1. Introduction and Summary

1. In November 1998, the Chancellor of the Exchequer announced a review into banking services. The Terms of Reference were:

• to examine the banking industry in the UK, excluding investment banking;
• to examine levels of innovation, competition and efficiency in various sub-markets, including relationships with SMEs
• to look at how these levels compare with international standards; and
• to consider whether there are options for change which the industry or the Government should consider.

1. In a previous consultation document (issued on 25 January 1999), Don Cruickshank, the Banking Review Chairman, set out the approach which was to be followed. The essence of this was to relate apparent problem areas to imperfections in the competitive process.
2. A central element in competition investigations concerns "market power", or the ability of companies to raise prices above competitive levels. Companies operating in competitive markets must keep prices low for fear of losing business. Where competition is less effective, however, the firms may be able to increase profitability by raising prices above these levels.

4. Market power reveals itself in a number of guises. One of these is in the earning of excessive, or "supernormal" profits. HM Treasury has consequently commissioned Pannell Kerr Forster (PKF), assisted by Horton 4 Consulting, to look into profitability in the banking sector with a view to addressing the question of whether and, if so to what extent, market power may be said to exist.
5. PKF is considering the profitability of banks operations in individual business areas, in particular:

• Current accounts
• Deposit accounts
• Personal loans
• Mortgages
• Credit cards

• Money transmission
• Deposit accounts
• Loans

4. A questionnaire has been sent to a number of financial institutions, mainly banks, in order to elicit data for the last ten years on revenues, costs and assets employed in these activities, and in residual activities, so that the figures may be reconciled with published accounts. The questionnaire responses will be used to derive various measures of profitability. These measures will be analysed with a view to establishing whether supernormal profits are being earned in particular areas of business.

The Consultation Exercise

5. The Review has adopted a transparent approach, consulting within the industry and elsewhere on its methodology. This paper consequently sets out the approach that PKF proposes to follow in evaluating banking profitability.
6. The Banking Review Team welcomes comments on the matters raised in the paper, and in particular on the specific questions asked in the course of the discussion. Comments should be sent to:

Sue Lewis,

HM Treasury,

Parliament Street

London SW1P 3AG

by the 6 August 1999.

The Key Questions

7. At the core of this document are three general questions:

1. Which indicators of profitability should be adopted for the purposes of identifying economic profit and market power?

8. The measurement of bank profitability raises issues that are not present in other industries. Profitability is a measure of a return to the funds employed, but with banks, funds are obtained as deposits and, as such, are themselves a part of their normal business operations. To treat banks' deposits simply as funds employed in the business would not recognise this aspect of banking. Our preferred approach is, consequently, to regard deposits as a core business function and to assess profitability after the costs of obtaining deposits have been deducted. Potential profitability measures and the specification of the asset base are discussed in Section 2 of this paper.

2. How can these indicators be derived at the level of the individual product?

9. Although accounting information is most readily available at the company level, this study aims instead to consider the profitability of banks operations at the product level. This raises a number of issues. First, there is the task of assigning those revenues and costs which are shared by a number of product lines (e.g. IT or branch and corporate overheads) to individual products. Secondly, there is the question of the appropriate interest rate at which to charge a transfer price for "loans" between different parts of the company or between products. Thirdly there is the question of deriving a suitable asset base for each product. These questions are discussed in Section 3 of this paper.

3. How are we to determine whether the resultant levels of profit are indicative of market power?

10. Lastly, having constructed profitability measures, we must determine how best to use them to assess market power. To this end we intend to construct an estimate of what constitutes non-excessive, or normal, profits. This involves estimating the cost of capital employing the most commonly used method, the Capital Asset Pricing Model (CAPM). Another approach which might be used is to compare the UK banking sector's profitability with that in other countries or in other business sectors.
11. We will also be looking to collect information to see if the profitability of banks' business varies in different parts of the country. The aim here will be to compare returns in banks operations in different parts of the country to ascertain whether market power is greater in certain areas than in others. We would also value views on whether other "intra-industry" (i.e. within the UK banking sector) comparisons of returns may be helpful in the assessment of market power.
12. Other approaches may, however, also be useful. For example, dividing the market value of a company by its book value (usually referred to as Tobin's q) may also be regarded as a useful measure of market power in certain instances where the information is forthcoming.
13. These approaches are considered further in Section 4.

