Financial Modeling for Banks

Financial modeling generally does not differ very much from industry to industry. For instance, if a person creates a financial model for a retail company, it could also be used for a restaurant with some minor changes. This is because most of these companies sell products or services. This means that when they sell these products, value leaves the firm in the form of goods, whereas value is received by the company in the form of monetary compensation.

However, financial modeling for banks is a completely different activity. This is because banks make money with money. Both the outflow and inflow involve money. Banks take loans from customers in the form of deposits and then loan out the same funds to borrowers. This means that they essentially make money because there is a difference in the interest rate, which they charge from borrowers’ vis-a-vis what they pay to customers.

The nature of the banking business is profoundly different from other businesses. This has many implications from a financial modeling perspective as well. Some of these effects have been listed down below.

Why is Financial Modeling for Banks Different?

• As mentioned in the previous article, Earnings before Interest, Taxes and Depreciation i.e., Operating Profit is a very important number in most companies. This number is useful because it separates the operating performance of a company from other factors such as interest rates and taxes. However, in the case of banks, it is not possible to separate the impact of operations and financing. This is because financing forms the core operations of a bank. Hence, interest rates are a part of both the revenues as well as the expenses.

• In normal businesses, the income statement is not so intertwined with the Balance Sheet. For instance, the number of units that a company like Wal-Mart sells has very little to do with the assets and liabilities on its balance sheet. This is not the case with a bank. The interest earned as well as the interest which has to be paid off completely depends on the balance sheet. Therefore, while creating a financial model for a bank, a modeler needs to first create the balance sheet. This balance sheet then becomes the starting point to project the income and expenses which will follow.

• As mentioned above, the deposits and assets growth is like revenue growth for banks. Once a projected balance sheet has been created, a tentative interest rate is assigned to every asset and liability. This interest rate then determines the various lines in the profit and loss statement of a bank. Banks also earn revenues via credit card fees, transaction fees, check issuance fees, etc. However, most of their revenues come in the form of interest.

• Banks have a lot more leverage as compared to normal companies. This means that a financial modeler must pay attention to the equity value of the bank. The concept of enterprise value is not applicable to financial institutions like banks.

• Also, concepts like “Free Cash Flow” don’t really apply to banks. This is because banks are always likely to face a liquidity crisis. A lot of their liabilities consist of demand deposits, whereas their assets consist of long term loans. Hence, there is a timing mismatch which is basically built into the business. The financial model has to be tweaked since free cash flow and working capital virtually become meaningless.

• Lastly, since banks take deposits which they have to return on demand to the public, they are supposed to keep a percentage of their capital ready to make good such demands. As a result, there are a lot of statutory requirements which mandate the amount of money a bank needs to keep on hand. There are other statutory requirements which also restrict how a bank can use the money it has on hand. Companies which sell goods and services are free to use their capital in any way they see fit. They are not subject to such regulations. This is the reason why a separate financial model needs to be built, which helps the management ascertain whether or not they are in compliance with the regulations.

• Banks need to report their assets and liabilities to the regulator on a daily basis. Banks also lend excess deposits that they have to other banks. As a result, a financial model needs to ensure that the assets and the liabilities of the banks must grow separately. One cannot grow faster than the others without causing solvency issues. Also, regulatory requirements limit the amount of dividend which can be given out by banks. Therefore, creating a financial model which values a bank using the dividend distribution model would not be a good idea. Banks also need to send timely reports about their liquidity and solvency ratios to the regulators.

The bottom line is that financial modeling for banks is very different as compared to financial modeling for other companies. The key metrics which need to be paid attention to, also change. Also, unlike normal companies, there are a lot of regulatory factors which need to be considered in the model. The process for creating a banking financial model is also different as compared to other financial models.