BIWS FIG Questions Answers

Bank & Financial Institution Modeling
Interview Questions & Answers
Bank & Financial Institution Interview Questions & Answers
This guide presents the most likely interview questions and answers on banks and financial
institutions. You might get these questions if you interview with FIG (Financial Institution Groups)
teams at banks.
A few notes:
1. This is advanced material, and, except for the first section, it’s not likely to come up in entry-
level interviews. These questions are more likely if you’ve had FIG deal experience or you’ve
listed something related to financial institutions on your resume/CV.
2. You will still get normal accounting, valuation, and modeling questions even if you interview
with FIG because many financial institutions, such as broker-dealers, fin-tech companies, and
asset management firms still follow standard accounting and valuation. Only commercial banks
and insurance firms are different, so we focus on those two types of firms here.
3. We do NOT explain the concepts in this guide. It is just a collection of questions and answers. If
you want to learn the concepts in-depth, please complete our Bank & Financial Institution
Modeling course.
Table of Contents:
Bank & Financial Institution Interview Questions & Answers .................................................................... 1

High-Level Questions & Answers ............................................................................................................ 2
Commercial Bank Accounting Questions & Answers ............................................................................. 9
Commercial Bank 3-Statement Modeling Questions & Answers ......................................................... 15
Insurance Accounting Questions & Answers ........................................................................................ 19
Insurance 3-Statement Modeling Questions & Answers ..................................................................... 26
Regulatory Capital Questions & Answers ............................................................................................. 29
Commercial Bank Valuation Questions & Answers .............................................................................. 35
Insurance Valuation Questions & Answers........................................................................................... 42
P&C vs. Life Insurance Questions & Answers ....................................................................................... 47
Bank M&A and Merger Model Questions & Answers .......................................................................... 49
Bank Buyout and Growth Equity Questions & Answers ....................................................................... 56
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High-Level Questions & Answers
These are the most important questions for entry-level interviews.
Even if you know more than the concepts here, you should downplay your knowledge in interviews
and set expectations low. Otherwise, you open yourself up to obscure technical questions.
1. How does a commercial bank make money?
First, the bank gets money (Deposits) from customers because customers need a place to keep their
money and earn a small amount of interest on it.
Then, the bank pools this money together and loans it out in larger quantities, at higher interest rates,
to businesses and individuals that need to borrow money.
A bank makes money based on the interest rate spread: For example, if it pays 1% interest on Deposits
but charges 4% interest on Loans, the spread is 3%.
Additionally, most banks earn significant non-interest revenue, such as service charges, credit card
fees, asset management fees, mortgage servicing fees, and principal investing (trading).
2. How does an insurance firm make money?
Insurance firms collect Premiums upfront from customers who pay to be protected in the case of an
accident (car, house, business, health) or death (Life Insurance).
They pay out Claims to customers if the accident happens.
In the meantime, they collect a lot of money upfront (similar to commercial banks), and they use this
money (“the float”) to make investments and earn interest and investment income.
Many insurance companies are unprofitable based on their Underwriting activities and only become
profitable due to their Investing activities.
3. How are commercial banks different from normal companies?
The biggest differences include:
1) Balance Sheet First – The Balance Sheet drives banks’ performance, and you start the financial
statements by projecting the Balance Sheet first.
2) Equity Value Only – You cannot separate a bank’s operating and financing activities as you can
separate those of a traditional company. So, the concept of Enterprise Value does not apply,
and you use Equity Value and Equity Value-based multiples instead.
3) Dividend Discount Models in Place of DCFs – “Free Cash Flow” doesn’t mean anything for
banks because the Change in Working Capital and CapEx do not represent reinvestment in the
business. So, you use Dividends as a proxy for FCF, Cost of Equity instead of WACC, and the
Dividend Discount Model instead of the Discounted Cash Flow analysis.
4) Regulations and Capital – Banks are highly regulated, and they must maintain minimum
amounts of “capital” (Tangible Common Equity with a few modifications) at all times. These
requirements constrain their growth.
5) Different Valuation Multiples – The Price / Book Value (P / BV), Price / Tangible Book Value (P /
TBV), and Price / Earnings (P / E) multiples are all important because these firms are Balance
Sheet-driven, and Interest is a huge part of their revenue.
4. What about asset management firms, broker-dealers, and financial technology firms? Are they
different as well?
The points above apply to commercial banks and insurance firms (though not quite as much to certain
insurance firms).
Companies such as asset management firms, broker-dealers, and fin-tech firms operate more like
normal companies.
So, you can still use multiples such as EV / Revenue and EV / EBITDA to value them, and the traditional
Unlevered DCF still works.
If the firm invests the upfront Cash it receives from customers and earns interest and investment
income on it, the differences above apply. If not, they do not.
5. How are insurance companies different from normal companies?
Most of the key differences above (Equity Value only, Dividend Discount Models, different valuation
multiples, regulations, etc.) also apply to insurance firms, but you do not start the financial projections
with the Balance Sheet.
That’s because Premiums, which appear on the Income Statement, act as the key driver rather than
Loans and Deposits.
A few other differences include:
• Non-Interest Revenue tends to be a higher percentage of revenue than it is for banks because
of the Premiums that insurance firms collect.
• They use Statutory Accounting, a different system from IFRS / U.S. GAAP that is closer to cash
accounting.
• Valuation is similar to commercial bank valuation, but Embedded Value is an important

