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The cost of capital of the financial sector

Author

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  • Tobias Adrian
  • Evan Friedman
  • Tyler Muir

Abstract

Standard factor pricing models do not capture well the common time-series or cross-sectional variation in average returns of financial stocks. We propose a five-factor asset pricing model that complements the standard Fama and French (1993) three-factor model with a financial sector ROE factor (FROE) and the spread between the financial sector and the market return (SPREAD). This five-factor model helps to alleviate the pricing anomalies for financial sector stocks and also performs well for nonfinancial sector stocks compared with the Fama and French (2014) five-factor model or the Hou, Xue, and Zhang (2014) four-factor models. We find that the aggregate expected return to financial sector equities correlates negatively with aggregate financial sector ROE, which is puzzling, as ROE is commonly used as a measure of the cost of capital in the financial sector.

Suggested Citation

  • Tobias Adrian & Evan Friedman & Tyler Muir, 2015. "The cost of capital of the financial sector," Staff Reports 755, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednsr:755
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    References listed on IDEAS

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    Cited by:

    1. Luis Fernández Lafuerza & Javier Mencía, 2021. "Estimating the cost of equity for financial institutions," Revista de Estabilidad Financiera, Banco de España, issue Primavera.
    2. Tobias Adrian & Nina Boyarchenko & Hyun Song Shin, 2015. "On the scale of financial intermediaries," Staff Reports 743, Federal Reserve Bank of New York.
    3. Anna Kovner & Peter Van Tassel, 2022. "Evaluating Regulatory Reform: Banks' Cost of Capital and Lending," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 54(5), pages 1313-1367, August.
    4. Venmans, Frank, 2021. "The leverage anomaly in U.S. bank stock returns," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 75(C).
    5. Ben Ammar, Semir & Eling, Martin & Milidonis, Andreas, 2018. "The cross-section of expected stock returns in the property/liability insurance industry," Journal of Banking & Finance, Elsevier, vol. 96(C), pages 292-321.
    6. Gabriella Chiesa & José Manuel Mansilla-Fernández, 2021. "The dynamic effects of non-performing loans on banks’ cost of capital and lending supply in the Eurozone," Empirica, Springer;Austrian Institute for Economic Research;Austrian Economic Association, vol. 48(2), pages 397-427, May.
    7. Carmichael, Benoît & Coën, Alain, 2020. "Real estate as a common risk factor in the financial sector: International evidence," Finance Research Letters, Elsevier, vol. 32(C).
    8. Akhtaruzzaman, Md & Chiah, Mardy & Docherty, Paul & Zhong, Angel, 2021. "Betting against bank profitability," Journal of Economic Behavior & Organization, Elsevier, vol. 192(C), pages 304-323.
    9. Lian, Ziying & Cai, Jun & Webb, Robert I., 2020. "Oil stocks, risk factors, and tail behavior," Energy Economics, Elsevier, vol. 91(C).
    10. Carmichael, Benoît & Coën, Alain, 2018. "Real estate as a common risk factor in bank stock returns," Journal of Banking & Finance, Elsevier, vol. 94(C), pages 118-130.
    11. Berger, Allen N. & El Ghoul, Sadok & Guedhami, Omrane & Roman, Raluca A., 2022. "Geographic deregulation and banks’ cost of equity capital," Journal of International Money and Finance, Elsevier, vol. 120(C).
    12. Fabrizio Spargoli & Christian Upper, 2018. "Are banks opaque? Evidence from insider trading," BIS Working Papers 697, Bank for International Settlements.
    13. Gabriella CHIESA & José Manuel MANSILLA-FERNÁNDEZ, 2018. "Non-Performing Loans, Cost of Capital, and Lending Supply: Lessons from the Eurozone Banking Crisis," Departmental Working Papers 2018-05, Department of Economics, Management and Quantitative Methods at Università degli Studi di Milano.
    14. Clark, Brian & Jones, Jonathan & Malmquist, David, 2023. "Leverage and the cost of capital for U.S. banks," Journal of Banking & Finance, Elsevier, vol. 155(C).
    15. Luis Fernández Lafuerza & Javier Mencía, 2021. "Estimating the cost of equity for financial institutions," Financial Stability Review, Banco de España, issue Spring.
    16. Huang, Qiubin & de Haan, Jakob & Scholtens, Bert, 2020. "Does bank capitalization matter for bank stock returns?," The North American Journal of Economics and Finance, Elsevier, vol. 52(C).
    17. Luis Fernández Lafuerza & Javier Mencía, 2021. "Estimating the cost of equity for financial institutions," Financial Stability Review, Banco de España, issue Spring.

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    More about this item

    Keywords

    asset pricing; cost of capital; capital structure; financial intermediation;
    All these keywords.

    JEL classification:

    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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