Banks’ profitability exceeds the market’s required return
News, Staff memo The major Swedish banks have had strong earnings in relation to the risk that the equity market considers their operations to entail. This is shown in a new analysis that examines banks’ profitability in relation to an estimated market-based required rate of return on equity.
The analysis, prepared by Dominika Krygier of the Financial Stability Department and Stephan Wollert, formerly of the same department, examines how the profitability of the major Swedish banks compares with an estimate of the equity market’s required return on banks’ equity. The required return is estimated using both the CAPM model and an implicit forward-looking method that derives banks’ cost of equity from current equity prices and analysts’ expectations regarding banks’ future development.
The results show that, on average, the major banks have had a return on equity that exceeded the estimated market-based required return. This can be interpreted as meaning that the banks’ profitability is high in relation to the risk that the market considers their operations to entail.
Profitable banks are important for financial stability. Profitability creates conditions for banks to build and maintain a strong capital base with buffers that can absorb unexpected losses. This enables banks to maintain lending to households and firms in both good and bad times. Overall, this reduces the risk that problems in the banking system will have broad impact on the real economy.
Staff memos
A Staff Memo provides Riksbank staff members with the opportunity to publish ad-vanced analyses of relevant issues. It is a staff publication, free of policy conclusions and individual standpoints on current policy issues. Publication is approved by the head of department concerned. The opinions expressed in Staff Memos are those of the authors and should not be regarded as the Riksbank’s standpoint.