methodology for Life Insurance (see the Valuation section).
• The Regulatory Capital requirements differ because it’s harder to define and calculate risk in
the insurance industry. The basic idea is the same – firms must maintain enough Tangible
Common Equity relative to their Assets – but the ratios and calculations are different.
6. How are the financial statements different for a commercial bank?
• Balance Sheet: Loans on the Assets side and Deposits on the L&E side are the key drivers; there
are new items, like the Allowance for Loan Losses (a contra-asset), and more categories for
Investments and Securities; items common for normal companies, such as Inventory, may not
be present.
• Income Statement: Revenue is divided into Net Interest Income and Non-Interest Income;
COGS do not exist; the Provision for Credit Losses is a major new expense; operating expenses
are labeled Non-Interest Expenses.
• Cash Flow Statement: The classifications are murkier; all changes in Balance Sheet items are
still reflected here, and Net Income still flows in as the first item. New items include the add-
back for the Provision for Credit Losses and the Changes in Gross Loans and Deposits.
7. How are the financial statements different for an insurance firm?
• Balance Sheet: Assets are split into Investment Assets and Non-Investment Assets (Cash,
Premiums Receivable, Reinsurance Recoverables, Ceded Unearned Premiums, Deferred
Acquisition Costs, etc.). The L&E side has Reserves for Claim Expenses and Unearned Premiums
(similar to Deferred Revenue).
• Income Statement: Revenue is divided into Premiums, Net Investment and Interest Income,
Gains / (Losses), and Other; COGS do not exist; Claims are the major expense, and other
expenses include G&A, Acquisition Costs, and Interest Expense.
• Cash Flow Statement: It’s similar, but you must reflect changes in the insurance-specific
Balance Sheet line items as well. Also, most insurance companies spend a significant amount on
Investments, and that could be considered a recurring item within Investing Activities.
8. How do you value a commercial bank?
You use Public Comps, Precedent Transactions, and the Dividend Discount Model in place of the
traditional Discounted Cash Flow analysis. Key differences include:
• Public Comps and Precedent Transactions: Screen based on Total Assets, Loans, or Deposits
rather than Revenue or EBITDA; focus on metrics like ROE, ROA, Book Value, and Tangible Book
Value; use multiples such as P / E, P / BV, and P / TBV.
• Dividend Discount Model: Project the bank’s future Dividends based on its Regulatory Capital
requirements, Total Assets, and Net Income, discount them to Present Value using the Cost of
Equity, and add them up. Then, calculate the bank’s Terminal Value with a P / BV or P / TBV
multiple or the Gordon Growth Method, discount it to Present value, and add it to the Sum of
PV of Dividends to determine the bank’s Implied Equity Value.
You cannot separate a bank’s operational and financial activities, so you use only Equity Value-based
metrics and multiples, and you use Dividends as a proxy for Free Cash Flow since CapEx and the Change
in Working Capital do not represent reinvestment for banks.
9. How do you interpret Public Comps for a bank? What’s the relationship between the key metrics
and multiples?
Banks with higher ROEs should have higher P / BV multiples, and banks with higher ROTCEs should
have higher P / TBV multiples. If a bank’s financial metrics have stabilized, you can calculate these
multiples with:
P / BV = (ROE – Net Income Growth Rate) / (Cost of Equity – Net Income Growth Rate)
P / TBV = (ROTCE – Net Income to Common Growth Rate) / (Cost of Equity – Net Income to Common
Growth Rate)
If a bank has not yet stabilized, these formulas won’t work, but there will still be some correlation.
There may be some correlation between P / E multiples and Net Income Growth, but it’s weaker than
the other pairings.
A bank might be undervalued if its ROTCE is on par with the median from the set, but it trades at a
much lower P / TBV multiple.
10. How do you value an insurance firm?
The same way you value a commercial bank: With P / E, P / BV, and P / TBV multiples for Public Comps
and Precedent Transactions, and with a Dividend Discount Model (DDM) instead of the traditional DCF
analysis.
You might screen for comparable companies and deals based on Total Assets or Premiums Earned.
You could also create a Net Asset Value (NAV) model where you mark everything on the firm’s Balance
Sheet to market value (if it has not already done so), and then you could create a P / NAV multiple by
dividing Equity Value by Net Asset Value.
For a Life Insurance firm, you could also use the Embedded Value methodology, which takes a firm’s
Net Asset Value (via the method described above) and adds it to the Present Value of future cash
profits from the insurance firm’s current policies to determine the firm’s Implied Equity value.
Embedded Value represents the Cumulative, After-Tax Cash Flows from Policies in Past Years + the
Present Value of Expected After-Tax Cash Flows in Future Years.
You could then create a P / EV multiple and alternate metrics such as ROEV based on this concept.
11. What is “Regulatory Capital”? Why do banks and insurance firms need it?
Both banks and insurance firms expect to lose money from customers defaulting or customers getting
in accidents.
They handle expected losses with specific items on their Balance Sheets: The Allowance for Loan
Losses for banks and the Claims Reserve for insurance companies.
But there are also unexpected losses, and Regulatory Capital exists to cover those. It consists mostly of
Tangible Common Equity (with adjustments and variations), which serves as a “buffer” against
potential, unexpected losses.
If a bank has to write down a Loan, something must decrease on the L&E side to balance the change. If
the bank has enough Regulatory Capital, that “something” will be its Equity rather than customer
Deposits (i.e., the money in your checking account).
Banks must keep their Regulatory Capital / Some Type of Assets above certain percentages, such as 3%
or 8%, at all times.
Banks must also maintain enough Liquid Assets to cover cash outflows and enough Stable Funding to
meet their “Required Stable Funding” (Assets multiplied by various adjustment factors).
12. What is Common Equity Tier 1 (CET 1), and why do banks need to maintain a certain level?
CET 1 equals Common Shareholders’ Equity – Goodwill – Other Intangibles +/- Other Adjustments. It’s
similar to Tangible Common Equity, but not the same due to the adjustments.
CET 1 is the most basic and important type of Regulatory Capital.
The CET 1 Ratio equals CET 1 / Risk-Weighted Assets. To calculate Risk-Weighted Assets, a bank
multiplies “risk weights” such as 50%, 75%, or 150% by all its on-BS and off-BS Assets and adds up
everything.
The minimum CET 1 Ratio under Basel III is 4.5%, but that climbs to 9.5% when you include various
buffers, and it’s even higher for large, systemically important banks.
Banks must maintain this capital to cover unexpected losses.
13. Why are banks so heavily regulated? What are the main requirements?
Banks are heavily regulated because they’re central to the economy and all other businesses. One large
bank failure could result in an apocalyptic recession, which governments prefer to avoid.
Here are the main requirements under Basel III:
• The CET 1 Ratio must be greater than or equal to 4.5% at all times;
• The Tier 1 Ratio must be greater than or equal to 6.0% at all times;
• The Total Capital Ratio must be greater than or equal to 8.0% at all times;
• A Conservation Buffer of 2.5% gets added to all these ratios;
• A Countercyclical Buffer of 2.5% gets added to all these ratios if economic growth is strong;
• Tier 2 Capital cannot exceed Tier 1 Capital;
• The Leverage Ratio must be greater than or equal to 3% at all times.
• Liquidity Coverage Ratio (LCR): The bank must maintain enough “high-quality Assets” to cover
100% of net cash outflows over a 30-day “stress period.”
• Net Stable Funding Ratio (NSFR): The bank’s “Available Stable Funding” must meet or exceed
its “Required Stable Funding” over a 1-year period.
14. What are the Regulatory Capital requirements for insurance firms?
The key ratio is the “Solvency Capital Requirement Coverage Ratio,” or SCR Coverage Ratio, which is
defined as Available Capital / Required Capital.
Insurance companies must keep that ratio above 100% at all times, but most firms stay comfortably
above it, with median percentages frequently in the 200-300% range.
“Available Capital” is similar to Total Capital for commercial banks: It’s mostly Tangible Common Equity
along with some longer-term Liabilities and funding sources.
Required Capital equals “the expected negative impact on Own Funds of a 1-in-200-year event,” so you
cannot calculate it with a simple formula. However, it is related to the firm’s Total Assets and its risk
from cumulative Written Premiums.
There’s also a “Minimum Capital Requirement” (MCR) ratio for insurance firms, which is similar to the
SCR Coverage Ratio but set to a 25-45% minimum threshold rather than 100%.
Insurance companies also pay attention to the Solvency Ratio (Statutory Cap & Surplus, a variation of
Shareholders’ Equity, divided by Net Written Premiums) and the Reserves Ratio (Net Technical
Reserves divided by Net Written Premiums).
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Commercial Bank Accounting Questions & Answers
These questions are more advanced than those in the “High-Level” section above.
Many of them relate to the Allowance for Loan Losses and Provision for Credit Losses, which are
unique to commercial banks.
If the interviewer asks you to walk through the financial statements after a change takes places, he/she
may also ask you to explain how the Regulatory Capital Ratios change, so each answer here also
explains that.
1. What’s the purpose of the Allowance for Loan Losses and Provision for Credit Losses? Where do
they show up on a bank’s financial statements?
The Allowance for Loan Losses is a contra-Asset netted against Gross Loans on the Balance Sheet to get
Net Loans; it represents how much the bank expects to lose on its current Gross Loans balance because
of defaults.
The Provision for Credit Losses is a non-cash expense on the Income Statement that gets added back
on the Cash Flow Statement. It represents how much the bank expects to lose on its Gross Loans in the
current period above and beyond the Allowance for Loan Losses.
Net Charge-Offs increase the Allowance (it is a contra-Asset, so it becomes less negative), and
additional Provisions reduce the Allowance by making it more negative on the Balance Sheet.
2. A bank’s Interest Income increases by $100, and its Interest Expense increases by $50. Nothing
else changes.
Assuming a 40% tax rate, walk me through the statements, and explain how the Regulatory Capital
Ratios change.
• IS: Pre-Tax Income is up by $50, so Net Income is up by $30 at a 40% tax rate.
• CFS: Net Income is up by $30, and nothing else changes, so Cash at the bottom is up by $30.
• BS: Cash is up by $30, so the Assets side is up by $30. The L&E side is also up by $30 because
Retained Earnings increases due to the $30 of Net Income, so both sides balance.
• Regulatory Capital: All the ratios increase because this additional Net Income increases the
bank’s Common Shareholders’ Equity, the bank has not increased its Risk-Weighted Assets, and
its Tangible Assets are only up by $30 (and they’re much bigger than the bank’s CSE).
Intuition: We get additional Net Interest Income and Net Income, but we don’t need additional Assets
or funding sources. It’s a free lunch! This scenario is not realistic.
3. A bank records a $10 Provision for Credit Losses. Walk me through the statements.
• IS: Pre-Tax Income is down by $10, and Net Income is down by $6 at a 40% tax rate.
• CFS: Net Income is down by $6, but you add back the $10 of Provisions, so Cash is up by $4 at
the bottom.
• BS: Cash is up by $4, but Net Loans is down by $10, so the Assets side is down by $6. The L&E
side is also down by $6 because Retained Earnings is down by $6 from the reduced Net Income.
• Regulatory Capital: All the ratios decrease because CSE decreases, but Risk-Weighted Assets do
not change, and the bank’s Tangible Assets decrease by the same amount as its CSE.
Intuition: This bank expects to charge off more of its Loans, so its “buffer capital” decreases to reflect
this expected loss. Cash increases due to the tax savings from this non-cash Provision expense.
4. A bank’s beginning Allowance for Loan Losses is $50. It records Gross Charge-Offs of $10,
Recoveries of $5, and Provisions for Credit Losses of $10 to reflect higher expected losses. What is its
ending Allowance?
Ending Allowance = Beginning Allowance – Gross Charge-Offs + Recoveries + Provision for CLs = $50 –
$10 + $5 + $10 = $55.
“Recoveries” refer to previously charged-off Loans from which the bank can now recover some money
due to collateral or other factors.
5. Walk me through what happens on the financial statements with these changes (Gross Charge-
Offs of $10, Recoveries of $5, and Provisions for Credit Losses of $10).
• IS: Only the $10 Provision for CLs shows up here; Pre-Tax Income falls by $10, and Net Income
falls by $6 at a 40% tax rate.
• CFS: Net Income is down by $6, but you add back the $10 of Provisions, so Cash is up by $4 at
the bottom. Gross Charge-Offs and Recoveries do not show up on the Cash Flow Statement.
• BS: Cash is up by $4, but the Gross Loans balance is down by $5 because of the $10 in Gross
Charge-Offs and $5 in Recoveries. The Allowance for Loan Losses also declines by $5, becoming
more negative, because of the $10 in Provisions and $5 in Net Charge-Offs. The Assets side is
down by $6. The L&E side is also down by $6 because of the $6 in reduced Retained Earnings.
• Regulatory Capital: The ratios will fall because CSE has declined by $6, but Gross Loans have
declined by $5, and the denominators of the ratios (Tangible Assets or Risk-Weighted Assets)
are much bigger than the numerators.
Net Charge-Offs cancel out because they affect both Gross Loans and the Allowance for Loan Losses,
so they make no impact on Net Loans. Only Loan Additions and the Provision for Credit Losses affect
Net Loans.
Intuition: This bank charged off some Loans and expects to charge off more Loans in the future. As a
result, its “buffer capital” falls, but its Cash increases because it had already expected to charge off the
now-charged-off Loans, and the new Provisions provide tax savings.
6. A bank issues new Loans, and its Loans and Deposits both increase by $100. Its Net Interest
Income then increases by $10, and its Provision for Credit Losses increases by $5. Walk me through
the statements.
• IS: Pre-Tax Income is up by $5, so Net Income is up by $3 at a 40% tax rate.
• CFS: Net Income is up by $3, but you add back the $5 in Provision for CLs as a non-cash
expense. The Changes in Loans and Deposits cancel out, so Cash is up by $8 at the bottom.
• BS: Cash is up by $8, and Net Loans is up by $95, so the Assets side is up by $103. On the L&E
side, Deposits is up by $100, and Retained Earnings is up by $3 due to the increased Net
Income, so both sides are up by $103 and balance.
• Regulatory Capital: Most likely, the ratios will decrease because Gross Loans is up by $100, but
CSE is only up by $3, and $100 is probably a greater percentage of the bank’s RWAs than $3 is
of the bank’s CET 1, Tier 1, and Total Capital.
Intuition: This bank issues some new, high-yielding Loans, but its capital ratios decline because its CSE
doesn’t increase by much relative to these new Assets. If it keeps doing this, it will need additional
Equity in the future.
7. A bank’s Allowance for Loan Losses is $60, but it experiences a sudden, unexpected loss, and it
must record $100 in Gross Charge-Offs. What happens on the financial statements?
In this scenario, the bank must increase its Allowance by allocating more Provisions to cover these
unexpected losses.
For simplicity, we’ll assume that its Provisions for Credit Losses increases by $40 so that its Allowance
can cover these Charge-Offs:
• IS: Pre-Tax Income is down by $40 due to the $40 in new Provisions, so Net Income falls by $24
at a 40% tax rate.
• CFS: Net Income is down by $24, but you add back the $40 in Provisions for CLs, so Cash at the
bottom is up by $16. Gross Charge-Offs do not appear on the CFS.
• BS: Cash is up by $16, and the Allowance for Loan Losses decreases from negative $60 to
negative $100, so the Assets side is down by $24. Then, Gross Loans decreases by $100, and the
Allowance for Loan Losses increases by $100, reaching $0, but those changes cancel out, and
the Assets side is still down by $24. The L&E side is also down by $24 due to the reduced Net
Income that flows into Retained Earnings.
• Regulatory Capital: All the ratios will decline because the $24 decrease in CSE represents a
greater percentage of the numerator in each ratio than the $100 decrease in Gross Loans
represents of the denominator. This scenario is the point of Regulatory Capital: To provide a
cushion for unexpected losses.
Intuition: This bank experiences a large, unexpected loss, so its Net Loans and Equity both fall. Cash
increases because of the tax savings on the additional Provisions the bank sets aside to cover this
unexpected loss.
8. A bank wants to issue $100 in additional Loans, and it needs additional funding to do it.
What are the trade-offs of raising this funding with Deposits vs. Subordinated Notes vs. Preferred
Stock vs. Common Equity?
If the bank has sufficient Regulatory Capital, it will almost always raise this funding via additional
Deposits because they are the cheapest funding source: Interest rates on Deposits are lower than the
rates on anything else, and they’re certainly below the Cost of Equity.
However, additional Deposits will not increase the Regulatory Capital Ratios, such as the CET 1, Tier 1,
and Total Capital Ratios (though they might improve the Net Stable Funding Ratio).
So, if the bank needs more Total Capital, it might prefer to raise Subordinated Notes since they count
toward Tier 2 Capital, which is a component of Total Capital. If the bank needs additional Tier 1 Capital,
Preferred Stock might make sense.
And if the bank needs additional CET 1 or TCE, it must raise Common Equity – the most expensive
funding source, but also the only one that boosts all the ratios.
9. A bank wants to return capital to its shareholders, and it is considering both Dividends and Stock
Repurchases.
How do these methods affect the financial statements and Regulatory Capital Ratios differently?
The financial statement impact is nearly the same: Both items appear in Cash Flow from Financing on
the CFS, and they both reduce the bank’s Cash on the Assets side and Equity on the L&E side.
The main difference is that Stock Repurchases also reduce the bank’s share count, but Dividends do
not (also, they affect different line items within Equity), so Stock Repurchases will boost the bank’s EPS.
The impact on the bank’s Regulatory Capital Ratios is also the same: Everything falls because the bank’s
Common Shareholders’ Equity falls, but its Risk-Weighted Assets stay the same.
10. Which ratios can you use to analyze a bank’s Charge-Offs and Provisions for Credit Losses?
A few of the most common ones include:
• Net Charge-Off Ratio: Net Charge-Offs / Average Gross Loans

o Meaning: How bad are the defaults?
• Net Charge-Offs / Reserves: Net Charge-Offs / Allowance for Loan Losses

o Meaning: Have we set aside enough to cover defaults in a given period?
• Reserve Ratio: Allowance for Loan Losses / Gross Loans

o Meaning: What % of our Loans do we expect borrowers to default on?
• Net Charge-Offs / Prior Year Provisions for Credit Losses

o Meaning: Were our predictions for Charge-Offs in-line with the real Charge-Offs?
• NPLs / Gross Loans: Non-Performing Loans / Gross Loans

o Meaning: What % of our Loans have borrowers that are late making payments and likely
to default?
• NPL Coverage Ratio: Allowance for Loan Losses / Non-Performing Loans

