(Extract from page 83 of BIS Quarterly Review, March 2018)
What's special about valuing banks? One key factor is regulation, which is much more stringent for banks than for corporates. Specifically, banks are typically required to maintain predefined regulatory capital adequacy ratios based on their book value of equity. More importantly, however, the accounting treatment of banks and their activities can differ substantially from that of non-financial corporates. As a result, book values are often more meaningful measures of value for financial firms than for non-financial ones.
Accounting for bank assets. Accounting practices are important for bank valuations for two reasons. First, the assets held by banks are typically in the form of financial instruments (loans, bonds and other securities as well as derivatives) that have well defined cash flows. The majority of bank assets (loans, investments and other assets) are reported at amortised cost. However, for larger banks many financial instruments are traded in relatively liquid markets, at least under normal conditions, or are substantially similar to traded assets. This is why marking traded and, in some cases, non-traded assets to market has long been established practice among banks. With a significant portion of assets on banks' balance sheets treated in this way, book values are much closer to market values than is the case for non-financial corporates, where most of the assets are carried at amortised cost. Similarly, depreciation, which can be a key driver of book values for corporates, tends to be much less important for banks, which hold relatively few real assets.
Second, it is natural for bank assets to be subject to credit and other risks that can imply the potential for large, possibly abrupt losses, with loss provisions being made to report estimated credit losses as an allowance reducing the value of the loan portfolio and reported earnings. In practice, banks have discretion in setting their provisioning policies. For a given loan portfolio, conservative banks will set aside more for loan losses, implying lower profits during good times than those generated by their more aggressive peers. Indeed, the literature suggests that delayed loss recognition (or "purposeful understatement of losses"; Huizinga and Laeven (2012)) has been a significant factor for US banks during the recent financial crisis, especially in the context of their mortgage market exposures. Expected credit loss accounting, due to be implemented globally during 2018-21, is intended to improve the incorporation of forward-looking credit risks into book asset valuations and earnings.
Against this background, depressed PBRs would tend to reflect the effect of accounting rules on recognised book values as well as attempts by bank managers to preserve their institutions' (book) capital positions.
Implications for bank valuation metrics. For banks and other financial firms, therefore, combining book- and market-based valuation metrics can provide useful information. In particular, price-to-book ratios (PBRs) above one - which have tended to prevail under normal market conditions - will tend to be driven by the market value of intangible assets and liabilities, which in turn may be affected by market developments and the competitive environment in ways that are not reflected in their book values.
Changing economic conditions would thus be expected to affect PBRs largely via their effect on intangibles, on both the asset (eg Diamond (1984)) and liability sides (Gorton and Pennacchi (1990)) of the balance sheet. For example, if interest rates are low for an extended period, having a stable base of core deposits may be less valuable to banks, to the extent that they are unable to reprice deposit rates in line with rates earned on the asset side of their balance sheets (BIS (2016)). Similarly, loan relationships may lose value if the economic environment implies a lower ability for banks to benefit from the cross-selling of services.
For a more detailed discussion, see Damodaran (2009) and Calomiris and Nissim (2014). See Cohen and Edwards (2017).