Vol. 21, No.

15 (14 April 2012 2012)

ROE: An Appropriate Measure of Bank Performance?*

Geun Woo Seoh

Summary Summary
There has been growing interest in reviewing ROE and other measures of bank performance since the 2008 financial crisis and the introduction of Basel III for not only having had an enormous impact on bank actions, but also for being the main yardstick used in bank decision-making, such as those for dividend payout and executive compensation. The use of ROE as a measure of bank performance is being criticized for representing only short-term profitability without any consideration for long-term income stability; but also for jeopardizing bank stability through excessive debt funding and acceleration of balance-sheet growth. It is a tall order to devise a measure of bank performance that is not captive to any one bank's peculiar circumstances, that captures the sources of a bank's risk while being general enough to be calculated as financial accounting data, and keeps bank management from excessive borrowing. As a result, a supplementary indicator should be used as a new measure of bank performance that has an appropriately adjusted income as the numerator over the equity capital denominator. It appears that MROE (Modified Return on Capital) can be used for this purpose. MROE is the equity divided by income while excluding the unrealized income from securities investments and allowing the provision that reflects the loan-loss experiences during the recent financial crises.

* Opinions expressed are those of the author and do not necessarily reflect the official positions of the Korea Institute of Finance.

Since the 2008 financial crisis, the major economies have been trying to change the rules of the game as they relate to the financial sector by reforming its regulatory framework. The key change has been in the capital requirements centered around the introduction of Basel III, but ROE is being reviewed for its appropriateness to serve as one of the measures of financial company performance. Capital adequacy and liquidity ratios are two key indicators needed in the financial regulatory framework for assessment, but ROE and other bank performance measures have become principal areas of review for having an immense impact on bank actions and for being the yardstick in important bank decisions, such as those of dividends and executive compensation.

ROE: Problem Areas

In gauging bank performance, ROE was considered the most important and ROE has the problem of stressing banks' short- term profits over long-term income stability, and causing excessive borrowings to maximize returns to shareholders. was most widely used two reasons, technical and industry. Technically, no other measure than ROE allowed for more objective earnings comparisons between two competing banks, for easier index calculations, and for easier earnings tabulation. From the vantage point of banks, ROE clearly stands out from other indicators as a measure of profitability that is based on equity capital, the most important indicator of bank stability in modern day banking. But ROE is criticized for prodding management towards short-term profits over long-term income stability when used as a measure to evaluate bank performance. Another point is that bank management that is oriented towards short-term earnings work only towards maximizing returns to limited liability shareholders through excessive borrowings and accelerating balance-sheet growth, which raises the specter of transferring losses to the real economy in whole in the event of bank insolvency. These technical reasons call attention to

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the possibility of management that is oriented towards maximizing short-term profits undermining long-term bank profitability because ROE ignores inherent risks in favor of either closing period or quarterly targets even though banking is grounded on long-term client relationships. A second problem that has been brought to attention is that a bank, in the event it suffers large losses from running risks above and beyond its ability to absorb losses through its equity alone, ultimately straps the burdens of debt onto the taxpayer through bailouts. If the said problems of using ROE to measure of bank profitability and management performance give credence to the limits of how ROE is treated in financial accounting, then there is also the aspect of ROE having been responsible for making today's banks TBTF institutions through deposit insurance system. In fact, ROE, as a measure of bank performance, is used more by equity analysts and other outside market participants rather than internally by banks. In other words, ROE is mainly used by bank analysts and other specialists who are dedicated to analyzing bank performance because it is readily facilitated for end of period financial accounting reporting and is convenient in comparing the earnings of competing banks. The problem is that the specialists using ROE as a measure of bank performance have an inordinate impact on bank management. Bank management cannot but consider ROE as an important indicator inasmuch as outside evaluators do since the stocks of the major banks are all listed. Management cannot but take an interest in improving ROE when they must meet investors every quarter to explain their earnings. Bank management cannot but regard as important a performance measure like ROE that financial analysts and others base their decisions on.

