The ESCP Europe Professor of Finance and LabEx-ReFi Academic Co-Director, Executive Committee member and Research Axis Supervisor, challenged the use of Return on Equity (ROE) as a main performance measure in banks and its incorporation in bank executives’ compensation contracts.
Christophe Moussu co-edited with Pierre-Charles Pradier (Université Paris I Panthéon-Sorbonne) a special issue of Réalités Industrielles providing an assessment of financial regulation 10 years after the financial crisis. This issue was followed by a conference of Annales des Mines and LabEx ReFi, which took place at the French Ministry of Economy and Finance. During this conference, Christophe Moussu made a presentation (video above with English subtitles) to discuss the role and danger of using RoE as a main performance indicator in the banking industry, which he had addressed in an article.
His arguments are based on the results of a paper published in Finance with Arthur Petit-Romec (ESCP Europe MiM and PhD graduate). In this paper, they document that pre-crisis ROE is a strong predictor of bank standalone risk and systemic risk for both the 2007-2008 and 1998 banking crises. In complementary tests, they reveal the existence of monetary incentives associated to RoE for the top management of banks. This points to a major flaw in the incentives system in banks, as performance is assessed using a metric which is inflated with higher risks. They also document that banks appear to be special, since the association between pre-crisis performance measures and the materialization of risk in crisis periods is not observed for firms outside the banking industry.
This empirical evidence strongly suggests that RoE, which remains the key metric of banking performance and used as a target in bank CEO incentive compensation, is a key ingredient of excessive risk-taking in banks. This behaviour is detrimental to shareholders during banking crises and is never associated with superior value creation for bank shareholders in normal times, as they revealed empirically in a follow-up paper on the topic (in French).
In his address, Christophe Moussu insists on the role of wrong beliefs in the banking industry. One of them is RoE. Another one is the belief that higher bank capital is detrimental to banks. However, as a substantial body of academic research has shown (see Réalités Industrielles for references), banks with higher capital levels are more resilient to shocks, are more efficiently managed, gain more market share and command the highest valuations on the stock market. Again, the fight of banks against higher capital requirements runs against the scientific evidence.
These wrong beliefs have obviously survived the financial crisis and still distort the asset allocation and the financial policy of banks, towards a model which does not benefit bank shareholders and runs at the same time against financial stability. “A decade after the financial crisis, the aim is no longer to express outrage at the extreme behaviour of some banks that ‘privatised profits and socialised losses', to borrow the popular expression, Christophe Moussu wrote. Banks play an important role in the economy and remain key financial actors. Despite considerable academic research to understand the causes of the financial crisis, beliefs have obviously not changed significantly.”
To his great regret, banks continue to consider more stringent capital requirements as value destructive and to use RoE as their main performance metric. “The work done by academics should be regarded as an opportunity, not a threat. Banks with higher capital levels are more resilient to shocks and command higher valuations in both crisis and non-crisis periods. Higher RoE means higher losses for shareholders during banking crises and no superior performance during non-crisis periods. Therefore, there is no antagonism between shareholder value creation and financial stability.”
Nor between the private interests of bank shareholders and the general interest of society at large. Hence, according to him it is important to continue to deconstruct erroneous beliefs and distorted incentives in the banking sector. In particular, capital requirements should not be relaxed and pay incentives based on RoE should be abandoned. Lastly, regulators must better anticipate the effects that regulations have on beliefs. “For in the end, beliefs give rise to a more or less resilient banking business model…”