Why do banks target ROE?

George G. Pennacchi, João A.C. Santos

Research output: Contribution to journalArticlepeer-review

Abstract

Until the 1970s, both banks and nonfinancial corporations relied on performance targets linked to their earnings per share (EPS). Over the next few decades, banks rapidly changed to emphasize return on equity (ROE) as a performance target. Investors seem aware of this change because ROE growth (EPS growth) better explains banks’ (nonfinancials’) stock market values. Also, manager compensation linked to ROE is more common for banks than for nonfinancials. This paper presents a model of a bank subject to fixed-rate deposit insurance and facing increasing competition that erodes its charter value. When the bank chooses its capital to maximize its shareholder value, its performance based on ROE appears better than its performance based on EPS. Thus, the increase in competition that started in the 1970s, along with fixed-rate deposit insurance, may explain banks’ growing preference for ROE over EPS as a performance target.

Original languageEnglish (US)
Article number100856
JournalJournal of Financial Stability
Volume54
DOIs
StatePublished - Jun 2021
Externally publishedYes

Keywords

  • Bank performance
  • Bank regulation
  • ROE

ASJC Scopus subject areas

  • Finance
  • Economics, Econometrics and Finance(all)

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