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The Long-Term Relationship between Capital and Earnings in Banking

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  • Hortlund, Per

    ()
    (Dept. of Economics, Stockholm School of Economics)

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    Abstract

    Contrary to received wisdom, some recent studies report a negative relationship between leverage and profitability in banking in the 1980s and early 1990s. This study presents new data on the leverage and profitability of Swedish commercial banks in 1870–2001, and explores the sign of the relationship in the long term. In the studied period, the capital-asset ratio decreased by a factor four, while return-on-equity more than doubled. The “leverage formula” postulates a positive linear relationship between return-on-equity and the debt-equity ratio. A strong positive linear relationship was found over the period 1871–1980, but not in 1980–2001. Thus, while supporting the results of the previous studies, a long-term “normal” positive relationship between leverage and profitability is also reaffirmed.

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    File URL: http://swopec.hhs.se/hastef/papers/hastef0611.pdf
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    Bibliographic Info

    Paper provided by Stockholm School of Economics in its series Working Paper Series in Economics and Finance with number 611.

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    Length: 25 pages
    Date of creation: 17 Nov 2005
    Date of revision: 17 Nov 2005
    Handle: RePEc:hhs:hastef:0611

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    Postal: The Economic Research Institute, Stockholm School of Economics, P.O. Box 6501, 113 83 Stockholm, Sweden
    Phone: +46-(0)8-736 90 00
    Fax: +46-(0)8-31 01 57
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    Web page: http://www.hhs.se/
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    Related research

    Keywords: Return-on-equity; Leverage; Bank capital;

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    1. Allen Berger, 1994. "The Relationship Between Capital and Earnings in Banking," Center for Financial Institutions Working Papers 94-17, Wharton School Center for Financial Institutions, University of Pennsylvania.
    2. Allen N. Berger & Richard J. Herring & Giorgio P. Szego, 1995. "The role of capital in financial institutions," Finance and Economics Discussion Series 95-23, Board of Governors of the Federal Reserve System (U.S.).
    3. Demirguc, Asli & Huizinga, Harry, 1999. "Determinants of Commercial Bank Interest Margins and Profitability: Some International Evidence," World Bank Economic Review, World Bank Group, vol. 13(2), pages 379-408, May.
    4. Capie, Forrest & Billings, Mark, 2001. "Profitability in English banking in the twentieth century," European Review of Economic History, Cambridge University Press, vol. 5(03), pages 367-401, December.
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