Measuring the cost of equity of euro area banks

Carlo Altavilla, Paul Bochmann,

Jeroen De Ryck, Ana-Maria Dumitru,

Maciej Grodzicki, Heinrich Kick,

Cecilia Melo Fernandes, Jonas Mosthaf,

Charles O'Donnell, Spyros Palligkinis

Occasional Paper Series

Measuring the cost of equity of euro area banks

No 254 / January 2021

Disclaimer: This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB.

Contents

Abstract		3
Non-technical summary	4
1	Introduction	6
2	Survey evidence	8
3	Empirical methodologies	13
	3.1	Factor models	13
	3.2	Aggregate cost of equity based on factor models	16
	3.3	The implied cost of equity models	19
	3.4	Results from implied cost of equity models	21
4	Results and model averaging estimates	23
	4.1	Comparison among models	23
	4.2	Cost of equity estimates based on a model averaging approach	23
	4.3	Estimated cost of equity and bank fundamentals	27
5	Cost of equity for unlisted banks	30
	5.1	Motivation	30
	5.2	Methodology	31
	5.3	Results	32
6	Additional evidence	34
	6.1	Backtesting using failure events	34
	6.2	Comparison of estimated cost of equity and CoCo yields	35
7	Conclusions	37
References		39
Appendix		44
	A.1	Robustness of factor models	44
	A.2	Data appendix for factor models	46
	A.3	Beta estimates and risk premia for factor models	47

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A.4	Models used for the implied cost of equity approach	51
A.5	Regression output for the relationship between model-specific
	cost of equity estimates and bank characteristics	54

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Abstract

The cost of equity for banks equates to the compensation that market participants demand for investing in and holding banks' equity, and has important implications for the transmission of monetary policy and for financial stability. Notwithstanding its importance, the cost of equity is unobservable and therefore needs to be estimated. This occasional paper provides estimates of the cost of equity for listed and unlisted euro area banks using a three-step methodology. In the first step, ten different models are estimated. In the second step, the models' results are combined applying an equal-weighting procedure. In the third step, the combined costs of equity for individual banks are aggregated at the euro area level and according to banks' business models. The results suggest that, since the Great Financial Crisis of

2007-08, the premia that investors demand to compensate them for the risk they bear when financing banks' equity has been persistently higher than the return on equity (ROE) generated by banks. We show that our estimates of cost of equity have plausible relationships to banks' fundamentals. The cost of equity tends to be higher for banks that are riskier (higher non-performing loan ratios), less efficient (higher cost-to-income ratio), and with more unstable funding sources (higher relative reliance on interbank deposits). Finally, we use bank fundamentals to estimate the cost of equity for unlisted banks. In general, unlisted banks are found to have a somewhat lower cost of equity compared to listed banks, with business model characteristics accounting for part of the estimated difference.

JEL codes: G20, G21, E44, G1

Keywords: cost of equity, monetary policy, financial stability, banking supervision

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