2. Measures of Profitability

1. In this section we discuss the measures of profitability that should be used as part of an evaluation as to whether firms enjoy market power. This discussion covers both general issues which arise in all markets and some issues which are specific to banking markets. We start by evaluating some of the main indicators of banking profitability and then discuss the key measurement issues that arise in calculating these indicators. In section 3, we consider the issues to be faced in estimating profits for individual products.

Main measures of bank profitability

2. We start by considering three conventional accounting measures of bank performance:

• Net return on total assets, pre-tax profits divided by total assets (whether financed by debt or equity);
• Net interest margin, the spread between the average rates on borrowing and lending; and
• Net return on equity, pre-tax profits divided by equity alone.

1. We do not intend to use the net return on total assets. This measure compares profits after interest payments with the total capital employed, including that financed by retail deposits. We consider this to be a confused concept and overly sensitive to gearing. If total assets are to be used as an asset base, we consider that gross profits would be a more appropriate numerator.
2. The net interest margin is often used for making comparisons within the banking sector - for example between banks in different countries. Its usefulness to this particular exercise is limited however. First, it is specific to the banking sector and cannot thus be compared with 'externally' constructed measures such as the cost of capital, or with rates of return in other industries. Second, it cannot be used for evaluating the profitability of non interest-based services such as money transmission or merchant acquiring.
3. The return on equity can be compared with an equity cost of capital and is not specific to particular banking activities. Of the three conventional measures of profitability, we regard this as the most suitable for our purposes. It is likely to require some adaptation, however. For example, there are some elements of debt that may legitimately be included in an asset base, such as loan capital that is eligible to be counted in the bank's capital resources. This was the measure used by the MMC for both of its enquiries into credit cards. These issues will be considered later in this section.
4. An alternative option is to use more sophisticated measures of the rate of profit. The accounting rate of return (ARR = Inflation adjusted profit/capital stock) has, for example, been used by the Office of Fair Trading in the assessment of profitability for competition purposes.

Q1. Is the most promising approach to derive returns to equity or capital resources at the product level and compare them with estimates of the cost of capital for the activities concerned?

Q2. Is it right to ignore the net return on gross assets and the net interest margin?

Q3. Are there any other measures such as the ARR which are suitable for the present purposes?

5. Having chosen a basis on which to calculate profitability, a number of further measurement issues arise. In particular:

• Because profitability is usually measured as a return divided by the asset base, the specification of the asset base is critical to the resultant measure of the rate of profit (paras 2.8- 2.13);
• Banks' profits are closely related to the credit cycle. Whilst good returns may be earned in good years, in bad years the costs of bad debts will have to be borne. An accurate assessment of profitability should allow for these cyclical effects (paras 2.14 - 2.18); and
• Inflation accounting - including the impact of changes in monetary asset values (paras 2.19 - 2.25).

1. Profitability is usually assessed with reference to the assets employed in an activity. The assets employed in any activity include the funds which are lent, working capital, an asset base sufficient to cover the risk of the operation (whether decided by economic or regulatory considerations), and any property or similar assets.
2. The definition of assets is likely to be a significant factor in assessing banking profitability, both at a firm level and also for individual products. The appropriate asset cover to assign to one element of an overall portfolio is a matter of considerable debate between banks, regulators, and academics. Assigning assets to individual products is a challenging part of this project. Even in theory there is not a unique method of saying what a capital requirement is.

