SILLY BANKING TRADITIONS AND ROE

Again, nothing happened. Banking legend has it that every October 30th, bankers that strip down to their skivvies, go to the nearest pumpkin patch and recite the name of "Alexander Hamilton," will have the secret revealed whether ROE or ROA is a better bank management measure. Last night, we followed the instructions and other than being mistaken for the Great Pumpkin by some passersby, nothing happened. As such, we will attempt to settle the debate. ROA measures how efficiently a bank utilizes assets. By using this measure, banks hope to make decisions on subcomponents such as NIM, non-interest operations and efficiency. Another way to say this is that ROA focuses on firm value. ROE on the other hand (we prefer to risk and capital adjust the measure, but a topic for another time), focuses on shareholder value. ROE is not only an operational measure, but also takes into account the structure and cost of capital. ROE reigns supreme as a management measure, due to the simple fact that it takes into account leverage. The reason why we endure such regulatory torture is that the government allows: A) banks to have insured deposits (resulting in below market funding), and B) the leveraging of capital. When you get down to it, this is why most of us got into banking in the first place. While we normally distrust leverage, in cases where a bank can fund themselves below wholesale levels, then leverage is not only good, it is tragic if not utilized efficiently. Being able to leverage capital is what structurally separates bankers from other industries like textiles or software design. This debate is far from just being academic. Bank managers are forced to make decisions every day that require a tradeoff between increasing ROA or increasing ROE. Many banks utilize FHLB Advances to finance lower margin assets, thereby hurting ROA while potentially increasing ROE. The more a bank is focused on shareholder return, the more important ROE becomes. If ROE is important, then banks either need to look at risk-adjusted ROE or specify the level of risk that should be targeted in order to achieve a given ROE. Stating that management should achieve an 18% ROE, gives free range to leverage assets, thereby potentially maximizing the risk of the institution. If this is the desired effect, that is perfect. However, given that many bankers are projecting an economic downturn, boards may not want to be increasing leverage at this time. For banks that are closely held, shareholder return may not be the #1 priority and ROA may be the better measure. ROA is a better gauge on the productivity of assets. Here, the management of capital and leverage becomes less important. Not to confuse things, but oftentimes we see boards talk about ROE, but really only care about higher earnings. Since management must make choices every day that may affect ROA, ROE and net income to differing degrees, boards should clarify the relative importance. While there is nothing scarier than a banker in their underwear at 9pm staring off into the distance, until boards give clear mandates on the amount of leverage and the relative importance of shareholder value, the debate over ROA and ROE will rage on. For us, the choice is clear - ROE is the superior measure. However, since we are a sucker for banking traditions, look for us in the pumpkin patch again next year. Have a Happy Halloween.