Economic Value Creation in the Banking Industry

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Overview of This Research Work

Economic value added (EVA) in corporate finance is an estimation of economic profits of companies and value is created in excess of required return of investors of the organization. In other words, EVA is the profit that is earned by the firm less cost of financing its capital. It is the value that is created by the companies when return on economic capital employed by the firm comes out to be greater than its cost of capital. Financial statements of the companies’ measure their earnings as residual after all factors of production have been paid for their services by them other than the shareholders (Kumar, 2013). The residual left over is the net income and this value then belongs to the investors. Equity capital is a scarce economic resource along with having an opportunity cost as being just any other factor of production. Yet, the financial statements do not consider the opportunity cost of equity capital. EVA is computed by subtracting from opportunity cost of equity capital from net income of the company. If net earnings of a business come out to be greater than the opportunity cost of its equity capital as employed by it then the business is said to have added a value. This added value is an increase in return to its shareholders

Traditionally, focus was always on accounting profits as well as earnings for measuring the performance of corporations but most recently residual income and cash flows have also gained attention. Measures of accounting profits like earnings per share, return on assets and equity as well as investment are among the most common used measures of performance but now they are criticized for not considering the total cost of capital and getting unduly influenced by conventions that are accrual based (Dermine, 2009). On the other side, EVA is now promoted as a measure of real profitability of a company which is the difference between after tax operating profits and total cost of capital of the firm. For investors, value is the primary concern therefore it is the considered that economic value added is the only measure of performance that is related directly to the intrinsic value of stock.

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The concept of economic value added is not important for the corporations but also for the banks. Banks play an important role in the economy for any country as it is a major source of financial intermediation as well as their deposit liabilities shows the bulk of stock of money of the nation (Schön, 2007). Thus, to evaluate and monitor their performance and financial condition is quite important from the point of view of investors, depositors as well as regulators. Evaluating their performance is a complex process and most of the criteria used like liquidity, profits, and assets turnover have made the evaluations more complicated. Owing to this, measuring the performance through EVA is considered as new approach. The financial sector of any country has a significant role in maintaining a balance of economic conditions in the nation. In this respect, service industry as of banks is one that solves the financial doubts and issues of the customers (GUPTA, 2010). In recent years, the European economy and banking sector has undergone some major changes owing to the financial crisis and break down. The credit crisis has resulted in poor returns for the shareholders and performance for the banks in U.K. Now with some signs of improvement the banks in the economy are trying to increase their shareholder’s value and earning a higher return to their investors

The banking industry of UK is dedicated to four big banks that include Barclays, RBS, HSBC and Lloyds Banking Group. These banks hold approximately 80% of customer lending stocks and deposits. Much part of the poor performance among banks in U.K. is because of the significant decline in major write downs of around 40% of the available and capital operating profitability. Poor performance in terms of return on equity has destroyed value from perspective of value added. Owing to this, with changing times, now it is mainly up to larger banks of the country to increase their value and thus return to the shareholders. The present dissertation will focus on investing and increasing shareholder’s economic value creation for one two banks of U.K., HSBC and Barclays Bank (Bitzenis, Marangos and Andronikidis, 2008). Both are multinational banks of the British economy and so expectations from these two are also high from the point of view of shareholders.

Scope of the research

In the past few years, owing to the economic crisis all over the globe, most of the industries have started recovering from it and making efforts in enhancing their performance except the banking sector. It is the one which is still facing problems because economic recession has resulted in poor financial market and thus reducing their performance. This also has an impact on shareholder’s value which has now become a significant measure of performance of the banks. In this respect, the scope of the present research on finding and investing into the shareholder’s economic value added of the two banks as HSBC and Barclays plc will help in evaluating the value added for the investors (Schiniotakis, 2012.). The results of the study has good scope for investors of the banks as it will help to know about financial performance and earnings of the banks as well as the return they can expect from their earnings. Also, this has a huge scope for the financial analysts as with the results they can also guide and suggest to the investors on expected returns from the two banks.

Literature Review

Literature review is the most significant part of a research project. This comprises of large pool of information and strong base that includes detailed data regarding the subject matter. This includes various theories, models and techniques as well as number of researches that have been done previously by the scholars. This section of literature review consists of studies done by researchers in the field of banking and the way of their working (Dawidowicz, 2010). This will underpin the findings and discussion on analysis of economic value creation of financial institutions like banks. This part of the reports consists of all secondary information in relation to the topic. This will focus on published data and records of the stock markets and financial indicators of Barclays Plc and HSBC bank.

Banking industry

In the past century, the sector of banking was limited only to accepting of deposits and channelling those deposits to lending activities (McCartan-Quinn, Donnell and Durkin, 2002). In other words, it was an institution that link together customers that have deficits in capital and those with capital surpluses. But, recently, with the vast expansion of global market in financial services, the scope of products and services offered have increased. This includes entrance of banks in retail, wholesale and merchant banking. Banks, now, also deliver products and services like that of insurance, investment in capital markets and securities (Adrian and Shin, 2008). Banks are now also providing advanced channels like that of Advanced Teller Machines (ATM), online and mobile banking. All these techniques have facilitated the customers to a significant level and increased the scope of products and services offered by the banks.

