Common Risk Factors in Bank Stocks

Abstract

This paper provides evidence on the risk factors that are priced in bank equities. Alternative empirical models with precedent in the nonfinancial asset pricing literature are tested, including the single-factor CAPM, three-factor Fama-French model, and ICAPM. Our empirical results indicate that an unconditional two-factor ICAPM model that includes the stock market excess return and shocks to the slope of the yield curve is useful in explaining the cross section of bank stock returns. However, we find no evidence that firm specific factors such as size and book-to-market ratios are priced in bank stock returns. We also provide evidence that shocks to the default spread are priced in a conditional version of the two-factor ICAPM model. These results have a number of practical implications for event studies of banking firms, estimation of bank cost of capital and investment performance, as well as regulatory initiatives to utilize market discipline to evaluate bank risk under Basel II.

Keywords: Asset pricing, Bank stocks, Event studies, Regulatory policy

JEL Classification: G12, G14, G21, G28