Equity Is Cheap for Large Financial Institutions

Across a wide panel of countries, the top 10% of financial stocks on average account for over 20% of a country’s market capitalization but earn on average significantly lower returns than do non-financial firms of the same size and risk exposures. In a bailout-augmented, rare disasters asset pricing model, the spread in risk-adjusted returns between large and small institutions depends on country characteristics that determine the likelihood of bailouts. Consistent with this model, we find larger spreads in countries with large and interconnected financial sectors, weaker capital regulation and corporate governance, and fiscally stronger governments. Valuation gaps increase in anticipation of financial crises. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.