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The persistence of bank profits: what the stock market implies

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  • Mark E. Levonian
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    Abstract

    This paper examines the speed with which abnormal economic profits vanish in the U.S. banking industry. A model is developed to infer expected speeds of profit adjustment from stock market and financial accounting data, deriving the rate of adjustment that is most consistent with observed cross-sectional relationships between bank stock prices and profitability. The model allows for the possibility that reported accounting income may be a biased and noisy signal of economic profit. Estimation is performed using generalized nonlinear least squares on a pooled series of cross sections. The results indicate that the expected rate of adjustment tends to be significantly greater than zero, although smaller than adjustment speeds found in studies of nonbank firms. The estimated speed of adjustment for negative profits is greater than for positive profits; for banks with high profit rates, the adjustment speed is near zero, implying that supernormal profits are very long-lived.

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    File URL: http://www.frbsf.org/publications/economics/review/1994/94-2_3-17.pdf
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    Bibliographic Info

    Article provided by Federal Reserve Bank of San Francisco in its journal Economic Review.

    Volume (Year): (1994)
    Issue (Month): ()
    Pages: 3-17

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    Handle: RePEc:fip:fedfer:y:1994:p:3-17:n:2

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    Keywords: Bank profits ; Bank stocks ; Banks and banking - Accounting ; Stock market;

    References

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    1. Lambson, Val Eugene, 1992. "Competitive Profits in the Long Run," Review of Economic Studies, Wiley Blackwell, vol. 59(1), pages 125-42, January.
    2. James Tobin & William C. Brainard, 1976. "Asset Markets and the Cost of Capital," Cowles Foundation Discussion Papers 427, Cowles Foundation for Research in Economics, Yale University.
    3. David Neumark & Steven A. Sharpe, 1989. "Market structure and the nature of price rigidity: evidence from the market for consumer deposits," Finance and Economics Discussion Series 52, Board of Governors of the Federal Reserve System (U.S.).
    4. Fisher, Franklin M & McGowan, John J, 1983. "On the Misuse of Accounting Rates of Return to Infer Monopoly Profits," American Economic Review, American Economic Association, vol. 73(1), pages 82-97, March.
    5. Ronn, Ehud I & Verma, Avinash K, 1986. " Pricing Risk-Adjusted Deposit Insurance: An Option-Based Model," Journal of Finance, American Finance Association, vol. 41(4), pages 871-95, September.
    6. Flannery, Mark J & James, Christopher M, 1984. " The Effect of Interest Rate Changes on the Common Stock Returns of Financial Institutions," Journal of Finance, American Finance Association, vol. 39(4), pages 1141-53, September.
    7. Marcus, Alan J & Shaked, Israel, 1984. "The Valuation of FDIC Deposit Insurance Using Option-pricing Estimates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 16(4), pages 446-60, November.
    8. Hannan, Timothy H & Berger, Allen N, 1991. "The Rigidity of Prices: Evidence from the Banking Industry," American Economic Review, American Economic Association, vol. 81(4), pages 938-45, September.
    9. Keeley, Michael C, 1990. "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review, American Economic Association, vol. 80(5), pages 1183-1200, December.
    10. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    11. Geroski, Paul A & Jacquemin, Alexis, 1988. "The Persistence of Profits: A European Comparison," Economic Journal, Royal Economic Society, vol. 98(391), pages 375-89, June.
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    Cited by:
    1. Acheampong, Yvonne J. & Epperson, James E., 1998. "International Variation Of Return On Equity In The Food And Beverage Industries," Faculty Series 16690, University of Georgia, Department of Agricultural and Applied Economics.
    2. Acheampong, Yvonne J. & Epperson, James E. & Park, Timothy A. & Gunter, Lewell F., 2000. "Profitability Adjustment Patterns In International Food And Consumer Products Industries," Faculty Series 16676, University of Georgia, Department of Agricultural and Applied Economics.

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