Does the Fama-Franch three-factor model work in the financial industry? Evidence from European bank stocks

The Fama-French three-factor model (Fama and French, 1993) has been subject to extensive testing on samples of US and European non-financial firms over several time windows. The most accepted evidence is that size premium and value premium as well as market risk premium help explain time-series changes in stock returns. However, scholars have always paid little attention to the financial industry because of the intrinsic differences between financial and non-financial firms. The few studies that have tested the model on financial firms have found mixed evidence regarding the role of size and the book-to-market ratio in explaining stock returns. We find, on a sample of European banks, that size and book-to-market (B/M) ratio seem to be sources of undiversifiable risks and should therefore be included as risk premiums for estimating the expected returns of financial firms. Small and high-B/M banks seem to be more risky. Smaller banks are not systemically important financial institutions and therefore do not benefit from government protection. HighB/M banks are likely to be unprofitable, without growth opportunities, and close to financial distress.