o Meaning: How well does the Allowance for Loan Losses cover Loans that are past due
and likely to go into default?
“Non-Performing Loans” typically refer to Loans where the borrowers are more than 90 days late
paying the required interest and principal.
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Commercial Bank 3-Statement Modeling Questions & Answers
These questions are less likely than the ones on Accounting. If an interviewer wants to test your ability
to build a 3-statement model, he/she will ask you to build a 3-statement model.
However, you could still receive high-level questions on the process and follow-up questions on any 3-
statement model you build, so we address both of those here:
1. How do you project the financial statements for a commercial bank?
You start by projecting the bank’s Balance Sheet, usually beginning with its Loans, Deposits, and other
Interest-Earning Assets and Interest-Bearing Liabilities.
Then, you project the interest rates for all these items and link them to a prevailing rate like the
Federal Funds rate or interbank rate of the country.
Use that information to calculate the Interest Income and Interest Expense on the Income Statement.
Estimate the Non-Interest Income and Expenses with simple percentage growth, percentage-of-
revenue, or percentage-of-Balance-Sheet-line-item estimates.
Project the bank’s Dividends based on the “capital” (roughly, Tangible Common Equity) it’s targeting
vs. how much it currently has. You can complete the full Cash Flow Statement by linking to the relevant
IS and BS line items and projecting a few items, such as CapEx and D&A, separately on the CFS.
2. How do you use the Balance Sheet of a bank to create its Income Statement?
First, determine the Assets that earn interest – the Interest-Earning Assets – and the Liabilities that
bear interest – the Interest-Bearing Liabilities.
Then, assign interest rates to these items based on historical rates or spreads against benchmark rates,
and use those rates to calculate Interest Income and Interest Expense.
Subtract the Interest Expense from Interest Income to calculate the bank’s Net Interest Income, which
appears on the Income Statement.
Then, base the Non-Interest items on percentage growth rates or percentages of other on- or off-
Balance Sheet items. For example, Credit Card Fees might be a percentage of Credit Card Loans.
3. How do you project a bank’s Loans and Deposits?
You almost always start with the bank’s Loans and then make Deposits a percentage of those Loans,
based on the historical trends.
To project the bank’s Loans, you could assume simple percentage growth rates.
Or, you could link the Loans to GDP Growth and assume that Total National Loans are a percentage of
GDP and that the bank’s market share changes in a certain direction over time.
4. You’re building Base, Upside, and Downside scenarios in a 3-statement model for a commercial
bank. What might be different about the assumptions in each scenario?
Loan Growth and Interest Rates tend to be highest in the Upside scenario and lower in the others (the
same applies to related assumptions such as GDP Growth and Market Share).
Net Charge-Offs and the Provision for Credit Losses are the opposite: They’ll be highest in the
Downside scenario and lowest in the Upside scenario.
Additionally, the bank’s margins, Non-Interest Income Growth Rate, and other figures may be highest
in the Upside scenario and lower in the others.
5. How do you balance a bank’s Balance Sheet?
Unlike the approach used for normal companies, where Cash and Shareholders’ Equity act as “plugs,”
you use Federal Funds Sold (AKA Funds with Central Banks or similar names outside of the U.S.) on the
Assets side and Federal Funds Purchased on the L&E side to balance the Balance Sheet.
If Total Assets are below Total L&E, you assume that the bank sells its excess funding to the central
bank or other banks in the country, which boosts its Federal Funds Sold.
And if Total L&E are below Total Assets, you assume that the bank borrows from the central bank or
other banks, which boosts its Federal Funds Purchased.
These items are interest-earning and interest-bearing, so it’s not “free money” for the bank – if the
bank borrows more, it has to pay to additional Interest, and if it sells excess funding, it earns interest
on that.
6. How can you tell if a bank is over-provisioning or under-provisioning for Loan Charge-Offs?
You could look at figures such as Net Charge-Offs / Reserves, the Reserve Ratio, and Net Charge-Offs /
Prior Year Provision for CLs to determine this.
For example, if the bank’s Net Charge-Offs / Reserves and Net Charge-Offs / Prior Year Provision for CLs
keep decreasing, but its Reserve Ratio keeps increasing, the bank may be over-provisioning.
If the opposite happens, the bank may be under-provisioning because it’s setting aside less of an
Allowance each year to cover Charge-Offs.
7. You’re the CEO of a large bank, and you’re looking at the firm’s Income Statement. Would you
prefer to see a higher percentage of Non-Interest Income or Net Interest Income?
It is often seen as positive if a higher percentage of the bank’s revenue comes from Non-Interest
Income because banks have more control over the fees and commissions they charge than they do
over prevailing interest rates.
But it also depends on the bank’s business model: If it’s more of a pure-play commercial bank, it might
want to earn a higher percentage of revenue from Net Interest Income (and vice versa if it is aiming to
diversify).
8. How do you calculate Dividends for a bank?
First, you check the bank’s Available CET 1 by taking its Common Shareholders’ Equity + Net Income to
Common + Other Items That Affect CSE – Goodwill and Other Intangibles, and then you compare that
to the Minimum CET 1 Required, which equals the bank’s Risk-Weighted Assets * Targeted CET 1 Ratio.
Subtract the Minimum CET 1 from the Available CET 1 to determine the capital available for Dividends.
For example, if the bank’s Available CET 1 is $100, and its Minimum CET is $80, then it can issue $20 in
Dividends.
Most banks target specific Payout Ratios, so you might multiply this bank’s targeted ratio by its Net
Income to Common to determine the Dividends it plans to issue (e.g., 50% Payout Ratio * $30 in Net
Income to Common = $15 in Dividends).
If the capital available for Dividends ($20 in this example) exceeds that figure, the bank can issue the
full $15 in Dividends. If not, it can only issue Dividends up to the capital available to do so.
9. You review a bank’s 3-statement model and find that the firm’s ROE and ROTCE increase each year
as its ROA decreases. How could that happen?
Most likely, this happens because the bank’s Non-Interest-Earning Assets are growing more quickly
than its Interest-Earning Assets (IEAs).
ROE, ROTCE, and ROA all use Net Income or Net Income to Common in the numerator, but the
denominators differ. ROE uses Equity, ROTCE uses Tangible Common Equity, and ROA uses Total
Assets.
So, if Net Income (to Common) keeps increasing, but ROA keeps decreasing, then the firm’s Total
Assets must be growing at a faster rate than its Net Income.
But if ROE and ROTCE keep increasing, then its Equity and Tangible Common Equity must be growing at
a slower rate than its Net Income.
That probably means that the bank’s Non-Interest-Earning Assets are growing more quickly than its
Interest-Earning Assets. Since IEAs correspond to Risk-Weighted Assets, the bank needs more Tangible
Common Equity to support them as it grows.
But since TCE and Equity grow at a *slower* rate than Total Assets, it seems like the bank’s Risk-
Weighted Assets and, therefore, its IEAs, are growing more slowly than the other Assets.
10. You finish a 3-statement model for a bank and find that its CET 1 Ratio in Year 5 is *highest* in
the Downside case and *lowest* in the Upside case. How is that possible?
You could easily get this result if you target the same CET 1 Ratio in the Upside and Downside cases,
but the bank’s Loan Growth is highest in the Upside case.
Higher Loan Growth means the bank will have more Risk-Weighted Assets, which means that the bank
will need more CET 1 to support those RWAs.
So, in the Upside case, the bank might be at or near its targeted CET 1 Ratio in most years.
But in the Downside case, with much lower Loan Growth, the bank won’t need as much CET 1, so it
could easily exceed its targeted CET 1 Ratio.
Return to Top.
Insurance Accounting Questions & Answers
Insurance accounting is even more complicated than commercial bank accounting because of
reinsurance and tricky revenue and expense recognition.
The nuances are unlikely to come up in interviews, so we’ll stick to higher-level questions here and
walk through a few common “3-statement scenario” questions.
1. An insurance company writes 1-year Premiums of $100 and collects the $100 of Cash from
customers midway through the year (June 30th).
What happens on the financial statements, assuming the company has not yet recognized any
expenses associated with these Premiums?
• IS: The company records $50 in Net Earned Premiums (NEP) because it can recognize only 50%
of these 1-year Premiums in this current year. Revenue is up by $50, as is Pre-Tax Income, and
Net Income is up by $30 at a 40% tax rate.
• CFS: Net Income is up by $30. However, the Unearned Premium Reserve (UEPR) – similar to
Deferred Revenue – also increases by $50 because of the $50 in Premiums set to be recognized
in the next year. An increase in a Liability boosts cash flow, so Cash at the bottom is up by $80.
• BS: Cash is up by $80, so the Assets side is up by $80. On the L&E side, the Unearned Premium
Reserve is up by $50, and Equity is up by $30 due to the increased Net Income, so both sides
balance.
Intuition: The company has collected $100 of Cash, but can only recognize 50% of it as revenue; it pays
taxes on just the 50% it can recognize, so its Cash balance increases by $80 rather than $100.
2. An insurance company writes $100 in Direct Written Premiums. It also reinsures $50 in Premiums
from other insurance companies, and it cedes 30% of its Direct Written Premiums to other
companies.
What is the company’s Net Written Premiums (NWP) for the year, and what appears as revenue on
its Income Statement?
Net Written Premiums = Direct Written Premiums + Assumed Premiums – Ceded Premiums, so $100 +
$50 – 30% * $100 = $120.
Only Net Earned Premiums appear as revenue on the Income Statement, so some number less than
$120 shows up there.
We don’t have enough information to determine this number because we don’t know the percentage
of Premiums the company earned this year.
3. Let’s take the same scenario and say that, on average, 50% of the company’s Written Premiums
are earned in a given year. What appears on the Income Statement as revenue?
If it’s a simple 50%, you can multiply $120 by 50%, which produces $60 as the Net Earned Premiums
(NEP) number that appears as revenue on the Income Statement.
If the earning percentages differed for each category of Premiums, you would multiply the numbers
above by the relevant percentages and add them up.
4. When an insurance company reinsures policies from other companies, what is the difference
between Quota Share (QS) and Excess of Loss (XOL) agreements?
A Quota Share agreement is based on simple percentages for both Premiums and Claims. For example,
another company cedes 30% of its Premiums to your company, so the other company pays 70% of the
Claims, and your company pays 30% of the Claims.
With Excess of Loss, by contrast, the Premium and Claim sharing is not proportional. For example, the
other company might cede 5% of its Premiums to your company, but then the other company might
pay for up to $1 million in Claims rather than 95% of all Claims.
Then, your company might pay for Claims between $1 million and $5 million, and the other company
might pay for Claims above $5 million.
These policies affect financial models because you make different expense assumptions depending on
the type of reinsurance.
5. Why do insurance companies have complex reinsurance policies? For example, why do they cede
their Premiums and assume Premiums from other companies?
They do it for risk management and diversification. For example, if 100% of a company’s policies were
from one geography, and a hurricane suddenly passed through, this company would take massive
losses as it pays out Claims to all its customers.
But if this company had distributed risk by ceding some of its policies and assuming policies from other
companies in different regions, the potential for massive losses would have been much lower.
6. What’s the purpose of the Loss & Loss Adjustment Expense (LAE) Reserve, otherwise known as the
Claim and Claim Adjustment Expense Reserve?
It’s similar to Accrued Expenses for normal companies. It reflects that insurance companies must
record expenses to match Net Earned Premiums because of the matching principle of accounting, but
that companies don’t necessarily pay out these same expenses in Cash in the periods shown.
For example, if a company has $120 in Net Written Premiums and $60 in Net Earned Premiums, with a
60% Loss & LAE Ratio, there are $36 in Claims on the Income Statement in the first year.
But the Cash payout of these Claims may be very different because customers could get into accidents
and file Claims over several years – not all in Year 1.
So, if the company only pays $20 in Cash Claims in Year 1, the Loss & LAE Reserve increases by $16.
If it then pays $8 in Cash Claims in Year 2 (vs. $0 in Claims on the Income Statement), the Loss & LAE
Reserve decreases by $8.
7. What is the “Loss Triangle” for insurance companies?
This term refers to how an insurance company incurs Loss & LAE Expenses each year and then pays
them out in Cash over time.
Over many years, this pattern creates a “triangle,” as shown below:
8. What are Ceded Unearned Premiums and Reinsurance Recoverables on an insurance company’s
Balance Sheet?
These are both line items on the Assets side of an insurance company’s Balance Sheet.
“Ceded Unearned Premiums” is like the Unearned Premium Reserve, but for reinsurers instead. When
the company cedes Premiums to other companies, Unearned Premiums for those ceded policies will
increase this item. Then, when the company earns those Premiums, this item will decrease.
“Reinsurance Recoverables” is like the Loss & LAE Reserve, but for reinsurers instead. This item
changes based on the difference between Losses Incurred and Losses Paid in Cash for Ceded Premiums.
9. What is the Deferred Acquisition Costs (DAC) Asset?
When an insurance company sells a new policy, it must pay a Cash commission to the broker that
referred the sale based on the policy’s entire value, even if it only recognizes part of it as revenue in a
given year.
For example, if it’s a 3-year policy for $1,000 of Premiums each year, the total value is $3,000. Initially,
the insurance company might pay a 5% commission to the broker for $150 in Cash.
On the Income Statement, however, the insurance company can record only the portion of that $150
that matches the Net Earned Premiums for the year.
So, if the company earns $1,000 in Premiums for this year, it can record only $50 in commissions.
On the Balance Sheet, the DAC Asset tracks this difference between Commissions Incurred on the
Income Statement and Cash Commissions Paid.
It’s similar to the Prepaid Expenses item for normal companies because they both represent Cash
payments made before the expenses have been recognized.
10. In Year 1, an insurance company records $100 in Net Written Premiums and $50 in Net Earned
Premiums and pays Commissions of 10%.
What happens on the financial statements? Ignore Claims for now.
The company must pay Cash Commissions of 10% * $100 = $10, but it can only recognize 50% of that,
or $5, on its Income Statement:
• IS: Revenue is up by $50, and there are $5 in Commission Expenses, so Pre-Tax Income is up by
$45. At a 40% tax rate, Net Income is up by $27.
• CFS: Net Income is up by $27, and the Unearned Premium Reserve is up by $50, so cash flow is
up by $77 so far. The Deferred Acquisition Costs Asset increases by $5, and, therefore, reduces
cash flow by $5. Cash at the bottom is up by $72.
• BS: Cash is up by $72 on the Assets Side, and the DAC Asset is up by $5, so the Assets side is up
by $77 total. On the other side, the Unearned Premium Reserve is up by $50, and Equity is up
by $27 due to the increased Net Income, so both sides are up by $77 and balance.
Intuition: The firm collects $100 in Cash, pays taxes on less than half that amount, and also pays
additional Cash Commissions, so its Cash increases by significantly less than $100.
11. Walk me through what happens in Year 2, when the remaining $50 in Net Earned Premiums gets
recognized. Assume there are no expenses other than Commissions, and that the company writes
and earns no new Premiums.
• IS: Revenue is up by $50, and the company records the remaining $5 in Commission Expenses,
so Pre-Tax Income is up by $45. At a 40% tax rate, Net Income is up by $27.
• CFS: Net Income is up by $27, but the Unearned Premium Reserve falls by $50 because the
company recognizes the remaining Premiums. So far, the company’s cash flow is down by $23.
The DAC Asset decreases by $5 because the company recognizes the remaining $5 in
Commissions, which boosts cash flow by $5. Altogether, Cash at the bottom is down by $18.
• BS: Cash on the Assets side is down by $18, and the DAC Asset is down by $5, so the Assets side
is down by $23. On the L&E side, the Unearned Premium Reserve is down by $50, but Equity is
up by $27 due to the increased Net Income, so that side is down by $23, and the Balance Sheet
balances.
Intuition: Cash decreases because the company must now pay taxes on some portion of the Premiums
it collected in Cash in a previous period. It realizes some tax savings because of the deduction for the
Commission Expenses, but not enough to offset the additional taxes on Net Earned Premiums.
12. Why do you link the Loss & LAE Ratio to Net Earned Premiums rather than Net Written
Premiums?
This ratio is defined as the Loss and Loss Adjustment Expense (LAE) on the Income Statement divided
by the Net Earned Premiums.
It’s defined this way because the Losses or Claims follow Earned Premiums more closely than Written
Premiums.
For example, if a customer buys a 2-year auto insurance policy, he or she can get in accidents and file
Claims over that entire 2-year period. But the company records Net Written Premiums for this policy
only in the first year in which it is sold.
13. How do you calculate the Expense Ratio, and what does it mean?
This ratio is defined as (Net Commission Expense + Underwriting Expense) / Net Written Premiums – so
you ignore the Loss & LAE Expense.
You divide by Net Written Premiums because both Commissions and Underwriting Expenses, such as
employee salaries, trend with Written Premiums more than Earned Premiums since most of the work
takes place when the company first sells the policy.
This ratio tells you how profitable the underwriting business of an insurance company is.
14. The Combined Ratio is defined as the Expense Ratio + the Loss & LAE Ratio. But how is that
possible? These ratios use different denominators!
There is no real, official reason other than “It is a quirk of the insurance industry, and it has been
calculated that way for decades.”
It doesn’t make much sense mathematically, but the argument for it is that Losses or Claims
correspond to Net Earned Premiums, but many other expense match Net Written Premiums.
It’s useful for getting a sense of the company’s underwriting profitability, but you should not take it as
a literal measure of the firm’s exact profit margin.
15. What are the typical ranges for these ratios? And what do they tell you about the insurance firm?
All these ratios measure the firm’s profitability and operational efficiency, and lower ratios mean the
firm is more profitable or “efficient.”
The Combined Ratio is usually in the 90-105% range, the Expense Ratio might be in the 20-25% range,
and the Loss & LAE Ratio might be in the 70-80% range.
These numbers vary based on the type of insurance and geography, but a Combined Ratio of 50% or
150% would be highly unusual.
Remember that many insurance companies lose money on their underwriting activities and only
become profitable via interest and investment income.
16. What’s the difference between Statutory Accounting and U.S. GAAP / IFRS Accounting?
Statutory Accounting is closer to cash accounting than U.S. GAAP / IFRS, which are both based on
accrual accounting.
One big difference is that the entire Cash Commission Expense shows up on the company’s Income
Statement under Statutory Accounting, but only the earned portion shows up under the other system.
Statutory Accounting is often more conservative as well (e.g., many Assets are not marked to market,
DTAs are more limited, and Goodwill may be amortized).
Additionally, Statutory Balance Sheets are “netted up,” so Reinsurance Recoverables and Ceded
Unearned Premiums do not show up as separate Assets. Instead, they are deducted from the
corresponding Reserves on the L&E side to get “Net Reserves” numbers.
Return to Top.
Insurance 3-Statement Modeling Questions & Answers
You’re not likely to receive interview questions on 3-statement models for insurance companies.
If an interviewer wants to test your skills, he or she will ask to you build a 3-statement model for an
insurance company.
However, you could still receive questions on the overall process or follow-up questions about your
model, so we cover those here.
1. How do you project the financial statements for an insurance company?
Start by projecting the company’s Direct Written Premiums – how much it is selling directly to
customers. Then, project the company’s Assumed Premiums and Ceded Premiums and the
percentages it is earning in all those categories to get its Net Earned Premiums.
Next, project the Claim and Claim Adjustment Expense Ratio, the commission rate, and the
underwriting expenses as a percentage of the Net Written Premiums.
List the company’s Net Earned Premiums and its Interest and Investment Income for revenue on the
Income Statement. You’ll need the Balance Sheet to get the full numbers for Interest and Investment
Income. Expenses consist of Claims, Commissions, Underwriting Expenses, and Interest. Calculate Pre-
Tax Income and Net Income the normal way.
The Balance Sheet flows in from the company’s revenue/expense recognition (the Reserves and
corresponding items on the Assets side), and Cash and Equity flow in as they normally do. You might
project Investments and Debt independently, or you might link them to Premiums.
The Cash Flow Statement works the same way: Start with Net Income, make non-cash adjustments,
factor in Changes in Working Capital, and sum up each section of the CFS to calculate the Net Change
in Cash at the bottom.
Finally, return to the Income Statement and link in Interest/Investment Income and Interest Expense,
which you projected based on Balance Sheet numbers and separate assumptions.
2. How do you project an insurance company’s Written Premiums?
You normally assume growth rates in volume and rates. For example, you might assume that the
company sells 10% more policies per year and raises its prices by 5% per year.
Those figures would result in a ~15% overall growth rate in Written Premiums.
Both components would be based on historical trends, the economy, what other insurance companies
are doing, and this company’s market share.
Direct Written Premiums tend to follow clear trends; Assumed and Ceded Written Premiums might be
a bit more random because they depend on other companies.
3. How do you project the Loss & LAE Ratio (AKA the Claim and Claim Adjustment Ratio)?
Normally, you link the Loss & LAE Ratio for the next year to this ratio from this year and adjust it by the
Premium Growth Rate and “Loss Cost Trend,” which represents the growth rate in Losses:
Next Year’s Loss & LAE Ratio = Ratio This Year * (1 + Premium Growth Rate) / (1 + Loss Cost Trend)
So, if the Loss & LAE Ratio is 75% this year, the Premium Growth Rate is 3%, and the Loss Cost Trend is
2%, the Loss & LAE Ratio the next year would be 75% * (1.03) / (1.02) = 74%.
This calculation tells you whether the company’s revenue or expenses are increasing more quickly.
4. How do you project other key expenses in the model, such as the Commissions and Underwriting
Expenses?
Both of these figures should be percentages of Net Written Premiums; the exact numbers vary by
region and company, but they often add up to around 20-30% of NWP.
You could base the numbers on historical trends or take an average over a few years if there’s no clear
trend. You could also look at industry-wide percentages or figures from comparable companies.
5. How do you project the key Balance Sheet items for an insurance company?
First, on the Assets side:
• Cash: Flows in from the bottom of the Cash Flow Statement.
• Investments: This one flows in from Investment Purchases on the CFS; you might link it to
historical spending, the company’s float, or the company’s Written Premiums. If the company is
growing, it should be spending more on Investments.
• Ceded Unearned Premiums: This balance increases by the difference between Ceded Written
Premiums and Ceded Earned Premiums each year.
• Reinsurance Recoverables: This item increases by the difference between Ceded Losses & LAE
Incurred and Ceded Losses & LAE Paid in Cash each year.
• Deferred Acquisition Costs: This item increases by the difference between the Cash
Commission Expense and the Commission Expense Recognized each year.
On the L&E side of the Balance Sheet, Debt, Equity, and other items work in similar ways. The main
items that are different include:
• Unearned Premium Reserve: This item increases by the difference between Gross Written
Premiums and Gross Earned Premiums each year.
• Loss & LAE Reserve: This item increases by the difference between Losses & LAE Incurred and
Losses & LAE Paid in Cash each year.
6. How do you project an insurance firm’s Interest and Investment Income and Gains / (Losses)?
First, you might assume that the Investment Assets grow based on the company’s cash flow available
to purchase more Investments, or you might link the growth rates to the company’s Premium Growth
Rates.
Then, you would assume an Interest Rate or Yield on each class of Investments, based on fixed rates or
a spread against benchmark rates.
Then, you could multiply those and sum up everything.
Gains / (Losses) are trickier to project because you don’t know how the values of stocks, bonds, and
other investments will change each year, but you might use historical averages or make them simple
percentages of the book values of Investments.
Return to Top.
Regulatory Capital Questions & Answers
Regulatory Capital is critical in bank and insurance modeling, but most interviewers just want to verify
that you know the key points rather than all the details.
This section focuses on Regulatory Capital for commercial banks because there’s more information on
it, there are more types of capital, and you’re more likely to get detailed questions on it.
1. What’s the basic idea behind Regulatory Capital, and how do you calculate it?
Regulatory Capital protects a bank against unexpected losses. The bank expects to lose something on
its Loans, which it reflects in the Allowance for Loan Losses. Regulatory Capital absorbs losses for
anything beyond that expected amount. The basic idea is:
Regulatory Capital / Some Types of Assets >= Certain Percentage
“Regulatory Capital” is related to Shareholders’ Equity or Tangible Common Equity (or variations), and
“Some Types of Assets” usually means Tangible Assets or Risk-Weighted Assets.
The bank must maintain a “buffer” of Equity so that unexpected losses reduce its Equity rather than its
Deposits, Debt, or anything else on the L&E side.
2. What are Risk-Weighted Assets (RWAs), and how do you use them in models?
To calculate Risk-Weighted Assets, a bank assigns a “risk weight” to each on-Balance Sheet and off-
Balance Sheet Asset, based on the Asset’s credit risk, and sums up everything.
For example, if the bank has $10 of Cash, $10 of Business Loans, and $10 worth of Subprime
Mortgages, the Cash might get a risk weight of 0%, the Business Loans might get 50%, and the
Subprime Mortgages might get 100%, producing total RWAs of $15.
Risk-Weighted Assets are often the denominator in Regulatory Capital Ratios such as the CET 1, Tier 1,
and Total Capital Ratio, and you project them based on the bank’s Interest-Earning Assets.
These capital ratios limit a bank’s growth and ability to issue Dividends.
3. Why is it so important to calculate Regulatory Capital Ratios based on Risk-Weighted Assets