Regulatory and economic assets

3. Regulatory authorities place asset and liquidity requirements on banks. These depend on the activities that they undertake. The Basle Agreement sets a floor and the FSA two higher levels, for action and notification. These ratios can be used as simple rules to calculate sums that can be assigned to loans. It is likely that institutions set an internal target above the three regulatory requirements.
4. Institutions may take a different view and hold capital which they consider to be economic, based on their value at risk or other models. These may well be different from the regulatory rules, for example non-zero for deposits and money transmission, and account for some of the surplus funds (in excess of regulatory requirements) which all institutions hold.
5. Economic concepts of assets are used particularly in pricing decisions, for example to assess the element of pure profit to include in addition to covering the cost of funds, bad debt, and other costs. One particular technique used is to adjust the size of the investment assumed to be made to allow for differences in the cost of capital for different activities.
6. The size of the investment being made is itself a matter of debate. The Basle Committee on Banking Supervision is currently consulting on the assessment of capital adequacy. The concept has normally been applied to assets, rather than to liabilities, and so might be argued to concentrate unduly on one side of the balance sheet, which is not problematic at the level of the institution but is at the product level, as is discussed in section 3. However, the committee is proposing to develop capital requirements for other sorts of risks, such as operational risk, which it recognises have been at the heart of important banking problems in recent years.

Q4. Which is the most suitable measure to use to approximate the asset base, economic capital or regulatory capital asset requirement? If economic capital is to be used, how should it be measured?

Bad debts and the credit cycle

7. Institutions provide for bad debt when they think default is about to occur and write it off when the default has occurred. However, lending is priced on the basis of the average cost of default. Since the distribution of bad debts is skewed heavily to a few bad years, provisions will normally be much less than the assumption used in pricing. Profits are therefore likely to be above average in all but a few years.
8. If there is a substantial back run of data available, an average figure for profitability over a business cycle can be obtained. This is our preferred method and we have accordingly asked institutions for this information. Our present view is that a backrun of ten years would be sufficient for this purpose.
9. In calculating an average provision, it would probably be necessary to make an adjustment for years before the early 1990s accounting policy change which resulted in interest charges no longer being made to accounts where default was likely and provisions therefore being lowered.
10. If an adequate backrun of data is not available, there may be a need to make an additional calculation of a "normal" level of bad debt. There are two sources for this: institutions' estimates and the long run average of provisions. We would expect institutions' estimates to be based on the long run average. However, there may be arguments for future provisions to differ from those in the past. This might happen, for example if banks were lending to riskier customers and pricing for risk, or if the period over which the past average was taken was atypical in some way.
11. When considering institutions' estimates, it will be necessary to have regard to the probability of default, the extent to which the debt would be outstanding at the time of default, and the proportion of the debt which would be recovered from security held.

Q5. Does the average rate of provision over the last ten years provide an adequate approximation to the long run equilibrium and, if not, what alternative measures should be used?

Current and Historic Costs

12. Accounts are normally presented on an historic cost basis. This approach is rarely used by competition authorities because historic cost accounts may not give an accurate picture either of the profit, in the sense of the increase in the net worth of the concern, or of the value of the assets employed. This is particularly the case given that we wish to look at profits over an extended period.
13. Profit may be incorrectly measured on a historic cost basis because of the omission of:

• Inflationary gains on net monetary liabilities
• Changes in the real value of fixed assets
• Changes in the real value of fixed interest or other financial assets

1. The value of assets to be used in estimating profitability should be the value of those assets to the company in the sense of the size of the stake they are putting into the business. This might be a replacement cost or an economic value. The extent to which this differs from what is contained in published banking company accounts has yet to be determined, and we are considering examining this in relation to one or two institutions.
2. In the banking sector this consideration is likely to impact in three ways. First, on measuring depreciation/revaluation, second, on the inflationary loss of net monetary assets and, third on the real price revaluation of monetary liabilities.
3. Depreciation/revaluation has two main components; the conventional measure of decrease in the stock of assets held (but valued at current prices) and an additional item of any holding gains or losses stemming from a change in their real price. It is therefore the change in the quantity of assets held times the closing price less the real rise in the value of the assets. However, if there is a significant concern, it is likely to stem from treatment of the financial assets and liabilities in the second and third terms. The inflationary loss on monetary assets is net monetary assets times the inflation rate. The real revaluation on liabilities is the change in the bond (or other asset) price above inflation times net liabilities.
4. If, as discussed earlier, we were to use the ARR, we would need to derive a value for the capital stock. In a given period, the capital stock is that at the start of the period valued at the minimum of replacement cost and economic value, where economic value is the maximum of the present value of its future earnings and its realisable value from sale. The value is uprated by the general inflation rate. The literature tends to assume earnings accrue at the end of the period. In practice the factor will be √(1 + p ), where p is the inflation rate, to take it to a mid-year point. A similar point applies to the asset "quantity". If the asset base varies substantially during the course of the year, it may be preferable to take period averages rather than beginning and end values and to make other adjustments to the calculations to allow for that.
5. If it should become necessary to use an inflation adjusted measure, we would propose to derive an approximation to the accounting rate of return by:

