are two ways to forecast the cost of risk. The first one is the easiest and is based on the track record of
the bank at different points in the course of the economic cycle. The second analyses the probability of default
and losses on the banks credit exposure as disclosed in the Pillar III report. Both methods can be used
independently or in association. We favour a combination of the two methods even if we are aware that not
every bank publishes a Pillar III report.
The first method and simpler one, consists in examining the cost of risk history of the bank on a five- to tenyear view so as to capture the provisioning level over the cycle and, if possible, over several cycles. While doing
this analysis it is possible to identify a mid-cycle cost of risk level, which is the point where the loss trends of a
banks loan portfolio tend to normalize.
The task will therefore consist in identifying where the bank positions itself at any given point in time vis--vis
this mid-cycle cost of risk. An important point is also to determine the past peak-to-trough costs of risks and to
determine to which extent the current cycle is similar or different to past ones.
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In this first way of forecasting cost of risk, the analysts judgment is quite critical to the overall assessment. For
example, and based on Figure 24, it seems that the trough-to-peak variation of Bank XYZs cost of risk (from
virtually zero to 2%) is quite extreme and reflect an important deterioration from a situation that was probably too
benign to begin with. The likelihood of such a credit cycle repeating itself as such will be a function of different
variables, including loan growth, LTVs, the banks credit policy, the macro-economic environment, etc.
The second method and more comprehensive way to forecast the cost-of-risk properly is to include an
analysis of the LGD (Loss-Given Default) and PD (Probability of Default) across different parts of the loan book.
This can only be done for banks reporting Pillar 3 reports among their public disclosure.
LGD is the percentage of loss over a total exposure when the counterparty of a bank defaults. The estimate of a
banks total exposure to a specific counterparty at the time of default of this counterparty is known as EAD
(Exposure at Default). LGD can be calculated easily as Losses % EAD. So typically if we assume that the client
of a bank defaults and that at the moment of default, the EAD was estimated at 1,000,000, and if we also
assume that the bank manages to sell the collateral attached to this transaction for 350,000, the LGD stands at
65%:
(1,000,000-350,000)/1,000,000.
The LGD depends fundamentally on the LTV if the loan is a mortgage. Collateral analysis is very important and
so is covenant analysis for types of corporate loans. Consumer loans tend to be uncollateralized.
PD measures the likelihood of default of a counterparty over a particular time horizon. The PD is a metric that
can be assessed with historic data. Keeping the same example as the counterparty mentioned above, the
default probability of the counterparty is assessed at 25%.
As mentioned above, the best place to source PDs and LGDs is the Banks Pillar 3 report, as the RWA
calculations under Internal Ratings-Based approach (IRB) depend on the Expected Loss (EL) the company
assigns to the various portions of its loan book. The EL is defined as LGD x PD.
In our example above, the EL on our 1,000,000 transaction would be: 65% x 25% = 16.25%.
Since the models used under IRB are internal, they are based on the companys own credit history. It is
therefore a good idea to cross check EL across banks with similar books in similar geographies and check for
inconsistencies or similar ELs.
Finally, Basel 3 (see Figure 46 below) requires banks to publish the difference between their provisions and the
ELs as per their IRB methods. Some companies post severe differences between both metrics, which is a good
indicator as to where the cost of risk may be headed in the future.
In that context, XYZ had virtually zero cost of risk five years ago but this metric deteriorated sharply and after
having reached mid-cycle in the course of Y-3, the asset quality of XYZ deteriorated and its cost of risk soared
to a severe 2% in Year Zero.
Considering the credit cycle history of XYZ and a thorough analysis of the ELs, PDs and LGDs through its Pillar
3 report, and also considering a more benign credit quality environment as well as sustained GDP recovery in
all the countries in which XYZ is operating, XYZs credit quality should start improving. This is also confirmed by
management guidance. What we do not know is the degree of improvement from one year to another. We
model the following:
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Figure 25: Past, present and future cost of risk of XYZ Bank
2.50%
2%
2.00%
1.50%
1.35%
1.25%
1.00%
0.80%
0.75%
0.50%
0.50%
0.50%
0.25%
0.02%
0.00%
Y-5
Y-4
Y-3
Y-2
Y-1
Year 1
Year 2
Generally and historically for a bank, a cost of risk of 1% is quite bad (except for consumer lenders, which have a
structurally higher cost of risk). At 2% or above it is catastrophic. So our modelling of a mild decrease until getting
to top-of-mid-cycle number in Y+2 is conservative enough in our view, as demonstrated by Figure 25.
Adding this metric to our XYZ P&L enables us to bring the operational P&L to a close and present a pre-tax
profit (PTP) forecast.
Bar the cost of risk, the only additional line to forecast in the PTP is the Income from associates share of the
results of companies in which the bank has a significant interest. Assuming the perimeter of the group stays the
same from one year to another, this line should be assumed to grow by the estimated profit growth of the
consolidated companies. As one can imagine, this growth can be very different depending on the sector and the
country in which the consolidated company operates. For simplicity reasons, we assume this contribution to be
flat at XYZ.
Stage 1: as soon as a financial instrument is purchased or originated, 12-month expected credit losses are
recognised in profit or loss and a loss allowance is established.
Stage 2: if the credit risk increases significantly and the resulting credit quality is not considered to be low
risk, full lifetime expected credit losses are recognized.
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Stage 3: If the credit risk of a financial asset increases to the point that it is considered credit-impaired,
interest revenue is calculated based on the amortised cost (i.e. the gross carrying amount adjusted for the
loss allowance).
Stage 2
Stage 3
Lifetime
expected credit
losses
Lifetime
expected credit
losses
Effective interest
on gross carrying
amount
Effective interest
on amortised
cost
Impairment recognition
12-month
expected credit
losses
Interest revenue
Effective interest
on gross carrying
amount
Source: IASB
The impairment requirement does not change the value of a company nor the asset quality of the portfolio, but
the loss recognition is front-loaded up to a point that it is not a loss recognition at all but more a small probability
of default that has to be accounted for (Stage 1). Judgment also has to be used in the course of Stage 2 as the
credit risk of the instrument has to increase significantly and the resulting credit quality is not considered to be
low credit risk. However, the instrument in stage 2 and 3 may not be impaired. By the time the instrument is
impaired (Stage 3), the marginal provisioning should be limited and only the accounting of revenues is
amended. Therefore, by the time a portfolio gets to Stage 3, there is probably a point where a lot of reversal
would take place (to acknowledge the fact that Stage 1 provisions were not necessary after all) while the
deterioration of credit quality will already have been recognised by Stage 2.
The pro-cyclicality of this method would probably smooth the provisioning of banks over the cycle but it would
also, in our view, make the credit cycle less identifiable by accounting disclosure and therefore could alter
analytical judgment over the credit quality of a bank.
Accounting regarding impairments may therefore become a little less important in the bank rating process than
other fixed data points (from the ECB AQR, the EBA stress test, etc).
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Current Year
Year 1
Year 2
Interest income
10.33
10.09
10.22
10.55
Interest expense
-6.00
-6.59
-6.45
-6.45
4.33
3.50
3.77
4.10
1.50
1.50
1.50
1.58
Trading gains
1.00
1.00
0.80
0.84
Insurance income
0.50
0.44
0.45
0.48
Other income
0.25
0.25
0.25
0.25
7.58
6.69
6.77
7.25
Personnel expense
-4.10
-3.90
-3.87
-3.66
-1.80
-1.70
-1.67
-1.56
-0.30
-0.30
-0.30
-0.30
-6.20
-5.89
-5.84
-5.52
1.38
0.80
0.92
1.73
-1.95
-1.35
-0.81
-0.52
0.25
0.25
0.25
0.25
-0.32
-0.30
0.36
1.46
As we can see, as a result of sharply deteriorating asset quality, XYZ has reported a pre-tax loss in Year Zero.
Despite an improvement in asset quality this Current Year, the bank will in our view continue to be loss-making,
because of weaker revenues. The improvement in profitability should be most visible in Year 2 because of the
impact of the cost-cutting program.
