A whole new industry is springing up as a result of the financial crisis to deal with a central issue: how to handle failing banks. INSEAD Professor of Banking and Finance Jean Dermine has taken his quarter-century's worth of research and turned it into something a bit more forward-looking: a book entitled 'Bank Valuation and Value-Based Management.' The thesis: if you focus on looking at long-term value rather than short-term cash flow, banks will be less risky and the financial world will be less susceptible to tremors from shaky deals. Then you apply this theory to quotidian bank management.
It is an elegantly simple idea whose time has come, ignored as it was in the wild world of subprime-rocketing loan returns and financial myopia. After all, why look too closely at a good thing? In his book, Dermine looks at banking through a new lens.
In history, there have been too many banking crises because risk was not priced properly, he opines. Too often, banks look at the short-term margins (on high-interest, risky loans) and then they take on more risky loans. When a bank goes into a five-year loan with high interest and high margins, it sees it as a wonderful year, a wonderful two years: there will be a wonderful profit.
This, claims Dermine, is about short-term cash flow, rather than value. When you talk about value, you have to look at long-term expected cash flows; therefore you see the short-term margin is quite often illusory because of future risk. You have to look way beyond the short-term cash flows. Remember all that re-setting of subprime mortgages, which brought the banking industry to its knees?
The first wave of bank closures came in such a rush, the authorities fell back on what worked in the last big banking crisis some 80 years ago: lock the doors, close the bank. But as the crisis persisted, theories of other solutions were created. Dermine believes that his ideas for bank valuation will go a long way to help another wave of insolvencies from occurring.
Dermine tackles the issue of bank valuation from two standpoints. First, if you were to liquidate the bank, how much value would you get out of it, taking into account the risk of loan default? But if you let the bank continue operations as a going concern, there would be added value by collecting low-cost deposits and granting higher-return loans, selling cash management services and asset management services, he says. So what we do in the book is to break the bank down into pockets of value related to different activities.
The second half of the book looks at how bank management based on long-term value (that is, value of future expected cash flows) can be achieved. For example, banks today have no choice but to meet higher capital requirements mandated by virtually every government in the free-market world. Dermine refers to a recent study by Goldman Sachs which commented on these new capital requirements, claiming banks will suffer as a result: Their capital will be much higher, and their leverage will go down. But when we talk about the value of a company, it's not only about return on equity; it's also about risk. So yes, banks will be affected by increased capital requirements because they will have lower return on equity, but they will be less risky.
Jumping to the consumer's viewpoint for a second, won't the cost of loans be higher, with the credit crunch taking an even harder bite out of consumers' pockets?
Yes, the cost of loans would be higher, replies Dermine. And I would say that's sound economics, as risk will be priced correctly. It would appear that regulators are on Dermine's side. The International Accounting Standards Board has been coming up with a proposal to force banks to create provisions on performing loans (previously only non-performing, long-overdue loans were considered a real balance sheet risk requiring provisions). That is to say, even if a loan is doing well today, we want to recognise a risk that may show up later on - therefore we are going to force you to create provisions early, Dermine says.
According to Dermine, this long-term conservative financial view is what saved Spain's banks during the crisis. When the economy in Spain was booming, the central bank of Spain forced Spanish banks to create general dynamic provisions, he points out. The idea was to say 'if ever we go into a recession' - which is the case today in Spain -- 'they can take money away from this provision.' What we say in the book is, it's not only important to create these dynamic provisions but so too is the issue of incentives: how do you evaluate a loan department? How do you make sure you reward them for making good decisions? Too often banks look at the short-term margins. Banks need to measure loan performance better and that is forcing banks to recognise risk and provision much earlier.
I am thoroughly convinced that one of the reasons for the financial crisis is that banks were way too short-term driven.
Jean Dermine's book 'Bank Valuation and Value-Based Management' is published by McGraw-Hill.