The persistence of bank profits: what the stock market implies

This paper examines the speed with which abnormal economic profits (that is, profits greater than or less than required to compensate for the real opportunity cost of capital including risk) vanish in the U.S. banking industry. Positive economic profits arise from random \"good luck,\" or from successful process innovations or product differentiation, and then erode as markets adjust. Negative profits arise from bad luck or strategic failures, but also tend to be corrected over time. 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 from 1986 through 1991. 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. When the sample is split into two groups - banks with negative economic returns and banks earning at least the opportunity cost of equity - the estimated speed of adjustment for negative profits is greater than for positive profits. For the group of banks with high profit rates, the adjustment speed is near zero, implying that supernormal profits are very long lived. The results also indicate that accounting returns tended to understate economic returns during the period studied.