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The Long-Term Relationship between Capital and Earnings in Banking: Sweden 1870–2001

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    Abstract

    Contrary to received wisdom, two recent studies report a negative relation-ship 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 explore the sign of the relation-ship 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 relation 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 re-sults of the previous studies, a long-term “normal” positive relationship be-tween leverage and profitability is also reaffirmed.

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    Bibliographic Info

    Paper provided by The Ratio Institute in its series Ratio Working Papers with number 63.

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    Length: 18 pages
    Date of creation: 03 Jan 2005
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    Handle: RePEc:hhs:ratioi:0063

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    Keywords: return-on-equity; leverage; bank capital;

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    1. Berger, Allen N, 1995. "The Relationship between Capital and Earnings in Banking," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(2), pages 432-56, May.
    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. Englund, Peter, 1999. "The Swedish Banking Crisis: Roots and Consequences," Oxford Review of Economic Policy, Oxford University Press, vol. 15(3), pages 80-97, Autumn.
    4. 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.
    5. 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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