Bank & Financial Institution Modeling

Quick Reference Guide for the Entire Course

Introduction and Table of Contents

Commercial banks and insurance firms are the companies most different
from traditional companies.

Within the Bank Modeling course, there are notes, slide summaries, and
other guides, but this document summarizes everything.

So, you can use this guide to review everything right before interviews.
You can also use it to determine which parts of the course you need to study:

1. How Banks & Insurance Firms Work

2. Bank Accounting 101
3. Insurance Accounting 101
4. Regulatory Capital
5. Valuation Multiples & Intrinsic Valuation
6. Bank-Specific and Insurance-Specific Valuation
7. M&A Deals and Merger Models
8. Buyout and Growth Equity Models
9. Recap and Summary

How Banks & Insurance Firms Work

“Normal companies” sell products and services to customers. Customers pay them
for these products and services, and companies record that money as revenue.

Commercial banks, by contrast, do not earn money by selling products directly to

customers. Instead, they earn money by fulfilling two needs:

1) People need to save their money somewhere.

2) Other people need to borrow money when they don’t have enough.

Banks protect peoples’ money and incentivize people to store it with them by paying interest on it.
This “stored money” is known as the bank’s Deposits.

Banks then pool that money together and lend it out in larger amounts to borrowers; the bank’s “lent-
out-money” is known as Loans. The borrowers pay the bank interest.

Banks make money based on the interest rate spread: The difference between the Interest Rate on
Loans and the Interest Rate on Deposits (and any other items that earn or bear interest).

1 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

For example, you deposit $1,000 from your paycheck into your JP Morgan bank account. JPM pays you
a 1% interest rate on it.

Then, JPM takes that money you just deposited, puts it together with funds from thousands of other
customers, and turns it into a $100 million loan for a large company.

That large company pays JPM 4% interest on the loan, so the interest rate spread is 4% – 1% = 3%.

That number tells us how much in Net Interest Income the bank can earn as it grows its Loans and
Deposits. For example, if the bank’s Loans and Deposits both grow by $100 million, it should earn 3% *
$100 million = $3 million in additional Net Interest Income.

Insurance firms are a bit different: Similar to traditional companies, they do

sell their products directly to customers.

Specifically, they sell policies to customers, which require the customers to

pay monthly Premiums in exchange for a payout when disaster strikes.

For example, an auto insurance policy might be: “Pay us $100 / month, and if
you get in a car accident, we’ll pay for up to $10,000 in repair costs”). Other types of policies could
cover homes, health, or lives.

If you get in a car accident, the insurance company must pay you a Claim for $10,000.

The insurance business model is more direct than the commercial bank business model, but many
insurance firms, like banks, earn significant Interest Income.

That happens because insurance companies collect Premiums upfront from customers, but they do
not have to pay out anything to customers immediately.

So, the Premiums act like a bank’s Deposits – insurance firms can invest the customers’ payments in
stocks, bonds, real estate, and other asset classes until they need to pay for Claims.

This strategy doesn’t work so well for shorter-term policies, such as ones for auto insurance, because
insurance firms cannot invest in longer-term, illiquid Assets. As a result, companies that specialize in
“Property & Casualty” (P&C) insurance look more like traditional companies.

But companies that offer longer-term policies with payouts decades into the future – such as life
insurance firms – look more like commercial banks.

2 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

The Implications of Commercial Bank and Insurance Business Models

1) Balance Sheet First – The Balance Sheet drives these companies’ financial performance, and
you often start the financial statements by projecting the Balance Sheet first. There are also
some industry-specific items and different accounting conventions.

2) Equity Value Only – You cannot separate a bank or insurance firm’s operating and financing
activities as cleanly as you can separate those of a traditional company. As a result, the concept
of Enterprise Value (“The value of core-business operations, but to all investors”) does not
apply to these companies. You use Equity Value and Equity Value-based multiples instead.

3) Dividend Discount Models in Place of DCFs – “Free Cash Flow” doesn’t mean anything for
these firms because the Change in Working Capital and CapEx do not represent reinvestment in
the business. So, you use Dividends as a proxy for FCF, Cost of Equity instead of WACC, and the
Dividend Discount Model instead of the Discounted Cash Flow analysis.

4) Regulations and Capital – Banks and insurance firms are both highly regulated, and they must
maintain minimum amounts of “capital” (Tangible Common Equity with a few modifications) at
all times. These requirements constrain their growth.

5) Different Valuation Multiples – The Price / Book Value (P / BV), Price / Tangible Book Value (P /
TBV), and Price / Earnings (P / E) multiples are all important because these firms are Balance
Sheet-driven, and Interest is a huge part of their revenue. For life insurance firms, Price /
Embedded Value (P / EV) is another important multiple.

The Fine Print

We’ve been assuming that banks only generate revenue via

Net Interest Income.

But that’s not true: Look at a large bank’s Income Statement,

and you’ll see revenue from “Service Charges,” “Corporate
Services,” credit card fees, insurance, consumer mortgages,
mortgage servicing fees, principal investing (trading), and a
host of other categories.

These sources of revenue are so significant that banks create

an entire category for them: Non-Interest Income.

