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Why do banks target ROE?

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  • Pennacchi, George G.
  • Santos, João A.C.

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.

Suggested Citation

  • Pennacchi, George G. & Santos, João A.C., 2021. "Why do banks target ROE?," Journal of Financial Stability, Elsevier, vol. 54(C).
    • Handle: RePEc:eee:finsta:v:54:y:2021:i:c:s1572308921000152
    DOI: 10.1016/j.jfs.2021.100856
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    More about this item

    Keywords

    Bank performance; ROE; Bank regulation;
    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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