Risk Taking, Diversification, and U.S. Bank Size Anomalies

The equity of too-big-to-fail banks could be deemed less risky due to implicit government guarantees. However, such guarantees could also amplify a moral hazard problem that induces large banks to take excessive risk. If such risk is mispriced by the market due to the increased complexity of large banks, then cross-sectional differences in realized stock returns should reflect corrections in market expectations rather than differences in the cost of capital. Proposing a novel diversification index to account for complexity, we find robust evidence consistent with mispricing among the most diversified large banks and attribute it to greater channels of uncertainty and interconnectedness