+ Sources

New loans

+ Increase in securities held + Increase in accounts receivable + Increase in net tangible assets + Increase in other assets

- Decrease in deposits

- Decrease in external debt

Potential dividends + Equity repurchases - Equity issues

When cash from operations is combined with sources and uses from the balance sheet, the result is free cash flow to shareholders, which is mathematically identical to dividends that could be paid to shareholders. This is usually not the same as actual dividends in a given year because management deliberately smoothes dividend payments across time. This topic is discussed in greater detail later in the chapter when we cover how to value banks from the outside.

Using the Spread or Income Model

The language of banking often expresses income as spreads earned on balances—that is, the difference between the rate paid on borrowings and the Exhibit 21.3 ABC Bank—Income Model

Exhibit 21.4 ABC Bank—Spread Model

rate received on loans and investments. Consequently, as a first step it is useful to show the equivalence between the traditional computation of earnings as reported in financial statements for nonfinancial companies, which for lack of a better phrase we shall call the income model, and the spread model that is common practice in banking.

The balance sheet and income statement for the hypothetical bank in Exhibit 21.3 show the traditional income model computation of net income. We assume that loans earn 12 percent, cash reserves at the Federal Reserve Bank earn nothing, deposits pay 5 percent, and the tax rate is 40 percent. Note that the income model, based on the financial statements, computes net income as $8.

The spread model is an alternative but equivalent approach for computing net income. It starts with the assumption that an opportunity cost of money (call it the money rate) is charged to the wholesale bank and credited to deposits. In our example, it is 8 percent. The spread model calculates net income by adding spreads times balances. It then adds a credit for the equity component of the bank's financing, since the spreads used assume that investments are 100 percent from borrowings. Likewise, income is reduced for reserves at the Federal Reserve since they do not earn interest. Exhibit 21.4 illustrates the spread-model net income calculation.

The spread model gives the same answer as the income model, but should be used with care. For example, the money rate used in the equity credit is not equivalent to the cost of equity: It is merely an accounting convention necessary to provide the right answer.

Valuing Banks from the Outside

Banks remain among the most difficult companies to value despite the multitude of regulatory and reporting requirements imposed on them. It is hard to determine the quality of their loan portfolio, to figure out what percentage of

Exhibit 21.5 Term Structure Slope Creates Mismatch Profits

Exhibit 21.5 Term Structure Slope Creates Mismatch Profits

their accounting profits results from interest-rate mismatch gains, and to understand which business units are creating or destroying value. Understanding Mismatch Gains and Losses

Normally, the term structure of interest rates is upward sloping, as shown in Exhibit 21.5. A bank that lends three-year money and borrows one-year money will earn a mismatch profit equal to the difference between the longer and shorter term rates of interest. Much of this profit is illusory because the one-year funds must be rolled over twice at future one-year spot rates that are expected to be higher than today's one-year rate. The mismatch profit observed in today's market should not, in most circumstances, be forecasted to persist.1

To illustrate how spreads would be expected to change, suppose a bank lends $1 million of three-year fixed-rate money and borrows $900,000 of one-year CDs that are rolled over each year for three years. The assumed term structure is as follows:


Maturity Yield forward rate (years) (percent) (percent)

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