Financial Services Firms

ZABIHOLLAH REZAEE, PhD, CPA, CFE, CMA, CIA, CGFM, is the Thompson-Hill Chair of Excellence and Professor of Accountancy at the University of Memphis and has served a two-year term on the Standing Advisory Group (SAG) of the PCAOB. He is a prolific writer, having published six books and 190 articles in a variety of accounting and business journals.

Preface xi Acknowledgments xvii

PART I: FINANCIAL SERVICES INDUSTRY: ITS MARKETS, REGULATIONS, AND GOVERNANCE 1

Chapter 1: Fundamentals of the Financial Markets and Institutions 3

Introduction 3

Financial Markets 3

Financial Information and Capital Markets 4

Financial Crisis and Financial Regulatory Reforms 5

Types and Roles of Financial Markets 15

Financial Services Firms 21

Conclusion 24

Notes 25

Chapter 2: Introduction to Financial Institutions 27

Introduction 27

Landscape of the Financial Services Industry 27

Structural Changes in the Financial Services Industry 28

Historical Perspective of American Banking 42

Current Trends in the Financial Services Banking Industry 43

Regulatory Reforms 46

Valuation Process 55

Conclusion 56

Notes 57

Chapter 3: Corporate Governance 61

Introduction 61

Corporate Governance Effectiveness 62

Global Regulatory Reforms 66

Sarbanes-Oxley Act of 2002 70

Dodd-Frank Act 74

Corporate Governance Functions 75

Board of Directors and Its Committees 78

Audit Committee Roles and Responsibilities 80

Executive Compensation 84

Conclusion 86

Notes 86

PART II: THE FOUNDATION: FINANCIAL INSTITUTIONS, VALUATIONS, MERGERS, ACQUISITIONS, AND REGULATORY AND ACCOUNTING ENVIRONMENT 89

Chapter 4: Overview of the Valuation Process 91

Introduction 91

Valuation Services 92

Valuation Profession 94

Valuation of the Business 97

Attracting Valuation Clients 105

Accepting a Client 109

Pricing Valuation Services 111

Importance of the Engagement Letter 112

Planning an Appraisal Engagement 114

General Planning 118

Appraiser’s Traits 121

Appraiser’s Due Diligence Process 124

Risk Assessment 125

Conclusion 126

Notes 126

Chapter 5: Overview of Mergers and Acquisitions 127

Introduction 127

Historical Perspective of Mergers and Acquisitions 128

Recent Trends in Mergers and Acquisitions 130

Regulations of Bank Mergers 136

Players in Mergers and Acquisitions 142

Motives for Business Combinations 146

Determinants of Mergers and Acquisitions 148

Perceived Shortcomings of Mergers and Acquisitions 152

Studies on Mergers and Acquisitions 155

Leveraged Buyout 159

Post Mergers and Acquisitions Performance 160

Shareholder Wealth and Effect of Mergers and Acquisitions 161

Joint Ventures and Strategic Alliances 162

Ethics in Mergers and Acquisitions 163

Governance in Mergers and Acquisitions 164

Mergers and Acquisitions Process 165

Conclusion 181

Notes 183

Chapter 6: Regulatory Environment and Financial Reporting Process of Financial Institutions 187

Introduction 187

Consolidation 187

Regulatory Environment 192

Bank Supervision 198

Financial Modernization: The Gramm-Leach-Bliley Act 205

Financial Reporting Process of Financial Institutions 208

Statement of Financial Accounting Standards No. 115 212

Auditing Proper Classifications of Marketable Securities 214

Tax Consideration of Fair Value 215

Recent Development of Fair Value Accounting 218

Financial Reporting Requirements of Financial Institutions 222

Corporate Governance of Financial Institutions 228

Conclusion 237

Notes 238

PART III: FUNDAMENTALS OF VALUATIONS: CONCEPTS, STANDARDS, AND TECHNIQUES 241

Chapter 7: Value and Valuation: A Conceptual Foundation 243

Asset-Liability Management 243

Investment Management 245

Lending Management 246

Liquidity Management 247

Nature of Value 249

Twelve Concepts of Value 250

Types of Property that Can Be Valued 260

Relationship among Different Types of Value 261

Principles of Valuation Theory 262

Pricing Value versus Reporting Value 263

Limitations of the Valuation Process 264

Conclusion 264

Notes 264

Chapter 8: Approaches to Measuring Value 267

Overview of the Valuation Process 267

Cost Approach to Valuation 268

Market Approach to Valuation 270

Income Approach to Valuation 273

Special Topics—Approaches to Intangible Asset Valuation 291

Special Topics—Business Valuation 294

Valuation and Business Concentrations 300

Special Topics—Closely Held Stock 301

Special Topics—Valuing Widely Traded Companies 304

Conclusion 305

Notes 305

Chapter 9: Valuations for Tax and Accounting Purposes 307

Tax Aspects of Mergers and Acquisitions 307

Typical Tax-Oriented Valuations 310

Accounting Aspects of Mergers and Acquisitions 313

Typical Accounting-Oriented Valuations 319

Acquisition Method 320

Presentation, Disclosure, and Transition Requirements of Business Combinations 324

