How Banks Create Shareholder Value

This chapter deals with a fundamental topic for shareholder value-oriented banks and how they can create shareholder value. In order to answer this question, we start from Market Value Added (MVA), which is calculated as the difference between the current market value of all capital elements and the historical amount of capital invested in the company. In order to create shareholder value, companies have therefore to increase what shareholders could obtain selling their participation. Since stock market prices are purely expectational the company’s market value is given by the net present value of all future profits discounted at the company’s cost of capital. By applying the Discounted Cash Flow (DCF) method to the Free Cash Flow to Equity (FCFE), the value of equity capital (which expresses the shareholders’ interest) is obtained by discounting the ‘expected cash flows to the equity’ at the Cost of Equity. Banks (as any firms) that strategically target shareholder value creation focus on the following decisions: Increasing the expected cash flows to equity, i.e. the residual cash flows after meeting all expenses, tax obligations, interest and principal payments. For banks, this can be achieved in several ways such as by increasing sales (e.g. increasing deposits, loans, off-balance sheet activities, inter-bank operations, etc.), increasing prices (e.g. increasing commissions, interest rates, etc.), increasing returns on risk-activities (such as trading on security, derivatives, etc.) and reducing operating costs (such as operating and administrative costs) and financial costs (such as interest expenses). Reducing the hurdle rate (i.e. the cost of equity or capital). In order to reduce the bank’s cost of equity, managers can only attempt to reduce the systematic (or market) risk of the bank, i.e. measured by beta (β). Since β expresses the relative correlation between the bank’s share returns with the market portfolio returns,1 managers can increase shareholder value by reducing this correlation. For instance, managers can diversify corporate activities abroad and, therefore, lower the covariance between the company’s share price and the market portfolio. Since the risk free rate (i.e. the rate of return of a risk free asset) and the market portfolio returns (i.e. the rate of return of a portfolio composed of all activities in the stock market) cannot be influenced, these are exogenous variables out of the managers’ control. Matching as closely as possible bank’s financing sources with bank’s investments. If a bank is able to employ financial sources with similar features (e.g. in terms of maturity, credit and/or interest rate risks) to the assets being financed, this bank will increase shareholder value since this reduces cash outflow (due to the cost necessary to manage the company’s liquidity) and reduces its overall risk (which influences negatively both the cost of equity and cost of debt).