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
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 |
ECB Occasional Paper Series No 254 / January 2021 | 1 |
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 |
ECB Occasional Paper Series No 254 / January 2021 | 2 |
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
ECB Occasional Paper Series No 254 / January 2021 | 3 |
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ECB - European Central Bank published this content on 02 January 2021 and is solely responsible for the information contained therein. Distributed by Public, unedited and unaltered, on 22 January 2021 10:03:06 UTC