Why Do Banks Target ROE?

40 Pages Posted: 20 Jun 2018

See all articles by George Pennacchi

George Pennacchi

University of Illinois

João A. C. Santos

Federal Reserve Bank of New York

Date Written: June , 2018


Historically, nonfinancial corporations relied on performance targets linked to their EPS. Up until the 1970s, banks also appeared to follow a similar practice, but since then they have favored ROE. Equity investors seem to be aware of these differences because EPS growth is better at explaining nonfinancials’ stock market value while ROE is better at explaining banks’ market values. In this paper we present a model of a bank with fixed-rate deposit insurance that faces increasing competition that erodes its charter value. When under these conditions the bank chooses its capital to maximize shareholder value, its performance based on ROE is much better than its performance based on EPS. We argue that such a situation characterized the banking industry during the 1970s and explains why it adopted an ROE target.

Keywords: banks, ROE, EPS

JEL Classification: G21, G28

Suggested Citation

Pennacchi, George G. and Santos, João A. C., Why Do Banks Target ROE? (June , 2018). FRB of New York Staff Report No. 855, Available at SSRN: https://ssrn.com/abstract=3199909 or http://dx.doi.org/10.2139/ssrn.3199909

George G. Pennacchi

University of Illinois ( email )

4041 BIF, Box 25
515 East Gregory Drive
Champaign, IL 61820
United States
217-244-0952 (Phone)

HOME PAGE: http://www.business.illinois.edu/gpennacc/

João A. C. Santos (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States
212-720-5583 (Phone)
212-720-8363 (Fax)


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