16 November 2015

Financial Times: Why banks come back to return on equity

Credit Suisse’s new chief executive Tidjane Thiam is trying to upend decades of received wisdom about how bank performance should be measured. He set out a number of new targets last month, and return on equity was conspicuous by its absence.

It is easy to see why. Mr Thiam noted that countless other banks have set ROE targets, only to have to cut them later when life did not turn out as planned.

One of the problems is that it is difficult for banks’ management to fully control ROE. Profits (the “return” part of the calculation) depend to some extent on interest rates. And the amount of equity that banks use is partly — although not exclusively — determined by regulators.

Arguably, the search for high ROE contributed to the financial crisis by encouraging bankers to load up on debt (keeping the “E” part of the equation low) and risk (keeping the “R” part high). For a while, it seemed to work. European banks regularly reported ROEs of more than 20 per cent before the crisis. Then, everything fell apart and, seven years on, we are still discovering exactly what sort of risks the banks were taking to produce those returns.

So, it is an unpredictable measure that can lead to target changes and excessive risk taking. No wonder Mr Thiam is pulling back. Yet somehow ROE persists in the face of all the criticism. One reason is that there are few good alternatives. Return on assets — or profits as a proportion of the whole balance sheet — is one, but its use might encourage banks to load up on risk again by cutting back on safer, lower yielding assets.

Another alternative is return on risk-weighted assets. This partly gets around the criticism that ROE takes no account of risk. But the risk-weighted asset calculation is itself controversial. Most big banks use their own assessments of risk when calculating RWAs, and there is no clarity about how they do so.

Full article on Financial Times (subscription required)

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