Bashing Barmy Banks: Rethinking Bank Valuation Models Post the Global Financial Crisis (GFC)

Abstract

In the wake of the Global Financial Crisis (GFC), the so-called “Market Knows Best” mantra is now openly questioned by even its most ardent admirers. Within Capital Markets, the “Market Knows Best” mantra influences the assumptions and conclusions of the Efficient Market Hypothesis (EMH) and the Capital Asset Pricing Model (CAPM). In this paper, we present a novel approach for valuing the equity capital in banks without resorting to either the EMH or the CAPM. We take the view that the two key risks faced by a bank are the risk of commoditization (as a result of burdensome regulations) and the risk of future financial crises. Taking a multiple time-period view of sustainable bank profitability, we explicitly consider the likelihood of commoditization as well as the likelihood of financial crises in a bank’s future, capture their impact in a probabilistic manner and incorporate any potential capital-raising to formulate a novel bank equity valuation model. We compare the results obtained from our valuation model with the share prices of developed market and emerging market banks.