The deregulation of the U.K. banking industry is responsible for substantial and tremendous growth to support the economy at large (Huizinga and Demirguc-Kunt, 2009). Major growth that has taken place through challenging of competition and structural changes include transforming of building societies to banks. The sector has also experienced a number of diversifications and merging consolidations among various banks in the nation (Badia, 2010). The banking industry of U.K. consists of incorporated banks both of U.K. as well as foreign owned banks that have the authority to operate in U.K. according to the latest figures; the economy of U.K. has grown by the fastest rate since the financial crisis of 2007-2008. This has expanded by 1.9% during the year 2013. This is because of the banking industry of the country that is now trying to increase their financial performance (Business blog. 2014). Since the crisis the shareholder’s value for the banks also decreased to a significant level but now the banks in the economy are keeping pace with the growing economy and thus creating value for their investors.

HSBC bank and Barclays plc

Barclays bank is a British multinational bank that grants financial services to the country with its headquarters in London. The main area of operations of the bank includes retail, wealth and investment management as well as wholesale banking (Chamberlin, 2008). At present, the bank is considered as the one that provides global financial services to the economy and carries on its operations through a number of branches and subsidiaries. It also has an extensive network and presence in international markets across 50 countries of Africa, Asia and USA. The primary objective of Barclays bank is to increase and thus maximize the overall wealth of its shareholders.

HSBC bank is also a British multinational company that is into banking and financial services and having its headquarters at London. It is considered as one of the largest banks in the world operating in around 85 countries across Europe, Asia, North and South America and Africa. The bank functions with an aim of connecting its customers to opportunities and thus enable the businesses to thrive and resulting in prosperity of economy thus increasing wealth of the shareholders (HSBC, 2014).

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Shareholder value and creation

The shareholder value (SHV) of a company is value of the firm less the future claims or dents. This is calculated as net present value (NPV) of all future cash flows of the firm and to this is added the value of non operating assets (Davies and et al., 2010). In other words, SHV is the value that an investor is able to obtain from investment done into a company. This consists of dividend payments, capital gains and other payouts that a firm might like to make to its shareholders. The term also implies ultimate measure of success of a firm to that extent to which it is able to enrich all of its investors (Davies and et al., 2010). The term shareholder value is used for referring to market capitalization of a business entity, concept that the main goal is that of wealth maximization of its investors by paying them dividends and thus causing the increment in the stock price.

Managing to create sustainable shareholder value is recognized as one of the major objectives for the banks in United Kingdom. In this respect, there are some of the major economic factors that have contributed to make SHV creation as one of the targets in banking and these are as follows –

Deregulation and re regulation – Traditionally, the banking industry was one of those that were highly regulated with a number of significant barriers to competition so that stability of the financial sector can be assured (Huizinga and Demirguc-Kunt, 2009). But because of increasing criticisms to this there have been new regulations that aim to guarantee stability to intermediaries in the competitive U.K. banking industry. This approach has several benefits but the framework is also a concern for the regulators as there is now the need of providing stability as well as efficiency by supplying a satisfactory amount of remuneration to the shareholders (Chamberlin, 2008).

Privatisation – The government of U.K. has now reduced their equity participation in banks by selling of their holdings and savings to the private investors (McCartan-Quinn, Donnell and Durkin, 2002). With having a lack of pressure of profits and also a system of monitor banks were managed in an efficient manner. So, after privatisation, inefficient management has made to decline by making shareholder value creation a primary target for the banks to achieve.

Mergers and acquisitions – The ability to create SHV is one of the necessary conditions for raising the value of the bank also and thus it plays an active role in this industry. Also, the businesses in which mergers and acquisitions take place managers are judged on the basis of creation of their shareholder value (Eldomiaty and et al., 2011).

Value creation

Value for an organization in the market is created by earning return on investment and that too higher than the opportunity cost of capital. The more one invests into a bank or organization at a return above the cost of capital then this leads to creation of value (Badia, 2010). With this, it is implied that growth creates more of value up to that extent till which there is more return on the capital and it exceeds the cost of capital. An organization has the responsibility of selecting the most appropriate strategies that can lead to maximization of present value of economic profits and expected cash flows (Ianotta, Nocera and Sironi, 2007). The returns that are earned by the shareholders depend more on changes in their expectations from the company they have invested in rather than its actual performance. Value for the shareholders is created when returns to shareholders, dividend as well as prices of shares of the company increases and they also exceed the cost of equity. In other words, it can be said that total return to the shareholder need to be higher than the cost of equity and then only the true value can be created. In the competitive scenario of the banking industry, value for the shareholders is created when bank or corporation invest into projects those are able to earn an excess return on the cost of capital (Nanto, 2009).

