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This paper examines whether the financial distress pricing puzzle observed for non-financial firms is also observed for financial firms and how this puzzle differs according to the extent of short-sale constraints. By using the eight distress measures developed for financial firms, we find that there is a strong negative relation in the cross-section between financial distress and subsequent bank stock returns, regardless of adjustment for risk. However, this distress pricing puzzle is statistically significant only for high short-sale constrained banks, but not for low short-sale constrained banks. Thus, short-sale constraints are at least one nonrisk attribute that causes the distress pricing puzzle for financial firms. We also find that despite its simple form, compared to the other complex distress measures, non-performing loans (NPLs) are the most informative in predicting future bank stock returns as well as bankruptcy and failure.

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