Measuring the Cost of Equity of Euro Area Banks

57 Pages Posted: 5 Mar 2021

See all articles by Carlo Altavilla

Carlo Altavilla

European Central Bank (ECB)

Paul Bochmann

European Central Bank (ECB)

Jeroen De Ryck

European Central Bank (ECB)

Ana-Maria Dumitru

Deutsche Bundesbank

Maciej Grodzicki

European Central Bank (ECB)

Heinrich Kick

European Central Bank (ECB); Goethe University Frankfurt

Cecilia Melo Fernandes

University of Amsterdam

Jonas Mosthaf

European Central Bank (ECB)

Charles O’Donnell

European Central Bank (ECB)

Spyros Palligkinis

European Central Bank (ECB)

Date Written: January, 2021

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 Classification: G20, G21, E44, G1

Suggested Citation

Altavilla, Carlo and Bochmann, Paul and Ryck, Jeroen De and Dumitru, Ana-Maria and Grodzicki, Maciej and Kick, Heinrich and Fernandes, Cecilia Melo and Mosthaf, Jonas and O’Donnell, Charles and Palligkinis, Spyros, Measuring the Cost of Equity of Euro Area Banks (January, 2021). ECB Occasional Paper No. 2021/254, Available at SSRN: https://ssrn.com/abstract=3797125 or http://dx.doi.org/10.2139/ssrn.3797125

Carlo Altavilla (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Paul Bochmann

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Jeroen De Ryck

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Ana-Maria Dumitru

Deutsche Bundesbank ( email )

Wilhelm-Epstein-Str. 14
Frankfurt/Main, 60431
Germany

Maciej Grodzicki

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Heinrich Kick

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Cecilia Melo Fernandes

University of Amsterdam ( email )

Roetersstraat 11
Amsterdam, NE 1018 WB
Netherlands

Jonas Mosthaf

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Charles O’Donnell

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Spyros Palligkinis

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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