The same is true of insurance firms, but an even higher percentage of their revenue comes from Non-
Interest/Investment sources because of the Premiums they collect.

3 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

So, it’s not as if banks and insurance firms are completely different from normal companies.

Instead, it’s that since a high percentage of their revenue comes from Interest and Investment Income,
we need to analyze, value, and model them differently.

This rule also means that if a “financial institution” does not earn a significant portion of its revenue
from Interest, then it’s pretty much the same as a traditional company.

That explains why wealth management firms, investment banks, brokerages, and fin-tech firms all
follow traditional methodologies for accounting, financial statement projections, and valuation.

Return to Top.

Bank Accounting 101

Balance Sheet

It’s still separated into Assets and Liabilities & Equity, but there are some
important differences:

• More Asset Classes: Federal Funds Sold acts as a “balancer”: It

increases if the bank’s L&E side has a surplus, and more Assets are
needed for the BS to balance. Investments and Securities are
often broken into many categories.

• Gross Loans, Allowance for Loan Losses, and Net Loans: “Gross
Loans” is how much the bank has issued, total. The bank expects a
certain number of borrowers to default, which is represented by
the “Allowance for Loan Loss” contra-asset. Net Loans equals
Gross Loans minus the Allowance for Loan Losses.

• More Liabilities: “Deposits” is the biggest one, but you also see
Federal Funds Purchased (a “balancer” on the L&E side) and many
types of Debt. Items like “Trading Liabilities” could represent
short positions in securities (i.e., the bank is betting that a stock’s
price will decline).

4 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

Income Statement

A bank’s Income Statement is split into three main sections: Net Interest Income (Interest Income
minus Interest Expense), Non-Interest Income, and Non-Interest Expenses. There are also a few items
in between these sections.

• Non-Interest Income: Investment banking fees, asset management fees, service charges,
mortgage fees, credit card fees, commissions, and gains and losses on securities.

• Non-Interest Expenses: Employee compensation, rent, technology, marketing, professional

services, amortization, and so on.

• Service Charges are based on the bank’s Deposits, but are

not linked to prevailing interest rates: They’re just a
percentage of Total Deposits.

• Trust Income often refers to fees from wealth management

and related services.

• Provision for Credit Losses: This number represents how

much the bank expects to lose on its Loans in the current
period above the Allowance for Loan Losses on its Balance
Sheet. Banks do not record actual Loan losses on their
Income Statements, only expected ones! (Although the two
are very similar.)

• Personnel: Often the biggest Non-Interest Expense; salaries,

benefits, training, and more.

• Other Expenses: Might include professional fees, marketing,

and IT services.

• Amortization of Intangibles and Goodwill Impairment:

Many banks are highly acquisitive, so these items are
common.

• Other Items: Most large banks have Noncontrolling Interests

and Preferred Stock, so you’ll see items for those here;
Discontinued Operations are also common since banks
frequently restructure and reorganize.

5 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

Cash Flow Statement

The main difference is that a bank’s Cash Flow Statement could

include items in different, seemingly random spots because there
isn’t a “strict” distinction between operating, investing, and financing
activities.

The CFS still starts with Net Income (or, outside the U.S., often with
Operating Income or Pre-Tax Income), and it still adjusts for major
non-cash items, such as the Provision for Credit Losses, D&A, and
Stock-Based Compensation.

It still includes familiar items, such as CapEx and Dividends, but their
meaning differs: CapEx is relatively small for most banks and does
not represent re-investment into the business. Dividends act as a
proxy for the bank’s “Free Cash Flow” but are also constrained by the
bank’s capital requirements.

The “Change in Deposits” and “Change in Gross Loans” here could

easily appear in Operating Activities instead of Investing and
Financing Activities.

The Cash Flow Statement isn’t terribly important for commercial

banks because you don’t need it for valuation purposes – just its
Dividends, Net Income, and Book Value, all of which you can project
without a Cash Flow Statement at all.

How Everything Links Together

1) You always start by projecting a bank’s Balance Sheet, usually beginning with its Loans,
Deposits, and other Interest-Earning Assets and Interest-Bearing Liabilities.

2) Then, project interest rates for all these items, and link them to a prevailing rate like LIBOR, the
Federal Funds rate, or the interbank rate in your country.

3) Use that information to calculate the Interest Income and Interest Expense on the Income
Statement. Estimate the Non-Interest Income and Expenses with simple percentage growth,
percentage-of-revenue, or percentage-of-Balance-Sheet-line-item estimates.

6 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

4) Project the bank’s Dividends based on the “capital” (roughly, Tangible Common Equity) it’s
targeting vs. how much it currently has. You can also complete the full Cash Flow Statement
and include the other items as well, linking to the IS and BS where necessary.

Here’s a diagram:

Return to Top.

Insurance Accounting 101

Although insurance firms and commercial banks are grouped together under
the “Financial Institutions” moniker, insurance is a more complicated beast,
with tricky accounting and new terminology to learn.

When you project insurance firms’ financial statements, you start with the
Income Statement because Premiums – not Loans or Deposits – drive all the
other items.

The Balance Sheet is still important, and many insurance companies earn significant Interest and
Investment Income from it, but Premiums act as the main driver.

