(updated 2021)
In graduate school, one of the topmost measures used to measure the strength of a business entity was Return on Equity (ROE). However, when I began work in the world of banking regulation, I was surprised to discover that ROE is generally discarded. Instead, Return on Assets (ROA) and Return on Average Assets (ROAA) are more important. I was also delighted when Robert Jenkins, a former Audit and Risk Committee Chair of the CFA Institute, not only confirmed this difference in his interview ROE: The Wrong Performance Measure for Banks, but he also explained the dichotomy in a manner that anyone can understand.1
The Evils
According to Mr. Jenkins, the use of ROE encouraged banks to maintain equity low and leverage high, which destabilizes the banking system. Although ROE is a measure shareholders are trained to monitor, it is a meaningless for year over year performance comparison. When 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 ~15 years. Unfortunately, institutions often misuse this measure and manipulate results to gain misguided shareholder buy-in.
BASEL III
Robert Jenkins believed that the right targets should be established to encourage maintenance of elevated levels of equity. His cause is helped by the research and development of new rules made effective by Basel III.2
Previously, financial institutions were required to measure the risk to capital; however, the system was not comprehensive. As we discovered during the 2008 financial crisis, the mortgage brokers that originated and sold bad assets to the banks were unregulated, and the rating agencies really had no way of identifying and rating the characteristics of complex mortgage derivatives. This disconnect created significant inaccuracies in the risk weighting of assets, leaving banks blind to the true level of risk on their balance sheets.
According to Mr. Jenkins, the use of ROE encouraged banks to maintain equity low and leverage high, which destabilizes the banking system. Although ROE is a measure shareholders are trained to monitor, it is a meaningless for year over year performance comparison. When 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 ~15 years. Unfortunately, institutions often misuse this measure and manipulate results to gain misguided shareholder buy-in.
BASEL III
Robert Jenkins believed that the right targets should be established to encourage maintenance of elevated levels of equity. His cause is helped by the research and development of new rules made effective by Basel III.2
Previously, financial institutions were required to measure the risk to capital; however, the system was not comprehensive. As we discovered during the 2008 financial crisis, the mortgage brokers that originated and sold bad assets to the banks were unregulated, and the rating agencies really had no way of identifying and rating the characteristics of complex mortgage derivatives. This disconnect created significant inaccuracies in the risk weighting of assets, leaving banks blind to the true level of risk on their balance sheets.
For a system to be effective, the right hand must know what the left hand is doing, and the same definitions must be used to create a common understanding. With Basel III the financial system is recognized as a system, so that systemic risks can be appropriately and sufficiently identified, measured, monitored, and controlled.
An Alternative
Mr. Jenkins further discussed the plausibility of a Return on Risk Weighted Assets (RORWA). Although RWA is utilized in capital calculations, (e.g. total risk adjusted capital to RWA), RORWA is a new concept, in considering profitability in relation to risk adjusted assets. I like the concept. It's a painless yet significant change; it works to shift the executive mindset, so that adjustments for risk become inherent in the business process; and as management utilizes a risk adjusted short-term measure, projections should converge toward the mean, becoming more reasonable and reliable.
”Since humans created the economic and financial systems, it should be no surprise that psychology plays a significant role.”
- The Psychology of Finance
An Alternative
Mr. Jenkins further discussed the plausibility of a Return on Risk Weighted Assets (RORWA). Although RWA is utilized in capital calculations, (e.g. total risk adjusted capital to RWA), RORWA is a new concept, in considering profitability in relation to risk adjusted assets. I like the concept. It's a painless yet significant change; it works to shift the executive mindset, so that adjustments for risk become inherent in the business process; and as management utilizes a risk adjusted short-term measure, projections should converge toward the mean, becoming more reasonable and reliable.
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1 CFA Institute: The Wrong Performance Measure for Banks
2 Basel Committee on Banking Supervision: BASEL III
