Measuring the cost of equity of euro area banks

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.