Record aggregate profits in 2023 will mean most European banks can (at last) cover their cost of equity, helping them to boost equity valuations. That could prove fleeting if interest rate support fades. Some domestic European commercial banks may struggle, in 2024, to clear cost of equity hurdles that can vary from 6.2% to 12.3%, according to S&P Global Ratings' estimates.
What's Happening
European banks' profitability spiked in 2023 amid higher net interest margins and lower-than-expected credit losses. European Central Bank (ECB) data shows that the aggregate return on equity (RoE) of EU banks was 10.3% in the third quarter of 2023, up from 6.7% in 2021 and at its highest level since 2007. Bank shareholders are reaping the rewards via increased dividends and share buybacks.
Yet, our estimates of European domestic commercial banks' cost of equity (generated using the capital asset pricing model (CAPM)) reveal significant differences between countries. For example, a diversified investor will demand a return of at least 6.2% from a Swiss domestic bank, but 12.3% from a Hungarian bank.
Differences are typically due to variations in risk-free rates (which reflect inflation expectations) and country-specific risks (such as political, property rights, and economic stability). Yet other factors can weigh on banks' cost of equity. For example, smaller, specialized lenders typically have a higher cost of equity than well-diversified retail banks, meaning the composition of a countries' banking sector can be a factor.
Why It Matters
European banks' difficulties in covering their cost of equity have contributed to historically weak valuations that undermine financial flexibility, not least by limiting access to further capital. That's why (after years of balance sheet restructuring) banks are focused on improving their valuations. That goal is supported by the RoE boost from higher rates and increased shareholder distributions.
Distributions are unlikely to affect bank credit ratings because our earnings base case is relatively benign for most of the sector and our assessment of banks' capitalization is forward-looking and rarely sensitive to small changes in capital ratios. That said, as rates come down and the cyclical earnings boost fades, we will watch for banks that increase risk to maximize returns.
What Comes Next
We expect European banks' RoE will decline over 2024 as higher funding costs squeeze margins and the cost of risk likely rises. Despite this, European banks' aggregate return on equity should remain about three percentage points above 2021 levels (before a wide increase in central bank rates) over the next two years.
Some European banks will still struggle to sustainably earn their cost of equity and will have to find new avenues of profitable growth while managing novel and growing risk. What's more, European financial sector fragmentation remains an obstacle to profitability and scale, with national champions firmly entrenched.
Background In Brief
About 40% of euro area banks use a variation of the CAPM to estimate their cost of equity, according to an ECB study. The CAPM formula we use is based on a model proposed by Aswath Damodaran (2023):
Cost of equity = risk-free rate + European bank equity premium + country risk premium, where:
- Risk-free rate: Yield on a 10 year government bond in the local currency adjusted for default risk.
- European bank equity premium is similar across all European countries considered and defined as: beta times equity-risk-premium.
- Beta for European banks: Estimated, based on the betas of domestically focused commercial banks in Europe.
- Equity risk premium for European markets: Difference between implied equity risk return and the 10 year government bond yield.
- Country risk premium: Estimated, based on each country's sovereign rating and reflecting differences in credit default swap spreads relative to 'AAA' rated countries.
Related Research
- Top European Bank Rating Trends In 2024: The Future Is Now, Jan. 24, 2024
- European Banks: Cyclical Earnings Boost Is No Panacea, Nov. 21, 2023
Other Research
- Country Risk: Determinants, Measures And Implications - The 2023 Edition, Damodaran, A.
This report does not constitute a rating action.
| Primary Credit Analysts: | Karim Kroll, Frankfurt 6933999169; karim.kroll@spglobal.com |
| Cihan Duran, CFA, Frankfurt + 49 69 3399 9177; cihan.duran@spglobal.com | |
| Secondary Contacts: | Nicolas Charnay, Frankfurt +49 69 3399 9218; nicolas.charnay@spglobal.com |
| Giles Edwards, London + 44 20 7176 7014; giles.edwards@spglobal.com |
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