1. The principle

Trades in corporate stocks, like trades on all markets, are made at the market price, ie, a price that involves both a buyer and a seller.

This market price is arrived at and explained by several factors, the purest of which theoretically, and the most widely used, is the discounting of free cash flows generated by the investment at a rate that reflects the market risk of this investment. This rate is determined as the risk free interest rate plus a risk premium that is proportional to the market risk of the asset. This risk premium that takes the form of the product of the ß ratio of the investment (1) and the difference between the expected market return and the risk, and the risk free interest rate: r = rf + ß × (E (rm) – rf).

In the euro zone, the expected rate of return on the market in mid 2007 is around 8% (2). Accordingly, on the basis of a risk free interest rate of around 4.7% corresponding to the 10-year government bond rate, the risk premium for the European equities market is currently below 4.0%.

2. Two radically different methods for estimating the risk premium

Estimates of the equity market risk premium, ie, the difference between the market return and the risk free interest rate, are currently arrived at using two possible approaches:

• Either on the basis of forecast data (future free cash flows) and the current share price, from which we deduct, after a few calculations, the discount rate used, and thus the risk premium since the discount rate is equal for the whole of the market at the risk free interest rate plus the risk premium.  In this case, we refer to the anticipated or forward risk premium (3), because it is based on investors' current expectations, both anticipated and not anticipated, because it is the risk that is anticipated not the premium, which is current.

In March 2006, the International Accounting Standards Board (IASB) published suggestions for a new way of presenting results.  The IASB suggests that the last line of the income statement should be referred to as “comprehensive income” (CI), and no longer as net income.  CI is defined as the periodic change in equity capital, excluding any dealings with shareholders, ie, payment of dividends and capital increases/decreases.  It includes, in addition to net income in its IFRS version, all unrealised foreign exchange gains and losses, asset re-valuations, cash flow hedging, changes in the fair value of financial instruments intended to be sold, and actuarial gains and losses (if any) relating to pension fund commitments. On this basis, net income will have become merely an intermediary balance on the statement of change in equity, with the difference between this net income and CI being referred to as “other comprehensive income” (OCI).

If this reform is adopted, it will be evidence that international accounting standards are shifting towards the principle of full fair value. The way the results are presented will highlight the change in the entity’s value more than the flows generated by the business. Accounting and finance academics at the University of Paris Dauphine (1) have looked into whether this notion could help to measure the financial performance of firms. They look at the respective contributions of operating income, net income and CI to the market value of firms. The usefulness of information contained in CI is limited in the five countries studied (the UK, Germany, France, Italy and Spain) compared with net income. On the other hand, OCI seems to add useful information to the valuation of share prices to that already contained in net income.

The authors also show that for firms that have already been publishing CI in anticipation of the reform, this figure does become more explanatory over time, especially in Germany.  For example, at the close of 2004, over 60% of German companies published their CI, compared with less than 10% in other European countries.

Using CI encourages the perception of accounting as a portfolio management tool, rather than a tool for managing a company.  The goal is to represent the whole of the value created for the shareholder over the period. This figure does however include a number of gains that have not yet been realised. According to the authors, this could be a source of possible manipulation of the figures when assessing the fair value of all of the unrealised gains and losses. Additionally, these figures are not always checked by management as they depend on market fluctuations.  Accordingly, the disciplinary power of CI remains to be demonstrated.

Professionals themselves appear to be divided on the issue, fearing that the reporting of value will end up replacing the reporting of performance, and that the distinction between income actually realised in cash and unrealised income will become increasingly difficult to make. Another cause for concern is the independence of the valuation. It would seem to be common sense to avoid giving the firm’s management the dual role of provider of information and (self)valuer, a job usually done by financial analysts.  After all, what thinking person would trust a film review written by the film’s director?

Regulatory capital is the amount of tangible capital (ie, following deduction of goodwill) that the banking regulators (the Central Banks) require banks to maintain, given the nature of the banking activity. Under the provisions of Basle I, banks are required to set aside capital amounting to at least 4% of their average weighted assets (referred to, following various deductions, as tier 1 capital) and total capital including the above and hybrid securities (tier 2 and tier 3) (1) of at least 8% of their weighted assets. Regulatory capital is intended to represent the share of a bank to the required global equity in the banking industry given the systematic risk entailed in banking.

Basle II, which applies from 2008 (for banks that have chosen to sign up early) and which is a regulatory requirement, brings regulatory capital closer to economic capital, by no longer calculating regulatory capital as a percentage of the bank's assets but by weighting them differently according to their risk profile. 

Economic capital corresponds to the difference between losses that a bank could incur in extreme cases and the losses it could incur in the ordinary course of business, during normal periods.  “Average” losses are generally covered by the interest margin.  Larger losses are covered by economic capital. The lower the bank’s equity capital compared with the economic capital requirement, the less able it will be to absorb extraordinary losses and the more fragile it will be. In the same way that we don't build dykes along rivers just to cope with normal flow, but to protect ourselves during the sort of floods that happen once every 100 years, economic capital is often fixed by the bank's management in order to cover around 99.5%, or even 99.97% of cases. In the latter case, which generally corresponds to an AA rating, the bank has a 0.03%, probability of going bankrupt, or to go back to the river analogy, once in every 3,333 years, a river will burst its banks and flow over the dyke.

However, economic capital is not only a measure of the bank's risk as an absolute.  It is also used to measure internally the adjusted return on the risk of a business line, a product, a client or a transaction, on the basis of the required economic capital calculated at each of these levels.

As we have seen, the amount of economic capital determines the level of risk that the bank’s shareholders and creditors run, in the same way that in a firm, the amount of equity capital compared with capital employed determines the level of shareholder risk. In a bank, economic capital is managed under the global constraints of regulatory capital because history has shown that when a bank goes under, the repercussions on the economy are far more serious than in the case of an ordinary firm going bankrupt, which is why the state authorities, through the banking regulators, maintain tighter control over the running of banks than of other firms.