Valuation of Bank Investments
Banks are the institutions that deals in money and its substitutes and provide other financial services. The main function of a bank is to act as an intermediary between money surplus units (lenders) and money deficit units (borrowers). Bank also does the job of an advisor or analyst that evaluates various money deficit units so that the lenders get better and safe returns. Though always the role of banks played in the economy is understated, the banking system is highly regulated. The crisis of 2007-8 in US economy and many other economies around the globe states the importance and sensitive role of banks in the economy.
Banks main function is to create a pool of money so that in can invest in various ventures and business that fetches it returns. For the pool of money, it collects deposits from public and gives an interest for the period of deposit. Amount of money that it may lend from the deposits it collected depends on the reserve ratio which is specified by Reserve Bank of India. By lending the deposit amount in other activities, the banks take the risk that the borrower repays the loan or the investment gives better returns than what it has to pay to the depositors. The significant difference between the interest the bank gets from loans and interest payments from the debt securities and the interest the bank pays on deposits is called “Spread” or “net interest income”.
Banks carefully gauge the risk before investing in various businesses to maximize the spread. It is risky to loan money. A bank never knows if they get the iveseted money back. Hence, the riskier the loan the more the interest rate the bank charges. Banks invest in different companies by buying shares or equity or issuing debt securities; this banks are called Investment Banks. These banks conduct extensive research on the health of the company and its cash flows and the industry it is operating in and the economic situation to assess the risk factor. Bank employ various models to estimate the worth of the company. Few models are given below:
Comparable Company Analysis:
In this method, the company under question is compared to the performance of its competitor or another company operating in same industry. Few parameters which can assess the performance of the company are chosen with care.
Discounted Cash Flow Analysis (DCF):
This method compares the cash flows of the company since it tells the returns of the company in present scenario. It uses to forecasting models to predict the cash flows in future to estimate the worth of company.
Precedent Transaction Analysis (M&A Comps):
This model considers previous transactions happened in same company or in same industry. This provides a kind of benchmarking with which the current transaction can be compared.
Conditions when the valuation technique to be applied:
The above mentioned models must be applied depends on various conditions such as industry, culture of company etc.
- The easiest among all is Comparable Company Valuation. The companies under comparison must trade publicly the securities, which can be used to estimate the value of the company. When only a minor stake is being acquired, this model is preferred.
- Discounted Cash flow analysis states that the current cash flow and that it generates in future is what the company is valued for. This method is most precise of all but it depends on the period for which the cash flows are estimated. Longer the period, the forecasting the cash flow gets difficult. Hence, this model is employed for companies with stable cash flows or in mature industries where the market conditions can be predicted with accuracy.
- If there are significant acquisitions in similar industry or in same company in the past, then Precedent Transaction Analysis model is used. The problem with this model might be that in many industries there might not be a mergers or acquisitions with which the value of company can be estimated.
Advantages and Disadvantages of valuation models:
Comparable Company Analysis;
Advantages: Due to market efficiency, if the parameters on which the company is compared are selected carefully, then they serve as good indicators of the performance of the company. The parameters must include the information about trends, growth factors, regulations and risk factors etc. associated with company or the industry it is operating in.
Disadvantages: The main drawback for this model is that no two companies are alike. The growth models they apply, the cultures and goals and vision and mission will be different for companies. The strategies they follow to gain advantage will play an important factor in success of the company but to predict the success is being increasingly difficult in present interconnected world.
Sometimes, the stock floated might not capture the exact worth of the company. The intangible assets will be difficult to compare.
DISCOUNTED CASH FLOW (DCF) ANALYSIS
Advantages: It is easy to calculate since it depends on the cash flow of the company.
Disadvantages: The cash flow can be subjected to manipulations by discounted rate assumptions. Besides the cash rich companies may not be strong company and may be having great future prospects or vice versa.
Moreover, predicting the cash flows of the company in the future will be difficult when strategies, goals are not considered.
PRECEDENT TRANSACTION ANALYSIS
Advantages: It is safe option since the valuation is done on the basis of previous transactions which act as benchmark.
Disadvantages: The conditions under which the transaction has been done in the past might not be similar to present conditions. The errors in valuation in previous transactions will be carried forward.
Moreover, the previous transaction might happened in favourable condition which is temporary. This might lead to false assumptions.
The process of estimating the worth of something. The valuation process mainly involved for something like financial asset or liability. Valuations generally done on assets like investments in marketable securities such as stocks, options etc…Or on liabilities like bonds issued by a bank. Valuations are needed for , financial reporting, capital budgeting, investment analysis, taxable events, merger and acquisitionto determine proper tax liability. Below are the regulations by RBI in evaluating the investments by various banks.
RBI regulations for evaluating:
- Held to Maturity
HTM investments are not ‘marked to market’ and will be carried at acquisition cost unlessthis type of investment is greater than the face value, in that case the premium should be amortized over the period that is remaining to maturity. The amortized amount must be displayed by the bank as a deduction in ‘Schedule 13 – Interest Earned: Item II – Income on Investments’. The deduction however need not be separately disclosed. The book value of the security should continue to be reduced, during the relevant accounting period, to the extent of the amount amortized.
