Skip to main content
SpringerLink
Log in

The Banks Cost of Capital: Theories and Empirical Evidence

  • Chapter
  • First Online:
Valuing Banks

  • 1043 Accesses

Abstract

In this chapter, we discuss the methodologies used for cost of capital estimation in the banking industry. In particular, we first consider the generic treatment of the cost of equity calculation techniques that we divided into those methods quantifying the systematic risk premium and those measuring the total risk premium. The first aim of this chapter is to modify the Hamada (1972) formula excluding deposits value from a banks’ asset beta. Following this approach, we obtain a better measure with which to represent asset risk that is, additionally, independent from bank leverage. The second aim is to discuss the equity pricing methods that enable the quantification of the total risk (such as total beta and the implied cost of capital measures), in particular, adapting the CaRM to the banking industry. In order to better understand the applicability of the models, the chapter provides examples on listed and non-listed banks.

This is a preview of subscription content, log in via an institution to check access.

Access this chapter

Log in via an institution
Chapter
USD 29.95
Price excludes VAT (USA)
  • Available as PDF
  • Read on any device
  • Instant download
  • Own it forever
eBook
USD 129.00
Price excludes VAT (USA)
  • Available as EPUB and PDF
  • Read on any device
  • Instant download
  • Own it forever
Hardcover Book
USD 169.99
Price excludes VAT (USA)
  • Durable hardcover edition
  • Dispatched in 3 to 5 business days
  • Free shipping worldwide - see info

Tax calculation will be finalised at checkout

Purchases are for personal use only

Institutional subscriptions

Notes

  1. 1.

    Beta debt is assumed equal to zero.

  2. 2.

    This demonstration exploits the data of an existing bank.

  3. 3.

    Similar assumptions are made in the case of industrial firms when the classic Hamada formula is applied.

  4. 4.

    Calculated as follow: \( \begin{array}{c}Ca{R}_{D,\%}=\frac{Debt-\frac{RO{A}_{low}}{r_f}\cdot TotAsset}{Debt}=\frac{285,957-26.52\%\cdot 318,386.474}{285,957}\\ {}=70.47\%.\end{array} \)

References

  • Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: the common stock investment performance of individual investors. Journal of Finance, 55(2), 773–806.

    Article  Google Scholar 

  • Benartzi, S., & Thaler, R. H. (2001). NaĂŻve diversification strategies in defined contribution saving plan. American Economic Review, 91(1), 79–98.

    Article  Google Scholar 

  • Barnes, M. L., & Lopez, J. A. (2006). Alternative measures of the Federal Reserve Banks’ cost of equity capital. Journal of Banking and Finance, 30(6), 1687–1711.

    Article  Google Scholar 

  • Beltrame, F., Cappelletto, R., & Toniolo, G. (2014). Estimating SMEs cost of equity using a value at risk approach: The capital at risk model. London: Palgrave Macmillan.

    Google Scholar 

  • Beltrame, F., Grassetti, L., & Previtali, D. (2015). Banks, specific risk and cost of equity: The Bank’s capital at risk model, in bank risk, governance and regulation. London: Palgrave Macmillan.

    Google Scholar 

  • Bris, A., Welch, I., & Zhu, N. (2006). The cost of bankruptcy: Chapter 7 liquidation versus Chapter 11. Journal of Finance, 61(3), 1253–1303.

    Article  Google Scholar 

  • Chen, N., Roll, R., & Ross, S. A. (1986). Economic forces and the stock market. Journal of Business, 59(3), 383–104.

    Article  Google Scholar 

  • Choi, J. J., Elyasiani, E., & Kopecky, K. J. (1992). The sensitivity of bank stock returns to market, interest and exchange rate risks. Journal of Banking & Finance, 16(5), 983–1004.

    Article  Google Scholar 

  • Claus, J., & Thomas, J. (2001). Equity risk premium as low as three percent? Evidence from analysts’ earnings forecasts for domestic and international stocks. Journal of Finance, 56(5), 1629–1666.

    Article  Google Scholar 

  • Damodaran, A. (2013). Valuing financial service firms. Journal of Financial Perspectives, 1, 1–16.