• Adding a sum equal to the general inflationary rate times net monetary liabilities;
• Adding changes in the real value of fixed assets or of fixed interest or other financial assets identified by institutions;
• Uprating asset stocks according to estimates in the returns of the degree of undervaluation;
• Uprating depreciation figures accordingly; and
• Multiplying the starting asset base by √(1+π), where π is the rate of inflation, to take it to a mid-year estimate.

1. In disaggregrating company profitability to the level of the product, three further issues arise. These are in attributing:

• The asset base to individual products (paras 3.2 - 3.9);
• Costs to individual products (paras 3.10 - 3.14);
• A value to internal transfers of funds within institutions (paras 3.15 - 3.19); and
• Tax payments to individual products (para 3.20);

This section discusses each of these in turn.

1. The general treatment of the asset base at the company level was discussed in Section 2. Allocating assets to individual products, however, raises further questions, which are discussed below.

Regulatory and economic capital

2. The distinction between regulatory and economic capital was discussed at the company level in section 2. This issue becomes even more important when looking at profits for particular products. In asking institutions for information we shall attempt to obtain their own assessments and also the data necessary to apply a common format. Use of the regulatory rules would seem to be the most obvious course for loans, because they do cause a need for assets and have been set after lengthy consideration of what level of assets is required. We therefore intend to follow this course. However, use of regulatory requirements may result in no regulatory capital assets being assigned to some activities, such as money transmission and deposit taking, with a consequent expectation of zero contribution to shareholder funds.
3. In cases where there are no regulatory assets, a different method is required for deriving the asset base. For example, it is necessary to consider whether the capital requirement which has been attributed to loans is, in fact, partly due to the fact that some of the funds lent have been obtained from depositors and whether another part of that capital requirement (or even a further requirement) should stem from the operational risks involved in money transmission etc.

Q7. What is the appropriate assumption when there is no formal regulatory capital requirement for a product, such as deposits?

Standalone and incremental capital

4. Capital requirements can, in theory at least, be viewed on a standalone or incremental basis. This is true of all joint costs, not just capital costs. Where an activity contributes to more than one product, economic theory suggests that the correct allocation of costs to a particular product will lie between the stand alone and incremental costs. Stand-alone costs are the cost of providing the product, if the other products with which it shares costs were not offered. Incremental costs are the costs of providing the product if the all the costs of providing the other products have already been incurred. These figures give a ceiling and a floor to estimates of joint costs, but may result in total cost estimates within a wide range.
5. To take an illustrative example, the economic capital required to cover a book of loans in the energy and metal smelting industries will be less than the total of the capital sums which would be required for each set of loans taken individually. The risks of the two sets are not completely correlated. For example, low energy prices would be of benefit to the smelting industry. A standalone estimate would look at the separate costs of energy and smelting loans taken separately. An incremental estimate (for energy) would subtract the smelting loans asset requirement from the joint requirement. In practice, it is not practical to analyse capital requirements to this degree of detail.
6. In any case, the concept of standalone assets may not be helpful. Standalone asset costs for each product might be in excess of present regulatory requirements and overstate what is needed. Although consideration of, say, the assets required by an institution engaged only in lending to SMEs might provide a ceiling to the costs, the probability is that, if there are significant economies of scope, the product will be provided by an institution also engaged in other financial services. We therefore doubt whether a stand alone assessment of capital requirements will be appropriate.