The below-the-line block
This important block is divided in three major components:
The non-recurring items;
The income tax;
Minority interest
Non-recurring items
Under IFRS, there is not really any non recurring below-the-line reporting, while under US GAAP both
exceptional items and extraordinary gains/losses are allowed. There are many non-recurring items to be
identified in a banks P&L and usually analysts are dependent on the banks willingness to identify these items
and communicate on them. They are usually restated from regular revenue and costs lines where they have
to be for accounting purposes, and it is the job of the analyst to restate them below the (pre-tax) line for
analytical purposes.
The most important ones are:
Capital gains (on property or on equity stakes). In that particular case, capital gains on trading or AFS assets
are usually considered as part of the day-to-day operations and are reported in trading gains in the P&L. Nonrecurring capital gains on large properties or on long-term investments are considered non-recurring and
therefore should be restated below-the-line. For example, if XYZ sells its 18% stake in a consumer finance
business, it will appear as revenue, but should be restated below the line. A capital gain (or loss) on a T-bill held
at market value is definitely a trading gain (or loss), and should remain a recurring item.
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These non-recurring capital gains are generally impossible to forecast, except when and if they are well-flagged
by the company. They only appear in analysts forecasts for the Current Year in which they have been
announced. So if the sale of that subsidiary was announced in Q1, then it would remain as is for the full year. In
the context of XYZ, the sale of the subsidiary brings a capital gain of 0.6 in the Current Year. There were none
announced in Year Zero we assume none realised in Years 1 and 2.
Restructuring charges. The second most important position among below-the-line items is restructuring
charges. Restructuring charges usually appear as an expense (cost) but they have to be restated from the
regular costs as restructuring charges, and therefore as one-offs. These charges are here to make a cost
savings plan possible, and they represent the costs of this savings program (in particular costs attached to
redundancies etc.). Usually, they represent between 70% and 100% of the achieved cost savings. They can be
accounted for as one-off, but more and more accounting rules demand that the charges be allocated as and
when the cost savings are taking place, so that restructuring charges can take several years to be accounted
for.
To come back on the very specific example of XYZ, we remember that the bank has a cost-savings program of
0.93 to be completed in YEAR 2. We assume for the purpose of this exercise, that to complete the plan XYZ will
have to recognize 0.7 of restructuring charges.
We also assume that these restructuring charges will be recognized proportionately to the implementation time
of the cost savings program, so 33%-66%-100% for Current Year, Year 1 and Year 2 respectively, so it means
charges of roughly 0.23 every annum.
Credit Valuation Adjustments/Debit Valuation Adjustments/Funding Valuation Adjustments (CVA/DVA/FVA).
Simply put, credit valuation adjustment is the amount subtracted from the mark-to-market value of a derivatives
position to account for the expected loss in case of counterparty defaults. For example, if Bank XYZ has
contracted a CDS on a large corporate with Bank ABC, the value of the derivative will have to take into account
the probability of ABC defaulting (and not just the credit fundamentals of the large corporate). In this case, the
CVA will be deducted from the value of the derivative, to reflect the possibility of ABC collapsing. But a trade is a
two-sided story and XYZ will also have to take into account its own creditworthiness to calculate the value of the
derivative properly. In the case of XYZ, the bank, both in Year Zero and in the Current Year, will have recorded
positive DVA gains on the basis of its deteriorating credit position.
While the bank has to recognize a loss reflecting the credit risk of the counterparty (CVA), it is also required by
the regulator to deduct all DVAs from its Common Equity Tier 1 capital.
FVA is a related concept. Traditionally, valuation methodologies employed for derivatives reflect the value of
cash-flows discounted by credit risk and funding cost. FVA is a parameter that integrates funding costs in the
valuation of uncollateralized derivatives. Again, we consider CVAs, DVAs and FVAs as below-the-line items
since they reflect very volatile items that are representative of a perception of a credit risk and only cover the
length of a particular trade.
Goodwill impairment. As the goodwill has to be submitted to impairment tests every annum, effective
impairments are not that frequent, except when market values end up being materially lower than the values at
which the goodwill is booked. Considering its non-recurring aspect, goodwill amortization definitely belongs
below the line.
However, a particular attention should be given to an item called Purchase Price Allocation (or PPA). Following
an acquisition, the excess purchase price paid over the net assets of an acquired company is usually (and
confusingly) called goodwill. In reality, there are two components to this goodwill.
First, the comparison between the identifiable fair value of assets and liabilities purchased and the book value of
these assets. For example, if we assume that a bank has paid 100 for the purchase of a company with net
assets of 20, the acquirer has to identify as much as possible the component of the excess 80. After careful
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auditing and valuation of the assets of the purchased company, the company certifies that about 35 can be
attributed to the fair value of property, plant, equipment, securities and identifiable intangible assets (such as
brand/trademark, technology, workforce..). This identified 35 is called Purchase Price Allocation.
The second, unidentified portion of the purchase price in excess of the net assets of the acquired company is
the goodwill proper.
This means that the 100 purchased price of the acquired company can be broken down between: (1) the reported net
assets of the company (20); (2) the PPA or identified intangibles (35); and (3) the goodwill proper (45).
It is very important to identify PPAs because the PPAs are amortisable over the life of the identified assets (no
more than ten years), while the goodwill is not (and is just annually tested for impairment).
Even if we do not plan to forecast any PPA for Bank XYZ, it is important to know about it as the amortization of
PPA can represent a sizeable non-cash charge to the P&L account. Conversely, if a bank has purchased a
company for less than its net assets, the acquirer will have to recognize a positive item (sometimes very
sizeable) to the P&L, which will artificially boost the results of the acquirer.
Figure 28: "Blow-the-line block" - non recurring items - Bank XYZ
Year Zero
Current Year
Year 1
Year 2
Capital gains
0.0
0.6
0.0
0.0
Restructuring charges
0.0
-0.24
-0.23
-0.23
CVA/DVA gains/losses
0.6
0.4
0.0
0.0
0.0
0.0
0.0
0.0
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Minority interests. In theory, the minority interests should follow the trend of the profitability of the company as a
whole; therefore proxying the pre-tax profit growth of the company as a whole to this line makes sense unless
the analyst benefits from divisional minority interest disclosure.
We are now ready to present Bank XYZs full P&L for the Year Zero-Year 2 time period.
Figure 29: Full Profit & Loss account forecasts of Bank XYZ
Year ZERO
Current Year
Year 1
Year 2
Interest income
10.33
10.09
10.22
10.55
Interest expense
-6.00
-6.59
-6.45
-6.45
4.33
3.50
3.77
4.10
1.50
1.50
1.50
1.58
Trading gains
1.00
1.00
0.80
0.84
Insurance income
0.50
0.44
0.45
0.48
Other income
0.25
0.25
0.25
0.25
7.58
6.69
6.77
7.25
Personnel expense
-4.10
-3.90
-3.87
-3.66
-1.80
-1.70
-1.67
-1.56
-0.30
-0.30
-0.30
-0.30
-6.20
-5.89
-5.84
-5.52
1.38
0.80
0.92
1.73
-1.95
-1.35
-0.81
-0.52
0.25
0.25
0.25
0.25
-0.32
-0.30
0.36
1.46
Capital gains
0.00
0.60
0.00
0.00
Restructuring charges
0.00
-0.24
-0.23
-0.23
CVA/DVA gains/losses
0.60
0.40
0.00
0.00
0.00
0.00
0.00
0.00
Income taxes
Minority interest
TOTAL NET ATTRIBUTABLE PROFITS
0.00
0.15
0.00
-0.21
-0.05
-0.05
-0.10
-0.25
0.23
0.56
0.03
0.76
This mock P&L of a completely made-up bank is enough to reflect the difficulties of bank analysis in general and
bank forecasting in particular.
On the basis of our forecasts, the underlying fundamentals of XYZ should improve. At the same time though,
the net attributable profit of the company tells a completely different story. A net profit of 0.23 in Year Zero more
than doubles to a profit of 0.56 in the Current Year but falls to virtually zero in Year 1. In reality we know that in
the Current Year the revenue environment should be weaker than in Year Zero and with loan losses remaining
high, it is only through non recurring items (capital gain of 0.6 and CVA/DVA gain of 0.4) that XYZ can report a
post-tax profit (while the bank was loss-making at pre-tax level).