    Google Scholar 

  • Das. S., Sy, A. N.R. (2012). How risky are banks’ risk weighted assets? Evidence from the financial crisis, IMF working paper/12/36.

    Google Scholar 

  • Denis, D. J., & Denis, D. K. (1995). Causes of financial distress following leveraged recapitalization. Journal of Financial Economics, 37(2), 129–157.

    Article  Google Scholar 

  • Di Biase, P., & D’Appolito, E. (2012). The determinants of systematic risk in the Italian banking system: A cross-sectional time series analysis. International Journal of Economics and Finance, 4(11), 152–164.

    Article  Google Scholar 

  • Diether, K., Malloy, C., & Scherbina, A. (2002). Differences of opinion and the cross section of stock returns. Journal of Finance, 57(5), 2113–2141.

    Article  Google Scholar 

  • Easton, P. (2004). PE ratios, PEG ratios, and estimating the implied expected rate of return on equitycapital. The Accounting Review, 79(1), 73–95.

    Article  Google Scholar 

  • Easton, P. (2009). Estimating the cost of capital implied by market prices and accounting data. Foundations and Trends in Accounting, 2(4), 241–364.

    Article  Google Scholar 

  • Easton, P., & Monahan, S. (2005). An evaluation of accounting-based measures of expected returns. The Accounting Review, 80(2), 501–538.

    Article  Google Scholar 

  • Easton, P., & Sommers, G. (2007). Effect of analysts’ optimism on estimates of the expected rate of return implied by earnings forecasts. Journal of Accounting Research, 45(5), 983–1015.

    Article  Google Scholar 

  • Fama, E. R., & French, K. R. (1992). The cross-section of expected stock returns. Journal of Finance, 47(2), 427–465.

    Article  Google Scholar 

  • Floreani, J., Paltrinieri, A., Pichler, F., & Polato, M. (2015). Credit quality, bank provisioning and systematic risk in banking business, in bank risk, governance and regulation. London: Palgrave Macmillan.

    Google Scholar 

  • Fu, F. (2009). Idiosyncratic risk and the cross section of expected stock returns. Journal of Financial Economics, 91(1), 24–37.

    Article  Google Scholar 

  • Gebhardt, W., Lee, C., & Swaminatham, B. (2001). Toward an implied cost of equity. Journal of Accounting Research, 39(1), 135–176.

    Article  Google Scholar 

  • Goetzmann, W., & Kumar, A. (2008). Equity portfolio diversification. Review of Finance, 12(3), 433–463.

    Article  Google Scholar 

  • Gordon, J., & Gordon, M. (1997). The finite horizon expected return model. Financial Analysts Journal, 53(3), 52–61.

    Article  Google Scholar 

  • Hamada, R. S. (1972). The effect of the firm’s capital structure on the systematic risk of common stocks. The Journal of Finance, 3(2), 435–452.

    Article  Google Scholar 

  • Hirshleifer, D. (2001). Investor psychology and asset pricing. Journal of Finance, 56(4), 1533–1597.

    Article  Google Scholar 

  • Jahankhani, A., & Lynge, M. J. (1980). Commercial bank financial policies and their impact on market-determined measures of risk. Journal of Bank Research, 11(3), 169–178.

    Google Scholar 

  • Kearney, C., & Potì, V. (2008). Have European stocks become more volatile? An empirical investigation of idiosyncratic and market risk in the Euro area. European Financial Management, 14(3), 419–444.

    Article  Google Scholar 

  • King, M. R. (2009). The cost of equity for global banks: A CAPM perspective from 1990 to 2009. BIS Quarterly Review, 9, 59–73.

    Google Scholar 

  • Lee, C. F., & Brewer, E. (1985). The association between bank stock market-based risk measures and the financial characteristics of the firm: A pooled cross-section time-series approach. Federal Reserve Bank of Chicago proceedings (no. 72).

    Google Scholar 

  • Lin, H. W., & McNichols, M. (1998). Underwriting relationships, analysts’ earnings forecasts and investment recommendations. Journal of Accounting and Economics, 25(1), 101–127.

