Betting against bank profitability

There is an ongoing debate about the economic implications of excessive bank risk-taking and profitability. We examine this issue from the perspective of bank shareholders. Contrary to evidence for non-financial stocks, we find that operating profitability is negatively related to risk-adjusted bank stock returns. This negative relationship can be attributed to the nature of the banking business, where profit and systematic risk are intrinsically linked, and the previously documented ‘betting against beta’ anomaly. We further demonstrate that more profitable banks are riskier and therefore have greater demand from leverage-constrained investors, resulting in higher valuations and lower than expected subsequent returns. The negative relationship between profitability and risk-adjusted returns is increasing in bank scale, as moral hazard problems and the use of market-based activities accentuate the link between profit and systematic risk in large banks.