ROE in Banks: Myth and Reality

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