Financial Institutions

General principles

Financial institutions (banks and insurance companies) have to abide by regulations which focus on their solvency:

  • For banks and other credit institutions (consumer credit, leasing, factoring...) : Basel 3
  • For insurance and reinsurance companies: Solvency 2

The calculation of these ratios is based on restated consolidated aggregates.

Custodians and asset managers often have a banking licence. In that case, they have to abide by the Basel 3 regulation.

For each country the regulation is performed by a domestic watchdog. In France, the ACPR (Autorité de Contrôle Prudentiel et de Résolution) monitors the solvency of financial institutions.

30 banks are looked upon as systemic ones. In other words, the bankruptcy of one of them would generate a systemic crisis for global finance. In that context, 8 European banks are regulated by the European Central Bank. 
The 30 systematic banks are:

  • 4 in France
    • BNP Paribas
    • BPCE
    • Crédit agricole
    • Société générale
  • 1 in Germany: Deutsche Bank
  • 1 in the Netherlands: ING
  • 1 in Spain: Santander
  • 1 in Italy: Unicredit

  • 4 in China
    • Agricultural Bank of China
    • Bank of China
    • CCB
    • ICBC
  • 8 in the USA
    • Bank of America
    • Bank of New York Mellon
    • Citigroup
    • Goldman Sachs
    • JP Morgan Chase
    • Morgan Stanley
    • State Street
    • Wells Fargo
  •  2 in Canada
    • Banque Toronto-Dominion
    • RBC
  •  3 in the United Kingdon
    • Barclays
    • HSBC
    • Standard Chartered
  • 2 in SwitzerlandCrédit suisseUBS
  • 3 in Japan
    • Mitsubishi UFJ
    • Mizuho
    • Sumitomo Mitsui


Each bank has to respect regulatory ratios, among which a Core Equity Tier 1 (CET1) ratio = CET1 / RWA:

  • CET1 = shareholders equity - intangible assets including goodwill - shareholdings in other financial institutions
  • RWA = Risks Weighted AssetsThe RWA correspond to the commitments that are undertaken by the bank, the main ones being the loans granted to retail and corporate clients. 

The weighting coefficients are generally calculated thanks to the bank's internal system that is closely monitored by the regulator(s). The weigthing coefficient is the more important as the risk of default of the borrower is high.

Since 2019, according to the Bank for International Settlements (BIS), the minimum CET1 ratio is 7.0% = 4.5% + 2.5% (capital conservation buffer) before taking a 0.0%-2.5% countercycle buffer which is applied when credit growth is judged to result in an unacceptable build-up of systematic risk.

A target CET1 ratio is prescribed to each bank by its regulator(s).

Given the magnitude of the CET1 ratio, it is systematically embedded in the valuation of a bank:

  • The bank's equity value is equal to the sum of present values of future dividends that correspond to forecasted levels of excess equity
    • Excess equity correspond to the maximum dividend that could be paid out to the bank's shareholders taking the target CET1 constraint into account. 
    • This is the reason why the valuation of a bank is based on a Dividend Discount Model (instead of DCF model)
  • A listed peers and/or M&A peers approach can also be conducted. The 3 main multiples are generally taken into account:
    • P/E
    • P/BV = market cap / book value of consolidated equity, group share
    • P/TBV= market cap / book value of consolidated tangible equity, group share
      • with tangible equity = book value of consolidated equity, group share - goodwills and intangible assets
    • ROE correlated P/BV
      • Determination of a and b, based on sample of peers, so that: P/BV = a.ROE + b
      • If the coefficient of determination (r2) of the statistics is meaninful (ie r2>50%), application of the obtained P/BV to the BV of the company to be valued
  • An alternative approach which is also based on a multiple, but which includes only the specificities of the company to be valued, consists in applyig the (ROE - g) / (k - g) multiple to its CET1 or, by approximation, to its TBV.

Example of excess equity calculation

  • Financial assumptions
    • RWA: 1 000
    • Target CET1 ratio: 10%
    • CET1: 120
  • Excess equity = CET1 - Required equity = 120 - (10% x 1 000) = 20 = theoretical dividend to be included in the DDM model.

The following slides present a detailed example: Slides

Underlying Excel file: Excel model

The Basel 3 regulation includes other constraints:

  • Leverage ratio = Tier 1 capital / Total exposure > 3%
    • Tier 1 = CET1 + Additional Tier 1 capital (AT1) 
    • AT1 = capital instruments that have no fixed maturity and with no incentive for the issuer to redeem them
      • Preferred shares
      • High contingent convertible securities (CoCos) because their structure is shaped by their primary purpose as a readily available source of capital for a firm in times of crisis.
  • Liqudity Coverage Ratio (LCR) = High Quality Liquid Assets / Total net liquidity ourflows over 30 days > 100%
  • Net Stable Funding Ratio (NSFR) = Available amount of stable funding / Required amount of stable funding > 100%
    • Available amount of stable funding = customer deposits + long-term wholesale funding (from the interbank lending market) + equity

Insurance companies

Insurance and reinsurance companies calculate a Solvency 2 ratio 

The defintion of the Solvency 2 ratio is : Equity / SCR

  • As for banks, the equity which is taken into account is reduced by goodwills and intangible assets
  • The SCR corresponds to the Solvency Capital Requirements
    • It includes 5 risks 
      • Underwriting risk in life, non life and health
      • Market risk
      • Counterparty risk
      • Risk relative to intangible assets
      • Operational risk
    • It is reduced by diversification benefits as the SCR includes coefficients of correlation between the various risks that may be negative or equal to 0
  • The Solvency 2 ratio has to be at leat equal to 1. Howerver, most global players (Axa, Allianz, Generali...) post a Solvency 2 ratio that is generally higher than 150%. The higher the Solvency 2 ratio is, the lower the cost of reinsurance contract is and the higher the technical profitability is.

The following document proposes a focus on SCR. It underlines the principle of their calculation in the Solvency 2 environement and the implied calculation of benefits of diversification for an insurance or a reinsurance company:

The calculations of the handout are coming from the below Excel file:

A focus is provided on SCR for specific underwriting risks:

Credit risk

Returns and risks: BHR, Distance to Default, MES, LRMES and SRISK  : Handout

Introduction to CDS: slides

Reference paper published by Moodys' KMV; Peter Crosbie & Jeff Bohn's distance to default : paper