The stock return predictability of the European banking sector

Introduction Many studies have documented that stock returns can be predicted by company- specific variables in a manner inconsistent with the accepted paradigms of modern finance - in particular, the capital asset pricing model of Sharpe (1964) and Lintner (1965). The influential work of Fama and French (1992) on the determinants of the cross- section of average stock returns has given focus to the literature. These cross-sectional asset-pricing studies typically have excluded financial institutions because of their high leverage and the high level of industry regulations due to the negative externalities arising from potential bank difficulties. However, because of the "special nature" of financial institutions and the importance of banks (most financial systems in Europe are dominated by banks, i.e. they are bank-based systems) there may exist important links between bank-specific fundamental variables and the cross-section of banking institutions' expected stock returns. In this paper, we examine the predictability of the cross-section of bank stock returns in Europe by evaluating this special nature of banks as compared to regular industrial firms, and taking account the development of the new, more competitive, European banking landscape. More specifically, in the past two decades, European banking markets have been subjected to structural changes, which were caused by modifications occurred in the external environment, especially as a consequence of the increasing monetary and financial integration. The gradual liberalization of capital flows, the prospect of the European common market, the rapid pace of developments in information technology, the product/service innovation in financial markets, the internationalisation of banking activities, the phenomenon of disintermediation, and the competitive pressure from foreign rivals are undoubtedly some of the prominent structural features of the European banking sector. Although the European banking sector is in a state of flux, it is possible to discern some overall patterns in the actions and strategies of individual banks making use of the banking industry's relative homogeneity. The effects of these responses are mainly reflected in changes in the structure of banks' financial statements (both balance sheet and profit and loss accounts). To judge the implications of the above mentioned developments, in this paper, we make use and examine the ability of bank-specific accounting ratios to price the cross- section of monthly bank stock returns in Europe. We employ fundamental variables from traditional and non-traditional financial intermediation activities that capture the dramatic changes recently experienced by the banking industry. Specifically, we examine predictability in the cross-section of bank stock returns in Europe using information contained in individual bank stock fundamental variables such as asset quality, leverage, off-balance sheet usage, and earnings' composition (income structure and cost amount). Evaluating the banks' overall performance and monitoring their financial condition and accounting structure is important to depositors, owners, potential investors, managers, and regulators. This paper contributes to the asset-pricing literature, since, as far as we are aware, this is the first attempt to capture the examined issue for the European banking sector. Recently, Cooper et. al. (2003), by employing quarterly US bank holding company data from the Federal Reserve System (Fed) over the period June 1986-December 1999 and using one-way sorts and cross-sectional regressions, found that variables related to percentage changes in non-interest income to net income, loan-loss reserves to total loans, earnings per share, the book value of equity to total assets, and standby letters of credit to total loans, are all univariately important in forecasting the cross-section of bank stock returns. A crucial question in asset pricing is whether the results obtained for U.S. stock markets can be generalized to markets in other countries. The structure of the paper is organized as follows: Section II displays the bank- specific fundamental variables used in our analysis, analyses the construction of our variables, provides the portfolio methodology employed to measure the relationship between the cross-section of fundamental variables and expected returns, and presents an analysis of the data. Section III contains the empirical results regarding the relationships between the bank-specific fundamental variables and the cross-section of future returns, and discusses the results. Some conclusions are offered in the final section download