FIG Interview Questions

Q. Walk me through a bank’s income statement.

• Net Interest Income: A bank’s income statement starts with interest income less interest expense, which equals "net interest income", the difference between the interest the bank earns on loans and the interest a bank must pay on deposits.
• Provision for Credit Losses: The next major line item can be thought of as a bad debt expense, as it is an expense that accounts for expected losses due to bad loans.
• Net Interest Income After Provision for Credit Losses: The bank’s core operating profitability will be next, which is equal to net interest income minus the provision for credit losses.
• Non-Interest Income: The next line items are income not related to interest, e.g. fees, commissions, service charges, and trading gains.
• Non-Interest Expenses: The next line item captures non-interest expenses, such as salary and employee benefits, amortization, and insurance expenses.
• Net Income: The final line item is income tax expense, which once subtracted, leaves us with net income.

Q. Walk me through a bank’s balance sheet.

• Assets: A bank’s largest asset will be its loan portfolio, which is comprised of residential and commercial real estate, as well as loans for both businesses and individuals. Other common assets include investments and cash.
• Liabilities: Deposits are typically the largest liability on a bank’s balance sheet, and interest-bearing deposits will contribute to its interest expense. Short and long-term borrowings typically account for the rest of a bank’s liabilities.
• Equity: The equity section of a bank’s balance sheet is fairly similar to that of a typical company’s, as it comprises of common stock, treasury stock, and retained earnings.

Q. How are the financials of a bank different from a traditional company?

For a typical company, revenue, COGS, and SG&A account for the majority of operating income, while non-operating items like interest expense, other gains and losses, and income taxes are presented after operating income.

Banks, on the other hand, derive the core of their revenues from interest income, while the majority of operating expenses come from interest expenses.

Thus, separating revenues from non-operating items like interest income and expense would not be feasible for a bank.

Q. What is the impact of an inverted yield curve on a bank’s profits?

Banks make a profit via long-term lending, which is funded via short-term borrowing, so banks make a greater profit when there is a larger spread between short and long-term rates.

When yield curves flatten or invert, the opposite is happening; i.e., the spread between short and long-term yields is shrinking, so the bank’s profits will contract.

Q. How do you value a commercial bank?

When valuing a commercial bank, the most common types of financial models used are:

• Leveraged Discounted Cash Flow (DCF) Analysis
• Dividend Discount Model (DDM)
• Residual Income Model (RI)
• Comps with Equity Value Multiples (P/B, P/E, etc.)

The approaches shown above value the equity directly, as opposed to separating operating value from non-operating value, which is impossible for a bank given that its core operations are tied to generating interest income.

Q. Walk me through a bank’s valuation using a levered DCF.

Since you can’t separate a bank’s operating cash flows from financing cash flows, you cannot conduct an unlevered DCF analysis. Instead, you would use a levered DCF analysis, which directly projects the equity value.

1. Forecast levered free cash flows (i.e. the amount left after paying off obligations) for 5-10 years.
2. Just like in an unlevered DCF, calculate the terminal value past the projection period.
3. Discount both the projected cash flows and the terminal value back to the present using the cost of equity instead of WACC.
4. The sum of the present value of levered cash flows represents the bank’s equity value.

Q. Walk me through a bank’s valuation using the dividend discount model (DDM).

Since banks typically have large dividend payouts, the dividend discount model is a common method of valuation.

• Development Stage (3-5 Years): Forecast dividends and discount them to the present using the cost of equity.
• Maturity Stage (3-5 Years): Project dividends based on the assumption that the cost of equity and the return on equity converge.
• Terminal Stage: Represents the present value of all future dividends of the mature company, which assumes a perpetual rate of growth in the dividend or a terminal P/B multiple.

Q. Walk me through a bank’s valuation using the residual income model. Why is it arguably better than the DCF or DDM?

The residual income approach values the bank’s equity based on the sum of its book value of equity and the present value of its residual income.

The present value of residual income looks at the extra equity value above a bank’s book value.

For example, if the bank has a cost of equity of 10%, a book value of equity of $1 billion, and an expected net income of $150 million next year, its residual income can be calculated using the following equation:

• $150 million – ($1 billion * 10%) = $50 million.

The residual income approach resolves the terminal value issue that arises in the DDM by assuming that all excess returns are reduced to zero by the terminal stage.

Q. What multiples are appropriate for valuing a bank?

• Price to Book Value (P/B)
• Price to Earnings (P/E)
• Price to Tangible Book Value (P/TBV)

Q. Why is the unlevered DCF approach inappropriate for banks?

The unlevered DCF corresponds to the free cash flows (FCFs) before the effects of debt and leverage, i.e. free cash flow to firm (FCFF).

Since banks generate the core of their revenues and derive the core of their expenses from interest, using FCFF would not be feasible for modeling a bank's financials.