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.
Related Research
Other Research
- Country Risk: Determinants, Measures And Implications – The 2023 Edition, Damodaran, A.
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