How Do Bank Policies Affect Equity Risk and Cost of Capital?

We examine the low-risk anomaly and the loan-growth effect in the cross section of U.S. bank stock returns. Using a return decomposition approach, we decompose bank stock returns into cost of equity capital, cash flow news, and discount rate news. Banks with higher equity risk exhibit lower subsequent returns mainly due to the cash flow news component, consistent with the argument that increasing bank equity risk negatively affects future earnings. Banks with a higher loan-growth rate underperform mainly due to the discount rate news component, consistent with the conjecture that fast loan growth elevates future equity risk. Both effects are underestimated by investors. Standard theory which predicts a positive association between equity risk and the cost of equity capital still holds ex ante. Policies to prevent excessive risk taking and to increase equity capital buffer by banks such as tightened capital requirements can be beneficially for both shareholders and the society.