ROE: No Banks Allowed

Return on Equity (ROE)
In graduate school, one of the topmost measures I was trained to use when measuring the strength of an institution is ROE. However, when I began work in the world of regulation I was surprised to discover that ROE was generally disregarded. Instead, Return on Assets (ROA) and Return on Average Assets (ROAA) are more important. I was also delighted that Robert Jenkins not only confirmed this difference in his interview ROE: The Wrong Performance Measure for Banks, he also explains the dichotomy in a manner such that anyone can understand.

SEE: Beyond ROE: How to Measure Bank Performance

The Evils
According to Robert Jenkins, FSIP, the use of ROE encouraged banks to maintain equity low and leverage high, which destabilizes the banking system. Furthermore, although ROE is a measure shareholders are trained to monitor, it is a meaningless measure year over year. If ROE is measured and monitored, the true test is for long-term value. Therefore, the value in assessing the institution’s performance in relation to a ROE target does not exist prior to approximately 15 years. However, institutions misused the measure; manipulating results to gain misguided shareholder buy-in.

Robert Jenkins believes that the right targets should be established to encourage maintenance of elevated levels of equity. I believe his cause his helped by the research and development of new rules made effective by Basel III.

SEE: Basel III: Third Time’s the Charm

Previously, Financial Institutions were required to measure the risk to capital; however, the system was not comprehensive. As we discovered, mortgage brokers and rating agencies went unregulated, creating inaccuracies in risk weighting. For a system to be effective the right hand must know what the left hand is doing and the same definitions must be used and understood throughout. With Basel III the financial system is recognized a system, so that systemic risks can be appropriately and sufficiently identified, measured, monitored, and controlled.

An Alternative
Mr. Jenkins further discusses the plausibility of a Return on Risk Weighted Assets (RORWA). Although RWA is utilized in capital calculations, (total risk adjusted capital to RWA), RORWA is a new concept, in considering profitability in relation to risk adjusted assets. I like the thought of such a measure, as it 1) it is a painless yet significant change, 2) it works to shift the executive mindset so that adjustments for risk become inherent in the business process, and 3) as management utilizes a risk adjusted short-term measure projections should converge toward the mean becoming more reasonable and reliable.

SEE: Biting Off Just Enough: Choosing Diversified Quality Over Quantity

About the Author

Maisha Smart, MBA founded Finance and Marketing to help small businesses excel, by bridging the gap between finance and marketing processes. Some of her favorite activities include fine arts, a good debate, and social engagement.

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