ROE is mainly used by banks' external evaluators

Banks use ROE, a ratio that divides financial book value income by the bank's

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equity capital, but banks in fact rely more internally on building assets and measures that track risk exposures that effect income stability, future growth industries, among other management accounting indicators. These, moreover, differ from bank to bank. In other words, banks had little choice but to improve their ROE in deference to the immense importance attached to it externally despite conducting operations wholly otherwise with indices that truly reflect performance and evaluation. The growing acceptance of ROE as an important measure of performance can cause management to pursue strategies that will elevate ROE. Inasmuch as it is possible, debentures may be issued or funds raised in the form of borrowings in order to elevate ROE rather than raising funds through secondary offerings like taking an equity stake in a subsidiary. When managing loans, balance-sheet performance can be abetted by directing focus into areas where it makes the least dent in the banks' equity in terms of BIS capital requirements. Increased demand from customer expectations of higher housing prices no doubt played a part in the jump in residential real estate loans, but so did the bank regulatory framework that allowed ROE to be elevated by making it possible to make more loans with the same level of equity.

Performance-Linked Indicators that Fan Short-Term Borrowings

Bank borrowings have become ingrained, and the prevalence of ROE as a standard performance measure has strengthened the tendency of following a policy of borrowings. Today's banking system aims for economic growth by mobilizing financial capital while addressing financial uncertainty from the possibility of bank failures through the deposit insurance system. Bank borrowings have thus come to be considered an almost natural extension of normal operations, and this predictable trend was further reinforced by the efforts of bank management to elevate ROE. Such tendencies can be said to have exploded

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the 2008 financial crisis as the rush to liquidate subprime mortgage loans exposed the underlying risks. Despite the many drawbacks of ROE as those mentioned above no clear alternative to it has been presented. Efforts to improve the problems of ROE since the 2008 financial crisis have proceeded along the lines of adjusting, financial accounting-wise, profitability of indices by taking account more aggressively the causes of bank risk. For example, RAROC (Risk-Adjusted Return on Capital), among others, have been forwarded as having potential for evaluation measures that can be improved upon even though they have long been known and used sparingly for the difficulty of objectively comparing two like and competing banks.

Technical Difficulties in Devising a Measure that Captures Risk

The problem is that performance measures that take bank management risk into account do not have the properties that a measure of bank performance like ROE does, like the possibility of making objective comparisons, and fast and simple calculations. To assess the risk profile of a bank's asset portfolio, RAROC cannot avoid being a quantitative model to measure bank-specific risk. Quantitative models must also make assumptions to reflect the distinctiveness of each bank's risk structure, but this has the problem of sharply reducing the possibility to compare banks since such assumptions would vary according to the sales climate and asset composition of each bank. It is technically arduous to be minute in measuring the portfolio risk of a bank's assets since, for example, the automatic linkage of PD (Probability of Default) to asset correlation had forced the possibility of capturing real asset correlation to be abandoned under Basel II. The fact that external bank It is hard to devise a universal and facile bank performance measure that also captures banks' risk profiles.

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specialists must also use internal bank data to measure each of the respective banks' risk portfolio poses another limitation, rendering the use of similar measures like RAROC difficult. If so, is there not a bank performance measure that is not only unbiased towards any respective bank's peculiar circumstances, that reflects sources of bank risk while making it possible for it to be calculated with commonly used financial accounting items, and keeps bank management from unduly following a strategy based on borrowings? Unfortunately, no such measure of bank performance that possesses all such properties is known. Until such time a new performance measure presents itself, the continued use of ROE appears unavoidable with a few iterations from other performance measures of merit.

Putting MROE to Use

The performance measure that could best stand in until that time the basic problems are addressed may well be ROA. Return on Assets is arrived at when ROE is divided by the borrowings ratio, where ROE is income over equity and the borrowings ratio is assets over equity. Because it is resistant even to increases in the borrowings ratio, ROA can take away management incentives to elevate ROE through excessive borrowings. The problem, however, is not only that both ROA and ROE have long been in use, but the risks that today's modern banks have inevitably come to carry from their relationships with clients leave in the performance measures no trace of the significance that equity capital has on absorbing those risks. Using ROA as the main performance measure would pose no problems if banks were like asset managers that earn performance fees from managing client assets in good faith rather than fixed yields. But what is needed is a performance measure that

