ROE in Banks: Performance or Risk Measure? Evidence from Financial Crises

Résumé Fr En

Le return on equity (ROE) est le principal indicateur de performance dans les banques. En nous centrant sur les crises de 1998 et de 2007-08, nous montrons que le ROE pré-crise est un déterminant important du risque individuel et du risque systémique d’une banque pendant la crise. Cette association reste robuste lorsque nous contrôlons pour de nombreux indicateurs de risque en particulier le levier. Des tests complémentaires révèlent une sensibilité de la rémunération des dirigeants de banques au ROE. Nos résultats questionnent le rôle de la focalisation sur le ROE comme inducteur de la prise de risque dans les banques.

Return on equity (ROE) is a central measure of performance in the banking industry. The reliance on ROE emerged with the risk management approach that inspired bank capital regulation. In this paper, focusing on the 2007-2008 crisis, we empirically assess the validity of ROE as a performance measure in the banking industry. We document that pre-crisis ROE is a strong predictor of both bank standalone and systemic risk during the crisis. These results are unchanged for the 1998 crisis. Banks appear to be special as the same association between pre-crisis performance measures and the materialization of risk in crisis periods is not observed for firms outside the banking industry. Complementary tests confirm the existence of monetary incentives associated to ROE. Overall, our findings challenge the use of ROE as a main performance measure in banks and its incorporation in bank executives’ compensation contracts.