Bank Capitalization and the Cross-Section of Bank Stock Returns

Abstract

We investigate the evolution of US bank capitalization and examine its role in the crosssection of bank stock returns. We use the book capital ratio (BCR), the market capital ratio (MCR) and the stressed capital ratio (SCR) as three proxies for bank capitalization and find that the MCR and the SCR have similar dynamics, while the BCR develops very differently. Our Fama-MacBeth cross-sectional regressions suggest a negative and significant relationship between bank capitalization and bank stock returns between 1994–2007, especially when bank capitalization is measured by the MCR or the SCR. We apply Fama-French factor models to estimate the risk-adjusted returns of our capital ratio-sorted decile portfolios and their sensitivities to systematic risk factors. We find that the BCR proxies for bank portfolio exposures to the market and value factors, while the MCR and the SCR contain some information on exposures to the market and size factors.