Pricing Bank Risk: Firm-Specific Factors, Size Anomalies, and Implicit Guarantees in European Bank Equities

Abstract

This paper investigates whether firm-specific risk factors can explain the time-series variation in expected stock returns in the European banking sector and whether implicit public guarantees influence equity pricing. Using the Fama-French five-factor model, the paper examines the return behaviour of size-sorted and systemically important financial institution (SIFI) portfolios across a comprehensive sample of publicly listed European banks from 1999 to 2024. The analysis evaluates performance in both the full sample and distinct pre- and post-crisis subperiods to capture the impact of the 2008 Global Financial Crisis and subsequent regulatory reforms. The results show that smaller banks consistently deliver higher risk-adjusted returns than larger and systemically important peers, with the excess returns primarily absorbed by the size factor. In contrast, large and SIFI banks do not earn return premia commensurate with their higher systematic and idiosyncratic risk, suggesting that investors anticipate state support during periods of financial distress. However, this perceived guarantee appears to weaken in the post-crisis period, consistent with regulatory changes such as SIFI designations and bail-in frameworks. The findings indicate that while standard factor models capture important aspects of bank equity returns, they remain incomplete. The paper highlights the need to incorporate regulatory context and investor expectations into asset pricing frameworks to better reflect the unique dynamics of the banking sector.