The Leverage Anomaly in U.S. Bank Stock Returns

Abstract

The relationship between leverage and returns on US bank stocks between 1973 and 2019 is slightly hump-shaped, almost flat. This observed relationship cannot be explained by standard risk factors such as correlation with the market return, book-to-market, size, momentum and term structure of interest rates. As a result, risk-adjusted returns (alphas) of highly leveraged banks are negative. Moreover, the stock returns exhibit a delayed reaction to changes in leverage. Highly leveraged banks that further increase their debt have high abnormal returns on the day of announcement, but tend to have low risk-adjusted returns during the following 6 months. This paper uncovers several explanations for this leverage anomaly. First, investors seem to underestimate the negative effect of leverage on future asset growth. Next, under-priced default risk, under-priced systematic risk and sensitivity to idiosyncratic volatility are prominent features of bank stock returns.