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has a bank's invested equity as the base since banks are financial institutions obliged to maintain a high level of liquidity along with their accountability to make guaranteed returns on customer deposits. Of course, the problem of whether or not the banking industry as a whole holds enough equity to offset bank risks is another matter altogether. But even if the banking industry needed to increase its capital base further, basing a bank's performance measure on its equity would be the appropriate thing to do. When looking at it this way, a supplementary indicator that has an appropriately adjusted income in the numerator should come to be used in conjunction with ROE while keeping equity in the denominator for now. For example, a new performance measure may be devisable from the net income that has already conservatively provided for losses and has excluded the unrealized income from securities and other investment assets. One newly devised performance measure that divides a conservative and accurately derived net income by equity is the Modified-ROE. Making such adjustments to the performance measure can be criticized for taking liberty with the principles of marking to market financial accounting and in applying severe conservative standards on loan loss provisions, but the resultant pain inflicted on the economy from bank failures would be reduced. The new performance measure has the added advantage of easing uncertainties that would likely engulf the financial markets had the unrealized increase in the book value of equity capital from securities investments served to expand loans and other bank assets. Assuming that the profits from bank investments in securities for expanding the size of assets remain unrealized, another clear advantage from the new performance measure would be the considerable pressure that would be taken off of a credit contraction had the de-leveraging that would have ensued to reflect a sudden diminution in equity commences. It is possible that a supplementary indicator will come to used that keeps equity in the denominator, but uses numerator income excluding paper profits.

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Focus & Brief

April 23-27

Policy Issue in Brief: Korean Hedge Funds Still Have a Long Way to Go News Briefs: - Q1 Won/Dollar Fluctuation Lowest in Four Years - EU Investments in Korean Securities Fell Sharply in 2011 - Regulation for Loan-to-Deposit Ratio of Credit Unions Introduced Market Indicators: April 23-27

Policy Issue in Brief: Korean Hedge Funds Still Have a Long Way to Go
JiEun Lee, Senior Research Fellow Summary: The Korean-style hedge funds were introduced in September 2011 following a revision of the Enforcement Decree of the Financial Investment Services and Capital Market Act (FSCMA). But since then, heavy regulation put forth by the government is impeding growth of the domestic hedge fund industry. To foster the Korean hedge fund industry, the government must relax some of its regulations as well as develop supervisory measure that minimizes risks. In an effort to diversify investment portfolios for investors and to foster the asset management industry, the Korean government has introduced Korean hedge funds in September 2011. Partial deregulation of existing private equity funds have occurred in the past; but because this brought such obligations (responsibilities) as corporate restructuring and/or investing that funds such as hedge funds were not possible.

 Although the global hedge fund market size significantly decreased during the 2008 financial crisis, but has since recovered pre-crisis levels in 2010 showing continuous upward growth. (See Graph 1.) The revised Enforcement Decree of the FSCMA in September 2011 extended the range of qualified investors, eased restrictions on management, strengthened reporting duties and established the Korean hedge funds. Korean-style hedge funds officially debuted in December 2011 and as of March 2012, 17 hedge funds have been set up by 12 local asset managers totaling only KRW500bn (USD441m). Heavy and strict regulations are impeding the growth and development of the Korean hedge funds. Asset managers that want to set up hedge funds must have at least KRW10tn of AUM (The Code of Financial Investment Services, Annex 2), while brokerages must have more than KRW1tn of their own capital, (FSC Bylaws) and investment advisors must have at least KRW500bn of discretionary assets and limits only big financial institutions to establish hedge funds in Korea. Because the regulations block small-sized firms and fund managers from participating in the newly established market, expectation of fostering new talents is low. The new law expanded the range of qualified investors, extending to allow individual investors to directly invest in hedge funds with the minimum investment requirement set at KRW500m, while hedge fund borrowing limits and the value at risk from derivative trading are set at four times the funds assets. Although most countries set qualification requirements for net worth, annual income, and minimum amount of investment, there is no restriction on types of leverage ratio, types of investment, or management of hedge funds.

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 The reason behind high entry barriers is in the interest of the investors and to keep the system safe; however, looking back at how much more damage the hedge fund failure added the volatility of the system in the US during the 2008 financial crisis, a policy direction for small and medium-sized hedge funds should be considered. Because failure of hedge funds were believed to be the main cause of the 2008 global financial crisis, the Korean financial regulators set hedge funds to be managed mainly by large companies with the required minimum assets. * Hedge funds concentrated its investment mostly on mortgage-backed
CDOs; however after the collapse of the housing market, the CDOs were worthless, which sparked the financial crisis. (See Graph 2.)