Income Statement

7 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

Instead of using categories like COGS and Operating Expenses, here’s how an insurance company might
organize its Income Statement:

• Revenue: Premiums, Net Investment Income (mostly

Interest), Net Investment Gains / (Losses), and Other
Revenue.

• Claims and Expenses: Claim and Claim Adjustment

Expenses (What they pay to customers who get in
accidents), General & Administrative Expenses,
Acquisition Costs (The commissions they’re paying to
acquire customers), and Interest Expense.

• Pre-Tax Income = Revenue – Claims and Expenses.

• Net Income = Pre-Tax Income * (1 – Tax Rate).

The trickiest part of an insurance company’s Income Statement is revenue and expense recognition.

For example, let’s say that a customer signs up for a $10,000 1-year auto insurance policy on June 30th.

You’d record the $10,000 as a Written Premium, but you would not recognize 100% of it as revenue in
Year 1: Only half, or $5,000, in Earned Premiums would count toward revenue for Year 1.

Insurance companies can recognize revenue only for policies they have delivered, so there is often a big
difference between Written and Earned Premiums.

On the expense side, you might link Claim and Claim Adjustment Expenses to Earned Premiums – for
example, maybe they represent 75% of Earned Premiums. In that case, you’d record $3,750 in Claim
and Claim Adjustment Expenses in this first year.

For 1-year policies, the math is straightforward. But the fun begins with policies that last for 2-3 years,
5-10 years, or even 20-30 years.

With multi-year policies, you still record on the Income Statement the Claim and Claim Adjustment
Expense that matches up with the Earned Premiums in a given year.

But the cash payout of those expenses may be much different.

8 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

For example, if it’s a 3-year policy with Premiums of $1,000 per year, you might say that the Claim and
Claim Adjustment Expense represents 75% of Earned Premiums each year.

So, you record $750 in Year 1, $750 in Year 2, and $750 in Year 3, for a total expense of $2,250.

But you might pay out in cash 60% of that $2,250 figure in Year 1, 30% in Year 2, and 10% in Year 3, for
Cash Expenses of $1,350, $675, and $225.

On top of that, insurance companies often reinsure policies of other insurance companies, and, in turn,
often hire other insurance companies to reinsure their policies (to distribute risk).

So, to calculate Net Earned Premiums – the figure that counts toward revenue – you must add
Premiums the company is reinsuring (“Assumed Premiums”) and subtract Premiums that other
companies are reinsuring for this company (“Ceded Premiums”).

Here’s a screenshot of a partial model with some of this setup in place:

We use different types of

Reserves to track revenue
and expenses that have been
recognized but not yet earned
or paid in cash.

The Unearned Premium

Reserve (UEPR) is the main
one that tracks Premiums
we’ve written but not yet
earned; it’s similar to
Deferred Revenue for normal
companies.

The Loss & LAE Reserve (“Loss

& Loss Adjustment Expense”
is another name for “Claim &
Claim Adjustment Expense”)
does something similar for
the company’s main expense.

Finally, we must track the same items for the Premiums that have been ceded to other insurance firms;
the Ceded Unearned Premiums and Reinsurance Recoverables line items on the Assets side do that.

9 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

Insurance Modeling = Inception?

Due to these complexities, insurance modeling sometimes feels like you’re in the movie Inception: You
think about policies within policies within policies… and then other companies insuring your policies,
while other companies insure their policies.

However, most interview questions and case studies test your knowledge of the fundamentals, so
don’t get too paranoid about this complexity.

Balance Sheet

On the Balance Sheet, insurance companies differ from both commercial banks and normal companies.

The Balance Sheet is still divided into Assets and Liabilities & Equity, but the organization and individual
items are very different:

Assets Side:

• Investments: Fixed Income, Equities, Real Estate, Joint

Ventures, Short-Term Investments… anything on which
the firm earns “Interest and Investment Income” goes
here.

• Non-Investment Assets: Cash, Premiums Receivable

(similar to Accounts Receivable), Reinsurance
Recoverables, Ceded Unearned Premiums, Deferred
Acquisition Costs, and then the usual items, like
Goodwill and Other Intangible Assets.

Reinsurance Recoverables, Ceded Unearned Premiums, and

Deferred Acquisition Costs are new items, but we need to look
at the L&E side of the Balance Sheet first to explain what they mean:

10 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

Liabilities & Equity Side:

• Liabilities: Claim and Claim Adjustment Expense

Reserves, Unearned Premium Reserves, Debt, Other
Payables, and Other Liabilities.

• Equity: Preferred Stock, Common Stock, Noncontrolling

Interests, APIC, Treasury Stock, Retained Earnings, and
Accumulated Other Comprehensive Income. It’s the
same!

The two most important new line items are:

• Claim and Claim Adjustment Expense Reserves (AKA “Loss and Loss Adjustment Expense
Reserve”): The Claim Expense on the Income Statement might differ significantly from the cash
Claims paid to customers; this reserve reflects those differences. Each year, you add the Claim
Expense on the Income Statement and subtract the Claims that are paid out in Cash. This
reserve reflects the total cash Claims the company must pay out in the future.

