Cost of equity is the new answer to banks' low profits


Dominic O'Neill
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Debate around the UniCredit-Commerzbank merger will centre on its impact on European banks’ share prices as Eurosceptic populism makes cost cutting more difficult.


A merger of UniCredit and Commerzbank would be the biggest bank M&A deal since the 2008 crisis. It is about the riskiest thing you could imagine a chief executive choosing to do. So how would it square with UniCredit CEO Jean Pierre Mustier’s insistence that his share price can rise, because he can do more to convince investors his bank is safer than before?

If you discount, for a moment, the idea that UniCredit might bid for Commerzbank, you can see where Mustier is coming from. After all, banks (especially UniCredit) have done the easy bits of cost cutting. Bank-bashing populists will increase the collateral damage of more aggressive staff reductions and branch closures. Future cuts may come more from technology, much of which is still under development.

At the same time, the populists have weighed on growth so much that European banks have to come to terms with the reality that the ECB is not going to help their interest margins any time soon. So what else can they do to boost their sorry share price performances, other than by trying to reduce their perceived risk?


Ultimately, banks must reach their profitability targets, which they set by looking at their cost of equity. That’s an estimate from interest rates and their share performance relative to the market and future earnings.

Some banks argue the stock market has insufficiently weighed their relative attractiveness, at a time when negative ECB rates have brought yields on other investments so low. The market should be happier with their profitability, in other words. But ECB calculations show that the risk-free rate’s impact on banks’ cost of equity has already been reduced to almost nothing.

European banks’ cost of equity has not come down much, if at all, though, because their perceived risk has not fallen, despite talk of banks becoming utility stocks. Even rate hikes under a new ECB governor later this year will not get them off the hook, as their cost of equity will rise further when the risk-free rate goes up.

Mustier tells us: “If you start from the premise that profitability of European banks is going to remain low, and probably be at best equal to your cost of capital, you should try to improve your profitability. But you need to make sure that your business model is such that investors will see a lower cost of capital from your operations.

“If you reduce your risk profile – if you have a capital level that is high enough, if you have stable net earnings over time – then your cost of capital, equity and debt should go down, and your share price should get closer to tangible book value. That’s the name of the game.”

So, will UniCredit’s long-suffering investors despair at the idea of the complexity of a big merger, only to increase exposure to low-profit Germany? Italian banks’ high single-digit ROE looks good compared to the low single digits Germany’s two big banks achieve. If you de-emphasise profitability, however, Commerzbank looks more attractive, because of Germany’s healthier economy and sovereign-debt situation compared to Italy.

Elsewhere in Europe, Eurosceptic populists are contributing to banks’ risk premia and therefore cost of equity – but especially in Italy, where high sovereign debt levels and banks’ own poor track records on asset quality further undercut their investment case. This is why UniCredit had to pay a sky-high coupon (7.83%) for a senior non-preferred bond late last year, despite offloading non-performing loans.

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Meanwhile, even in Scandinavia, new worries about anti-money laundering deficiencies mean banks will have to continue to produce unusually high returns. It’s why Swedbank’s cost of equity has recently gone up, according to Berenberg.

Casper von Koskull, chief executive of Nordea – Scandinavia’s biggest bank – adds that banks’ cost of equity has not fallen, despite cuts to costs and balance-sheet risks, partly because of efforts by European regulators to shift the burden of failing banks away from taxpayers, something which is much more real in Italy. “Yes, we should be more resilient, but shareholder equity is more at risk than ever before,” he tells us.

Von Koskull may be right in so far as bail-in rules increase banks’ overall funding costs and involve new restrictions on dividend payments. But fears about litigation costs have increased banks’ cost of equity across Europe, even for well-diversified lenders like BNP Paribas.

In fact, banks can work to lower their cost of equity – investing more in compliance, for example.

Moreover, as Mustier implies, they can change their business mix and the approach to loan growth. Lloyds, as a counter-example, has an unusually high return on equity, and unusually high cost of equity. Now its emerging market exposure is minimal, that’s surely to do with growth in areas such as credit cards, as well as Brexit.

Given the low confidence in European bank management, Mustier may be right to choose a safer path. Meeting cost of equity through low returns in low-risk jurisdictions – as in Germany – may be just as hard as doing so through high returns in high-risk countries, like Société Générale in Russia. Low returns in a high-risk jurisdiction, however, is the worst of both worlds.