It is really at the end of Year 2 that we are expecting XYZ to significantly improve its profitability and report a net
profit at least in line with its improving operating trends (the cost-cutting plan and decreasing provisions in
particular).
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Wrapping-up the forecasts: adjusting the balance sheet for earnings and distributions
After having forecast the P&L in some detail we are now ready to complete the balance sheet forecasts of XYZ.
To do this, we need to increase (or decrease) the capital base of XYZ by the amount of net attributable profit (or
loss) reported for the year, MINUS the dividend distribution for the year, MINUS the AT1 coupons when paid out
of net profits MINUS the share buy backs completed by the bank in the course of the period under review, PLUS
the portion of the dividend that the company will have decided to pay in scrip.
From the historic position of Year Zero - when the bank decided to pay no dividend in light of its operating
losses, we assume that XYZ will want its shareholders to benefit from the capital gain on the sale of the
consumer credit business in the Current Year. If we assume XYZ will distribute 50% of the pre-tax capital gain
this represents a dividend of 0.3. Out of a net attributable profit of 0.56, this is a pay-out ratio of 54%.
Despite being just breaking even in Year 1, we will assume that XYZ will still want to reward its shareholders for
their loyalty that year, with another dividend of 0.3 (the payout this time is a multiple of the net profits). With the
strong recovery in Year 2, XYZ should also manage to maintain the payout at an absolute level of 0.3,
representing a payout ratio of 39%.
We note it is important to forecast the expected payout of the company as it enables the credit analyst to
forecast the retained earnings and therefore properly assess the shareholders equity base of a bank arguably
a cornerstone of bank credit analysis.
We adjust the asset side of the balance sheet with the cash position of the bank, to make sure that assets and
liabilities remain perfectly balanced.
Figure 30: Balance sheet Bank XYZ Year Zero
Assets
Cash
25
Customer deposits
100
20
80
Government Bonds
85
CDs
95
Other Bonds
65
15
subordinated debt
10
Derivatives (obligations)
85
Equities
Total Loans
30
100
Derivatives (rights)
80
20
Technical provisions
20
10
Other assets
Other provisions
Equity-accounted investments
Other liabilities
Intangible assets
Total Liabilities
423
Goodw ill
Shareholders' Equity
20
Fixed assets
Total Assets
443
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Figure 31: Balance sheet Bank XYZ Current Year final
Assets
Cash
31.3
Customer deposits
105.0
20.0
72.0
Government Bonds
72.3
CDs
80.8
Other Bonds
58.5
18.0
Equities
30.0
subordinated debt
10.0
Total Loans
100.0
Derivatives (obligations)
79.2
Derivatives (rights)
74.5
3.0
16.0
Technical provisions
17.4
Other assets
5.0
Other provisions
10.0
Equity-accounted investments
2.0
Other liabilities
5.0
Intangible assets
2.0
Total Liabilities
400.3
Goodw ill
7.0
Shareholders' Equity
20.3
Fixed assets
2.0
Total Assets
420.6
420.6
Cash
32.7
Customer deposits
107.1
20.0
70.4
Government Bonds
72.3
CDs
80.8
Other Bonds
58.5
21.6
Equities
32.1
subordinated debt
8.0
80.6
Total Loans
102.5
Derivatives (obligations)
Derivatives (rights)
75.8
3.0
12.0
Technical provisions
17.4
10.0
Other assets
5.0
Other provisions
Equity-accounted investments
2.0
Other liabilities
5.0
Intangible assets
2.0
Total Liabilities
403.8
Goodw ill
7.0
Shareholders' Equity
20.0
Fixed assets
2.0
Total Assets
423.8
423.8
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Figure 33: Balance sheet Bank XYZ Year 2 final
Assets
Cash
23.7
Customer deposits
110.3
20.0
71.0
Government Bonds
75.0
CDs
75.0
Other Bonds
60.0
23.0
Equities
35.3
subordinated debt
6.0
Total Loans
106.1
Derivatives (obligations)
83.9
Derivatives (rights)
79.0
3.0
8.0
Technical provisions
17.4
Other assets
5.0
Other provisions
10.0
Equity-accounted investments
2.0
Other liabilities
5.0
Intangible assets
2.0
Total Liabilities
404.7
Goodw ill
7.0
Shareholders' Equity
20.5
Fixed assets
2.0
Total Assets
425.1
425.1
We can see that because of a structurally low profitability and a generous dividend distribution, the
shareholders equity of XYZ does not increase much and grows from 20.0 to 20.5 in four years, a limited CAGR
of 0.8%.
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Revenues
Costs
Loan loss charges
Pre-tax profits
Some banks provide an individual divisional tax rate. Some allocate directly the taxes and the minority interest
to the unallocated portion of the P&L, also known as the corporate centre.
Some banks segregate their business geographically. Some others segregate by businesses. Some banks give
a minimum breakdown of two very generic business lines while others split their businesses in ten or twelve
different business lines.
Some others even present a matrix-based approach of their financials between geographies and individual
business lines.
Divisional balance sheet 1.0
Generally, the information provided on business lines is sufficient to forecast divisional profitability, but it
becomes way too insufficient at balance sheet level. If a bank provides the capital allocated to each business
line, this in turn helps the analyst determine risk-weighted assets (RWAs) by division. This assumes that the
bank provides the normative common equity Tier 1 on which the allocation is based.
For example, if a bank has two business lines, and we know through public disclosure that the first one is being
allocated a CET1 of 3 and the other one a CET1 of 2, it is easy to calculate the RWAs if the normative CET1
ratio of the bank for the purpose of allocating capital to business lines is 10%. The divisional RWA will be 30
(3/10%) and 20 (2/10%) respectively.
At times, it is nonetheless helpful to have more than the allocated capital as a balance sheet metric for divisional
analysis. Some banks are very good at disclosing divisional balance sheets, while some others are more
reluctant. For the latter, a possible proxy for determining divisional assets lies in analysing the RWAs % Assets
ratio. The analyst should use the RWA % Assets ratio of the last reported period to forecast total assets on the
basis of RWA levels.
Some banks publish their loan book by division. In this case, it can be more practical (and more accurate) to use
the RWA % Loans ratio, also because the bulk of RWAs are credit risks, and therefore tied to the loan book to a
large extent.
To come back to our earlier example we have shown that the two business lines of the bank we used as an
example have estimated RWAs of 30 and 20 respectively. If the ratio of RWAs % Assets stood at 33% on the
last reported quarter, then the total assets of both divisions should be 30/33% and 20/33%, so 91 and 61
respectively.
Sometimes an allocated capital number is the only information available to an analyst to make divisional
balance sheet forecasts and in this case, total assets or total loans are the only balance sheet metrics that
can be assessed with a minimal degree of comfort.
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When and if banks make more information available, then the divisional balance sheet should be forecast via
the same methodology that we used in the balance sheet section of this methodology.
Divisional profitability forecasts
First of all, it is important to identify the different business lines. For convenience purposes, we shall use the
main business lines contained in Scopes bank rating methodology:
We will add also the Corporate Centre/Unallocated items to the forecasts methodology. We could have added
a specialised lending division but to be fair these businesses (mortgage lending, consumer lending, leasing)
are all derivatives of the RCB business, with more wholesale funding and different cost of risks patterns but the
fundamentals and forecasting aspects are broadly similar.
Figure 34 presents the divisional P&L and allocated capital presented by Bank XYZ in Year Zero.
Figure 34: Divisional profitability of Year Zero- Bank XYZ
dRCB
Revenues
Costs
Pre-provision profits
Provisions
Associates
Pre-tax profits
Other
fRCB
WAM
WIB
Unallocated
/corporate
centre
2.50
1.10
1.40
2.00
0.58
7.58
-1.95
-0.88
-0.98
-1.40
-0.99
-6.20
0.55
0.22
0.42
0.60
-0.41
1.38
-1.00
-0.70
0.00
-0.25
0.00
-1.95
0.00
0.15
0.05
0.00
0.05
0.25
-0.45
-0.33
0.47
0.35
-0.36
-0.32
0.00
0.00
0.00
0.00
0.60
0.60
0.00
0.00
-0.05
-0.05
Taxes
Minority interests
Net attributable profits
Allocated capital
Total
0.23
7.00
3.00
1.00
7.00
2.00
20.00
400.00
Cost-income ratio
78%
80%
70%
70%
171%
82%
-4%
-7%
31%
3%
-12%
-1%
dRCB
If anything, the forecasts attached to the domestic retail banking operations are the ones that are the most
closely replicable to the work we have done for the P&L as a whole in an above section. Usually, the bank will
provide a breakdown of its loan book (mortgage loans, consumer loans, etc.).
