As long as the return on levered funds exceeds the cost of using them, leverage will increase a bank’s return on book equity. But what will happen to the price of its common stock? If the increased return on equity merely serves to compensate the investor for increased risk, the stock price will not benefit from leverage.
By providing us with estimates of the rates of return normal for various risk levels, modern capital theory enables us to modify the question to read as follows: When a bank introduces additional leverage into its capital structure, does its common stock exhibit a positive abnormal return? Without exception, a sample of 10 levered banks experienced subnormal returns following the introduction of debt into their capital structures. Perhaps when banks issue debt, it raises questions in the investor’s mind about the quality of bank management.