The Leverage Anomaly in U.S. Bank Stock Returns
28 Pages Posted: 19 Jun 2018 Last revised: 9 Oct 2019
Date Written: June 4, 2018
The relationship between leverage and returns on US bank stocks between 1973 and 2015 is slightly hump-shaped, almost flat. The observed relationship is not explained by standard risk factors such as correlation with the 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, both under-priced default risk and under-priced systematic risk are prominent features of bank stock returns. Finally, government bail-outs decrease risk for large highly leveraged banks.
Keywords: asset pricing anomaly, bank regulation, capital requirements, leverage
JEL Classification: G12, G14, G21
Suggested Citation: Suggested Citation