• Unearned Premium Reserves: This item serves a similar function, but for Premiums rather than
Claims. Each year, you add the Premiums the company has written, and you subtract the
Premiums the company has recognized as revenue. This figure reflects the total amount of
Premiums the company will recognize as revenue in the future.

Two of the new items on the Assets side are directly related to items on the L&E side:

• Reinsurance Recoverables refers to the Claim and Claim Adjustment Expense Reserve, but for
policies the company has ceded to other insurance companies.

• Ceded Unearned Premiums refers to the Unearned Premium Reserve, but for policies the
company has ceded to other insurance companies.

The last one, Deferred Acquisition Costs, is simpler: Each year, the
company pays cash commissions to brokers and salespeople that
referred new customers.

But the company can’t recognize the entire cash expense right away
since it does not recognize all the Written Premiums right away.
Instead, it recognizes only the portion of the commission expense
that corresponds to the Earned Premiums in the year.

11 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

The company defers the rest and recognizes it over time, and the Deferred Acquisition Costs Asset
tracks how much will be recognized in the future (similar to Prepaid Expenses).

Cash Flow Statement

The Cash Flow Statement for insurance companies is similar to the CFS for normal companies: Start
with Net Income (or sometimes other metrics, such as Operating Income or Pre-Tax Income), make
non-cash adjustments, and factor in Changes in Working Capital to calculate Cash Flow from
Operations.

Cash Flow from Investing is also similar: It includes purchases of and proceeds from investments and a
bit of CapEx, often embedded in an “Other” line item.

Finally, Cash Flow from Financing also includes familiar items: Issuing and repaying Debt, issuing and
repurchasing Stock, and issuing Dividends.

Since you also value insurance companies with a Dividend Discount Model rather than a DCF, the Cash
Flow Statement is not terribly important for valuation purposes.

How Everything Links Together

Here’s a summary of how to project an insurance company’s financial statements:

1. Start by projecting the company’s Direct Written Premiums – how much in Premiums it is
selling directly to customers. Then, project the company’s Assumed Premiums and Ceded
Premiums, and the percentage that it’s earning in each category.

2. Next, project the Claim and Claim Adjustment Expense Ratio, the commission rate, and the
underwriting expenses as a percentage of the Written.

3. List the company’s Net Earned Premiums and its Interest and Investment Income for revenue
on the Income Statement. You’ll need the Balance Sheet to get the full numbers for Interest
and Investment Income. Expenses consist of Claims, Commissions, Underwriting Expenses, and
Interest. Calculate Pre-Tax Income and Net Income the normal way.

4. The Balance Sheet flows in from the company’s revenue/expense recognition (the Reserves
and corresponding items on the Assets side), and Cash and Equity flow in as they normally do.
You might project Investments and Debt independently, or you might link them to Premiums.

12 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

5. The Cash Flow Statement works the same way as well: Start with Net Income, make non-cash
adjustments, factor in Changes in Working Capital, and sum up each section of the CFS to
calculate the Net Change in Cash at the bottom.

6. Return to the Income Statement and link in Interest/Investment Income and Interest Expense,
which you projected based on Balance Sheet numbers and separate assumptions.

Return to Top.

Regulatory Capital

Both banks and insurance firms invest customers’ money to make money
– which means that they could also take on too much risk and lose their
customers’ money.

As a result, regulations in both industries limit the risk-taking potential of

these firms.

Of course, both types of companies expect to lose some amount of

money over time. Banks reflect this expectation with the Allowance for
Loan Losses; insurance companies do it with their Claims Reserve.

“Regulatory Capital” exists to cover unexpected losses – it’s a “cushion” that ensures that even if
something goes horribly wrong, the firm will survive (in theory).

Here are the most important Regulatory Capital metrics you need to know:

• Banks: Common Equity Tier 1, Tier 1 Capital, Total Capital, Liquidity Coverage Ratio, and Net
Stable Funding Ratio.

• Insurance: Solvency Capital Requirement Coverage Ratio.

Common Equity Tier 1 (CET 1) for banks is Tangible Common Equity (Common Shareholders’ Equity
minus Goodwill minus Other Intangible Assets), plus or minus a few other adjustments.

It serves as a buffer against potential unexpected losses.

Think about what happens if a bank writes down a Loan that it did not expect to write down: If
something on the Assets side decreases, something on the Liabilities & Equity side must also decrease.

13 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

If the bank does not have a capital buffer, that “something” might be Deposits or Debt – both of which
would be bad (customers and lenders would stop trusting the bank).

So, Common Equity Tier 1 and its variants ensure

that you, the consumer, do not lose money in
your checking account when a bank experiences
unexpected Loan losses.

Tier 1 Capital equals CET 1 + Preferred Stock. And

Total Capital equals Tier 1 Capital + “Tier 2
Capital.”

Tier 2 Capital includes some hybrid instruments

(e.g., Convertible Bonds), Subordinated Notes, and
a portion of the Allowance for Loan Losses.

It’s known as “Gone Concern Capital” because the

items within it can absorb losses only if the bank
stops operating (i.e., there’s a bankruptcy or other
shutdown).