There will also be a breakdown of revenues (between net-interest income, non-interest income and sometimes
trading gains but it is likely that the trading in this context reflects pure retail-based execution).
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In the context of Bank XYZ, we have assumed that the deposit war that we alluded to at the beginning of this
report created a 10% revenue fall in dRCB revenues between Year Zero and the Current Year. At the same
time, we have acknowledged the cost savings that the division benefitted from on the basis of the restructuring
plan. Also, we have included in our forecast the proportion of the restructuring charges that we believe are
allocated to this division.
Lastly, a thorough examination of the cost of risk of the division based on the provision history of the division
has enabled us to assess the potential level of loan loss charges in the Current Year, Year 1 and Year 2.
fRCB
Foreign Retail banking again will follow the same analytical pattern as dRCB, with similar disclosure. However,
depending on the markets, the growth rates and the cost of risk will be different. It is frequent in emerging
market economies to post rapid revenue growth rate, but also important cost growth rates, in particular if the
inflation rate in a given economy is high. Costs of risk will tend to be higher and more volatile, while cost-income
ratios will tend to be lower than in mature economies.
As we stand, we have defined XYZ as a bank that was mainly operating in three/four mature/developed
economies. We therefore do not believe that revenue growth expectations should be held up too highly.
Conversely, also because of a high cost-income ratio, we have assumed that the fRCB division would also be
benefitting from the restructuring plan announced at group level. Therefore we are forecasting that about 38% of
the restructuring costs of the plan should be allocated to the fRCB division based on company guidance.
As XYZ applied a similar deposit policy at home and abroad, we have assumed a 4.5% decline in revenues in
the Current Year, followed by roughly a 3% revenue growth in Year 1 and Year 2 respectively. We expect the
cost of risk to experience a steady decline, in line with our analysis at group level.
WAM
Wealth and Asset Management (WAM) covers four different businesses, each one needing a specific forecast
approach:
Asset Management;
Wealth management and private banking;
Custody/Asset administration;
Insurance (life and non-life).
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an advisory mandate, which itself will be more active than a discretionary mandate. As a result, a brokerage
mandate will be low-margin, while a discretionary mandate is a high-margin product. There is a narrow
positive correlation between the workload and the responsibility of the bank on one given mandate, and the
margin.
Foreign-exchange income is also a very important component of private banking revenues considering that
world-wide clients will transact in a limited number of core currencies.
Historically, private banking margins have proven to be extremely stable with some recent exceptions linked to
the de-risking of private client portfolios post the crisis, and for some very specific countries, the pressure on the
banking secrecy which used to warrant a premium margin.
Nonetheless, the key variable for a reliable forecast of the gross margin remains the total assets under
management (AuMs).
As Figure 35 demonstrates, the assets under management at one given time can be determined as follows:
The above determination of AuMs is valid for both private banking and asset management. Looking at each item
individually:
The net new money inflows (or outflows) are a function of the franchise of the company, and its strength at one
particular moment in time. Usually, pricing is not a key determinant of money flows, but rather the track record of
the bank over a long period of time, its reputation and the market performance of the different portfolios.
Reputation aspects tend to be more important as a flow factor in private banking than in asset management.
The market performance is a reflection of the outlook that the analyst has on different asset classes (bonds,
money-market funds, equities, alternative assets, property). Recently, in light of very volatile markets, market
performance has been the main driver of AuMs. In more stable market, usually net new money can become an
important driver of AuM trends. Forecasting market performance for one given portfolio can be made easier if
the bank discloses the asset allocation of its different portfolios. When this is not the case, the forecast has to be
more approximate.
Foreign exchange movements are important, particularly vis--vis the reporting currency of the bank under
review. For a bank reporting in EUR, if the bulk of its AuMs are labelled in USD and if the USD weakens
significantly versus other major currencies, the assets under management of the bank will look weaker in EUR
than they would be in USD.
Figure 35: AuM growth XYZ Year Zero to Year 2
Current Year
Y1
Y2
BOY AuMs
400.00
344.81
352.40
-60.00
0.00
10.57
340.00
344.81
362.97
11.10
7.59
17.88
-6.29
0.00
18.78
344.81
352.40
399.63
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For the purpose of this exercise we will assume that XYZ has no insurance business and that its WAM business
is a combination of Asset Management and Private Banking. To take the example of Bank XYZ and starting
from a position of total AuMs of 400 in Year Zero. In the Current Year, XYZ has ben pretty vocal about
significant client outflows following the bad performance of a discretionary portfolio. The bank made clear that its
WAM division would lose 15% of its assets in the course of the year. At the same time, capital markets
improved a little bit and we believe that XYZ will record a performance of 3% in the course of the Current Year
(amalgamating the estimated weighted-average asset class performance of all the portfolios). Lastly, let us
assume that economists are forecasting a marginal decrease of the value of the USD versus XYZs local
reporting currency and, as it happens, a lot of XYZs assets are accounted for in US dollar.
Figure 36: Assumed gross margin XYZ
0.36%
0.35%
0.35%
0.35%
0.34%
0.34%
0.34%
0.33%
0.33%
0.33%
0.32%
0.32%
0.32%
0.31%
Year Zero
Current Year
Year 1
Year 2
In Year 1 (and following company guidance), we believe that the outflows will have stopped but that XYZ will not
be able to collect new clients. At the same time, market performance should continue steadily (at +2%) while we
do not expect severe F/X changes. Altogether, XYZs AuMs should be up 2.2% versus the Current Year, to 352.
For Year 2, it is assumed that net new money should start improving with a collection of 11 (so about +3%)
while market performance should accelerate (+5%). Part of this gain is compound by a positive 5.25% forex
effect, due to an expected strengthening of the USD against XYZs reporting currency. AuMs are therefore up
by a healthy 13% in Year 2 to 399.6 almost back to Year Zero level despite the loss of the mandate. This
example shows that forex movements can have a distorting impact on the performance of an asset
management division.
Once the work on the AuMs is done, there is not much to do on the revenue side: the margin on AuMs stood at
35bps in Year Zero. We assume that with the loss of high-margin portfolios, the gross margin level on average
AuMs will have declined by about 3bps in the Current Year, before stabilising at around 33-34bps in Year 1 and
Year 2. As one can see, we do not expect strong margin volatility for XYZ. The lower margin in Year 2 is due to
the fact that the revenues in Year 2 do not fully capture the net new money growth in Year 2 yet, nor the inflated
F/X impact.
As for the costs, it all depends on the model under which the bank operates. In private banking, brokeragebased models (i.e. models where the bulk of the revenues are generated by client transactions) tend to post
higher cost-income ratios than advisory-based models (where the bulk of the revenues are made of
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management fees). Indeed, brokers tend to be compensated on the basis of generated income, which triggers
higher cost bases.
After an acceptable cost-income ratio of 70% in Year Zero, we would assume that in the Current Year, XYZ
will not be interested in adjusting its cost base yet on the basis of its willingness to hang on to its remaining
market shares. But following another moderately successful year in Year 1, we would expect the bank to start
cutting costs in Year 2.
WIB
With WAM, WIB (Wholesale & Investment Banking) is the only division where the forecasts rules are slightly
different from the regular bank forecasts that we have already expanded on. Effectively, WIB can be broken
down in two different sub-business lines:
Corporate banking
Advisory & Capital Markets
Corporate Banking is arguably a banking business which is very similar in methodology to the Retail Banking
business. In both cases, the businesses are quite balance-sheet intensive (since they both include loans), they
both are in part funded with deposits (corporate deposits are more volatile than retail deposits), and there are
also specific corporate costs of risks, depending on specific business cycles. The revenue structure will also not
be dissimilar, with net interest income and fees representing the bulk of the income in this division.
