Conditional Factor Models for European Banks

The objective of this study is to analyze the risk factors and their time-variability that may be well suited to explain the behavior of European bank stock returns. In order to test for the relative importance of risk factors over time, we employ a novel democratic orthogonalization procedure proposed by Klein and Chow (Orthogonalized equity risk premia and systematic risk decomposition. Working Paper, West Virginia University, 2010). The time-variability in estimated coefficients is further modeled by conditional regression specifications that incorporate macroeconomic as well as stock market based information variables. In a final step, these conditional multifactor models are evaluated on their ability to capture return information related to traditional cross-sectional variables. Overall, we provide empirical evidence on time-varying relative factor contributions for explaining European bank stock returns. Moreover, we conclude that conditional multifactor models explain a significant portion of the size, value and momentum effects in cross-sectional regressions.