Size, value, and asset quality premium in European banking stocks

Banking firms exhibit unique business and financial dynamics that are priced in their stock returns. This paper compares traditional empirical asset pricing models on portfolio of banking firms from fourteen European countries and proposes a banking specific risk factor. We compared a single factor CAPM with three factors Fama and French model on exchange rate adjusted returns and found substantial support for firm specific factors of size and value. We propose that asset quality premium (proportion of non-performing loans to total advances and measured as BMG - bad minus good) constitutes an important asset pricing factor for banking stocks. The portfolios sorted on size, value and asset quality explained the maximum variation in returns depicting asset quality as a critical investment factor for banking stocks. These results have considerable implications for investment appraisals, cost of capital and risk management in financial stocks.