The concept and practice of shareholder value creation is considered as vital necessity for the organizations. It is also stated that high profitability for a business does not guarantee creation of value for the shareholders (Adrian and Shin, 2008). This is because value for investor operates under some important rules. One of them is that when there is the concept of value creation it is not necessary that more profitable company will have any advantage to the one that has low profitability. Another rule is that all of the management teams of all firms start on a level playing field that can lead to more than expected returns for the shareholders (Acheampong and Wetzstein, 2001). One other rule is that all companies face different challenges while working to create value for their investors. Thus, with this, it can be said that corporations that adhere and aim to this concept then they should adhere to the cash flow rather instead of the profits.

The creation of value for investors consists of much more than mere monitoring and evaluating the performance of the firm. This is created when there is an active participation of managers to identify good investment opportunities available to them and also recognize those that can give higher returns on cash flow than expected (Fraker, 2006). In addition to this, a focussed measurement of capital market along with a reward system that can tie employee level performance is also required. This can help in promotion of developing of benefits for everyone and thus creating of value for the shareholders. There is also the requirement of the companies to understand the factors that can lead to it and also assess the means through which managers can create an environment that can result into value for the shareholders (Holthausen and Watts, 2001).

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Shareholder value creation is not an easy task for the companies and they are facing various challenges related to it. Managers are now required to make the process simple, reducing uncertainty and risks as well as make quick decisions. There are some of the strategies that can help the banks and other companies to create value for their investors. Among these include the bringing superiority in operations, having an optimum capital structure of the business, being focussed on the aims and objectives of the company and bringing a growth in the earnings (Tan and Floros, C., 2012). This also includes enhancing the quality of information that is disclosed to the shareholders and that must be transparent, making repurchases of stock as when value creating investments are not available then repurchases of shares is a supplement of dividends so as to return cash to the investors. Thus, by following some of the intelligent strategies the banks and corporations can lead to creating value for their shareholders (Schiniotakis, 2012).

References

  • Burney, A., 2008. INDUCTIVE & DEDUCTIVE RESEARCH APPROACH. [pdf]. Available through: http://www.drburney.net/INDUCTIVE%20&%20DEDUCTIVE%20RESEARCH%20APPROACH%2006032008.pdf > [Accessed on 27th June 2014].
  • Business blog. 2014. [Online]. Available through: < http://www.theguardian.com/business/series/guardian-business-live > [Accessed on 27th June 2014].
  • Four Options for Measuring Value Creation. 2013. [Online]. Available through: < http://www.journalofaccountancy.com/issues/2009/aug/20091518 > [Accessed on 27th June 2014].
  • HSBC. 2014. [Online]. Available through: < https://www.hsbc.co.uk/1/2/ > [Accessed on 27th June 2014].
  • Maximizing Shareholder Value: Understanding Economic Value Added. 2014. [Online]. Available through: < http://www.cbiz.com/valuationgroup/page.asp?pid=1549 > [Accessed on 27th June 2014].

Books and journals

  • Acheampong, Y.J. and Wetzstein, M.E., 2001. A comparative analysis of value added and traditional measures of performance: an efficiency score approach. Social Science Research Network Electronic Paper Collection. pp. 01-04
  • Adrian, T., and Shin, H. 2008. Liquidity, Monetary Policy, and Financial Cycles. Current Issues. 14(1), pp. 1-7.
  • Badia, B. T. M., 2010. Connecting productivity to return on assets through financial statements: Extending the Dupont method. International Journal of Accounting and Information Management. 18(2). pp.92 – 104.
  • Bitzenis, A. A., Marangos, M. J. and Andronikidis, A., 2008. Evaluating the banking reforms in Serbia using survey results. Studies in Economics and Finance. 25 (1). pp.49 - 71
  • Bryman, A. and Bell, E., 2003. Business Research Methods. New York: Oxford University Press.
  • Chamberlin, G., 2008. Recent Trends in UK Corporate Net Lending. Economic & Labour Market Review. 2(7), pp. 53-58.
  • Christensen, L., 2008. Educational research: Quantitative, qualitative, and mixed approaches. Thousand Oaks, CA: Sage Publications.
  • Davies, R. and et al., 2010. Evolution of the UK Banking System. Bank of England Quarterly Bulletin, 4th Quarter. 5(4), pp. 321-332
  • Dawidowicz, P., 2010. Literature Reviews Made Easy: A Quick Guide to Success. IAP.
  • Dermine. 2009. Bank Valuation And Value Based. Tata McGraw-Hill Education.
  • Eldomiaty, T. and et al., 2011. Indices, firm identity and performance: implications from the European financial services. European Business Review. 23(5). pp.524 – 544.
  • Fraker, G. T., 2006. Using Economic Value Added (EVA) to Measure and Improve Bank Performance. RMA
 

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