    Article  Google Scholar 

  • Lintner, J. (1965). The valuation of risky assets and the selection of risky investments in stock portfolios and capital budget. Review of Economics and Statistics, 47(1), 13–37.

    Article  Google Scholar 

  • Maccario, A., Sironi, A., & Zazzara, C. (2002). Is banks’ cost of equity different across countries? Evidence from the G10 countries major banks? SDA Bocconi Research Division working paper no. 02-77.

    Google Scholar 

  • Malkiel, B. G., & Xu, Y. (2002). Idiosyncratic risk and security returns, working paper.

    Google Scholar 

  • Merton, R. C. (1974). On the pricing of corporate debt: The risk structure of interest rates. Journal of Finance, 29(2), 449–470.

    Google Scholar 

  • Merton, R. C. (1987). A simple model of capital market equilibrium with incomplete information. Journal of Finance, 42(3), 483–510.

    Article  Google Scholar 

  • Mueller, E. (2008). How does owners’ exposure to idiosyncratic risk influence the capital structure of private companies? Journal of Empirical Finance, 15(2), 185–198.

    Article  Google Scholar 

  • Ohlson, J., & Juettner-Nauroth, B. (2005). Expected EPS and EPS growth as determinants of value. Review of Accounting Studies, 10(2–3), 349–365.

    Article  Google Scholar 

  • Rosenberg, B., & Perry, P. R. (1978). The fundamental determinants of risk in banking. NBER working paper no. 265.

    Google Scholar 

  • Ross, S. A. (1976). The arbitrage theory of capital asset pricing. Journal of Economic Theory, 13(3), 341–360.

    Article  Google Scholar 

  • Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19(3), 425–442.

    Google Scholar 

  • Stever, R. (2007). Bank size, credit and the sources of bank market risk. BIS working paper no. 238.

    Google Scholar 

  • Smith, C., & Stulz, R. (1985). The determinants of hedging policies. Journal of Financial and Quantitative Analysis, 20(04), 391–405.

    Article  Google Scholar 

  • Stulz, R. (1984). Optimal hedging policies. Journal of Financial and Quantitative Analysis, 19(02), 127–140.

    Article  Google Scholar 

  • Vander Vennet, R., Baele, L., & De Jonghe, O. (2005). Determinants of systematic and idiosyncratic banking risk in Europe. Working paper, Ghent University.

    Google Scholar 

  • Vassalou, M., & Xing, Y. (2004). Default risk in equity returns. Journal of Finance, 59(2), 831–868.

    Google Scholar 

  • Yang, J., & Tsatsaronis, K. (2012). Bank stock returns, leverage and the business cycle. BIS Quarterly Review, March, 45–59.

    Google Scholar 

  • Zimmer, S. A., & McCauley, N. (1991). Bank cost of capital and international competition, Federal Reserve Bank of New York. Quarterly Review, 15(3–4), 33–59.

    Google Scholar 

Download references

Author information

Authors and Affiliations

  1. University of Udine, Udine, Italy

    Federico Beltrame

  2. Luiss Guido Carli University, Rome, Italy

    Daniele Previtali

Authors
  1. Federico Beltrame
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Daniele Previtali
    View author publications

    You can also search for this author in PubMed Google Scholar

Copyright information

© 2016 The Editor(s) (if applicable) and The Author(s)

About this chapter

Cite this chapter

Beltrame, F., Previtali, D. (2016). The Banks Cost of Capital: Theories and Empirical Evidence. In: Valuing Banks. Palgrave Macmillan Studies in Banking and Financial Institutions. Palgrave Macmillan, London. https://doi.org/10.1057/978-1-137-56142-8_5

Download citation

  • DOI: https://doi.org/10.1057/978-1-137-56142-8_5

  • Published:

  • Publisher Name: Palgrave Macmillan, London

  • Print ISBN: 978-1-137-56141-1

  • Online ISBN: 978-1-137-56142-8

  • eBook Packages: Economics and FinanceEconomics and Finance (R0)

Publish with us

Policies and ethics

Search

Navigation