Convergence in Accounting Standards on Mergers and Acquisitions 327

Conclusion 328

Notes 329

Chapter 10: Intangible Asset Valuation 331

Nature and Types of Intangible Assets 331

Amortizable versus Nonamortizable Intangible Assets 334

Measuring the Useful Life of an Intangible Asset 336

Establishing Value of Intangible Assets 338

Amortization Methods 341

Supporting Intangible Asset Valuation and Amortization 341

Goodwill Impairment 342

Conclusion 343

Notes 344

PART IV: ASSESSMENT OF FINANCIAL INSTITUTIONS 345

Chapter 11: Financial Analysis of Banks and Bank Holding Companies 347

Types and Sources of Financial Data 347

Overview of Financial Statements 351

Composition of Bank Assets 355

Composition of Bank Liabilities 359

Off–Balance Sheet Items 361

Composition of Bank Capital 362

Regulatory Capital Components 364

Risk-Based Capital 367

Value-at-Risk Models 370

Composition of Bank Income 371

Composition of Bank Expenses 373

Balance Sheet Analysis Illustration 376

Income Statement and Profitability Analysis Illustration 381

Loan Risk Analysis Illustration 385

Liquidity and Investment Portfolio Analysis Illustration 389

Portfolio Equities Analysis (REALM Model) 390

Special Bank Holding Company Considerations 391

Liability Management 392

Conclusion 392

Notes 392

Chapter 12: Internal Characteristics Assessment 395

Objectives and Benefits of an Internal Characteristics Assessment 396

Ten P Factor Framework 396

Shareholder Value Creation 405

Conclusion 412

Notes 413

Chapter 13: External Environment Assessment 415

Impact of External Environment on Value 415

Political Analysis 416

Economic Analysis 416

Social Analysis 417

Technological Analysis 420

Other Analysis 421

Conclusion 423

Notes 423

PART V: VALUATION OF MERGERS AND ACQUISITIONS 425

Chapter 14: Bank Merger and Acquisition Process 427

Strategy Phase 427

Negotiation and Investigation Phase 435

Finalization and Integration Phase 439

Other Considerations 443

Conclusion 446

Notes 446

Chapter 15: Valuing a Bank as a Business Enterprise 447

Business Enterprise versus a Collection of Assets 447

Concept of the Banking Franchise 448

Difference between Strategic and Tactical Valuations 449

Why the Cost Approach Is Not Used for Strategic Bank Valuations 450

Application of the Market Approach to Valuing a Bank 450

Application of the Income Approach to Valuing a Bank 454

Sensitivity of Value Estimate to Assumption Changes 461

Value-Creation Opportunities and the Acquisition Price 463

Valuation Methods for Mergers and Acquisitions 465

Sophisticated Valuation Techniques for Mergers and Acquisitions 470

Relation between Price and Value and Effect on Stockholders 475

Conclusion 478

Notes 478

Chapter 16: Valuation of Tangible Bank Assets 479

Tangible Physical Assets 480

Tangible Financial Assets 481

Tangible Assets in Bank Mergers and Acquisitions 486

Intangible Assets in Bank Mergers and Acquisitions 486

Conclusion 487

Chapter 17: Core Deposits as a Special Type of Intangible Asset Valuation 489

Concept of Core Deposit Base as an Intangible Asset 489

Internal Revenue Service Position on Core Deposits 490

Important Core Deposit Tax Court Cases 490

Deposits to Be Included in Valuation 497

Alternative Approaches to Valuing a Core Deposit Base 497

Core Deposit Base Life Estimation 499

Application of the Cost Savings Approach 502

Application of the Future Income Approach 505

Systemically Important Financial Institutions 508

Conclusion 511

Notes 511

Chapter 18: Derivative Financial Instruments 513

Authoritative Guidelines on Derivatives 515

Derivative Markets 516

Derivatives Risk Management 518

Derivatives Risk Management Policy 519

Accounting for Derivatives 528

Tax Considerations of Derivatives 535

Audit of Derivative Transactions 535

Sources of Information on Derivatives 537

Derivatives Valuation Models 538

Derivatives under the Dodd-Frank Act of 2010 542

Conclusion 543

Notes 543

Chapter 19: Real-World Bank Valuation Complications 547

Banks Experiencing Recent Losses 548

Banks with Low Equity Capital 551

Banks with Uncertain Future Loan Loss Exposure 554

Preferred and Common Stock 556

Highly Leveraged Banks 557

Branch Acquisitions 557

European Banking Model 559

Initial Public Offering 561

Islamic Banking System 562

Emerging Issues in the Financial Services Industry 564

Conclusion 568

Notes 568

About the Author 569

Index 571