The Cost of Capital for Banks: Evidence from Analyst Earnings Forecasts

Abstract

We extract cost of capital measures for banks using analyst earnings forecasts, which we show are unbiased. We find that the cost of equity and the cost of debt decrease in the Tier 1 ratio, whereas total cost of capital is uncorrelated with the Tier 1 ratio. These findings suggest that investors adjust their return expectations for banks in accordance with the Modigliani–Miller conservation-of-risk principle. Hence, increased capital requirements arenotmade socially costly based on a notion that market pricing violates risk conservation. Equity can nevertheless still be privately costly for banks because of reduced subsidies.