Do Lower Returns on Bank Stocks Suggest Lower Cost of Capital? An Explanation for the Low Risk Anomaly and the Loan Growth Effect

Banks with higher equity risk and faster loan growth have lower abnormal stock returns. By disentangling ex ante cost of capital from cash flow and discount rate news in bank stock returns, we show that the lower returns do not suggest lower cost of capital. The underperformance of banks with higher equity risk is explained by the poorer cash flow news. The underperformance of banks with faster loan growth is due to both the cash flow and the discount rate news components. Overall, the evidence points to the nontrivial role of investors’ inefficient forecasts of expected bank risk and fundamentals.