(RWAs) in addition to ratios based on Tangible Assets (TA)?
Because neither one tells the whole story. Banks can “game the system” and assign unrealistically low
Risk Weights to Assets if you only examine the bank’s Risk-Weighted Assets.
But if you only calculate Tangible Assets, you ignore off-Balance Sheet Assets and the fact that certain
mortgages, business loans, and securities are riskier than others.
4. What’s the difference between Tier 1 Capital and Tier 2 Capital?
Tier 1 Capital is “Going Concern Capital” and is available to absorb unexpected losses when the bank is
still up and running. It consists of Shareholders’ Equity – Goodwill & Other Intangibles +/- Other
Adjustments.
You can also say that Tier 1 Capital = CET 1 + Preferred Stock +/- Other Adjustments.
Tier 2 Capital is “Gone Concern Capital” and can absorb unexpected losses only when the bank is
shutting down in a bankruptcy/liquidation scenario.
It consists of Hybrid Instruments (e.g., Convertible Bonds), Subordinated Notes, a portion of the
Allowance for Loan Losses, and various Reserves.
5. What’s the Leverage Ratio, and why might we look at that in addition to the CET 1, Tier 1, and
Total Capital Ratios?
Leverage Ratio = Tier 1 Capital / Tangible Assets, but you may also adjust Tangible Assets for off-
Balance Sheet items.
The Leverage Ratio is harder to manipulate than the other ratios since it uses numbers straight from
the bank’s Balance Sheet, so it’s useful as a way to cross-check everything.
It’s similar to the Tangible Common Equity (TCE) Ratio, but it’s a bit less conservative since it also
includes Preferred Stock and various adjustments.
6. What’s the difference between Common Equity Tier 1 (CET 1) and Tangible Common Equity (TCE)?
They’re similar since they’re both based on Common Shareholders’ Equity – Goodwill & Other
Intangibles, but banks often make adjustments to CET 1, whereas TCE comes straight from the Balance
Sheet.
For example, a portion of the bank’s Noncontrolling Interests may count toward CET 1, and some
Deferred Tax Assets may be deducted from it. Also, the Goodwill and Other Intangibles you subtract to
calculate the CET 1 must be net of the associated Deferred Tax Liabilities.
7. How are Noncontrolling Interests (NCI) treated in the Regulatory Capital calculations?
Under Basel III, banks can count a portion of the NCI toward CET 1, but only in relation to their Surplus
CET 1.
For example, let’s assume that the bank’s NCI is $20, representing the 20% it does not own in another
company, and the bank has Surplus CET 1 of $10 (e.g., its minimum CET 1 is $100, but it has $110
currently).
In this case, the bank can count NCI – Surplus CET 1 * (1 – Ownership %) toward its CET 1. That would
be $20 – $10 * (1 – 80%) = $18 here.
The bank can do the same thing in its Tier 1 Capital, but it must subtract the amount it has already
recognized within CET 1. So, in this example, the bank could recognize a maximum of $2 within the
additional amount that contributes to its Tier 1 Capital.
For Tier 2 Capital, the bank must subtract the amounts it has already recognized within both CET 1 and
Tier 1 Capital.
In practice, these rules mean that banks with huge amounts of Surplus CET 1 cannot count much of
their Noncontrolling Interests toward Regulatory Capital.
8. How do you factor Deferred Tax Assets (DTAs) and Deferred Tax Liabilities (DTLs) into the
Regulatory Capital calculations?
When you deduct Goodwill and Other Intangibles from CET 1 (and the other figures), they must be net
of associated DTLs.
Also, you must deduct the net DTAs that arise from net operating loss (NOL) and tax credit
carryforwards when calculating the same figures.
It’s extremely difficult to determine these numbers on your own, so you usually hold the bank’s
“adjustments” in its filings constant or project them with simple percentages.
9. What’s the purpose of the Liquidity Coverage Ratio (LCR), and how do you calculate it?
The LCR ensures that the bank has enough high-quality Liquid Assets to cover 100% of net cash
outflows during a “stressed 30-day period.”
You calculate it with Liquid Assets / Stressed Net Cash Outflows, and the minimum is 100%.
Usually, you make Liquid Assets a percentage of Cash and Investments.
Then, you assume a “Run-Off Rate” on the bank’s Deposits, subtract scheduled Loan repayments, and
add items like Derivatives Payable that might disappear in a panic, to calculate the Stressed Net Cash
Outflows.
10. What’s the purpose of the Net Stable Funding Ratio (NSFR), and how do you calculate it?
The NSFR ensures that the bank has enough stable, long-term funding for its Assets (i.e., the bank
should not be dependent on short-term borrowings that might disappear overnight).
You calculate it with Available Stable Funding / Required Stable Funding, and the minimum is 100%.
Available Stable Funding consists of longer-term, stable Deposits plus Total Capital (or a variation
thereof) plus other Liabilities with maturities greater than 12 months.
Required Stable Funding consists of the sum of “Adjustment Factors” multiplied by the bank’s Interest-
Earning Assets and off-Balance Sheet Assets, plus all the bank’s non-Cash, non-Interest-Earning Assets.
11. A bank’s CET 1 Ratio is 10.0%, its Liquidity Coverage Ratio (LCR) is 95.0%, and its Net Stable
Funding Ratio (NSFR) is 95.0%. What’s the BEST way for this bank to solve this problem?
The bank’s CET 1 Ratio is acceptable, but its LCR and NSFR are below the minimum percentages.
Therefore, the bank has no reason to raise Common Equity if it can boost its LCR and NSFR via other
means.
This bank should raise additional Deposits and keep the proceeds in Cash. Deposits cost far less than
Common Equity, Preferred Stock, or Long-Term Debt, and additional Deposits kept in Cash would boost
the LCR and NSFR.
The LCR would increase because the bank’s Liquid Assets would go up, while its Stressed Net Cash
Outflows would rise by only a slight amount – since the Run-Off of Deposits is a low percentage.
The NSFR would increase because the bank’s Available Stable Funding would increase while its
Required Stable Funding would stay the same.
12. Under Dodd-Frank in the U.S., how does the Federal Reserve “stress test” banks?
The two main tests are Comprehensive Capital Analysis and Review (CCAR) and Dodd-Frank Act Stress
Testing (DFAST). Under CCAR, the Fed uses the bank’s plan for Dividends and Stock
Issuances/Repurchases and assess whether or not the bank could maintain its minimum capital ratios
and a CET 1 Ratio of 5% even if “stressful conditions” emerge.
To test these conditions, the Fed creates adverse scenarios based on lower Loan growth, higher default
rates, lower interest rates, and so on.
Under DFAST, the Fed ignores the bank’s business plan and assumes Dividends at similar levels to
those in past years. It assumes no other changes to Equity capital except for Stock-Based
Compensation and Stock Issuances for planned M&A deals.
Large banks must pass these tests to receive approval for their Dividend and Stock Repurchase plans.
13. What happens if a bank does not comply with its Regulatory Capital requirements?
If a bank does not comply with these requirements, government regulators may impose restrictions on
the bank’s Dividends, Share Repurchases, Acquisitions, and other activities.
They might limit employee compensation, and the government might even take over the bank if its
ratios fall too low.
14. How do you use Regulatory Capital in real-life models?
You usually use it to determine the Dividends a bank can issue. For example, if the bank’s targeted CET
1 Ratio is 10%, and it’s currently at 11%, it can only issue Dividends representing 1% of its Risk-
Weighted Assets.
You also use these ratios to constrain a bank’s Loan/Deposit growth by ensuring that it has enough
Tangible Common Equity. If the bank’s ratios drop too low, you might even assume that the bank has
to issue Stock to boost its ratios.
These ratios are a critical part of all models for banks because banks can take action only in relation to
their capital.
15. How are the Allowance for Loan Losses and Regulatory Capital related?
The Allowance covers expected losses, and Regulatory Capital covers unexpected losses.
If a bank suddenly experiences an unexpected loss, it will have to increase its Allowance for Loan
Losses by increasing its Provision for Credit Losses.
If the Provision increases by $100, Net Income decreases by $60 at a 40% tax rate.
On the CFS, Net Income is down by $60, but you add back the $100 Provision, so Cash at the bottom is
up by $40.
On the BS, Cash is up by $40 on the Assets side, and the Allowance for Loan Losses is down by $100, so
the Assets side is down by $60. Gross Loans then decreases by $100, and the Allowance increases by
$100, but those changes cancel each other out.
On the L&E side, Retained Earnings is down by $60, so Equity is down by $60, and both sides balance.
The Regulatory Capital here allowed the bank to absorb these unexpected losses because the after-tax
Provision flowed directly into the bank’s Common Shareholders’ Equity.
Return to Top.
Commercial Bank Valuation Questions & Answers
These questions, especially the ones on the Dividend Discount Model, could easily come up in entry-
level interviews.
You’re less likely to get questions on more advanced methodologies, such as the Residual Income
Model, since they don’t come up as much in real life.
Also, note that we covered several valuation questions in the first section of this guide. We’re not
going to repeat those questions and answers here, so please refer to that section for the basics.
1. How might you conclude that a bank is overvalued or undervalued from an analysis of Public
Comps?
You focus on the relationship between P / BV and ROE and P / TBV and ROTCE. If the bank you’re
valuing has Returns-based metrics on par with the medians of the set, then its P / BV and P / TBV
multiples should also be close to the medians.
The bank might be undervalued if its multiples are below the medians, but its Returns-based metrics
meet or exceed the medians; vice versa if the bank’s multiples are above the medians.
You might also look at metrics such as the CET 1 Ratios and Efficiency Ratios of the banks; if the bank
you’re valuing has worse performance metrics than its peers, it should be valued at lower multiples.
2. How do you adjust a bank’s metrics and multiples if it has Excess or Deficit Capital?
If a firm has Excess Capital, e.g. its CET 1 Ratio is 15%, but peer companies are targeting only 12%, and
the company itself is also targeting 12%, then you reduce its Equity Value, Book Value, and Tangible
Book Value, and reduce its Net Income by the after-tax amount it earns on that Excess Capital.
If the bank has “Deficit Capital,” you do the opposite and increase all those metrics.
As a result, the P / TBV multiples tend to increase when a bank has Excess Capital, but the P / E
multiples tend to decrease (the opposite applies for Deficit Capital).
3. A bank’s Current Equity Value is $10,000, and its Tangible Book Value is $6,000. Its CET 1 is $5,500,
its Net Income to Common is $600, and its Risk-Weighted Assets are $55,000. It is targeting a CET 1
Ratio of 12%.
If you assume a 2% rate of return on Excess / (Deficit) Capital and a 40% tax rate, what are this
bank’s P / TBV and P / E multiples after you adjust for Excess / (Deficit) Capital?
The bank’s CET 1 Ratio is currently $5,500 / $55,000 = 10%. Since it is targeting 12%, it has Deficit
Capital of $55,000 * 2% = $1,100.
You add this Deficit Capital to its Equity Value and Tangible Book Value, so they become $11,100 and
$7,100, respectively.
You also increase the bank’s Net Income to Common by $1,100 * 2% * (1 – 40%), so it becomes $613.2.
So, the bank’s P / TBV multiple will be 1.56x, and its P / E will be 18.1x after these adjustments.
4. How can management manipulate both Earnings-based multiples and Book Value-based multiples
for commercial banks?
Management has significant discretion with both these multiples because the Provision for Credit
Losses reduces Net Income, and the Allowance for Loan Losses reduces Book Value.
So, the management team could over-provision for Loan losses, which would reduce its Net Income
and Book Value and increase the P / E and P / BV multiples as a result.
5. What might be different about a set of Precedent Transactions for a bank vs. a set of Public
Comps?
The main difference is that you’re less likely to adjust for Excess / (Deficit) Capital in the Precedent
Transactions because the acquired companies may be quite different from each other. A regional,
pure-play bank and a diversified, multi-national bank probably don’t target similar CET 1 Ratios.
Also, you may focus on historical metrics and multiples due to the lack of data for the projected
metrics in Precedent Transactions.
If you do not have information on the ROA, ROE, and ROTCE for each acquired bank, you might focus
on metrics such as the share-price premium or % Cash vs. Stock in each deal as well.
6. Your co-worker claims that you *can* value a bank with a DCF, but only if you use a Levered DCF
so that you capture the bank’s Net Interest Income. Is this co-worker correct?
No! Although Levered FCF will capture the bank’s Net Interest Income, it still won’t be accurate
because CapEx and Working Capital do not represent “reinvestment in the business” for a bank in the
same way they do for normal companies.
So, if you wanted to use a Levered DCF, you would still have to modify it to capture the bank’s
reinvestment in some way (e.g., by capitalizing employee hiring and training costs).
Given the effort required, it’s easier to use the standard Dividend Discount Model.
7. Walk me through a basic Dividend Discount Model (DDM) for a commercial bank.
First, assume an Asset Growth Rate, and make Risk-Weighted Assets a percentage of Total Assets.
Then, project Assets and Risk-Weighted Assets based on these figures. Assume a Return on Assets
(ROA) for the bank, and use that to project Net Income.
Then, assume a Targeted CET 1 Ratio (e.g., 10% or 12%), and calculate the bank’s CET 1 for the year
based on that percentage times its Risk-Weighted Assets.
Back into the Dividends Issued by taking the bank’s CET 1, adding Goodwill and Other Intangibles,
subtracting the beginning Shareholders’ Equity, and subtracting Net Income and anything else that
might affect CET 1.
Then, discount the Dividends based on the Cost of Equity, and sum up all the discounted values.
Calculate the Terminal Value using the Multiples Method (typically based on P / TBV) or the Gordon
Growth method, and discount it to its Present Value, also using the Cost of Equity.
