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Rethinking how banks create value

Return on equity (ROE) is often used by banks as a measure of profitability and performance, and to determine managerial compensation on the basis of comparing realised ROE to a target figure or the level of return on equity of competing banks. This approach is unfortunate, because it encourages bankers to choose a strategy of high leverage and risky investments to drive performance, which is not always the best way to generate shareholder value.

The focus on ROE also fuels strong resistance by banks to new regulations requiring them to have more equity on their balance sheets. Increased equity requirements may not be good for ROE, but they do not prevent value creation by banks and, by protecting against future banking crises, they are good for the economy.