What drives Austrian banking subsidiaries’ return on equity in CESEE and how does it compare to their cost of equity?

This short study analyzes the relative profitability of Austrian banking subsidiaries in Central, Eastern and Southeastern Europe (CESEE) using two separate approaches. First, we address the subject from an accounting point of view based on a DuPont analysis. We dissect the return on (the book value of average) equity (ROE) to highlight how profit and loss drivers as well as financial leverage affected this profitability metric from 2004 to 2016. This prepares the ground for our second part, where we switch to a market perspective for the period from 2006 to 2016 to deduce the cost of (average) equity (COE) of these subsidiaries from the Capital Asset Pricing Model (CAPM) in order to compare the model-based profits that would be expected (i.e. demanded) by investors to those that have actually been realized. The analysis is complemented by a similar exercise for a peer group consisting of listed CESEE banks. We find that the ROE dropped substantially during the global financial crisis and only started to recover in 2016. An accounting-based DuPont analysis reveals that – over the entire analyzed time span – this was primarily caused by a rise in risk costs at the onset of the global financial crisis and their strong improvement in 2016, as well as a continuous reduction of financial leverage. The negative contribution of a lower operating income margin and positive effects of an improved cost-income ratio roughly canceled each other out. We also provide a (cautious) medium-term outlook for the future development of the ROE of Austrian banking subsidiaries in CESEE, which is likely to depend on the balance between the weakened net interest income and reduced credit risk costs (that still have to prove their sustainability). When switching to a market perspective and the question of the subsidiaries’ COE, we find that the latter is substantially lower than often assumed, but still too high to be fully compensated by realized profits (except in 2016). In aggregate, other CESEE peer banks fared better, which was mostly due to their higher profitability. These results call for continued and persistent efforts to further improve Austrian banking subsidiaries’ risk-return profile in CESEE.