However, when you consider the huge impact the failure of hedge funds of major investment banks had on the worsening the systemic risk during the global financial crisis, creation of small and medium-sized hedge funds should be considered for the asset management industry. Deregulation of establishment, management, and investment is necessary to further foster the Korean-style hedge funds. To further the innovation in the asset management industry, financial regulators must foster competition for transaction costs, management capability, and development of new products in the market through relaxing its regulations on entry barrier. By relaxing the size-oriented requirements and strengthening the screening of fund managers qualifications, experiences and performances, the hedge fund can play an important role as a catalyst in sparking competition; while guaranteeing the autonomy of the hedge fund management. For individual investors to invest in hedge funds, regulations not only on minimum investment size, but also on net worth and income should be applied. Regulations and supervisory measures which risks should also be formulated. Financial regulators must make it mandatory for hedge funds to minimize systemic

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report the size of borrowing, while strengthening supervisory capabilities, keeping a hedge fund trading DB, and crisis management system. It is also important to make sure that counterparty risk is managed properly when financial institutions are either investing in hedge funds or granting credit.

<Graph 1> Size and Earnings of the Global Hedge Fund Market
(inUSDBillion) 2,500 Size Earnings (%) 20 15 2,000 10 5 1,500 0 5 1,000 10 15 500 20 25 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 30

Source: Hedge Fund Research

<Graph 2> Hedge Funds and the Conversion of Household Debt into Securities

Source: The Turner Review (FSA, 2009)

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 Policy & Industry News Briefs: April 23-27

Q1 Won/Dollar Fluctuation Lowest in Four Years According to the BOK, the intra-day fluctuation of the won-to-dollar exchange rate in Q1 2012 dropped the lowest level since Q4 2007 to 5.0 won and the daily fluctuation recorded 3.9 won. The relaxing of both the geopolitical risk on the Korean peninsula and Europes debt crisis contributed to the reduction of the exchange rate. During Q1, the average foreign exchange transactions between Korean banks per day was USD22.45bn, a 7.8%p rise from the previous quarter (USD20.8bn). However, net buying of NDFs by nonresident investors fell significantly to USD8.6bn compared to the previous quarters USD7.38bn purchase.

EU Investments in Korean Securities Fell Sharply in 2011 According to the BOK, foreign investment in Korean securities by the EU at the end of 2011 was at USD132.4bn, a significant drop of USD13.6bn compared to the previous year. The European debt crisis in October 2011 sparked a massive capital flight of EU financial firms selling of Korean securities. On the flip side, foreign investments by Japan, South East Asia and China rose by USD5.7bn, USD4.5bn, and USD3.3bn respectively compared to investments in 2010. Koreas net overseas investment recorded USD435.6bn in 2011, an increase of 8.2%p compared to 2010 while Koreas net foreign investment recorded USD839.2bn. Regulation for Loan-to-Deposit Ratio of Credit Unions Introduced The FSC has proposed an amendment to Koreas Credit Unions Act in order to lead stable management of household debt and to protect financial consumers. The amendment includes providing legalizing the loan-to debt regulation and providing deposit insurance scheme for insurance policies by the credit union as well. The FSC will suggest the loan-to-deposit ratio within 80% and enforcement will start in Q2.

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 Market Indicators: April 23-27

2011 Avg. Call Rate (1d) CD Rate (100 mil. won) Industrial Finance Bond Corporate Bonds (3yr, unsecuredAA-) Korean Treasurys (3yr) Nat'l. Housing Bonds (5yr) KOSPI (1 Jan 1980 = 100) Trading Value Investment Balance Foreigner Net Purchases Won/Dollar Won/Yen Won/Euro 3.10 3.44 3.66 4.41 3.62 4.10 1,983.41 68,308 174,122 -371 1,107.96 1,391.92 1,541.48 Mar. Avg. 3.25 3.54 3.72 3.88 3.55 4.35 2,023.41 53,632 189,140 242 1,126.49 1,364.47 1,488.75 April 23 3.25 3.54 3.52 4.20 3.47 3.82 1,972.63 35,744 182,829 -1,219 1,139.50 1,405.23 1,498.90 April 24 3.26 3.54 3.52 4.20 3.47 3.82 1,963.42 50,367 179,267 93 1,140.80 1,400.79 1,505.86 April 25 3.26 3.54 3.53 4.21 3.49 3.83 1,961.98 50,867 178,201 -22 1,141.30 1,402.78 1,509.03 April 26 3.26 3.54 3.53 4.20 3.49 3.83 1,964.04 53,427 177,110 1,743 1,136.20 1,400.81 1,500.01 April 27 3.54 3.51 4.16 3.46 3.79 1,975.35 52,869 3,069 1,135.20 1,399.58 1,498.69

Interest Rates (%)

KOSPI & Trade Value (KRW 100 mil.)

FX Rates

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