Views on improving the integrity of global capital markets
08 February 2012

Bank Earnings: Investors Should Pay Attention to Risk-Adjusted Performance

Posted In: Uncategorized

As we delve further into earnings season, investors no doubt will closely monitor trends in earnings and realized return on equity (ROE) among reporting banks. This is especially true given the backdrop of a challenging economic environment coupled with ongoing risks related to European sovereign debt.

That said, there is a commonly held view that investors tend to largely focus on ROE without paying sufficient attention to the risk-adjusted ROE of banks. Bank of England Financial Policy Committee member Robert Jenkins raised this very point at the November 2011 CFA Institute European Investment Conference, stressing the widespread and misguided fixation by investors on banks’ reported ROE numbers.

The potential illusory nature of returns in the financial services sector also was highlighted by fellow conference speaker Roger Bootle, chief economist at Capital Economics. He described the erratic spread of returns among financial services firms over time, where there is a tendency towards ‘picking small dimes for elongated time periods, before being steam-rollered’. An inference to make from Bootle’s description of erratic returns is that recurrent single-period returns of financial institutions are likely misleading because they’re often achieved at the cost of a high — and often overlooked — likelihood of significant future losses.

Drivers of ROE

An analysis of the drivers of ROE also shows why a naïve, at-face-value interpretation of ROE numbers could end up distorting investors’ understanding of economic value added (EVA) of banking firms. A DuPont Model-equivalent decomposition of banking sector ROE, sourced from Future of Finance, illustrates this concept:

ROE= (Total Assets/Tier 1 Capital) * (Tier 1 Capital/Common Equity) * (Net Income/Risk-Weighted Assets) * (Risk-Weighted Assets/Total Assets)

The above decomposition shows that ROE is influenced by financial leverage, common equity margin, return on risk-weighted assets, and unit risk. As a result, banks can simply drive up reported ROE through higher levels of leverage (i.e., total assets/Tier 1 capital) or by holding relatively higher levels of Tier 1 capital (i.e., Tier 1 capital/common equity).

The excessive and exponential increase of banking sector leverage over the last few decades has been well chronicled. The crisis did put the brakes on and help reverse the trend of leverage increases, with a number of key financial institutions shrinking their balance sheets during the last four years. Nevertheless, investors should monitor the interplay between leverage and ROE and, as appropriate, disentangle the extent to which increased leverage may actually drive any reported ROE improvements. Whilst monitoring leverage, investors should not forget to factor in off-balance-sheet items as these will likely increase the effective leverage.

It is also important to critically evaluate the reported risk-weighted assets because related inaccuracies can lead investors to make flawed judgments regarding the return on risk-weighted assets (RoRWA) (i.e., net income/risk-weighted assets). RoRWA is one variant of a risk-adjusted performance measure. However, it is challenging for investors to evaluate how faithfully representational the reported risk-weighted assets really are. Consistently interpreting reported risk-weighted assets is difficult due to doubts about the reliability and comparability of risk-weighted assets across different financial institutions. This is because financial institutions tend not to be very transparent on how these are determined, as reported in the July 2011 issue of Risk Magazine.

Challenges of Evaluating Risk Information and Economic Capital

The risk-adjusted economic capital can be an important part of evaluating risk-adjusted performance. Minimum bank capital requirements are primarily dictated by regulatory rules, and although there has been a concerted effort by regulators (e.g., Basel rules) to create equivalence between regulatory and economic capital, we’re still likely to see a divergence between these two definitions of capital. This could arise when the risk weights applied by regulatory rules do not reflect actual economic risk. For example, whenever distressed sovereign exposures have a zero percent risk weight assigned or off-balance-sheet exposures have unduly low risk weights. It could also be that the formula used to convert risk-weighted assets into capital requirements does not necessarily reflect the required cushion for unexpected losses in the future. Although the pursuit of convergence between regulatory and economic capital remains a continued focus of Basel rules, there is increasingly growing evidence that banks have been significantly undercapitalized for a long time.

Finally, it is worth noting that it is generally daunting for investors to assess the adequacy of capital levels. Banking capital ideally should reflect the economic capital required beyond minimum regulatory requirements. Investor difficulties in evaluating adequacy of capital, in part, arise due to the often fragmentary risk information provided through the annual reports.

As conveyed through the CFA Institute study on risk disclosures, investors have their work cut out for them when attempting to evaluate the information related to the different financial risk categories such as credit, liquidity, and market risk. For banks, the risk disclosures made in the annual reports are dictated by both accounting standard requirements (e.g., IFRS 7) and regulatory requirements (e.g., Basel Pillar 3). However, banks tend to communicate these as disparate sets of information, and there are challenges for investors to assess the link between specific risk-exposure information and the translation to capital requirements. In the case of financial assets held, banks could report maximum credit exposure as required by IFRS 7 and then, as required by Pillar 3, separately report the related credit exposure at default and economic capital for credit risk.

Banking analysts should ask probing questions to better establish the link between risk information and economic capital in annual reports. Greater scrutiny of risk can in turn contribute to a better assessment of the inputs used to measure risk-adjusted performance.


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About the Author(s)
Vincent Papa, PhD, CPA, FSA, CFA

Vincent Papa, PhD, CPA, FSA Credential, CFA, was the director of financial reporting policy at CFA Institute. He was responsible for representing the interests of CFA Institute on financial reporting and on wider corporate reporting developments to major accounting standard setting bodies, enhanced reporting initiatives, and key stakeholders. He is a member of ESMA’s consultative working group for the Corporate Reporting Standing Committee, EFRAG user panel, and a former member of the IFRS Advisory Council, Capital Markets Advisory Committee, and Financial Stability Board Enhanced Disclosure Task Force. Prior to joining CFA Institute, he served in investment analysis, management consulting, and auditing roles.

2 thoughts on “Bank Earnings: Investors Should Pay Attention to Risk-Adjusted Performance”

  1. Eisuke Shimizu says:

    I am a member of CFA Japan society, and volunteering to translate this article. Could you please let me know what is “Future of Finance” cited in this article? Is it a magazine or a book?

  2. Many thanks for your feedback. In response to your query, The Future of Finance is a text book consisting of a number of excellent write-ups by distinguished economists and financial commentators. A synopsis of the book can be found here.

    The reference I made on the ROE determination was from Chapter 2 of the book: “What is the contribution of the financial sector: Miracle or mirage?,” by authors Andrew Haldane, Simon Brennan, and Vasileios Madouros.

    Best regards,
    Vincent Papa, PhD, CFA
    Director of Financial Reporting Policy
    CFA Institute

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