Advisory & Capital Markets is a completely different activity mix as it encompasses businesses that are either
less capital-intensive (advisory does not necessitate any allocated capital) or very demanding in regulatory
capital (like Fixed Income, Currency & Commodities (FICC) businesses).
Advisory and Capital Markets can be further divided between:
Primary business
o Advisory/M&A;
o Equity capital markets (ECM);
o Debt capital markets (DCM);
Secondary business
o Equities trading;
Cash Equity
Equity Derivatives
Prime Brokerage
o Fixed-Income, Currency & Commodities (FICC) trading;
Rates;
Credit;
Structured Products;
Currency
Commodities
The ranking of the five Advisory & Capital Markets divisions as spelled out above can be read from least
capital intensive to most capital intensive.
While Advisory/M&A is just what it says, ECM and DCM are more capital intensive as the bank can commit to
underwrite some of the issues it manages until they are sold to the marketplace.
Equities trading is not a very capital intensive business, except for prime brokerage, where the bank can be in a
position to offer financing.
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Overall, the vast majority of the allocated capital of the Advisory and capital markets sub-division can safely be
said to be allocated to FICC. This assumption tends to make the forecasting work a bit easier.
Indeed, it is usually impossible to get to a level of granularity that would enable the analyst to analyse in detail
every sub-division of the Advisory and Capital Markets division. Therefore the forecast work is usually limited
to three large revenue blocks:
Investment Banking (combination of Advisory, DCM and ECM);
Equities trading;
Fixed-Income trading.
So overall, Bank XYZs WIB division as a whole would look like this:
Figure 37: WIB breakdown Bank XYZ Year Zero
Corporate Bank
Corporate Bank Revenues
TOTAL
0.60
0.60
0.20
0.20
0.40
0.40
0.80
0.80
Revenues
Costs
Pre-provision profits
Provisions
0.60
1.40
2.00
-0.30
-1.10
-1.40
0.30
0.30
0.60
-0.25
0.00
-0.25
Pre-tax profits
0.05
0.30
0.35
Allocated capital
2.50
4.50
7.00
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extent, offset this phenomenon since they are higher-margin businesses but the growing importance of CCPs
for the clearing of OTC derivatives cannot be good news for future margins of equity derivatives.
Therefore Equity revenue margins should in theory decline but as this business is an intensely volume-driven
business, revenues are likely to be very cyclical.
Fixed Income Trading revenues are even more difficult to capture than equities because the underlying asset
classes are very different: bonds, interest rates-swaps, CDSs, currency, commodities. Fixed income instruments
are also, by their nature, very fragmented, which means that the idea of one integrated global fixed income
market (like the cash equity market for example) is an impossibility. Therefore, a lot of the transactions will be
done OTC, implying that margins are higher. Capital costs are also higher as banks can maintain fixed-income
instruments in inventory as the liquidity of each instrument is limited.
This added complexity is also an advantage, as the capital intensity means that returns can be calculated. If
returns can be calculated, they can be compared over different past cycles, and therefore they can be replicated
in the future even if there is a fair share of volatility in this market.
If we come back to some of the assumptions we made on the divisional balance sheet, we assume that the
allocated capital of the Advisory & Capital Markets division is benchmarked against a core Equity Tier 1 of 10%.
Therefore for the A&CM division, the corresponding RWAs amount to 45 in Year Zero (4.5/10%). If, as we also
said in this section, the RWA % Assets stand at 33%, then we can proxy that the total assets of the A&CM
division stand at 136 (45/33%).
If we now assume that the totality of this capital is allocated to FICC trading (not a bad assumption considering
the capital intensity of that business), then we can deliver an estimated FICC return. At Year Zero, for Bank
XYZ, the gross income return on assets will be: 0.80/136 = 0.59%.
While the gross margin on a Private Banking or an Asset Management business can be compared throughout
the industry (as the reporting and the accounting are reasonably homogeneous), it would be quite dangerous to
do the same with the FICC gross margin, as the internal models that are used to determine the risk-weights of
FICC assets are vastly different from one bank to the other. However, such a number will be helpful to
determine trends within one bank (assuming that the bank has not too materially changed its internal modelling
from one year to another - and this can be seen through the RWA % Assets ratio).
We have imagined Bank XYZs historical FICC margin over the last five years (finishing with Year Zero). Maybe
this trend will help us figure out what is coming next for XYZs FICC margin.
Figure 38: FICC margin Bank XYZ, last five years
2.50%
1.95%
2.00%
1.50%
1.50%
1.00%
1.00%
0.59%
0.50%
0.50%
0.00%
0.00%
Y-5
Y-4
Y-3
Y-2
Y-1
Year Zero
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As we can see in Figure 38, the FICC margin of XYZ has shown considerable volatility and this type of
volatility is extremely difficult to duplicate when one makes FICC forecasts. To be fair, a very well-guided
monetary environment where any suggestion of interest rates going up is carefully prepared and communicated
to the widest possible audience, should reduce FICC volatility. At the same time, the simple idea of tapering
created some notable volatility on FICC businesses world-wide in the summer of 2013 showing that managing
the impact of monetary policy on banks profit and loss accounts is as much an art as it is a science.
On the cost side, an important aspect of the Advisory & Capital Markets business is the level of
compensation. For some banks where WIB operations are important, personnel expenses are disaggregated.
Issues around non-cash based compensation and deferred compensation have to be addressed and the ratio of
compensation expenses % income can be analysed in more detail.
For the purpose of this report though, we will stick to the cost-income ratio at divisional level.
Obviously, there are (theoretically) no loan loss provisions for investment banks but often securities impairments
will be recorded on this line.
We are now ready to prepare forecasts on Bank XYZs WIB division.
Figure 39: WIB breakdown Bank XYZ Current Year
Corporate Bank
Corporate Bank Revenues
TOTAL
0.60
0.60
0.20
0.20
0.40
0.40
0.80
0.80
0.60
1.40
2.00
-0.30
-1.10
-1.40
Revenues
Costs
Pre-provision profits
0.30
0.30
0.60
-0.15
0.00
-0.15
Pre-tax profits
0.15
0.30
0.45
Allocated capital
2.50
4.80
7.30
Provisions
TOTAL
0.62
0.62
0.18
0.18
0.34
0.34
0.62
0.62
Revenues
0.62
1.14
1.76
-0.34
-1.19
-1.53
Pre-provision profits
0.28
-0.05
0.23
Provisions
0.09
0.00
0.09
Pre-tax profits
0.37
-0.05
0.32
Allocated capital
2.50
4.50
7.00
Costs
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Figure 41: WIB breakdown Bank XYZ year two
Corporate Bank
Corporate Bank Revenues
TOTAL
0.65
0.65
0.18
0.18
0.60
0.60
0.70
0.70
0.65
1.48
2.13
-0.36
-1.09
-1.45
Revenues
Costs
Pre-provision profits
0.29
0.39
0.68
-0.02
0.00
-0.02
Pre-tax profits
0.27
0.39
0.66
Allocated capital
2.50
4.50
7.00
Provisions
Corporate bank forecasts: The Current Year shows no revenue progression versus Year Zero considering that
XYZ has decided to reduce its loan growth following difficult years, as we have explained in the first part of this
methodology. This restrictive policy has been applied to all the divisions of the banks, not only dRCB and fRCB.
Following the Current Year, Year 1 and Year 2 show revenue growth that is in line with the growth of the loan
book (+3.5% to +4% respectively). We have kept the cost income ratio unchanged at 50% in the course of the
Current Year, but have considered that increased market shares in Year 1 and Year 2 would be funded by a
faster expense growth, hence the cost income ratio growing to 55% in these two years. Lastly, in light of a
strongly improving credit situation on the corporate side, we have lowered the cost of risk of XYZ from a high
level in Year Zero to virtually zero in Year 1 and Year 2 (including even net releases in Year 1).
Advisory & Capital Markets forecasts: Management made clear that in the Current Year the Advisory &
Capital Markets revenues would be in line with Year Zero. Considering that the allocated capital to the division
is slightly higher in the Current Year than in Year Zero we choose to slightly decrease the gross FICC margin of
XYZ to offset the impact of the higher capital and therefore maintain FICC revenues stable.