Add the Present Value of the Dividends to the Present Value of the Terminal Value to determine the
bank’s Implied Equity Value. Compare this to the bank’s Current Equity Value.
8. How is a Dividend Discount Model for a normal company different from a DDM for a bank?
For a normal company, you don’t need to “back into” Dividends based on targeted Regulatory Capital
ratios such as a 10% or 12% CET 1 Ratio.
Instead, you project Revenue down through Net Income, assume a simple Dividend Payout Ratio,
discount and add up the Dividends, calculate Terminal Value based on P / E, discount the Terminal
Value to Present Value, and add up everything to get the company’s Implied Equity Value.
9. How do you calculate Cost of Equity for a bank, and what should you do if the normal method
produces odd results?
You can still use the normal method: Cost of Equity = Risk-Free Rate + Equity Risk Premium * Levered
Beta.
But banks tend to have very similar capital structure percentages, so you don’t need to un-lever the
Betas from the comparable companies, find the median, and then re-lever it based on the company
you’re valuing.
If you get odd results, you might need to expand the set of comparable banks or use Dividend Yield +
Dividend Growth Rate to calculate the Cost of Equity.
10. What are the flaws with using a DDM to value a bank?
Just like a normal DCF, it’s sensitive to far-in-the-future assumptions such as Terminal Value, and you
might lack enough information to forecast Dividends properly.
Also, a DDM may not work well if the bank does not issue Dividends, and the results could be distorted
if the bank issues/repurchases significant Stock or uses significant Stock-Based Compensation.
11. What makes the biggest difference in a DDM: The Payout Ratio, the Discount Rate, the Net
Income Growth Rate, or the Terminal Value?
As in a DCF, the Terminal Value tends to make the biggest difference because the PV of the Terminal
Value often accounts for over 50% of the company’s Implied Equity Value.
After that, the Discount Rate also makes a big impact since it affects everything in the analysis. The Net
Income Growth Rate makes a smaller impact, and the Payout Ratio makes an even smaller impact
because a bank’s capital ratios constrain its Dividends.
12. Could you use a Dividend Discount Model to value a bank that does not currently pay Dividends?
Yes, but you have to assume that it starts paying Dividends in the future, or the bank’s entire Implied
Equity Value will come from the PV of its Terminal Value, which makes the analysis silly.
If the bank is so new that it has no plans to start issuing Dividends anytime soon, a multiples-based
valuation or Residual Income Model (see below) may be better.
13. How do Stock Issuances/Repurchases and Stock-Based Compensation affect a DDM?
Ideally, you should exclude them from the DDM altogether so that only Net Income to Common and
Dividends affect the bank’s Common Shareholders’ Equity.
If you do include them, you need to adjust the bank’s current share count based on their future
impact.
For example, you might calculate the Present Value of the net amount the bank spends on these items,
and then add up everything and divide by the bank’s current share price to estimate the number of
new shares that will be created in the future.
Then, you could add those new shares to the bank’s current share count and use that new figure to
calculate the bank’s Implied Share Price.
14. If you’re building a multi-stage Dividend Discount Model for a fast-growing bank that will
eventually reach maturity, what changes in the analysis?
The ROA, ROE, Payout Ratio, and Targeted CET 1 Ratio will likely change in each period until the bank
reaches maturity.
Also, the Cost of Equity might change in each year because a mature bank should have lower risk and
lower potential returns than a younger, high-growth bank.
If that happens, then you need to calculate the Cumulative Discount Factor for each period and use
that to calculate the PV of Dividends and the PV of Terminal Value. You can’t just divide by ((1 + Cost of
Equity) ^ Year #) anymore because the Cost of Equity changes in each period.
15. How do you factor Excess / (Deficit) Capital into a DDM?
You shouldn’t need to factor it in if you’ve assumed that the bank issues Dividends such that it meets
its Targeted CET 1 Ratio; any Excess Capital will be distributed in the form of Dividends.
And if the bank has Deficit Capital, it won’t be able to issue Dividends until it achieves its Targeted CET
1 Ratio.
If you have not set up the model like that, then you’ll have to add Excess Capital or subtract Deficit
Capital when you calculate the bank’s Implied Equity Value at the end.
16. When is a Residual Income Model most useful, and how does it differ from a DDM?
The Residual Income Model is most useful for banks that are not currently issuing Dividends, but which
have easy-to-establish figures for ROE and Cost of Equity.
It may also be useful if you believe that much of the bank’s Implied Equity Value comes from its current
Balance Sheet, and you’re uncertain of the bank’s future Dividends.
The model setup is very similar to the one for a DDM, and you still “back into” Dividends based on the
bank’s Targeted CET 1 Ratio.
But instead of summing up the Present Values of the Dividends, you sum up the Present Values of the
Residual Income (also known as Excess Returns).
Residual Income equals ROE * Shareholders’ Equity – Cost of Equity * Shareholders’ Equity, and it
represents how much actual Net Income exceeds expected Net Income.
Then, you add the Present Values of these Residual Income figures to the current Book Value (or
Common Book Value) of the bank to get its Implied Equity Value.
If the bank’s long-term ROE differs from its long-term Cost of Equity, you’ll also have to calculate the
Residual Income Terminal Value, discount that to its Present Value, and add it to everything above.
The intuition is that a bank’s Equity is worth about its current Book Value, but it might be worth more
than that if its ROE exceeds its Cost of Equity in the future. If the opposite happens, the bank’s Equity
might be worth less than its current Book Value.
17. What are the advantages and disadvantages of a Residual Income Model?
The advantage is that the Residual Income Model is grounded in the bank’s current Balance Sheet, so
most of the bank’s Implied Equity Value comes from that rather than future Dividends.
The disadvantage is that it sometimes doesn’t tell you much beyond the obvious – that Book Value and
Equity Value are closely related for banks.
Also, many bankers view this methodology as academic or overly theoretical, so it’s not common in
real life.
18. Why does the Residual Income Model often assume no Terminal Value?
The Residual Income Model includes Terminal Value only if the bank’s Long-Term ROE differs from its
Long-Term Cost of Equity.
You often assume that ROE differs from Cost of Equity in the explicit forecast period, but that the two
converge in the Terminal Period, which means there is no Terminal Value.
If you did not make that assumption, you could calculate Terminal Value with:
Residual Income in Year 1 of Terminal Period / (Cost of Equity – Terminal Net Income Growth Rate)
Then, discount it to its Present Value with the Cost of Equity, and add it to the Sum of the PVs of
Residual Income and the bank’s Book Value.
19. How might you use a Regression Analysis to value a bank?
Since P / BV and ROE and P / TBV and ROTCE are related, you could gather data on all those metrics for
a wide set of publicly traded banks in a certain region and then create a Regression that lets you
“predict” your bank’s multiples based on its Returns metrics.
For example, you might plot this data and get an equation such as:
P / TBV = 12.9 * ROTCE – 0.13
If your bank’s ROTCE is 12%, then its P / TBV should be 1.4x according to that formula. You might then
compare that Implied P / TBV Multiple to the bank’s Current Multiple to see if it’s valued appropriately.
If there’s strong correlation in this data, you might take these results more seriously.
The Regression Analysis is useful as a “sanity check,” but not as useful as a strict valuation
methodology.
Return to Top.
Insurance Valuation Questions & Answers
Insurance valuation is very similar to bank valuation, and similar metrics and multiples apply because
both businesses are Balance Sheet-centric.
So, we’re not going to repeat everything in the bank valuation section and the first section of this
guide; instead, we’ll focus on what’s different, which means “many questions on Embedded Value.”
1. How do you screen for Public Comps and Precedent Transactions for an insurance company?
You use criteria such as Total Assets, Written Premiums, or Earned Premiums rather than Revenue or
EBITDA; geography is also very important due to regulations, as is the subsector of the companies (you
should not compare diversified insurance firms to ones that only do Life or P&C).
2. What other multiples might you use for insurance firms in addition to P / E, P / BV, and P / TBV?
If the insurance firms you’re analyzing do not mark their Balance Sheets to fair market value, you could
also use P / NAV (Equity Value / Net Asset Value).
Other options include the P / GWP (Equity Value / Gross Written Premiums) and P / NWP (Equity Value
/ Net Written Premiums) multiples, which are similar to revenue or bookings multiples for normal
companies.
On the Life Insurance side, there’s also Embedded Value and Embedded Value-based multiples such as
P / EV (see the Embedded Value questions below).
3. Why might the P / E and P / BV multiples be misleading for insurance firms?
Just like commercial banks can distort these multiples by over- or under-provisioning, insurance firms
can do the same thing with their reserves, such as the Loss & LAE or Claims Reserve.
If the company keeps recording aggressive Claims expenses on the Income Statement, for example, its
Net Income will be lower, and so will its Book Value (since its Reserves on the L&E side will be higher).
Those changes, in turn, will increase its P / E and P / TBV multiples.
4. How does a Dividend Discount Model (DDM) work for an insurance company?
The basic setup is similar to the one for commercial banks: You “back into” the firm’s Dividends based
on its targeted Regulatory Capital, but with insurance, that target is based on the SCR Coverage Ratio
or Solvency Ratio rather than the CET 1 or Tier 1 Ratio.
You start by assuming an Asset Growth Rate or Premiums Growth Rate and using that as the key driver;
you might base the company’s Net Income on ROA, ROE, or related metrics.
You then make assumptions for the firm’s Required Capital and Available Capital, often linking them to
firm’s Total Assets and Statutory Capital & Surplus, respectively.
Then, you back into the Dividends by assuming that the firm meets the minimum SCR Coverage Ratio
or Solvency Ratio it is targeting.
Finally, you discount all the Dividends to their Present Value, add them up, calculate the Terminal
Value with P / E, P / BV, or P / TBV, discount that to its Present Value, and add it to the Sum of the PV
of Dividends to determine the firm’s Implied Equity Value.
5. Walk me through a Net Asset Value (NAV) Model for an insurance firm.
First, you adjust everything on the Assets side up or down based on its fair market value. Goodwill &
Other Intangibles usually goes to $0, and Reinsurance Recoverables are often discounted because of
the risk of a reinsurer not paying out Claims; investments may also be marked to market.
Next, you adjust the firm’s Liabilities, and you may discount some of the Reserves depending on the
trends in Premiums and Claims. Then, you subtract the Adjusted Liabilities from the Adjusted Assets to
calculate the Net Asset Value.
You may make another adjustment at this stage if there’s Excess or Deficit Capital (e.g., the firm is
targeting a 200% SCR Coverage Ratio but is only at 150% currently).
Finally, you divide the NAV by the Shares Outstanding to get NAV per Share, which you can then
compare to the company’s current share price.
6. Walk me through an Embedded Value model for a Life Insurance firm.
Embedded Value = Net Asset Value + Present Value of Future Cash Profits from Current Policies.
You start by calculating the firm’s Net Asset Value, marking everything to market value (if the firm
doesn’t already do that), and then subtracting all the Liabilities from all the Assets.
Then, you assume that the insurance company writes no new policies in future years so that its
expected after-tax cash flows all depend on its policies as of today.
You project the firm’s revenue based on its Net Earned Premiums and “Lapse Rate,” which represents
cancellations (remember, no new policies), plus Interest and Investment Income.
The main expenses include Cash Claims, Cash Commissions, and other Cash Operating Expenses. You
might estimate these with the changes in the company’s Reserves in past years.
Then, you multiply Pre-Tax Income by (1 – Tax Rate) to calculate the After-Tax Cash Flow from the
policies in each year; if the company needs more or less capital, you also factor that in, along with the
after-tax interest on it.
You project these figures until the policies “run out” (i.e., until their terms end or cancellations reduce
revenue to $0).
Then, you take the Present Value of those After-Tax Cash Flows, using Cost of Equity for the Discount
Rate, and add it to the firm’s Net Asset Value to determine its Embedded Value.
You might project Embedded Value in a model by assuming that the company writes new policies each
year, but Embedded Value in a specific year is always based on just the firm’s policies as of that year.
7. Why does Embedded Value only apply to Life Insurance firms?
Life Insurance companies have extremely long-term policies (20-30 years or more), so policies written
today may still be generating cash flows decades into the future, and they’ll contribute significantly to
a firm’s Implied Equity Value.
Embedded Value doesn’t make sense for P&C Insurance firms because their current policies might only
last for 1-3 years. So, very little of the firm’s Implied Equity Value would come from the Present Value
of Future Cash Profits from Current Policies.
You’d have to assume that the P&C Insurance firm keeps writing new policies in future years for the
analysis to make sense, and if you do that, you might as well just use a Dividend Discount Model.
8. How do you calculate Embedded Value Profit, an alternative to Net Income?
Embedded Value Profit = Value of New Business + Unwind of Discount Rate
