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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)

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.

Suggested Citation

  • Hortlund, Per, 2005. "The Long-Term Relationship between Capital and Earnings in Banking," SSE/EFI Working Paper Series in Economics and Finance 611, Stockholm School of Economics, revised 17 Nov 2005.
  • Handle: RePEc:hhs:hastef:0611
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    File URL: http://swopec.hhs.se/hastef/papers/hastef0611.pdf
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    References listed on IDEAS

    as
    1. 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.
    2. Berger, Allen N, 1995. "The Relationship between Capital and Earnings in Banking," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(2), pages 432-456, May.
    3. Berger, Allen N. & Herring, Richard J. & Szego, Giorgio P., 1995. "The role of capital in financial institutions," Journal of Banking & Finance, Elsevier, vol. 19(3-4), pages 393-430, June.
    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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    More about this item

    Keywords

    Return-on-equity; Leverage; Bank capital;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • N23 - Economic History - - Financial Markets and Institutions - - - Europe: Pre-1913
    • N24 - Economic History - - Financial Markets and Institutions - - - Europe: 1913-

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