Capital ratios and the cross-section of bank stock returns: Evidence from Japan
Abstract We propose a market-valued capital ratio as an indicator to gauge the riskiness of banks. In particular, we examine the cross-sectional relation between the market-valued capital ratio and stock returns of listed Japanese banks. It is found that banks with lower market-valued capital ratios have had higher returns on average than banks with higher market-valued capital ratios. However, we show that this negative relation between market-valued capital ratio and average stock returns could essentially be attributed to differences in exposure to risk factors. The market-valued capital ratio appears to proxy for sensitivity to common risk factors in bank stock returns. We also relate the cross-sectional variation in market-valued capital ratios to systematic patterns in relative profitability by showing that low market-valued capital ratio signals persistently poor profitability. Finally, we provide evidence to show that the market-valued capital ratio can indeed serve as a strong predictive indicator for bank's share performance during the financial crisis in the late 1990s, even after controlling for a variety of other traditional risk measures.
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