In Year 1 it seems inevitable that interest rates will not be held at their current levels. Therefore forecasting a
reduction in FICC margins of around 20% seems like a reasonable thing to do: this number is neutral enough
to lead to moderate upgrades or downgrades if the situation is materially better/worse than expected. We expect
that higher interest rates are likely to have a negative impact on equities and investment banking deals as well,
leading to a reduction in equity revenues and investment banking revenues by 10% to 15%. At the same time,
as WIB was not part of the restructuring plan that XYZ announced at the end of Year Zero, the bank was not
able to reduce its cost base versus the previous year, which means that the Investment Banking & Capital
markets division ended up being loss-making at pre-tax level in Year 1.
In Year 2, the main beneficiary of a better economic environment validated by higher interest rates has to be, in
our view, the equity markets. This is why we are expecting the revenues of this business to surge by 76%. We
kept the pure investment banking revenues flat, as we expect that the revenue recognition of XYZs primary
deals will probably lag. Lastly, on the back of good markets, fixed income should benefit too but to a lower
extent we therefore choose to moderately increase the FICC margin from the low base of Year 1 but on the
basis of Figure 42, we can see that the analyst expects XYZs FICC margins to remain at historically low levels.
Maybe these low levels represent a new normal for FICC profitability in a Basel 3 world.
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2.50%
1.95%
2.00%
1.50%
1.50%
1.00%
1.00%
0.59%
0.50%
0.55%
0.50%
0.45%
0.51%
Year 1
Year 2
0.00%
0.00%
Y-5
Y-4
Y-3
Y-2
Y-1
Corporate centre
We are now getting to the black box of bank accounting: the corporate centre. The corporate centre (CC)
gathers the unallocated costs, headquarters costs, central functions (Investor Relations, CFO) but also group
treasury. Very often the CC also includes dividends of equity stakes, and can also consolidate non-core
businesses (legacy portfolios, private equity, property companies etc.). Sometimes these non core businesses
are disclosed, sometimes they are not.
Depending on the degree of disclosure pertaining to the CC, the management then has some leeway to adjust the
banks divisional reporting. This has happened a lot in Europe in recent years with banks issuing restatements,
sometimes on a very frequent basis. In some cases, some treasury functions have been directly allocated to the
divisions leading to a deterioration of the corporate centres results. Indeed, the vocation of the CC is to post
negative pre-tax profits as the CC carries the cost of doing business at group level.
The black box syndrome is all the more potent given that every division will have to negotiate transfer costs with
the corporate centre. For example, in some cases, group general counsel will have to help the dRCB division. It
is important for the division to pay the CC for its services at arms length so that the divisions are comparable
between different banking groups. Unfortunately we have no guarantee that these transfer prices remain stable
over time within each bank, the same way we do not know whether the perimeter of the CC is consistent from
one period to the other.
Also, the CC is frequently the centrepiece for all the one-off items happening in the P&L in one given time period
(DVA, capital gains). As a result, it is necessary to restate a lot of the CCs one-off items below the line to be
able to have a less muddy view about this division.
Until recently, on an annual basis, and restated from below-the-line items, CC results were reasonably
consistent. Clearly there were some cyclicalities (the coupon paid on a group subordinated debt or some
dividends perceived would not recur at the same time in the course of the year) but annually there was some
consistency.
This consistency has to a large extent remained on the expense side but since the cost of liquidity for the banks
has increased in particular the fact of having a lot of money held at Central Banks for very low (or even
negative) returns, CC revenues have in turn become more volatile.
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While until recently it was common practice to proxy the last reported years corporate centre P&L to the
forthcoming years, now it is more prudent and frequent to use averages. In the case of XYZ, the increased
liquidity cost has driven a collapse in revenues from Year Zero to the Current Year. We believe that liquidity
commitments should be slightly less stringent going forward which is why our CC revenues reflect an average
between the revenues of Year Zero and the revenues of the Current Year. On the cost side, we have left the
number unchanged, as it was consistent in Year Zero and in Year 1.
fRCB
WAM
WIB
Unallocated
/corporate
Total
2.25
1.05
1.20
2.00
0.19
6.69
-1.70
-0.78
-0.98
-1.40
-1.03
-5.89
0.55
0.27
0.22
0.60
-0.84
0.80
Provisions
-0.70
-0.50
0.00
-0.15
0.00
-1.35
Associates
0.00
0.15
0.05
0.00
0.05
0.25
Pre-tax profits
-0.15
-0.08
0.27
0.45
-0.79
-0.30
Other
-0.15
-0.09
0.00
0.00
1.00
0.76
0.15
0.15
-0.05
-0.05
Taxes
Minority interests
Net attributable profits
Allocated capital
0.56
7.00
3.00
1.00
7.30
2.00
20.30
357.00
Cost-income ratio
76%
74%
82%
70%
542%
88%
-1%
-2%
18%
4%
-26%
-1%
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Figure 44: Divisional profitability of Year 1 Bank XYZ
dRCB
Revenues
Costs
Pre-provision profits
fRCB
WAM
WIB
Unallocated
/corporate
Total
2.36
1.08
1.18
1.76
0.39
6.77
-1.60
-0.70
-0.98
-1.53
-1.03
-5.84
0.76
0.38
0.20
0.23
-0.65
0.93
Provisions
-0.50
-0.40
0.00
0.09
0.00
-0.81
Associates
0.00
0.15
0.05
0.00
0.05
0.25
Pre-tax profits
0.26
0.13
0.25
0.32
-0.60
0.37
-0.15
-0.08
0.00
0.00
0.00
-0.23
0.00
0.00
-0.10
-0.10
Other
Taxes
Minority interests
Net attributable profits
Allocated capital
0.03
7.00
3.00
1.00
Cost-income ratio
7.00
2.00
20.00
365.00
68%
65%
83%
87%
268%
86%
2%
3%
16%
3%
-19%
1%
fRCB
WAM
WIB
Unallocated
/corporate
Total
2.41
1.11
1.22
2.13
0.39
7.25
-1.50
-0.65
-0.89
-1.45
-1.04
-5.53
0.91
0.46
0.33
0.68
-0.66
1.72
Provisions
-0.30
-0.20
0.00
-0.02
0.00
-0.52
Associates
0.00
0.15
0.05
0.00
0.05
0.25
Pre-tax profits
0.61
0.41
0.38
0.66
-0.61
1.45
-0.15
-0.08
0.00
0.00
0.00
-0.23
Taxes
-0.21
-0.21
Minority interests
-0.25
-0.25
Other
Allocated capital
0.76
7.00
3.00
1.00
Cost-income ratio
Return on allocated capital
@normalised tax rate of 35%
(%)
7.00
2.00
20.00
375.00
62%
59%
73%
68%
270%
76%
6%
9%
25%
6%
-20%
5%
Clearly the most important aspect is that the divisional forecasts must match the group balance sheet and P&L
formats. In other words, the sum of all divisional forecasts must equal the group consolidated balance sheet and
P&L.
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More specifically, the group P&L and balance sheets forecasts (for the banks that are not mono-business or
mono-geography) must be driven by the divisional numbers.
Often divisional reporting is less detailed than consolidated reporting. When this is the case, it can happen that
for forecasts purposes the revenues will not be disaggregated between net interest income, fee income and
trading income. Also, personnel and non personnel expenses are sometimes not split by division. Same thing
with the below-the-line items.
It is therefore the analysts job to estimate the accounting breakdown of divisional forecasts, so that they all add
up to the same number as we can demonstrate here: the divisional P&L numbers of Figures 43, 44 and 45
add up to the consolidated P&L forecasts of Figure 29.
Regulatory forecasts
There is one last layer of forecasting left to be done in the context of a proper credit ratings job: forecasting
regulatory ratios. The calculation can be severely complicated, all the more that banks disclosure is often not up
to expectations. However, disclosure is improving and we believe that the accurate forecast of these metrics
(the liquidity ratios in particular) is only a matter of time.
These ratios are to a large extent templated by regulators so that for the analyst, it is just a matter of filling the
form properly and check the results versus the companys own forecast or targets.
