Cost of capital: making it up as you go along

IFR 2284 18 May to 24 May 2019
5 min read
EMEA
Steve Slater

It is a number regarded by many top executives and investors as crucial to judging an institution’s success. But the abstract nature of cost of capital in the banking industry can leave managers making key strategic decisions - including where to allocate investment - based on a large dose of guess work. JP Morgan boss Jamie Dimon has even described cost of capital as a fictitious number.

The concept of cost of capital (aka cost of equity - the terms are often used interchangeably in banking) is central to how the industry operates, even though critics say the measure isn’t much use in the real world because it is based on rickety theoretical estimates.

“It’s tricky. The root of the problems is that all the standard ways of calculating cost of equity empirically don’t work very well for banks,” said Dan Davies, an analyst at Frontline Analysts.

Cost of capital is nonetheless hugely important as it sets the bar a bank needs to get its returns above. So if a bank estimates too high a cost of capital, it will ignore business areas that rivals may happily snap up. But if it sets the number too low, it will commit resources to areas that will erode profitability.

“ABOUT 10%”

Given it’s centrality, it matters that there is little consensus on cost of capital calculations.

Frequently, the number for banks is approximated as “about 10%” (the use of a ballpark number itself reflecting a lack of confidence in more precise estimates). But some have tried to be more specific.

The New York Federal Reserve estimated the average cost of capital for US banks was about 10.5% from 2000 to 2007, but then spiked to over 15% in 2008 and 2009 and has now returned near to 10.5% (see Chart).

The IMF said in late 2017 the implied cost of capital was 11% for global systemically important banks, but noted that masked a wide range - from 8% to 15% - for individual institutions.

The Bank of England’s November 2017 stress test results said BoE staff estimated the “aggregate cost of equity for major UK banks” ranged from 9% to 14%, and centred on 11.5%. But the British banks in question thought the cost was much lower: the aggregate cost submitted by the banks was 8.7%.

But none of those UK banks will say what they think their cost of capital is publicly. Indeed, no major banks worldwide disclose such calculations.

LACK OF CLARITY

The lack of clarity is to some extent understandable given that the arrival of more complex capital structures - including debt that converts into equity - after 2009 has made calculations trickier.

“The cost of equity for banks is notoriously difficult to calculate because of the nature of the balance sheet. And the post-2008 banking world is different to the pre-2008 banking world,” one banker said.

“The regulatory environment has changed so much. It has left banks with quite complex capital structures, and that carries a cost. Getting a meaningful, weighted cost of capital is difficult,” he said.

SUBJECT TO UNCERTAINTY

The uncertainty is to a large extent explained by the subjectivity of the inputs used to calculate cost of capital.

Those are essentially investor expectations about three factors: the risk-free interest rate (usually 10-year US Treasuries); the market equity risk premium; and the volatility of a bank’s stock relative to the rest of the market (its “beta”).

But as HSBC says in its annual reports, those elements are “subject to uncertainty and require the exercise of significant judgement”.

“NUTS”

There are many critics of this inexact science, however. They say calculating the beta is arbitrary, and often based on historical estimates that swing depending on the timeframe.

“People know how the capital asset pricing model works, but nobody is particularly inclined to apply it to banks,” said Frontline’s Davies.

“Doing numbers on cost of debt versus cost of equity and trying to blend them into a weighted average cost of capital is just a rabbit hole for banks. The problem is the fundamental mathematics aren’t on your side, the data don’t give consistent answers, and as a result people fall back on rules of thumb.”

Billionaire investor Warren Buffett and his sidekick at Berkshire Hathaway, Charlie Munger, have told their investors they are skeptical of the measure. They have said it’s taught at business school but the calculation never makes sense.

“I’ve never heard an intelligent discussion about cost of capital,” Munger has been quoted as saying. He has also said using a stock’s volatility to measure risk was “nuts”.

JP Morgan’s Dimon isn’t a fan either. “I think the cost of capital itself is a fictitious number. Just so you know,” he told analysts when quizzed on it on a 2017 results conference call.

Dimon hearing with House committee.jpg
Cost of capital for US banks