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Why do banks target ROE?

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Abstract

Historically, nonfinancial corporations relied on performance targets linked to their EPS. Up until the 1970s, banks also appeared to follow a similar practice, but since then they have favored ROE. Equity investors seem to be aware of these differences because EPS growth is better at explaining nonfinancials? stock market value while ROE is better at explaining banks? market values. In this paper we present a model of a bank with fixed-rate deposit insurance that faces increasing competition that erodes its charter value. When under these conditions the bank chooses its capital to maximize shareholder value, its performance based on ROE is much better than its performance based on EPS. We argue that such a situation characterized the banking industry during the 1970s and explains why it adopted an ROE target.

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  • George Pennacchi & João A. C. Santos, 2018. "Why do banks target ROE?," Staff Reports 855, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednsr:855
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    3. Shilov Kirill & Zubarev Andrey, 2021. "Прибыльность И Эффективность Российских Банков После Глобального Кризиса," Russian Economic Development (in Russian), Gaidar Institute for Economic Policy, issue 11, pages 66-75, November.
    4. Benetton, Matteo & Eckley, Peter & Garbarino, Nicola & Kirwin, Liam & Latsi, Georgia, 2021. "Capital requirements and mortgage pricing: Evidence from Basel II," Journal of Financial Intermediation, Elsevier, vol. 48(C).
    5. Dietrich, Diemo & Gehrig, Thomas, 2021. "Speculative and Precautionary Demand for Liquidity in Competitive Banking Markets," VfS Annual Conference 2021 (Virtual Conference): Climate Economics 242347, Verein für Socialpolitik / German Economic Association.
    6. Blandina Walowe Kori & Stephen M. A. Muathe & Samuel Mwangi Maina, 2020. "Financial and Non-Financial Measures in Evaluating Performance: The Role of Strategic Intelligence in the Context of Commercial Banks in Kenya," International Business Research, Canadian Center of Science and Education, vol. 13(10), pages 130-130, October.
    7. Grandi, Pietro & Guille, Marianne, 2023. "Banks, deposit rigidity and negative rates," Journal of International Money and Finance, Elsevier, vol. 133(C).

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    More about this item

    Keywords

    banks; ROE; EPS;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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