You always divide these metrics by some variant of

Total Assets: The two most common ones are Risk-
Weighted Assets, which “weights” the Assets to
reflect the fact that Loans to the government of
Greece are far riskier than Loans to Google, and
Tangible Assets.

For example, the “CET 1 Ratio” equals Common Equity Tier 1 / Risk-Weighted Assets. The “Leverage
Ratio” equals Tier 1 Capital / Tangible Assets (+/- various adjustments).

Banks must maintain capital ratios above certain levels at all times to avoid penalty fees, restrictions on
Dividends and Stock Repurchases, and other limitations. If their capital ratios fall to too low a level, the
government may come in and take over.

For example, under Basel III, the minimum CET 1 Ratio is 4.5%; with the “capital conservation buffer,”
that climbs to 7.0%, and with the “countercyclical buffer” included, it’s 9.5%.

The minimum Tier 1 Capital Ratio is 6.0%, and the minimum Total Capital Ratio is 8.0% (both would
also increase by 2.5% or 5.0% with the buffer(s) included).

14 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

Banks also have to comply with requirements for liquidity and stability.

The Liquidity Coverage Ratio (LCR) requires banks to maintain enough “high-quality assets” to cover
100% of net cash outflows during a 30-day “stressed period.” To measure that, you examine the bank’s
liquid Assets (primarily Cash) and compare them to the percentage of Deposits and other funding
sources that might dry up in a crisis.

The Net Stable Funding Ratio (NSFR) requires banks to maintain “available stable funding” that equals
or exceeds the “required stable funding” over a 1-year period.

“Available Stable Funding” is, roughly, Total Capital plus various Liabilities and funding sources with
maturities of 1 year or more; “Required Stable Funding” consists of the bank’s Assets plus off-Balance
Sheet commitments, weighted by various percentages.

Insurance is similar, but a bit simpler: The key ratio is the “Solvency Capital Requirement Coverage
Ratio,” or SCR Coverage Ratio, which is defined as Available Capital / Required Capital.

Insurance companies must keep that ratio above 100% at all times, but most firms stay comfortably
above it, with median percentages frequently in the 200-300% range.

“Available Capital” is similar to Total Capital for commercial banks: It’s mostly Tangible Common Equity
along with some longer-term Liabilities and funding sources.

Required Capital equals “the expected negative impact on Own Funds of a 1-in-200-year event,” so you
cannot calculate it directly with a simple formula. However, it is related to the firm’s Total Assets and
the amount of risk it has taken on via cumulative Written Premiums.

There is also a “Minimum Capital Requirement” (MCR) for insurance firms, which is similar to the SCR
Coverage Ratio but set to a 25-45% minimum rather than a 100% minimum.

This one is like “the point of no return” for insurance firms; if a firm approaches this level, regulators
will step in to run the business.

Why Does Regulatory Capital Matter?

15 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

It matters because it constrains the assumptions in operating

models and valuations for financial institutions.

You can’t blindly assume a Loan or Premium Growth Rate – you

must ensure that the firm meets its regulatory capital requirements
no matter what you do.

So, for example, if you assume that a bank grows its Loans at 30%
per year, you might find that the bank’s CET 1 Ratio falls below its 10% targeted level by Year 5.

If that happens, you need to assume slower Loan Growth or assume that the bank raises additional
equity via a follow-on offering so that its CET 1 Ratio complies with the minimum.

These requirements also influence the Dividends that banks and insurance firms can issue: Dividends
always reduce Equity, and all regulatory capital ratios are linked to Equity.

So, in the scenario above, another solution might be to keep the 30% Loan Growth Rate, but assume
that the bank reduces its targeted Dividend Payout Ratio.

Since you value both banks and insurance firms with the Dividend Discount Model, these
requirements directly influence the implied values from that methodology.

You can’t just say, “This bank will grow its Loans at 30% per year and issue Dividends representing 50%
of its Net Income each year.” That assumption only works if the bank also complies with its regulatory
capital requirements.

Banks often raise Debt or Equity, divest divisions, or acquire other companies because of regulatory
capital concerns. You might even adjust the comparable public companies for excess or deficit capital
or screen for companies or transactions based on regulatory capital.

Return to Top.

Valuation Multiples & Intrinsic Valuation

The two key valuation multiples for both banks and insurance firms are P / E
(Price per Share / Earnings per Share, or Equity Value / Net Income) and P / BV
(Price per Share / Book Value per Share, or Equity Value / Book Value).

A third common multiple is P / TBV (Price per Share / Tangible Book Value per
Share, or Equity Value / Tangible Book Value); Tangible Book Value subtracts
Goodwill and Other Intangible Assets from the normal Book Value metric.

16 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

P / E measures the firm’s value relative to its after-tax profitability. You use Net Income rather than
EBITDA or EBIT because you want to include Net Interest Income for these companies. Also, Net
Income and Dividends tend to be closely related for financial institutions.

P / BV and P / TBV are important because they are strongly correlated with a
firm’s ROE (Return on Equity) and ROTCE (Return on Tangible Common Equity),
respectively.

In other words, if a firm’s ROE is higher than the median ROE of its peer
companies, then its P / BV multiple should be higher than the median P / BV of the set. If it is not, then
the firm might be undervalued.