Surplus assets

7. Summed over all the activities of the institution, assets employed do not necessarily equal the assets of the institution. There is often a "surplus" of total assets over the regulatory requirements. This may result from incorrect assessment of the assets actually employed in each business, incorrect valuation of total assets, or from the presence of another activity against which the funds are really held. For example, an acquisition may be contemplated.
8. Regardless of how assets are assigned to individual activities, it is likely that there will be a surplus. We shall need to consider arguments that the economic asset base absorbs the total but, in general, it may well be the case that institutions retain excess funds to finance possible new ventures or acquisitions. Our working hypothesis is that there are surpluses that do not need to be assigned to products.

Q8. Are we correct not to allocate surplus capital to particular products?

Joint Costs

9. In evaluating profitability of individual products, costs will have to be allocated between the various products supplied by institutions. Some costs may be easily identified with a particular product; for example the cost of sending out credit card statements. Other costs are common to a number of products and are harder to allocate. These are known as joint costs. Examples of activities which contribute to more than one product include running a branch network and a cheque clearing centre.
10. The extent to which costs are common can be overstated. For example, although a cheque clearing centre will be used for both SME and customer business, many of the processing costs will arise from one or other of the product areas. Sometimes costs are said to be joint, merely because their link with particular products has not been recorded.
11. In our questionnaire, institutions have been asked to provide returns in which all joint costs, such as IT, corporate overheads, and branch costs, are apportioned between products. The reason for this approach is because the institutions themselves are likely to be in the best position to assess the most appropriate allocations.
12. If firms are unable or unwilling to provide such an allocation of costs for all years, we will calculate our own allocation using one of the two following methods:

• By using data from other institutions, or from the same company in different years, to derive a ratio (allowing for differences in product sales volumes) with which to apportion costs.
• Estimate upper and lower bounds to costs. Institutions have not been asked to give estimates of stand alone and incremental costs. However, ceilings and floors can be given to such estimates by counting as joint costs, on the one hand, all the company's costs in any category of joint costs which have been assigned to the product and, on the other hand, none of the joint costs.

1. An alternative would be to consider profitability at a higher level, for example for retail banking as a whole. This would not permit estimation of the profitability of individual products.

Q9. We propose to use cost allocations provided by institutions, subject to a check for reasonableness. What is the appropriate method for cost allocation if there are cases where allocations are not provided?

Interest Transfer Pricing

2. A core function of banks and other financial intermediaries is to transform funds paid in by depositors into loans to other business and personal customers. Where institutions use funding from depositors to finance loans to third parties, an estimate of the profitability of each of these product areas will depend on the rate of interest at which funds are transferred from one part of the business to the other.
3. There may be significant variation between institutions in the methods of interest transfer pricing. For example, some will use LIBOR, whereas others may charge managers a risk-adjusted rate by adding the likely average loss on their loans to LIBOR. Institutions' returns will reveal whether this extends to the management accounts. There is clearly a risk of double counting here if bad debts are already included as a cost.
4. In our view the interest rate used for calculating transfers, should be that on a virtually risk free transaction. The interest rate transfer price used for calculating profitability should not be a charge for risk. Although the extra "credit risk" associated with different customer groups is covered by higher interest payments to borrowers, the corresponding item on the cost side of the account is the expected cost of default on loans. The latter is included through provisions for bad debt (actual or normalised), and not the interest rate transfer price. The risk of the operation, mainly in the variability of the incidence of default or of net interest income, is covered by the economic (or regulatory) assets that are assigned to the product and on which a return is earned.
5. There are two broad options for the rate - a short-term interbank rate or a rate for a loan or deposit of the same term as the deposit or loan which is supplying the funds or for which they are required. The choice is less simple than might at first appear. A financial institution will manage the terms of its loans and deposits so that the risk it incurs is reduced or matched by higher earnings. Greater exposure may require a greater asset base or a higher return and so higher profits. The risk being considered here is not that of default but of differing movements in interest rates on deposits and loans. Thus a longer-term rate would only be appropriate for fixed rate deposits or loans. If these are in the minority a short-term rate will normally be appropriate. However, since even variable rates change with a lag, it may be appropriate to use a 1-3 month interbank rate.
6. If this is what an institution has used to price transfers, there is little case for investigating an alternative. If not, there may be, although we acknowledge that this could prove complex to achieve on a consistent basis.

