Determinants of cost of equity for listed euro area banks

The objective of this paper is to identify the banks’ cost of equity determinants. We rely on a two-step approach. First, we estimate the cost of equity (COE) for listed euro area banks through multi-factor models, which are widely used in the asset pricing literature. We propose a new specification with overall market, banking sector and country risks and conclude that it has the best performance among all considered alternatives to mimic the bank’s realized returns dynamics. Then, this specification is employed to estimate the banks’ return sensitivities to each of the common risk factors and the COE. In the second step, we consider bank-specific and country-level variables and infer whether they explain the estimated COE time series dynamics and differences in COE across banks. We conclude that changes in ECB’s interest rates and government bond rates were crucial to explain the evolution of the COE between 2012 and 2020. Moreover, we find that some variables related to business and financial cycles, and bank-specific variables such as Nonperforming Loan ratio, Tier1 ratio and Return on Assets are also important.