You can even link these metrics formulaically and say that, for a stabilized firm:

P / BV = (Return on Equity – Net Income Growth Rate) / (Cost of Equity – Net Income Growth Rate)

If the P / BV multiple is above 1x, ROE exceeds the Cost of Equity; if it’s below 1x, ROE is below the Cost
of Equity (in theory…).

As with normal companies, you also select and use comparable public companies and precedent
transactions for banks and insurance firms.

But the selection criteria are different: Instead of screening by Revenue or EBITDA, you might screen
based on Loans, Deposits, Premiums, Total Assets, or other Balance Sheet items.

Also, the geography is extremely important because both industries are highly regulated, and the rules
may differ significantly in different countries.

Other Variations of Multiples

You will see non-recurring adjustments for P / E multiples, as well as

adjustments for “excess or deficit capital,” which apply to all the multiples
above.

In other words, if a bank has too much CET 1 (e.g., a 15% ratio vs. 10% for its
peers), you might subtract the excess CET 1 from the bank’s Equity Value,
Book Value, and Tangible Book Value, reduce its Net Income based on the earnings from that excess
capital, and then recalculate all the multiples.

17 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

In insurance, if the firm does not mark its Balance Sheet to market value, you might see P / NAV (“Net
Asset Value”) multiples as well.

The “Net Asset Value” is an estimate of the market value of the firm’s Assets minus the market value of
its Liabilities.

Embedded Value and P / EV multiples are also important for life insurance companies, but we’ll cover
those below.

Intrinsic Valuation

The most important intrinsic valuation methodology for banks and many insurance firms is the
Dividend Discount Model.

“Free Cash Flow” is meaningless for these companies because CapEx and the Change in Working
Capital do not represent re-investment in their core businesses – so you cannot use a traditional DCF
to value them.

Instead, you use Dividends as a proxy for Free Cash Flow. Since Dividends are only available to
common equity investors, you use Cost of Equity for the Discount Rate, and you base the Terminal
Value on multiples such as P / E, P / BV, or P / TBV.

Here’s how you might set up a simple Dividend Discount Model (DDM) for a commercial bank:

1. Assume an Asset Growth Rate, and make Risk-Weighted

Assets a percentage of Total Assets.

2. Project Assets and Risk-Weighted Assets based on these

figures.

3. Assume a Return on Assets (ROA) for the bank, and use

that to project Net Income. ROA = Net Income / Average
Total Assets, so Net Income = ROA * Average Total Assets.

4. Then, assume a Targeted CET 1 Ratio (e.g., 10% or 12%), and calculate the bank’s CET 1 for the
year based on that percentage times its Risk-Weighted Assets.

5. Back into the Dividends Issued by taking the bank’s CET 1, adding Goodwill and Other
Intangibles, subtracting the beginning Shareholders’ Equity, and subtracting Net Income and
anything else that might affect CET 1.

18 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

You constrain the Dividends issued by setting it up this way.

6. Discount the Dividends based on the Cost of Equity, and sum up all the discounted values.

7. Calculate the Terminal Value using the Multiples Method (typically P / TBV) or the Gordon
Growth method, and discount it to its Present Value, also using the Cost of Equity.

8. Add the Present Value of the Dividends and the Present Value of the Terminal Value to
determine the bank’s Implied Equity Value. Compare this to the bank’s Current Equity Value.

Step 5 is the crucial difference between a DDM and a DCF: You can’t make arbitrary assumptions about
growth, profitability, or payout ratios. If you do, and the CET 1 falls below the target, the bank will not
even be able to issue Dividends.

Here’s what a simplified DDM might look like:

19 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

In real life, the Targeted CET 1 Ratio would probably be higher; the Total Asset Growth might also drop
to less than 4% by the end of the projection period.

Return to Top.

20 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

Bank-Specific and Insurance-Specific Valuation

Valuation – Bank-Specific

You use the DDM outlined above 99% of the time when valuing banks.

But there is another, closely related methodology, known as the

Residual Income or Excess Returns Model.

With that one, the starting point is the bank’s Book Value: You assume
that the bank’s Implied Equity Value is initially equal to its Book Value.

Then, if the bank earns excess returns – if its Return on Equity (ROE)
exceeds its Cost of Equity (Ke) in future periods – you calculate, discount,
and add all these “excess returns” to the Book Value.

If the bank earns some amount of excess returns, its implied P / BV

should be above 1x; if not, it should be less than or equal to 1x.

You set up this model almost the same way you set up a Dividend Discount Model – you still assume a
Targeted CET 1 Ratio, and you still back into Dividends based on the bank’s actual vs. targeted CET 1.

But you do NOT value the bank based on those Dividends.

Instead, you calculate the Residual Income or Excess Returns each year with: (ROE * Shareholders’
Equity – Ke * Shareholders’ Equity). And then you discount and sum up those values and add them to
the bank’s current Book Value to determine its Implied Equity Value.

With this methodology, most of the bank’s Implied Value comes from its current Balance Sheet, so it’s
less speculative than a DDM. It also works well for banks that are not currently issuing Dividends.