20. Estimates of the normal rate of profit obtained by considering the cost of capital are normally after payment of corporate tax or, if pre-tax, assume an effective rate of corporate tax. In order to derive post-tax rates of profit to compare with estimates of required post-tax returns to investors (or to derive a pre-tax return to investors) company tax payments must be assigned to product lines. Unless there are significant capital allowances attributable to, say, investments to facilitate retail banking, it would probably be sensible to allocate tax in proportion to profits net of interest payments.

21. We are currently minded to consider pre-tax and post-tax historic cost results using a regulatory asset base of capital resources, actual bad debt provisions, banks' estimates of joint costs, and interest transfers at a short term interbank rate and to investigate other options only as variants. However, the inflation accounting variant will have to be considered particularly carefully.

1. This section discusses potential methods for applying the profitability indicators to the question of market power. A number of approaches are possible. These include:

• To construct a benchmark of normality, such that, if profits exceed this level, they may be deemed supernormal and indicative of market power;
• To compare the resultant profitability figures with those earned elsewhere, such as in other countries or in other industries;
• To compare profitability within the sector, for example between retail and other banking or regionally;
• To adopt some other measure of market power (e.g. Tobin's q).

1. We propose to focus most effort on the first approach, but to use other measures where they may be of assistance.

Normal profitability

2. Normal profits are being earned when a company's profitability is equal to its cost of capital, the minimum return just sufficient to attract investors into the business. If, on the other hand, profitability consistently exceeds the cost of capital, then profits may be deemed supernormal.
3. The cost of capital cannot be directly observed and must be estimated. Two approaches are commonly used, the capital asset pricing model (CAPM) and the dividend growth model (DGM).

The Capital Asset Pricing Model

4. The central element of the CAPM is to distil the cost of capital into a risk-free rate of interest and its risk premium. The risk-free rate is commonly taken to be the real rate of interest on index-linked gilts. The risk premium is calculated by multiplying the average risk premium in the market by the company's "beta coefficient", which measures the extent to which a company's returns are correlated with the market as a whole.
5. Capital generally comes from two sources: equity and debt. The overall cost of capital will thus be the weighted average of the debt and equity costs of capital. We consequently intend to use the following formulation for the pre-tax weighted average cost of capital (WACC):



where G is gearing (defined as the ratio of debt finance to debt plus equity finance), t_c is the effective corporation tax rate, t_p the personal tax rate, β_e and β_d the betas on equity and debt respectively, r_f the risk-free interest rate, and r_m the market rate. r_m - r_f is the market risk premium.

6. It may be useful to illustrate some of the numbers that might be used in such a formula. Equity betas for NatWest and Lloyds are estimated by LBS at 1.20 and 1.32 respectively. The risk-free real interest rate is, as measured on index-linked gilts, about 2-2.5%. The risk premium is the subject of great controversy and variously estimated at 3.5% (OFFER), between 1% and 5% (OFWAT reporting city views), 3.5-5% (MMC), 3-4% (ORR) and 8.4% (Brealey and Myers Principles of Corporate Finance 1996 edition).
7. Much of the difference in risk premia relates to different concepts being used, although there is not agreement on when they should be used. Returns to stocks are highly volatile. A series of annual real returns to equities might be, say, 15%, -10%, 22%, -2%, 30%, -38%, 50%, and 13%. The arithmetic average of these numbers is 10%. Real returns to risk-free assets have been low over the long run, perhaps because of the impact of high-inflation periods, and averaged about 1%. Subtracting this number would give a market risk premium of about 9%. However, the cumulative effect of the returns is to increase the initial investment by 69%, a compound growth rate of 6.8%, giving a premium of under 6%. In looking at rates of profit, which are smoothed, it may be the case that this second, geometric average, approach is the more appropriate.
8. Another argument in assessing the size of the market risk premium relates to whether premia calculated when the risk-free rate was 1% real (if, indeed, it was) can be used at a time when the forward looking risk-free rate is much higher at, say, 4% as it was a few years ago and so during the time period in which we are interested. There must surely be a limit to the (geometric average) return to the market as a whole equal to something like the real yield plus the long run rate of growth of the economy. The premium would be this overall return less the forward-looking risk-free rate.
9. The table below is purely illustrative but uses some of the numbers discussed. It is in real terms. In a proper analysis it would be appropriate to consider a range of values for each of the variables as is done, for example, in the various MMC reports on utility price controls.