Since the start of the crisis, regulators throughout the world have relentlessly worked on two major issues,
widely known to have been at the core of the banking sectors problems since June 2007: capital and liquidity.
Our regulatory forecast work will therefore focus on the four enforced regulatory ratios, two for capital
assessment, and two for liquidity assessment knowing that for some of these ratios (the two liquidity ratios in
particular), current disclosure makes it very difficult to assess the level of these ratios. For the moment, an
analyst using public disclosure can only forecast components of these ratios, and not the full ratios themselves.
We also mention TLAC and MREL which are addressed in more detail in the Wholesale Funding Forecasts
section of this methodology.
The last section of this forecast methodology will include:
Calculation of Basel 3-compliant risk-weighted capital ratios (according to CRD 4/CRR and using the
post 01.01.2018 disclosure of the rules text Composition of capital disclosure requirement published in
June 2012);
Calculation of the Basel 3-compliant unweighted Leverage Ratio;
TLAC/MREL;
Net Stable Funding Funding Ratio (NSFR);
Liquidity Coverage Ratio (LCR) or at least some of its most easily identifiable components.
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Figure 46: Basel 3 capital calculation (post 1 January 2018 disclosure template)
Figure 46: Post 1 January 2018 Disclosure template
Common shares issued plus related stock surplus
+Retained earnings
+Accumulated OCI (and other reserves)
+Restated Minorities (Basel 3 definition)
=Common Equity Tier 1 capital before regulatory adjustments (1)
Prudential Valuation adjustments
+Goodwill and other intangibles
+DTAs based on future profitability (TLCFs)
+Cash Flow Hedge reserves
+/-AFS reserves (add-back losses , deduct gains)
+Shortfall of provisions to Expected Losses (EL)s
+Securitisation gain on sale
+Gains and losses due to changes in own credit
+Defined-benefit pension fund net assets
+Own shares (if not netted in CET 1 capital defined above)
+Cross-holdings
= "straight" regulatory adjustments (2)
Common Equity Tier 1 before threshold deductions (3) = (1) - (2)
Investments in financial companies (banks, insurance...) where bank stake is <10%
+Investments in financial companies (banks, insurance...) where bank stake is >10%
+Mortgage servicing rights
+DTAs arising from temporary differences
= "Specified items" as per Basel 3 Annex 2, p. 65 (4)
Maximum combined recognition of specified items (5) = 17.65% x ((3)-(4))
Investments in financial companies (banks, insurance...) where bank stake is <10% - capped at 10% of (3)
+Investments in financial companies (banks, insurance...) where bank stake is >10% - capped at 10% of (3)
+Mortgage servicing rights - capped at 10% of (3)
+DTAs arising from temporary differences - capped at 10% of (3)
= Maximum Recognition of "Specified items" (6)
AMOUNT OF SPECIFIED ITEMS RECOGNIZED IN CET1: (7) = LOWER OF (5) OR (6)
ADJUSTMENT TO CORE EQUITY TIER 1: (8) = (7) - (4)
COMMON EQUITY TIER 1 (9) = (3) + (8)
Additional Tier 1 Capital (10)
TIER 1 CAPITAL (11) = (9) + (10)
TIER 2 CAPITAL (12)
TOTAL CAPITAL (13) = (11) + (12)
Risk Weighted Assets (14)
Source: BIS, Scope Ratings
This table is sourced from a combination of data and definitions extracted from CRD 4 and the Basel 3
regulatory frameworks, complemented by our attempts at simplifying some lines. The main analytical
adjustments to be made are:
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The AFS reserve within the OCI. These are to be excluded from CET1 calculation, so that the gains are
deducted and the losses are added back. These adjustments are in any case phased out by CRD 4 until
31.12.2017. Also the concept of AFS under IFRS disappears after that date. It is likely to be replaced by a
FVOCI reserve (see our section on classification and measurement of financial instruments earlier in this
report).
Prudential Valuation Adjustments (PVA). This concept was defined by CRR and has been fine-tuned for
implementation by a draft Regulatory Technical Standard (RTS) dated 31 March 2014. Simply put, PVA are
valuation adjustments that are applied to all fair-valued positions, whether in the banking book or in the
trading book. These adjustments concern essentially unearned credit spreads, close-out costs, operational
risks, market price uncertainty, early termination, investing and funding costs, future administrative costs
and, where relevant, model risk. The sum of all these negative adjustments to the fair value of a banks
trading and banking book positions have to be deducted from CET1 as made clear by Figure 46 above.
These adjustments are known as AVA (Additional Valuation Adjustments).
Minority interests: these are eligible to be recognized as CET1, minus the amount of the surplus common
equity Tier 1 of the subsidiary attributable to the minority shareholders (Basel 3, article 62). The way to take
this aspect into account is usually to consider that 50% of the minority interests of a bank are eligible for
CET1. This is a convention generally accepted by the banks.
Derogations: Pretty much every line under CRD 4 is susceptible to an exemption or a delay. These
exemptions and delays need to be taken into account because they can be significant and sometimes they
prevent banks from being comparable on a cross-border basis. A well-known example is insurance, which in
theory should be deducted under the threshold method spelled out on Figure 46. However, Article 471 of
CRD 4 exempts banks from such deductions until YE 2022. Instead, these equity holdings can be
alternatively risk-weighted at 370%.
Risk-Weighted Assets: Basel 3 RWAs can only be forecast with the help of company guidance (particularly
on the additional weight of counterparty risk). To be able to forecast RWAs properly, the analyst will have to
be very mindful of the achievability of RWA reductions, as well as the way some portfolios are weighted
under Pillar 3. A good top-down way to assess the degree of conservatism in a banks RWA accounting is to
assess the evolution of the RWAs % Assets ratio over time.
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potential future exposure over the remaining life of the contract. This add-on is a percentage which is applied to
the notional principal amount of the derivative which means an off-balance sheet factor is included. Versus the
consultative document published by the BCBS in June 2013, the January 2014 final framework authorises some
derivatives exposure reduction, particularly the cash portion of variation margin and trades cleared through
central counterparties both in specific circumstances.
SFTs are included in the exposure measure, but some cash payables and cash receivables in SFTs with the
same counterparty may be measured net if specific criteria are met. Qualifying master netting agreements may
be used in certain circumstances to reduce the exposure.
The off-balance sheet items include commitments (including liquidity facilities), whether or not unconditionally
cancellable, direct credit substitutes, acceptances, standby letters of credit and trade letters of credit. Depending
on the risk profile of these items, a credit conversion factor will be applied to the nominal value of these items.
Some of the elements composing the exposure measure will be difficult to estimate, in particular the derivatives
add-ons. However, considering the fact that banks are starting to report their fully-phased CRD 4 leverage
ratios, and considering that the Tier 1 capital is reasonably easy to identify, the exposure measure can be
deducted and used to forecast leverage ratios going forward, on the basis of the balance sheet growth expected
for the company. Also, considering that the numerator can be easily estimated in the situation where the
company discloses the leverage ratio, the exposure measure can be assessed with reasonable confidence
and hence, by difference, the LR-compliant derivatives exposure. This number can then be compared with the
on-balance sheet present value of derivatives to ease the forecasts going forward.
Clearly, the reading of the Basel 3 leverage ratio is different from one country to another. In particular, the
European Commission published a Delegated Act establishing a common definition of the leverage ratio for
European banks, largely aligned with Basel 3. The leverage ratio is published from the beginning of 2015
onwards.
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relationships with the bank that make deposit withdrawal unlikely; or the deposits are in transactional accounts
(e.g. accounts where salaries are automatically deposited).
Less Stable deposits are defined as deposits that are not covered by an effective deposit insurance scheme or
sovereign deposit guarantee; high-value deposits; deposits from sophisticated or high net worth individuals;
deposits that can be withdrawn quickly; and foreign currency deposits.
