Is the cost of equity higher for risky banks? Evidence of stock market discipline using the implied cost of capital

Elfers, Ferdinand ; El Chamaa, Marwan

Document Type: Conference presentation
Year of publication: 2016
Conference title: 39th EAA Annual Congress 2016
Location of the conference venue: Maastricht, Netherlands
Date of the conference: 11.-13. Mai 2016
Publication language: English
Institution: Business School > ABWL, Unternehmensrechnung u. Empirische Kapitalmarktforschung (Daske 2007-)
Subject: 330 Economics
Abstract: In this paper we use the implied cost of capital (ICC) to gauge market monitoring by banks' stockholders. Estimating the ICC allows us to disentangle the discount factor from (possibly positive) cash flow effects from risky bank behavior and thus provides a clearer understanding of the relation between banks' distress risk and stock prices. For a large sample of U.S. bank holding companies from 1990 to 2012, we find that the implied risk premium (IRP) increases significantly with established accounting measures of bank risk. Second, the IRP has informative value in predicting bank distress on top of such accounting risk indicators, but is inferior to other market based risk indicators in the short run. Our results suggest that (a) banks' stock prices are indeed sensitive to business risk and (b) banks' IRP can serve as an early warning indicator for bank risk.

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