But the disadvantage is that it’s far less common than the DDM, so it will require some explanation if
you decide to use it. Many bankers also think of this methodology as “academic” and not as useful in
real life.

Valuation – Insurance-Specific

Embedded Value is an important valuation methodology for life insurance companies.

21 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

It’s similar to the Residual Income Model described above because you take the insurance firm’s
Balance Sheet as the starting point in the valuation, and then you add the present value of future cash
profits from the insurance firm’s current policies.

Since life insurance contracts last for much longer than property & casualty (P&C) contracts, you can
reasonably project cash flows and profits 20-30 years into the future.

To calculate Embedded Value, start with the firm’s Net Asset Value and add
the present value of all expected, future cash profits.

“Net Asset Value” means that you mark the insurance firm’s Balance Sheet to
market value if it is not yet marked-to-market, and then you subtract all the
Liabilities from all the Assets.

You can also think of Net Asset Value as the cumulative, after-tax cash flows
generated from policies in previous years.

So, Embedded Value = Cumulative, After-Tax Cash Flows from Policies in Past Years + Present Value of
Expected After-Tax Cash Flows in Future Years.

When you calculate Embedded Value on today’s date, you assume that the insurance company writes
no new policies in future years. The expected after-tax cash flows, therefore, are all based on the
company’s policies as of today.

In real life, you may project Embedded Value by assuming that the company writes new policies in each
future year.

HOWEVER, projected Embedded Value in Year 4 or Year 10 is still based on the assumption that the
company writes no new policies after Year 4 or Year 10.

Embedded Value is an intrinsic valuation methodology, but you can also calculate a P / EV (Equity
Value / Embedded Value) multiple based on this analysis.

It’s one of the most important multiples for life insurance companies, and you often use it in addition
to or in place of P / E and P / BV.

Return to Top.

22 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

M&A and Merger Models

You shouldn’t worry about these topics too much because they are extremely
unlikely to come up in interviews.

But since you asked, here are the main differences in bank M&A deals and
merger models (sorry, I’ve never been able to find much on insurance):

1) Form of Payment – Most banks can use only Debt or Stock to fund deals; they need to keep
significant Cash available to cover possible Deposit withdrawals. Sometimes other banks also
hold a significant percentage of the bank’s Cash.

2) Mark-to-Market Balance Sheet – In any M&A deal, the Buyer must mark the Seller’s Balance
Sheet to market value, which usually means adjusting the value of the Seller’s Loans (“Loan
Marks”) because of interest rate or credit risk differences. The combined company must then
amortize these adjustments over the estimated useful lives of the Assets and Liabilities:

3) Write-Down of the Allowance for Loan Losses – Accounting rules require the Buyer to write
down the Seller’s Allowance for Loan Losses since it is also marking the Loan portfolio to fair
market value.

23 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

4) Core Deposit Intangibles – A new Intangible Asset, which represents the “funding advantage”
of the Seller’s most stable Deposits, gets created. The combined company amortizes it over
time, and the amortization is typically not deductible for cash-tax purposes.

5) Deposit Divestitures – The Buyer may have to divest some of the Seller’s Loans and Deposits
for regulatory reasons. For example, in the U.S., banks cannot end up owning over 10% of total
national deposits as a result of M&A deals (but they can reach that level organically).

6) Cost Savings and Restructuring – Cost savings opportunities are a bit easier to predict in bank
M&A deals because most commercial banks have the same business model. In many deals,
Buyers plan to cut 20%, 30%, or even 40% of the Seller’s Non-Interest Expenses, which would
be massive in other industries. Buyers must spend some upfront cash on Restructuring to
realize these Cost Savings.

7) Capital Ratios, Dividends, and Federal Funds – The Buyer’s Regulatory Capital, Dividends, and
Federal Funds Sold and Purchased will all be impacted by the deal. Depending on the numbers,
the Buyer may have to raise more Equity, increase or reduce Dividends, and increase or reduce
its Federal Funds line items.

8) Alternative Assessments – Beyond EPS accretion/dilution, you can also look at the
accretion/dilution of metrics such as Dividends per Share and Book Value per Share, and you

24 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

can evaluate deals by calculating the Internal Rate of Return (IRR) or the Net Present Value
(NPV) of Synergies. A Contribution Analysis is also useful for majority-Stock deals.

A merger model is still a merger model, so you still combine all the financial statements, allocate the
purchase price, and so on – it’s just that the new items above complicate the model.

For example, the Purchase Price Allocation Schedule becomes more involved because you also have to
factor in the mark-to-market adjustments, the write-down of the Allowance for Loan Losses, and the
new Core Deposit Intangibles when calculating Goodwill.

Return to Top.

Buyout and Growth Equity Models

Traditional “leveraged buyouts” are quite rare for commercial banks (they’re more common in other
sectors of financial services, including insurance).

That’s because of regulations and deal math:

1) Regulations: If a private equity firm comes to own more than 25% (or sometimes even less) of a
bank’s voting shares, the PE firm may be classified as a “bank holding company,” which means
that it must comply with regulatory capital and other requirements.

2) Deal Math: Most banks are already highly leveraged and cannot take on much additional Debt
to fund a deal. Also, if too much Debt is used, the bank’s CET 1 Ratio could fall below the
minimum (since the bank’s Equity is written down 100% in a control deal).