Banks must recognize any kind of reduction other than temporary in the value of their investments in subsidiaries/joint ventures, which are included below Held To Maturity and provide therefore. This kind of reduction should be determined and provided for each investment
To identify if the impairment has occurred is a continuous process and the need for a determination will be required in the following situation like organization has defaulted on in quittance of its debt obligations or restructuring of loan amount of the company with any bank or down gradation of credit rating of a company below the investment grade; If an organization is making loss and the net worth has been reduced by 25%;In case an organization is unable to meet the breakeven point in an stipulated period of time.
If the damage is with respect to any a subsidiary or joint venture then thebank seekqualified value toevaluate the investment and make provision in case of anydamage.
- Available for Sale
In case of Available for Sale the investment will be marked to market, at quarter end or can be morefrequent. The Domestic Securities under Available for Sale will be assessed scrip-wise and depreciation/ appreciation will be summed for each classification referred in the RBI site. The Foreign investments under Available for Sale willbe assessed scrip-wise and depreciation/ appreciation will be summed for five categorizations: Government/Shares/Debentures & Bonds/Subsidiaries / joint ventures. Besides, investment in a particular categorizationsboth in domestic and foreign securities might besummed for arriving at net depreciation/appreciation of investments under that classification.
Net depreciation will be provided and for Net appreciation will be ignored in the books of account. The Net depreciationshould provided for in any one categorizations must not be reduced on account of net appreciation in any other categorizations. Banks can report the foreign securities in three classifications:Government securities /Subsidiaries and/or joint ventures abroad. Individual securities’ book value would not go any change after the mark of market.
- Held for Trading
TheHeld for trading category will be marked to market on monthly or can be on frequent intervals and provided for like those in the Available for Sale. Accordingly, the book value of the individual securities’ book valueof Held for Trading would also not change after marked to market.
- Investment Fluctuation Reserve(IFR) and Investment Reserve Account Investment Fluctuation Reserve (IRA)
(a) Banks were proposed to make an Investment Fluctuation Reserve (IFR) of a minimum 5% of the investment portfolio within a time of 5 years, keeping a view to building up of adequate reserves to hold against any potential reversal of interest rate environment in future due to unnoticed developments,
(b) Ensuring smooth transition to Basel II norms banks were advised on 24th June, 2004 to maintain capital charge for market risk in a phased manner on a 2 year period as mentioned below:
In respect of securities included in the Held For Trading classification, open gold position limit or open foreign exchange position limit or trading positions in derivatives and derivatives enrolled in for hedging trading book exposures by 31st Mar, 2005, and
In respect of securities included in the Available for Saleclassification by 31st Mar, 2006.
- Investment Reserve Account (IRA)
In the event, provisions made on account of depreciation in the ‘Available For Sale’ or ‘Held For Trading’ categories are found to be in extra of the required amount in any year, the extramust be credited to the Profit and Loss Account and an equivalent amount ( i.e. net of taxes, if any and net of transfer to Statutory Reserves as relevant to such excess provision) mustbe allowed to an IRA Account in Schedule 2 – “Reserves & Surplus” under “Revenue and Other Reserves” and would be eligible for inclusion under Tier-II within the overall ceiling of 1.25 % of total Risk Weighted Assets dictated for General Provisions or Loss Reserves.
(1) Banks may utilize IRA as follows:
The provisions required to be made on account of depreciation in the ‘Available For Sale’ or ‘Held For Trading’ categories must be debited to Profit and Loss Account and an equivalent amount (i.e.net of tax benefit, if any and net of transfer to Statutory Reserves), can be transferred from the IRA to the Profit and Loss Account.
Exemplifying, banks can draw down from the Investment Reserve Account IRA to the extent of provision built during the year towards depreciation in investment in ‘Available for Sale’ or ‘Held for trading’ categories ((i.e. net of taxes, if any and net of transfer to Statutory Reserves as relevant to such excess provision). In simple words, a bank that pays a tax of 30% and must appropriate25% of the net profits to Statutory Reserves SR, can draw down Rs.52.50 from the IRA, if the planning made for depreciation in investments included in the ‘Available For Sale’ or ‘Held For Trading’ categories is Rs.100.
Amounts debited to the Profit and Loss Account (P&L) for provision must be debited under the head ‘Expenditure – Provisions & Contingencies’. The amount transferred from the IRA to the P&L Account, must be displayed as ‘below the line’ item in the P&L Appropriation Account, after determining the profit for the year. Provision for any erosion in the value of an asset is an item of charge on the P&L account, and hence must appear in that account before appearing at the profit for the accounting period. Acceptation of the above would not only be acceptation of a wrong accounting principle but also willlead in a wrong statement of the profit for the accounting period:-
- the provision mentioned above is allowed to be adjusted directly against an item of Reserve without being displayed in the P&L account ora bank is permitted to draw down from the IRA before arriving at the profit for the accounting period (i.e., above the line) ora bank is permitted to built provisions for depreciation on investment as a below the line item, after coming at the profit for the period.
Therefore no above options are permissible.
According to the guidelines on payment of dividend by banks, dividends should be payable out of current year’s profit only. The amount pulled down from the IRA, therefore, will not be usable to a bank for payment of dividend among the shareholders. Nevertheless, the balance in the IRA shifted ‘below the line’ in the P&L Appropriation Account to Statutory Reserve, General Reserve or balance of P&L Account would be entitled to be calculated as Tier I capital