Predictability in the cross-section of European bank stock returns

This paper investigates the impact of individual bank fundamental variables onstock market returns using data from a panel of 235 European banks from 1991to 2005. The sample period marks a significant transition in the European bankingsector, characterized by higher competition, lower profit margins in the traditionalinterest-related business and increasing non-interest income in terms offees and commissions. In panel regressions, we relate bank stock returns to fundamentalaccounting information and use several corrections for the standard errorsto control for heteroscedasticity, autocorrelation and spatial correlation. Ourresults indicate that several bank-specific variables exhibit a robust explanatorypower across different model specifications. Most important, there is a positiveimpact of the ratio of loans to total assets, the ratio of non-interest income to totalincome, and the ratio of off-balance sheet items to total assets on subsequentbank stock returns. In contrast, the ratio of loan-loss-provisions to net interestrevenue and the ratio of book value of equity to total assets load negatively onsubsequent bank stock returns. Overall, the valuation of bank stocks incorporatesboth the traditional loan-related side of the banking business and the growingoff-balance activities.