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

We use analyst earnings forecasts for banks to extract cost of capital measures. We find that the cost of equity and debt capital are decreasing in the Tier 1 ratio, whereas the total cost of capital is uncorrelated with the Tier 1 ratio. These findings suggest that investors adjust their expectations for banks in accordance with the Modigliani-Miller (1958) conservation of risk principle. We show that the principle also applies at equity issuances following increased capital requirements and that the associated tax shield loss is economically small. Finally, we show that our results are not driven by biased investor expectations