ROE in Banks: Performance or Risk Measure? Evidence from Financial Crises

Return on equity (ROE) is a central measure of performance in the banking industry. The reliance on ROE emerged with the risk management approach that inspired bank capital regulation. In this paper, focusing on the 2007-2008 crisis, we empirically assess the validity of ROE as a performance measure in the banking industry. We document that pre-crisis ROE is a strong predictor of both bank standalone and systemic risk during the crisis. These results are unchanged for the 1998 crisis. Banks appear to be special as the same association between pre-crisis performance measures and the materialization of risk in crisis periods is not observed for firms outside the banking industry. Complementary tests confirm the existence of monetary incentives associated to ROE. Overall, our findings challenge the use of ROE as a main performance measure in banks and its incorporation in bank executives’ compensation contracts.