Variable	Illustrative value
G	25%
tc	30%
rf	2.25%
βd	.02
rm	6%
tp	25%
βe	1.2
Cost of equity	6.2%
Cost of capital	5%
Pre-tax	7.2%

10. Profitability figures for individual product lines should be compared with a cost of capital for the particular product. Arguably, the β for lending to SMEs will be larger than on personal mortgagees and so the cost of capital higher. It may be possible to use the costs of capital of firms which specialise in particular products to estimate costs of capital for those products as a whole. We may then be able to derive costs of capital for other products by residual. This could be done by inverting the equation relating a firm's overall cost of capital to the weighted some of costs of capital of its component parts. Care will need to be taken to ensure that errors in the early stages of such an analysis are not then magnified in the results.

Q13. Is the CAPM the most suitable method for estimating the cost of capital in the banking sector?

Q14. What values should be used for the component variables in the WACC formula?

Q.15 What is the best approach to applying the CAPM at the product level?

The Dividend Growth Model

11. The DGM assumes that the stock market value of a company is equal to the value of current and expected future dividends discounted at the appropriate cost of capital allowing for perceived risk. The cost of capital can consequently be derived from the dividend, share price, and expectations of the future revenue stream.
12. These expectations cannot, however, be observed directly and any figures used stem from judgement. The views of analysts or market participants may be helpful in this context but can only be a guide.

14. Another form of comparison that can be made is with profitability more generally in the banking section. One comparison is with returns in other parts of UK banking, as the MMC did for credit cards, but the activities under consideration account for a large proportion of the institutions' total activities. Indeed, the Banking Review's focus is on the banking sector as a whole. Nonetheless, a comparison of profitability information within the sector may assist the assessment of sector-wide profitability. We intend to compare profitability in different sectors and, if possible, regions.

15. The profitability of UK financial services can be compared with those earned in other countries. Such a comparison, while helpful, would have to be qualified to allow for other explanations of differences for profit rates in various national markets the (for example differences in the regulatory framework).
16. A further issue is how to secure suitable data for international comparisons. The OECD hold some data but only unadjusted and at company, rather than product, levels. Even at the company level, balance sheet data do not always include capital resources and so the profitability figure generally available is gross profits as a percentage of the total balance sheet. Capital resources figures are available for some countries and so other limited comparisons can be made at an aggregate level.

Q19. To what extent are international comparisons helpful in assessing market power in the UK?

Other UK industries

17. Alternatively, the profitability of UK banking services can be compared with those earned in other UK industrial sectors. Different industries, however, are subject to different pressures and, again, if inferences are to be made on the basis of such a comparison, they must be qualified. Inflation accounting would be likely to be an important factor. The degree of qualification will vary according to which particular sectors are used for the comparison.

18. Certain measures using accounting information have been constructed in order directly to assess the question of market power. Of these, the most commonly used is the ratio of a firm's market value to the book value of its assets, known as Tobin's q.
19. If a firm is operating in a competitive market and the capital markets' expectations of future profits are accurate, then the market's value of the firm should equal the cost of replacing all its assets (i.e. both tangible and non-tangible assets). In such circumstances, therefore, q should be equal to unity. If, however, q exceeds unity, then this may be regarded as an indication that the market expects supernormal profits to be earned.
20. q has the benefit that it does not require the cost of capital to be estimated. It does, however, also have certain limitations as an indicator of market power. These include:

• First, the market's expectations may not always be accurately, most notably in the case of banking, because of cyclical over-optimism. Similarly, short-term disturbances in the product market will also distort the ratio. These problems may, however, be addressed by looking at q over the course of the cycle.
• Secondly, while tangible assets may be accurately measured, measuring non-tangible assets (such as investment brands, know-how, people, systems) is likely to be more problematical.
• Thirdly, q cannot be used for an assessment of market power by individual product where securities specific to this line of the company's business are not traded. It is thus generally used for assessing market power at the level of the institution.