Value of New Business: Let’s say that a firm writes a new set of policies and that the Present Value of
Future Profits from them is $500 when the firm initially writes them.
In the next year after that initial year, the Value of New Business would be $500 because that’s the
“new business” that the company just wrote.
Unwind of the Discount Rate: This is the Discount Rate * the PV of Future Profits from that initial year.
So, if the Discount Rate is 10%, the Unwind of the Discount Rate is $50 here.
The Embedded Value Profit, therefore, is $550. This number is an “alternative way” of viewing the
firm’s profitability; unlike Net Income, it is based on expected future cash flows.
Cash Profit vs. Embedded Value Profit for a single policy over a 20-year time frame looks like this:
9. If a Life Insurance firm keeps growing and writing new policies each year, how does its Embedded
Value Profit change over time?
All else being equal, the Embedded Value Profit keeps increasing because the Value of New Business
keeps increasing if the company is growing.
In the graph above, the Embedded Value Profit decreases from Year 1 to Year 2 because it corresponds
to one policy written in a single year, and we assumed that the firm writes no new policies.
10. Will the Embedded Value and Shareholders’ Equity (or NAV) of a Life Insurance firm ever
converge on the same value?
They will converge only if the firm stops writing policies, or if you’re only calculating the cash flows for
a single policy written in a single year (as in the example above).
They will converge in the year that the policy’s cash profit goes to $0. Here’s what it looks like if that
happens in Year 20 (assuming the firm only writes new policies once in the beginning):
11. Are Embedded Value and EV Profit more conservative or more aggressive than traditional
metrics like Shareholder’s Equity and Net Income?
They’re more aggressive because they are based on the Present Value of expected future profits.
The total profits over the term of a policy are the same, but under Embedded Value, the firm
recognizes them earlier on.
12. How do Market Consistent Embedded Value (MCEV) and European Embedded Value (EEV) differ
from normal Embedded Value?
With EEV, you also adjust for Net Unrealized Gains when calculating the Net Asset Value of a company.
And rather than just discounting and summing up future profits, you also factor in the Cost of Capital
and the Value of Options and Guarantees (by subtracting both).
With MCEV, you discount the cash flows at different rates, and you also recognize investment returns
above the risk-free rate as they’re earned, rather than entirely upfront.
Return to Top.
P&C vs. Life Insurance Questions & Answers
You could view these questions as “more advanced,” but they’re somewhat likely to come up in
interviews since they’re all high-level questions.
Also, Property & Casualty (P&C) and Life Insurance companies are quite different, from the business
models to the financial statements to the valuation methodologies.
If you’re interviewing with a FIG banker, you should have at least a basic idea of these differences.
1. How are P&C and Life Insurance companies similar and different?
Both types of companies collect Premiums upfront, recognize them as revenue over time, recognize
Claims as expenses and pay them out in Cash over time, and make money from both Underwriting and
Investing.
Beyond that, they’re quite different:
• Policy Length: Life Insurance policies last for much longer: 20-30+ years vs. 1-3 years for P&C.
• Business Model: P&C is more of a flow business, dependent on winning and servicing new
customers and profiting from underwriting activities, while Life is more of a spread business,
more dependent on investments and interest rates.
• Financial Statements: Life Insurance firms have more complex Balance Sheets with additional
items, such as Separate Accounts.
• Valuation: You can use the Dividend Discount Model and P / E, P / BV, and P / TBV multiples to
value both types of firms, but with Life Insurance, there’s also Embedded Value and related
metrics and multiples, such as P / EV and ROEV.
2. How do the financial statements of P&C and Life Insurance firms differ?
Items on the financial statements are similar, but the proportions are different. For example, Life
Insurance companies earn a higher percentage of revenue from Interest and Investment Income.
Also, Life Insurance firms have “Separate Accounts” line items on their Balance Sheets to distinguish
between money that they manage directly and the funds that policyholders manage.
They also tend to have more investment categories on the Assets side since investments are more
important for Life Insurance firms.
3. Would a P&C or Life business have a bigger “loss triangle” in its supporting schedules?
The Life Insurance firm would almost always have a bigger “loss triangle” because its policies last for
decades rather than years, and it pays out Cash Claims over a far longer period.
If a customer purchases a 2-year auto insurance policy, the customer could easily get in a car accident
and file a claim a few months after the policy begins.
But if the same customer purchases a 30-year life insurance policy, he/she is not likely to die within the
next few months.
4. How do you value P&C and Life businesses differently?
You can still use multiples such as P / E, P / BV, and P / TBV for both types of firms, along with the
Dividend Discount Model.
But for Life Insurance, Embedded Value (see the Valuation section), which equals a firm’s Net Asset
Value + Present Value of Future Cash Profits from Current Policies, is a new, important methodology.
You could create many metrics and multiples based on Embedded Value as well, such as Return on
Embedded Value (ROEV) and P / EV.
5. How do a P&C firm’s growth and profitability change over the industry life cycle?
As Premium Growth increases, Underwriting Margins normally decline, and vice versa:
Return to Top.
Bank M&A and Merger Model Questions & Answers
Interview questions on bank M&A and merger models are extremely unlikely.
Bank merger models are quite complex and go beyond the usual knowledge tested in entry-level
interviews, and plenty of Analysts and Associates don’t even know enough to ask detailed questions on
the topic.
So, you should study these questions only if you have more advanced knowledge, significant
experience in FIG, or FIG-related M&A deals on your resume/CV.
1. Why would a bank buy another bank?
Because it believes that the Purchase Price of the other bank is less than the Present Value of the other
bank’s future cash flows.
In practice, most banks acquire other banks to expand geographically, diversify their businesses, realize
significant Cost Synergies, or strengthen their Regulatory Capital positions.
2. How is a merger model different for commercial banks?
You still combine the financial statements of the Buyer and Seller, adjust for acquisition effects, create
Goodwill, and calculate EPS accretion/dilution.
However, the specifics of the model are quite different.
For example, most banks must use primarily Debt or Stock to fund deals since they need Cash to cover
Deposit withdrawals.
Also, acquirers must mark targets’ Balance Sheets to market value and amortize these adjustments.
Acquirers also write down targets’ Allowances for Loan Losses as part of that process.
“Core Deposit Intangibles,” which represent the funding advantage of the bank’s most stable Deposits,
also get created in bank M&A deals and are amortized over time.
The acquirer may have to divest some of the target’s Deposits for regulatory reasons, and even if the
acquirer can realize significant Cost Synergies, it will have to spend a significant amount upfront on
Restructuring to do so.
You will also have to recalculate Regulatory Capital, Dividends, and the “balancer” line items (e.g.,
Federal Funds Sold and Purchased) since the combined company’s Balance Sheet will change.
Finally, you may evaluate bank M&A deals by using alternative accretion/dilution metrics as well as
IRR, the NPV of Synergies, and a Contribution Analysis.
3. Why do banks usually use a high percentage of Stock when acquiring other banks?
Partially, it’s because banks usually can’t use much Cash to fund deals because they need to keep a
certain amount of Liquid Assets available to cover Deposit withdrawals.
Also, most banks are already highly leveraged and cannot necessarily raise significantly more Debt to
fund deals.
But the other reason is related to Regulatory Capital: Since the Seller’s Common Shareholders’ Equity
is written down in the deal but most of its Risk-Weighted Assets remain, the Combined Company could
easily experience a CET 1 shortfall unless the Buyer uses significant Stock to fund the deal.
4. Why might an acquirer mark a target bank's Balance Sheet to market value?
Because the fair market values of the target bank’s Assets and Liabilities could easily “drift” from their
book values, and banks do not mark everything to market value. For example, they record Loans and
Deposits at historical cost less amortization.
The fair market values might change if prevailing interest rates or credit risk change.
For example, if the bank issues 10-year Loans at a 6% coupon rate, market interest rates on similar
Loans are also 6%, and there’s no credit risk, the book value and fair market value of the Loans will be
the same initially.
But if market interest rates then rise to 7%, and the credit risk of the borrower increases so that there’s
only a 99% chance of repayment, the fair market value of those Loans will decline.
The Acquirer completes this process for all the Assets and Liabilities of the Target that are not already
marked to market.
5. An acquired bank has $1,000 in Gross Loans and $1,200 in Deposits. The Acquirer believes that the
fair market value of the Gross Loans is 98% of their book value and the fair market value of the
Deposits is 99% of their book value.
The average maturity of the Gross Loans is 5 years, and the average maturity of the Deposits is 2
years.
How will the Acquirer record the amortization of these mark-to-market adjustments on its Income
Statement?
The Gross Loans decrease by $20 since $20 is 2% of $1,000, and the Deposits decrease by $12 since
$12 is 1% of $1,200.
The acquirer then amortizes the $20 adjustment over 5 years for $4 per year, and it lists this as a
positive $4 on the Combined Income Statement.
Then, it amortizes the $12 adjustment over 2 years for $6 per year, and it lists this as ($6) on the
Combined Income Statement.
So, in the first two years, the amortization will be ($2) on the Income Statement, and in the last three
years, it will be $4.
6. What do Core Deposit Intangibles (CDI) represent in a bank M&A deal, and how do you calculate
them?
Core Deposit Intangibles represent the “funding advantage” of the acquired bank’s most stable, long-
term Deposits over other Deposits on which it would have to pay higher rates.
Technically, you could calculate this number by comparing the interest rates on those Deposits to
market interest rates and calculating the Present Value of the difference.
But you rarely have enough information to do that, so you normally base the Core Deposit Intangibles
on a small percentage of the acquired bank’s “Core Deposits,” which it discloses in its filings.
7. Why might a Buyer divest a Seller’s Deposits in an M&A deal?
A Buyer might divest a Seller’s Deposits because of regulatory reasons. For example, in some countries,
such as the U.S., banks are prohibited from holding more than a certain percentage of Total National
Deposits via M&A deals.
So, if the country has $1,000 of Total Deposits, Bank A has $100 of Deposits, Bank B has $50 of
Deposits, and a single bank cannot come to hold more than 13% of Total Deposits via M&A, Bank B
would need to divest $20 of Deposits.
But a Buyer might also divest some of the Seller’s Deposits if it wants to exit a certain geography or
market segment.
8. In a bank M&A deal, the Buyer has $1 billion of Deposits, and the Seller has $200 million of
Deposits. The Total Deposits in the country are $10 billion, and no bank can come to hold more than
11% of Total Deposits via M&A.
The Buyer’s Tax Rate is 40%, and it will receive a 10% premium for the Seller’s Divested Deposits.
The Seller’s Loan / Deposit Ratio is 10%, and its Securities / Deposit Ratio is 90%. Walk me through
the Balance Sheet impact of this Deposit Divestiture.
11% * $10 billion = $1.1 billion, so the Buyer will have to divest $100 million of the Seller’s Deposits.
It will receive a 10% premium for those Deposits, which means $10 million * (1 – 40%) = $6 million
after taxes.
On the Balance Sheet, the After-Tax Premium increases the Combined Company’s Cash balance by $6
million, and it increases Retained Earnings by $6 million on the L&E side.
The Combined Company’s Deposits decrease by $100 million after the divestiture, and on the Assets
side, its Loans decrease by $10 million, and its Securities decrease by $90 million.
9. How do the Purchase Price Allocation and Balance Sheet Combination processes differ in bank
merger models?
In the PPA Schedule, you must factor in all the mark-to-market Balance Sheet adjustments, the write-
down of the Seller’s Allowance for Loan Losses, and the new CDI created in the deal.
The other adjustments are all standard: Write down the Seller’s CSE, write down its existing Goodwill
and Other Intangibles, create new Goodwill and Other Intangibles, possibly write up its PP&E, and
create a new DTL based on the new Intangible and Tangible Write-Ups.
The Balance Sheet Combination reflects all these differences, and you must also include the impact of
Deposit Divestitures, including corresponding Loans and Securities divested and premiums received.
You record all the standard items in the Balance Sheet Combination as well: Cash, Debt, and Stock used
to fund the deal, and the new Goodwill, Other Intangibles, and other write-ups.
10. How can you tell if there will be Tangible Book Value per Share (TBVPS) dilution in a bank M&A
deal?
TBVPS dilution depends on how the Buyer’s Tangible Book Value changes relative to the change in its
share count.
So, anything that results in a lower Tangible Book Value or a higher share count contributes to the
dilution.
Dilution is more likely if the Buyer uses significant Debt or Cash to fund the deal, if the Buyer is trading
at a lower P / E multiple than the Seller, or if the Buyer pays a low premium over the Seller’s Book
Value.
11. How are Cost Synergies and Restructuring Charges linked in a bank merger model?
