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A new approach to the valuation of banks

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Abstract

We argue that the business model of the bank exhibits such pe-culiarities that it deserves a special treatment in the approach to its valuation as well. In particular, the exposure to interest rate risk is a major characteristic of its business, not only in the process of maturity transformation but also as a major determinant of price margin and business volume. There exists no common framework to value a bank which adequately accounts for these features. We propose a valuation model for banks based on Merton's (1974) structural model of the firm, which we adapt to the banking firm by the help of term struc-ture models of the interest rates. In this setting, we interpret banks as a particular portfolio of long and short positions in interest-rate sensitive assets. In doing so, we are able to show another peculiarity of bank valuation, i.e. that the exercise price of a call option on the firm value, representing the bank's equity, is not the face value of bank liabilities but their economic value. JEL classification: C22, G12, G13, G21.

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... According to [2], little has been written on the valuation of banks using the contingent claim approach. Most of the work done on bank valuation can be found in textbooks and practitioners' guide which include ([3]- [7]). ...
... The new models according to [2], do not aim at introducing a new paradigm in asset pricing theory. Rather, the common features of these models is the attempt to better grasp the underlying characteristics of the business in which equity is the residual claim-when compared to standard approaches. ...
... In their study, [2] proposed a valuation model for banks derived from [10], Black-Scholes pricing model and the concept of matched maturity marginal value of funds (MMMVF). However, the model has a few shortcomings: it is abstracted from taxes, reserve requirements, minimum capital requirements and other regulatory factors, and it does not include non-cash items in valuation (depreciation, amortization, etc.). ...
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... , , , , , , , , , , Other authors [9], [8] and [10] have also tried to model the value of banks. In particular, Owoloko et al gave the value of bank via the contingent claim approach [8]. ...
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