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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