Complications in Bank Valuations  757
You can think of a bank’s trading results as driven by the size of its trad-
ing positions, the risk taken in trading (as measured by the total VaR), and the 
trading result per unit of risk (measured by return on VaR). The ratio of VaR 
to net trading position is an indication of the relative risk taking in trading. 
The more risk a bank takes in trading, the higher the expected trading return 
should be, as well as the required risk capital. The required equity risk capital 
for the trading activities follows from the VaR (and RWA), as discussed ear-
lier in the chapter. Operating expenses, which include information technology 
(IT) infrastructure, back-office costs, and employee compensation, are partly 
related to the size of positions (or number of transactions) and partly related 
to trading results (for example, employee bonuses).
Fee- and Commission-Generating Activities  A bank’s fee- and commission-
generating activities, such as brokerage, transaction advisory, and asset man-
agement services, have different economics, based on limited asset positions 
and minimal risk capital. The value drivers in asset management, for example, 
are very different from those in the interest-generating businesses, as the ge-
neric example in Exhibit 38.16 shows. Key drivers are the growth of assets 
under management and the fees earned on those assets, such as management 
fees related to the amount of assets under management and performance fees 
related to the returns achieved on those assets.
EXHIBIT 38.16  Value Drivers: Asset Management (Simplified)
Value creation
Growth
Cost of equity
Return on equity
Operating 
expenses1
Equity
Management fee 
revenues
Performance-related 
management fee1
Assets under 
management
Basic management 
fee1
Cost/income
3
1
1
2
3
4
5
6
5
6
2b
2a
Key value drivers 
Assets under 
management: Value 
of customer assets 
under management
Advisory fees: 
Performance fees 
and annual 
management fees
Operating 
expenses: E.g., 
investment 
professionals
Equity: Required 
equity levels
Growth: Growth 
of volumes (e.g., 
assets under 
management from 
capital appreciation 
and net inflow)
COE: Cost of equity
4
 1 After taxes.

758  Banks
Along with these variables in activities, remember that banks are highly 
leveraged and that many of their businesses are cyclical. When performing a 
bank valuation, you should not rely on point estimates but should use sce-
narios for future financial performance to understand the range of possible 
outcomes and the key underlying value drivers.
Summary
The fundamentals of the discounted-cash-flow (DCF) approach laid out in 
this book apply equally to banks. The equity cash flow version of the DCF 
approach is most appropriate for valuing banks, because the operational and 
financial cash flows of these organizations cannot be separated, given that 
banks are expected to create value from funding as well as lending operations.
Valuing banks remains a delicate task because of the diversity of the busi-
ness portfolio, the cyclicality of many bank businesses (especially trading and 
fee-based business), and high leverage. Because of the difference in under-
lying value drivers, it is best to value a bank by its key parts according to 
the source of income: interest-generating business, fee and commission busi-
ness, and trading. To understand the sources of value creation in a bank’s 
interest-generating business, supplement the equity DCF approach with an 
economic-spread analysis. This analysis reveals which part of a bank’s net 
interest income represents true value creation and which reflects not value but 
charges for maturity mismatch and capital. When forecasting a bank’s finan-
cials, handle the uncertainty surrounding the bank’s future performance and 
growth by using scenarios that capture the cyclicality of its key businesses.