Usually, you assume that Cost Synergies represent a percentage of the Seller’s Non-Interest Expenses
based on the number of branches the Buyer plans to consolidate or close. The percentage might be
anywhere from 5-10% up to 30-40% in very aggressive deals.
You assume that it takes several years to realize these Cost Synergies fully (e.g., 50% realization in Year
1, 75% in Year 2, and 100% in Year 3).
Then, you assume that the Buyer incurs Restructuring Charges that represent some percentage of the
fully realized annual Cost Synergies. It usually pays for these Charges upfront in Cash, and the
Combined Net Income declines as a result.
Often, you focus on accretion/dilution metrics in years after the company has incurred the
Restructuring Charges so that you exclude their impact.
12. How do you treat Federal Funds Sold and Purchased in a bank merger model?
These items (and other Balance Sheet “balancers”) work the same way in a merger model as they do in
a standalone 3-statement model, but you must recalculate them based on the new Balance Sheet.
In other words, you can’t just add together the Buyer and Seller’s figures to determine the combined
numbers.
Instead, you must determine the combined numbers by taking the Combined Company’s Assets in
Current Period + Fed Funds Sold in Prior Period and comparing that to the Combined Company’s L&E in
Current Period + Fed Funds Purchased in Prior Period.
If the Combined Company needs more funding, increase Federal Funds Purchased; if it has excess
funding, increase Federal Funds Sold.
You must also factor in the differences in Interest Income and Interest Expense because of how these
items change over the standalone numbers from the Buyer + Seller.
13. How do a bank's Regulatory Capital and Dividends change after it acquires another bank?
There’s no universal answer because it depends on the Buyer and Seller’s Regulatory Capital and
Dividend Payout targets, the transaction funding, and the relative sizes of the Buyer and Seller.
For example, if the Buyer is targeting a higher CET 1 Ratio than the Seller, they both target similar
Dividend Payout Ratios, and the Buyer uses 100% Stock to fund the deal, the Buyer may have to cut
Dividends initially because the Seller had lower capital before the deal took place.
If the Buyer uses less than 100% Stock, it will have to cut Dividends even more and possibly issue
additional Equity.
On the other hand, if the Seller is targeting a higher CET 1 Ratio than the Buyer, and everything else
stays the same, then the Buyer might be able to increase its Dividends after the deal closes.
14. Besides EPS accretion/dilution, how else might you evaluate a bank M&A deal?
You might calculate accretion/dilution of other metrics, such as Dividends per Share, Book Value per
Share, Tangible Book Value per Share, or CET 1 per Share.
Also, you might create a Contribution Analysis and assess how much of the Combined Company the
Buyer and Seller “should own.” If the actual ownership levels differ significantly, then the Purchase
Price might be inappropriate.
You could also evaluate the deal by calculating its IRR and comparing that to the Buyer’s Cost of Equity,
and you could calculate the NPV of Synergies realized in the deal.
The last one is not a strict valuation methodology; it’s a way to gauge how dependent a deal is on
Synergies and how plausible those Synergies are.
15. Walk me through the IRR calculation in a bank M&A deal.
To set up this analysis, assume that the Equity Purchase Price is the upfront investment, shown with a
negative in Excel.
Then, show any Equity Capital Infusions into the target with negatives as well, and calculate Combined
Dividends – Buyer Standalone Dividends in each projected year to determine the additional Dividends
generated as a result of the deal.
In the final year, capitalize the Seller’s Net Income, after adjustments for Synergies and other Cash
acquisition effects, at a reasonable P / E multiple.
Apply the IRR or XIRR function to this entire series of cash outflows and inflows to determine the IRR.
16. How would you calculate the Net Present Value of Synergies in a bank M&A deal?
Assume that the Restructuring and Integration Costs count as the “upfront investment,” and project
the Cash acquisition effects, which should be mostly Cost Synergies and the Net Interest Income
impact of differences in the Federal Funds line items.
Multiply by (1 – Tax Rate) to get the After-Tax Cash Flow each year, and capitalize Synergies in the final
year by multiplying by a reasonable P / E multiple.
Then, use the NPV or XNPV function to calculate the Net Present Value of Synergies, and compare it to
the Equity Purchase Price to see how much the deal depends on Synergies.
Return to Top.
Bank Buyout and Growth Equity Questions & Answers
These questions are even less likely than the ones on bank M&A and merger models.
You might get them if you happen to interview with one of the few private equity firms or other
investment firms that focuses on the financial services sectors, but they’re unlikely in investment
banking interviews.
Still, we do cover this topic in the Bank & Financial Institution Modeling course, so we wanted to
feature corresponding interview questions and answers.
1. Why are traditional leveraged buyouts rare for commercial banks?
They’re rare because of regulatory reasons and deal math. If a PE firm acquires over 20-25% of a bank,
it will be classified as a “bank holding company” in many countries, and it will have to comply with
Regulatory Capital and other requirements.
Also, most commercial banks are highly leveraged already and cannot take on additional Debt to fund
deals; that restriction makes it difficult for traditional LBOs to work.
2. How can PE firms avoid these problems and invest in commercial banks anyway?
Most firms avoid these issues by purchasing minority stakes in banks, investing in something other
than Equity, or doing “club deals” with multiple PE firms such that all the firms own small percentages
of the bank’s Equity.
3. How do PE firms generate returns from minority-stake investments or buyouts of banks?
The main returns sources are Tangible Book Value Growth, P / TBV Multiple Expansion, and Dividends.
There’s no real difference between the returns sources in a minority deal vs. a 100% buyout deal, but
you’re more likely to see strategies such as add-on acquisitions and divestitures in true buyouts.
Unlike in traditional LBOs, Debt Paydown and Cash Generation is not a source of returns because banks
use Debt differently than traditional companies and don’t necessarily “repay it” over time.
4. Your firm acquires a $100 Tangible Book Value bank for 2.0x P / TBV, and it plans to sell the bank
in 5 years for 3.0x P / TBV. The bank will not issue any Dividends during the holding period.
By how much must its TBV grow for your firm to realize a 25% IRR?
A 25% IRR over 5 years means that your firm must triple its Invested Equity in that time frame. Since
your firm purchases the bank for an Equity Value of $200, it must sell it for an Equity Value of $600.
Since $600 / 3x = $200, the bank’s TBV must increase to $200.
5. How does your answer change if the bank issues $5 in Dividends each year?
These Dividends will reduce the required Exit TBV slightly because of the time value of money.
It’s hard to do this math in your head because IRR is a polynomial function, but one simple way to
estimate it is to say that $5 in Dividends per year = $25 in Total Dividends.
Therefore, you won’t need all $600 in Equity back at the end; you need more like ($600 – Slightly More
Than $25). You could say that “slightly more than $25” means $30, so the required Exit Equity Value is
around $570.
$570 / 3x = $190, so the bank’s TBV must increase to $190.
If you do the math in Excel, the actual number is $189.7.
6. Your firm acquires a $200 Tangible Book Value bank for 2.0x P / TBV, and it plans to hold it for 3
years. The firm’s Cost of Equity is 10%, its ROTCE is 15%, and its Net Income Growth Rate is 5%. Its
TBV is projected to grow to $250 over 3 years. The bank does not plan to issue any Dividends.
Is it plausible for your firm to realize a 25% IRR in this deal?
To realize a 25% IRR over 3 years, your firm must double its money in that time. It pays an Equity
Purchase Price of $400 for the bank, so it must get an Exit Equity Value of $800 at the end.
If the firm’s TBV is $250 in Year 3, the Exit P / TBV must be $800 / $250 = 3.2x.
Initially, the purchase P / TBV = 2.0x because (ROTCE – NI Growth) / (Cost of Equity – NI Growth) =
(15% – 5%) / (10% – 5%) = 2.0x.
So, to reach a 3.2x multiple, the bank must earn a higher ROTCE, reduce its Cost of Equity, or grow its
Net Income more quickly.
Of those, it’s most plausible for the bank to increase its ROTCE and Net Income Growth.
If its ROTCE were 21% instead of 15%, the Exit P / TBV would be 16% / 5% = 3.2x.
Or, if its Net Income Growth were 7.7% instead of 5%, the Exit P / TBV would also be 3.2x.
These increases are possible, but not particularly easy, especially if the bank is already mature.
So, we would say the deal is plausible but a bit of a stretch unless there’s a really good reason to
assume higher ROTCE or Net Income Growth over several years.
7. What type of result from a Returns Attribution Analysis would make you reluctant to support a
bank buyout deal?
An analysis that indicates that the deal is overly dependent on Multiple Expansion (e.g., 80% of returns
come from there) would make us reluctant to support a bank buyout deal because Multiple Expansion
is inherently speculative.
It’s better if the majority of the returns come from TBV Growth, with a portion also coming from
Dividends.
8. How might you evaluate a growth equity deal for a bank?
Growth equity deals are primarily about P / TBV Multiple Expansion and TBV Growth, so you would
create projections for the bank and evaluate the growth potential for both of those.
For example, if a bank’s P / TBV Multiple is at all-time lows, and you believe its financial performance
will improve, it might be a good growth equity candidate since Multiple Expansion is plausible.
The TBV Growth assumptions must also be grounded in reality. For example, if the required TBV
Growth means that a bank must grow its Loans at 3x the rate of GDP growth, the deal is probably not
feasible in a developed country.
You would look at the deal in different scenarios and decide whether or not it’s plausible to achieve
your targeted IRR and MoM Multiple in each case; if it is, you might recommend the deal.
9. Walk me through a buyout model for a bank.
First, make assumptions for the Purchase P / TBV Multiple or Purchase Premium if the bank is public.
Then, create the Sources & Uses and Purchase Price Allocation Schedules, and adjust the bank’s
Balance Sheet for acquisition effects, such as new Goodwill & Other Intangibles, the write-down and
replacement of Common Shareholders’ Equity, and so on.
Next, project the bank’s Balance Sheet and Income Statement based on your assumptions for
Loan/Deposit Growth, Yields and Interest Rates, and other factors, and “back into” the Dividends based
on the bank’s targeted CET 1 Ratio.
At the end, assume a reasonable range of Exit P / TBV Multiples, and calculate the IRR and MoM
Multiple based on the Equity Purchase Price, Dividends, and Exit Proceeds.
10. How do you estimate the Exit Multiple when investing in a bank?
You could calculate it with the formula that relates P / TBV to ROTCE, Net Income to Common Growth,
and the Cost of Equity.
However, the bank’s financial metrics may not stabilize by the end of the holding period, so you may
get nonsensical results with this formula.
If that happens, you may have to determine the range of Exit Multiples based on the Public Comps or
the bank’s trading history (e.g., find a time when its ROTCE was similar to its Exit Year ROTCE, and use
its P / TBV from that time).
11. How might you decide whether or not to invest in a bank?
You can make an investment decision by creating operational scenarios for the bank and determining
whether or not you could achieve your targeted IRRs and multiples in the different cases. For example,
you might target a 1.2x multiple in the Downside Case, a 20% IRR in the Base Case, and a 30% IRR in
the Upside Case.
If you can’t achieve those numbers, you should lean against an investment in the bank.
If you can, you then look into the qualitative criteria that might support or refute the deal. For
example, is the bank a clear market leader, or does it have many similar competitors?
If the qualitative factors support the deal, then you’ll keep moving toward a recommendation.
Finally, you need to examine the risk factors and determine whether or not they’re serious problems
and how you might be able to mitigate them.
If you can do all that, you might recommend an investment in the bank.
The hardest part of this process is coming up with reasonable numbers in the different scenarios. To do
that, you might review data from peer companies on Loan Growth, Interest Rates and Spreads, and
other assumptions.
To get the numbers in the Downside case, you might go back to the last recession or look at
underperforming peer companies.
12. What are the main risk factors when investing in a bank? How could you mitigate them?
The biggest risk factors are Multiple Contraction and a lack of TBV Growth. You can evaluate the risk of
both by looking at the bank’s historical trading multiples and growth rates and the same data for peer
companies.
Other risk factors include the bank needing to raise additional Equity Capital in the future, which would
dilute your firm, and changes in the regulatory environment.
You can’t do much to mitigate these risks in a buyout for 100% of a bank, but you can find a bank that
might be able to divest Assets or otherwise change its business to respond.
13. How might you evaluate whether or not divestitures or add-on acquisitions are worth it in a bank
buyout deal?
You have to calculate their impact on the bank’s CET 1, TBV, and other financial metrics and ratios and
see if the benefits of these deals outweigh their drawbacks (such as reduced CET 1 or an increased
Investor Equity contribution from the sponsor).
For example, if a bank divests Non-Performing Loans (NPLs), and its CET 1 and TBV fall significantly due
to Realized Losses, the bank needs to generate a significantly higher TBV by the end of the holding
period to make up for that.
It might be able to do that by earning higher Loan Yields or boosting its Revenue and Net Income, but it
may or may not be enough to boost the IRR and MoM Multiple to acceptable levels.
Return to Top.

