Many bankers believe return on equity equates with shareholder value. Consequently, ROE is the primary performance measure to which bank senior management incentive compensation is tied. Competition among banks sometimes leads to a ROE race in which high targets of 20% or more are set. Achieving such a target in the current low-rate environment is likely to be difficult without incurring significant business and financial risk and raising the concern of regulators.
ROE is an incomplete performance measure because it ignores risk. Thus, it encourages banks to increase risk exposures leaving them unable to withstand market downturns. You cannot create value by simply assuming more risk. It may appear to work during benign markets, but losses occur during the inevitable market correction. Using ROE as a performance measure without a risk adjustment is like trying to fly a plane without an altimeter. Sooner or later you will hit something.
The financial crisis demonstrates the need to reincorporate risk considerations into performance measurements. This can be accomplished by focusing not on ROE, but on the spread between ROE and an institution's cost of equity. Cost of equity is the return investors require to compensate them for the risk of their investment relative to the market. Banks with ROE greater than cost of equity are creating shareholder value and trade at a multiple of book value. In fact, the spread between ROE and cost of equity times the bank's book value can be seen as its economic profit.
ROE is observable. Cost of equity, however, must be calculated. This can be accomplished using the Capital Asset Pricing Model, which states cost of equity is the risk premium over the risk-free government bond. The 10-year Treasury rate, currently around 2.5%, is typically used for this purpose. The risk premium reflects the relative risk of a bank's share price to the market a stock's beta times the market price of risk known as the equity risk premium. Beta estimates are available from a variety of sources. The historical equity risk premium from 1926 to 2012 is currently estimated at 5.9%.
Using this approach, it is possible to calculate the cost of equity for your bank. Take, for example, Wells Fargo. Its current stock beta is 1.3. This means it is considerably more volatile than the general market. It makes sense for banks to have a higher beta given the current tumultuous state of the industry.
Multiplying Wells' beta of 1.3 by its 5.9% equity risk premium and adding it to the 10-year Treasury rate of 2.5% yields a cost of equity of 10.2%. This is consistent with the 9% to 11% cost of equity range used by many banking analysts. Well's ROE of 14% is 1.37 times its cost of equity, which is consistent with its current premium price-to-book ratio. Banks, conversely, unable to earn their cost of equity trade at discounts to their book value.
This cost of equity calculation is applicable to small and privately held institutions as well. Public banks with as little as $1 billion to $2 billion in assets are covered by analysts that can provide the needed inputs. Private institutions can construct proxy estimates based on public peers. Some may complain this is too complicated, but the process is no more complex, and certainly no less precise, than calculating risk-weighted assets.
Cost of equity is probably the most important number for your bank. You cannot make meaningful performance conclusions without it. Analysts and investors are computing cost-of-equity estimates when looking at your bank. You need to understand what they are focusing upon to respond appropriately.
Perhaps, most importantly, focusing on the ROE-cost of equity spread can prevent value-destroying tactics. Many banks are trying to regain their higher pre-crisis ROE levels by increasing their risk appetite. This is unlikely to succeed as ROE increases will be offset by a rising cost of equity, leaving the spread at best unchanged. Furthermore, higher regulatory capital requirements have reduced bank cost of equity. Thus, banks can trade at premiums-to-book value, like Wells Fargo, at more modest ROE levels.
The answer to the question of how much ROE is enough depends on a bank's cost of equity, which reflects its risk level. Currently, this means a ROE above 11% for most banks. The answer should be updated as the cost of equity inputs change.
Hopefully, by reintroducing risk into performance evaluation and compensation, we can protect against value-destructive, unwarranted risk appetite increases. Of course, no single performance is perfect. This approach, however, gets managers' thinking about risk in the right way. Mind the spread.
J.V. Rizzi is a banking industry consultant and investor. He is also an instructor at DePaul University Chicago.