ROE in Banks: Myth and Reality

43 Pages Posted: 3 Jan 2014

Date Written: January 2, 2014

Abstract

Return on Equity (RoE) is a central measure of performance in the banking industry, which is used to allocate capital inside and across divisions. The reliance on this metric emerged from the risk management approach to banking which underlies bank capital regulation. Using the financial crisis, we reveal that the pre-crisis RoE has a strong impact on the destruction of value for shareholders for a sample of large banks in 28 countries. This impact is very robust to the introduction of numerous observable risk variables, the restriction of the sample to deposit-taking banks and alternative definitions of RoE. We document a sensitivity of bank CEO compensation to RoE. Our results strongly suggest that the reliance on RoE as a performance measure is a key incentive to excessive risk-taking in banks.

Keywords: return on equity, risk-taking, financial crisis, bank performance

JEL Classification: G01, G21, G28, G32

Suggested Citation

Moussu, Christophe and Petit-Romec, Arthur, ROE in Banks: Myth and Reality (January 2, 2014). Available at SSRN: https://ssrn.com/abstract=2374068 or http://dx.doi.org/10.2139/ssrn.2374068

Christophe Moussu (Contact Author)

ESCP Europe ( email )

79 Avenue de la République
Paris, 75011
France

Arthur Petit-Romec

ESCP Europe ( email )

79, avenue de la République
Paris, 75011
France

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