15%
Martin Wolf in the FT has a very lucid analysis of banks’ Return on Equity (RoE) targets. For most banks, this target is around 15%. The analysis is sanguine, its thrust being that such a return is impossible in an economy growing at 2% per year. Instead:
when banks tell us that 15 per cent (or something in that neighbourhood) is their target returns on equity, they are saying that their businesses are very risky and/or protected against competition and/or well subsidised and probably a bit of all three.
Wolf then goes on explaining that this analysis formed the basis for the UK’s Independent Commission on Banking recommendation to ringfence retail and investment banking.
In my view, it is not undesirable per se for banks to aim for for a 15% RoE, but the political and social climate is such at the moment that there is no possibility to achieve it. With higher capital charges a given, the only way to get such a return would be through leverage and that may will be restricted by direct limits on leverage ratios.
Even if it weren’t, the public (and by extension politicians) will no longer be wiling to bail out such risky entities, especially if ringfencing is enshrined in law. This means that outright default becomes a real possibility for banks, and their shareholders may well force the management to curb their risk profile as a result.
In this environment, banks should probably start by signalling that the lofty 15% target will not be met for some time—something their shareholders already know anyway—and ensure they make the most of the capital they have, for example by investing in risk management systems that provide a holistic view across asset classes, enabling bankers to truly direct capital to the highest-returning projects, by extension lowering their risk profile and theoretically obviating the need for higher returns.
Ironically however, in a striking case of mixed messages, the Bank of England’s Financial Policy Committee indicated that rather than encouraging banks to increase their capital buffers, they should be running them down at the moment in order to lend more to the economy at large. As long as such discordant voices exist among the regulators, it will be difficult for banks and their shareholders to come to terms with the new reality of lower RoE.
