The persistence of bank profits: what the stock market implies

This paper examines the speed with which abnormal economic profits vanish in the U.S. banking industry. A model is developed to infer expected speeds of profit adjustment from stock market and financial accounting data, deriving the rate of adjustment that is most consistent with observed cross-sectional relationships between bank stock prices and profitability. The model allows for the possibility that reported accounting income may be a biased and noisy signal of economic profit. Estimation is performed using generalized nonlinear least squares on a pooled series of cross sections. The results indicate that the expected rate of adjustment tends to be significantly greater than zero, although smaller than adjustment speeds found in studies of nonbank firms. The estimated speed of adjustment for negative profits is greater than for positive profits; for banks with high profit rates, the adjustment speed is near zero, implying that supernormal profits are very long-lived.