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Bank & Financial Institution Modeling

Interview Questions & Answers

Bank & Financial Institution Interview Questions & Answers

Bank & Financial Institution Interview Questions & Answers .................................................................... 1

High-Level Questions & Answers

These are the most important questions for entry-level interviews.

1. How does a commercial bank make money?

2. How does an insurance firm make money?

They pay out Claims to customers if the accident happens.

3. How are commercial banks different from normal companies?

The biggest differences include:

5. How are insurance companies different from normal companies?

A few other differences include:

• Valuation is similar to commercial bank valuation, but Embedded Value is an important

6. How are the financial statements different for a commercial bank?

7. How are the financial statements different for an insurance firm?

8. How do you value a commercial bank?

10. How do you value an insurance firm?

CET 1 is the most basic and important type of Regulatory Capital.

Banks must maintain this capital to cover unexpected losses.

Here are the main requirements under Basel III:

• A Conservation Buffer of 2.5% gets added to all these ratios;

• Tier 2 Capital cannot exceed Tier 1 Capital;

• The Leverage Ratio must be greater than or equal to 3% at all times.

Commercial Bank Accounting Questions & Answers

• IS: Pre-Tax Income is up by $5, so Net Income is up by $3 at a 40% tax rate.

A few of the most common ones include:

• Net Charge-Off Ratio: Net Charge-Offs / Average Gross Loans

• Net Charge-Offs / Reserves: Net Charge-Offs / Allowance for Loan Losses

• Reserve Ratio: Allowance for Loan Losses / Gross Loans

• Net Charge-Offs / Prior Year Provisions for Credit Losses

• NPLs / Gross Loans: Non-Performing Loans / Gross Loans

• NPL Coverage Ratio: Allowance for Loan Losses / Non-Performing Loans

Commercial Bank 3-Statement Modeling Questions & Answers

1. How do you project the financial statements for a commercial bank?

3. How do you project a bank’s Loans and Deposits?

5. How do you balance a bank’s Balance Sheet?

8. How do you calculate Dividends for a bank?

Insurance Accounting Questions & Answers

7. What is the “Loss Triangle” for insurance companies?

Over many years, this pattern creates a “triangle,” as shown below:

9. What is the Deferred Acquisition Costs (DAC) Asset?

What happens on the financial statements? Ignore Claims for now.

Insurance 3-Statement Modeling Questions & Answers

1. How do you project the financial statements for an insurance company?

2. How do you project an insurance company’s Written Premiums?

First, on the Assets side:

• Cash: Flows in from the bottom of the Cash Flow Statement.

Then, you could multiply those and sum up everything.

Regulatory Capital Questions & Answers

Regulatory Capital / Some Types of Assets >= Certain Percentage

3. Why is it so important to calculate Regulatory Capital Ratios based on Risk-Weighted Assets

4. What’s the difference between Tier 1 Capital and Tier 2 Capital?

Usually, you make Liquid Assets a percentage of Cash and Investments.

14. How do you use Regulatory Capital in real-life models?

Commercial Bank Valuation Questions & Answers

13. How do Stock Issuances/Repurchases and Stock-Based Compensation affect a DDM?

15. How do you factor Excess / (Deficit) Capital into a DDM?

19. How might you use a Regression Analysis to value a bank?

P / TBV = 12.9 * ROTCE – 0.13

Insurance Valuation Questions & Answers

3. Why might the P / E and P / BV multiples be misleading for insurance firms?

Those changes, in turn, will increase its P / E and P / TBV multiples.