Figure 47: Components of Available Stable Funding (ASF) and Associated ASF Factors
ASF
Factor
100%
Total regulatory capital (excluding Tier 2 instruments with residual maturity of less than one
year)
Other capital instruments and liabilities with effective residual maturity of one year or more
95%
Stable non-maturity (demand) deposits and term deposits with residual maturity of less than one
year provided by retail and SME customers
90%
Less stable non maturity deposits and term deposits with residual maturity of less than one year
provided by retail and SME customers
50%
0%
Funding with residual maturity of less than one year provided by non financial corporate
customers
Operational deposits
Funding with residual maturity of less than one year from sovereigns, public sector entities
(PSEs), and multilateral and national development banks
Other funding with residual maturity of not less than six months and less than one year not
included in the above categories, including funding provided by central banks and financial
institutions
All other liabilities and equity not included above categories, including liabilities without a stated
maturity (with special treatment for deferred tax liability and minority interest)
NSFR derivative liabilities net of NSFR derivative assets if NSFR liabilities > NSFR derivative
assets
Trade debt payables arising from purchases of financial instruments, foreign currencies, and
commodities.
Source: BIS
Computing the denominator: required stable funding for assets and on-balance sheet exposure
The amount of required stable funding is measured based on the broad characteristics of the liquidity risk profile
of an institutions assets and OBS exposure. The required amount of stable funding is calculated by first
assigning the carrying value of an institutions assets to the categories listed on Figures 48a and 48b. The
amount assigned to each category is then multiplied by its associated Required Stable Funding (RFS) factor
and the total RFS is the sum of the weighted amounts added to the amount of OBS activity (or potential liquidity
exposure) multiplied by its associated RFS factor.
The definitions now used by the NSFR are totally consistent with the concepts of High Quality Liquid Assets
(HQLAs) defined for the determination of the Liquidity Coverage Ratio and addressed in detail in the next
section.
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0%
5%
Unencumbered Level 1 assets, excluding coins, banknotes and central bank reserves
10%
15%
50%
65%
85%
100%
Unencumbered loans to financial institutions with residual maturities of less than six months,
where the loan is secured against Level 1 assets as defined in LCR paragraph 50, and where
the bank has the ability to freely rehypothecate the received collateral for the life of the loan.
All other unencumbered loans to financial institutions with residual maturities of less than six
months not included in the above category
Unencumbered Level 2A assets
Unencumbered Level 2B assets
HQLA encumbered for a period of six months or more and less than one year
Loans to financial institutions and central banks with residual maturities between six months
and less than one year
Deposits held at other financial institutions for operational purposes
All other assets not included in the above category with residual maturity of less than one year,
including loans to non-financial corporate clients, loans to retail and small business customers,
and loans to sovereigns and PSEs
Unencumbered residential mortgages with a residual maturity of one year or more and with a
risk weight of less than or equal to 35% under the Standardised Approach.
Other unencumbered loans not included in the above categories, excluding loans to financial
institutions, with a residual maturity of one year or more and with a risk weight of less than or
equal to 35% under the Standardised Approach
Cash, securities or other assets posted as initial margin for derivatives contracts and cash or
other assets provided to contribute to the default fund of a CCP
Other unencumbered performing loans with risk weights greater than 35% under the
Standardised Approach and residual maturities of one year or more, excluding loans to
financial institutions
Unencumbered securities that are not in default and do not qualify as HQLA with a remaining
maturity of one year or more and exchange-traded equities
Physical traded commodities, including gold
All assets that are encumbered for a period of one year or more
NSFR derivative assets net of NSFR derivative liabilities if NSFR derivative assets are greater
than NSDFR derivative liabilities.
All other assets not included in the above categories, including non-performing loans, loans to
financial institutions with a residual maturity of one year or more, non-exchange-traded
equities, fixed assets, items deducted from regulatory capital, retained interest, insurance
assets, subsidiary interests, and defaulted securities
Source: BIS
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Figure 48b: Composition of off-balance sheet categories and associated RFS factors.
RSF Factor
5% of the
currently
undrawn portion
National
supervisors can
specify the RSF
factors based on
their national
circumstances
Source: BIS
Overall, as a ratio to forecast, the NSFR is manageable to the extent that the different components can be
identified. The analyst will have to make assumptions on the degree of encumbrance of each portfolio (if this
information is not disclosed by the company) as well as on the stability of each deposit. With the enforcement
of the Bank Recovery and Resolution Directive (BRRD), we believe that a more granular disclosure around
deposits will happen at one point or another, enabling us to forecast the NSFR more accurately (something that
is more difficult to do at this stage considering the lack of appropriate disclosure).
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The 40% cap on Level 2 assets and 15% cap on Level 2B assets should be determined after the application of
required haircuts, and after taking into account the unwind of short-term securities financing transactions and
collateral swap transactions maturing within 30 calendar days that involve the exchange of HQLAs.
Instead of copying the definition from the master Basel document, we have decided to reproduce the Annex 4 of
the paper entitled Basel 3: The Liquidity Coverage Ratio and liquidity risk monitoring tools in Figures 49a, b, c
and d.
Figure 49a: definition of Stock of HQLA
Item
Factor
Stock of HQLA
A. Level 1 assets:
Coins and bank notes
100%
85%
100%
Qualifying RMBS
75%
50%
50%
Source: BIS
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3%
5%
10%
0%
5%
10%
25%
5%
Cooperative banks in an institutional netw ork (qualifying deposits w ith the centralised institution)
25%
Non-financial corporates, sovereigns, central banks, multilateral development banks, and PSEs
40%
20%
100%
C. Secured funding:
Secured funding transactions w ith a central bank counterparty or backed by Level 1 assets w ith any
counterparty
0%
15%
Secured funding transactions backed by non-Level 1 or non-Level 2A assets, w ith domestic sovereigns,
multilateral development banks, or domestic PSEs as a counterparty
25%
25%
50%
100%
Source: BIS
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Market valuation changes on derivatives transactions (largest absolute net 30-day collateral flow s
realised during the preceding 24 months)
20%
Excess collateral held by a bank related to derivative transactions that could contractually be called at
any time by its counterparty
100%
Liquidity needs related to collateral contractually due from the reporting bank on derivatives
transactions
100%
Increased liquidity needs related to derivative transactions that allow collateral substitution to nonHQLA assets
100%
100%
100%
5%
10% for credit
30% for liquidity
40%
40% for credit
100% for liquidity
100%
National discretion
0-5%
50%
100%
100%
100%
Source: BIS
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0%
Level 2A assets
15%
Level 2B assets
Eligible RMBS
25%
Other assets
50%
50%
100%
0%
Operational deposits held at other financial institutions (include deposits held at centralised institution of netw ork
of co-operative banks)
0%
50%
Amounts to be received from non-financial w holesale counterparties, from transactions other than those listed
in above inflow categories
Amounts to be received from financial institutions and central banks, from transactions other than those listed in
above inflow categories.
50%
100%
100%
National discretion
Source: BIS
The definitions reproduced here are self-explanatory. Versus the situation two years ago, the definitions related
to cash inflows and cash outflows are now much clearer. In its most recent document, we note that BCBS
makes certain Central Banks facilities eligible as Level 2B assets (while previously these facilities could only be
used by jurisdictions with insufficient HQLAs to meet the needs of the banking system). European law, in the
context of CRD4/CRR, has nearly completely adopted the definition of the LCR as given by the Basel 3
framework.
Despite the increased level of detail in the ratios definition, the LCR remains as difficult to forecast as it ever was.
However, we believe that the analyst can arrive at a good proxy for HQLAs, considering that not many assets are
eligible for HQLA status. Usually most of these assets are willingly disclosed (except for RMBS and covered bonds
which are Level 2 assets).
As a result of the above, Scope ratings has included in its Bank Rating Methodology some ratios based on
Level 1 HQLAs. Because of the way Level 2 assets are capped, Scope can estimate a maximum level of
HQLAs that can be defined as:
Max. Total HQLAs = Level 1 HQLAs / 60%
Based on the fact that Total HQLAs = Level 1 Assets + Level 2 Assets.
Using Level 2 Assets under the constraint of the 40% cap, we can rewrite the equation above as:
Max. Total HQLAs = Level 1 Assets + (40% of Total HQLAs)
Or 60% Max. Total HQLAs = Level 1 Assets.
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While disclosure improves on the LCR and before there is more clarity on the NSFR, Scope ratings will use
more traditional liquidity ratios such as comparing liquid assets to total wholesale funds or short-term
wholesale funds.
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