733
38
Banks
Banks are among the most complex businesses to value, especially from the 
outside in. Published accounts give an overview of a bank’s financial perfor-
mance but often lack vital information about its underlying economics, such 
as the extent of its credit losses or any mismatch between its assets and li-
abilities. Moreover, banks are highly levered, making bank valuations even 
more contingent on changing economic circumstances than are valuations in 
other sectors. Finally, most banks are in fact multibusiness companies, requir-
ing separate analysis and valuation of their key business segments. So-called 
universal banks today engage in a wide range of businesses, including retail 
and wholesale banking, investment banking, and asset management.
In the view of some academics, managers, and regulators, the size, com-
plexity, and lack of transparency of universal banks in the United States and 
Europe has led to undesirable systemic risks, among them that some banks 
have become “too big to fail.”1 During the 2008 credit crisis, the threat of col-
lapse by some large universal banks led governments to bail out these institu-
tions, triggering an ongoing debate about whether such institutions should be 
split into smaller and separate investment and commercial banks.2
This chapter provides a general overview of how to value banks and high-
lights some of the most common valuation challenges peculiar to the sec-
tor. First, it discusses the economic fundamentals of banking and trends in 
performance and growth, and then it describes how to use the equity cash 
flow approach for valuing banks, using a hypothetical, simplified example. It 
concludes by offering some practical recommendations for valuing universal 
banks in all their real-world complexity.
1 See M. Egan, “Too-Big-to-Fail Banks Keep Getting Bigger,” CNNMoney, November 21, 2017, money 
.cnn.com. Also see “Universal Banking: Together, Forever?” The Economist, August 12, 2012, www 
.economist.com.
2 For analyses of the costs and benefits of large universal banks, see Global Financial Stability Report 2014, 
International Monetary Fund, April 2014, www.imf.org; and Large Bank Holding Companies: Expectations 
of Government Support, GAO-14-621, U.S. Government Accountability Office, July 2014, www.gao.gov.

734  Banks
Economics of Banking
After years of strong profitability and growth in the U.S. and European bank-
ing sectors, the crisis in the mortgage-backed securities market in 2007 sent 
many large banks spiraling into financial distress. Many large institutions on 
either side of the Atlantic went bankrupt or were kept afloat with costly gov-
ernment bailouts. The fallout in the real economy from what was originally 
a crisis in the banking sector ultimately curtailed growth in almost all sectors 
around the globe, bringing economic growth to a halt worldwide in 2008.
Since then, the sector has gone through years of restructuring, involving 
mergers, government bailouts, nationalizations, and bankruptcies. Regulation 
has intensified, leading to stricter capital requirements, restrictions on trading 
operations, and—in some European countries—caps on bonus payments for 
bank employees and executives. By 2018, banks in the United States had rid-
den stronger domestic economic growth, rebounding loan demand, and a re-
duction in bad debts to regain and even surpass their pre-crisis profit levels. In 
contrast, European banks were still below their pre-crisis profit levels, mainly 
due to lower economic growth across the European Union and the 2010 euro 
sovereign-debt crisis.
The credit crisis demonstrates the extent to which the banking industry 
is both a critical and a vulnerable component of modern economies. Banks 
are vulnerable because they are highly leveraged and their funding depends 
on investor and customer confidence. This can disappear overnight, sending 
a bank plummeting into failure. As a result, more uncertainty surrounds the 
valuation of banks than the valuation of most industrial companies. There-
fore, it is all the more important for anyone valuing a bank to understand 
the business activities undertaken by banks, the ways in which banks create 
value, and the drivers of that value creation.
Universal banks may engage in any or all of a wide variety of business 
activities, including lending and borrowing, underwriting and placement of 
securities, payment services, asset management, proprietary trading, and bro-
kerage. For the purpose of financial analysis and valuation, we group these 
activities according to the three types of income they generate for a bank: net 
interest income, fee and commission income, and trading income. “Other in-
come” forms a fourth and generally smaller residual category of income from 
activities unrelated to the main banking businesses.
Net Interest Income
In their traditional role, banks act as intermediaries between parties with 
funding surpluses and those with deficits. They attract funds in the form 
of customer deposits and debt to provide funds to customers in the form of 
loans such as mortgages, credit card loans, and corporate loans. The difference