To get around these problems, PE firms typically invest in the sector in one of three ways:

• Option #1: Structure the deal as a minority-stake investment for 5%, 10%, or 20% of the bank’s
common shares.

• Option #2: Invest in something other than the bank’s Common Equity – Preferred Stock,
Convertibles, or Mezzanine. Or purchase specific Assets, such as a portion of the bank’s Loan
portfolio.

• Option #3: Do the deal with multiple PE firms such that it is a buyout for 100% of the bank, but
no firm controls more than, say, 20% of the bank’s voting shares. The deal would be funded
with 100% Equity, or a percentage close to 100%.

25 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

“Bank buyouts” are more like growth equity deals or debt investments than traditional LBOs.

The differences are clear if you think about the sources of returns in a traditional LBO model vs. a
“bank buyout” model:

Traditional LBO Model – Returns Attribution Analysis:

“Bank Buyout” Model – Returns Attribution Analysis:

The goal in almost any bank buyout or minority investment is to boost the bank’s P / TBV or P / BV
multiple. Assuming a stabilized bank, you can calculate these multiple with formulas:

P / BV = (ROE – NI Growth Rate) / (Cost of Equity – NI Growth Rate)

P / TBV = (ROTCE – NI to Common Growth Rate) / (Cost of Equity – NI to Common Growth Rate)

Most PE firms attempt to boost banks’ ROTCE or ROE via cost cuts, higher Asset growth, higher-yielding
Assets, or lower-cost funding sources.

A simplified outline of a “bank buyout” deal might look like this:

26 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

Return to Top.

Recap and Summary

Here’s a summary of the key points in this guide:

• How Banks & Insurance Firms Work: They make money with money; they accept Deposits or
Premiums from customers, pay Interest or Claims on them (eventually), and then they invest
the customers’ funds in Loans or Investments and earn money on those; they also earn money
from commissions, fees, and other non-Interest sources.

• Bank Accounting 101: The key items on a bank’s Balance Sheet are Loans and Deposits; Gross
Loans minus the Allowance for Loan Losses (what the bank expects to lose) equals Net Loans;
banks have many investment/asset categories and funding sources; the Income Statement is
split into Non-Interest vs. Interest Revenue and Expenses, and the Provision for Credit Losses
represents what the bank expects to lose over and above the Allowance on the BS.

• Insurance Accounting 101: The Income Statement is split into Revenue (Premiums and
Investment/Interest Income) and Claims & Expenses; revenue/expense recognition is tricky
because policies can last many years but are often paid for upfront; the Balance Sheet has
Investment/Non-Investment Assets, and the L&E side has Reserves for Claims and Claim

27 of 28 http://breakingintowallstreet.com
 Bank & Financial Institution Modeling
Quick Reference Guide for the Entire Course

Adjustment Expenses and Unearned Premiums; companies often assume premiums from and
cede premiums to other insurance companies.

• Regulatory Capital: Common Equity Tier 1 (Tangible Common Equity with a few adjustments),
Total Capital, etc. all protect commercial banks from unexpected losses; if a bank suddenly has
to write down its Loans, the losses will affect Shareholders’ Equity rather than Deposits or Debt.
For insurance, the Solvency Capital Requirement Coverage Ratio, defined as Available Capital /
Required Capital, is similar.

• Valuation Multiples & Intrinsic Valuation: P / E, P / BV, and P / TBV are key multiples for both
commercial banks and insurance firms; the Dividend Discount Model is used in place of a DCF,
and all assumptions must be tied to regulatory capital, i.e. Loans and Deposits can grow only if
the bank has enough Equity to support the additional Risk-Weighted Assets. You back into the
Dividends issued each year based on Targeted CET 1 vs. Actual CET 1.

• Bank-Specific and Insurance-Specific Valuation: For banks, you may use a Residual Income
Model, which uses Book Value + Present Value of Future Residual Income (Residual Income =
ROE * Shareholders’ Equity – Cost of Equity * Shareholders’ Equity in each year) to value the
company. For life insurance, you may use Embedded Value, which values a company based on
its current Net Asset Value plus the Present Value of the after-tax cash flows from its current
policies.

• M&A and Merger Models: There are many differences; banks tend to use only Debt or Stock to
fund deals, there are mark-to-market Balance Sheet adjustments, Core Deposit Intangibles get
created, the Seller’s Allowance for Loan Losses is written down, and there may be Deposit
Divestitures; Cost Savings and Restructuring are very important; the Capital Ratios, Dividends,
and Federal Funds line items will change; you may look beyond EPS accretion/dilution and
assess deals with IRR, the NPV of Synergies, and other methods.

• Buyout and Growth Equity Models: Traditional leveraged buyouts are rare for commercial
banks (more common in insurance and other sectors of financial services); PE firms typically
make minority-stake investments, purchase specific assets, or do club deals if they invest in the
sector; returns sources are TBV growth, P / TBV multiple expansion, and Dividends; banks can
rarely take on additional Debt to fund a deal.

Return to Top.

28 of 28 http://breakingintowallstreet.com