ECB vs RoE: towards a new banking profit benchmark?

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The European Central Bank called Wednesday for a key benchmark of EU banking sector profitability to be scrapped as the main measure of performance.

"Recent events have shown that the most common measure for a bank's performance, i.e. RoE (return on equity), is only part of the story," the ECB said as it published a broad review of the European Union (EU) banking sector.

RoE measures a bank's profitability by determining how much profit it generates with the money shareholders have invested.

"This approach has clearly not proven adequate in an environment of much higher volatility - such as during the global financial crisis," the central bank said in an appendix to its report.

In the future, "the consistency of risk appetite with the business structure and strategy of a bank appears to be one of the most important elements in the assessment of a bank's capacity to perform," the report argued.

"It's correct to say that we would need a measure of risk," Barclays Capital economist Thorsten Polleit told AFP.

But he added that "at the end of the day, the investor who puts up his equity capital wants to be remunerated, so it's fair to say that in general, return on equity is the key measure investors are interested in."

The ECB's proposal to establish a new benchmark was part of a thorough review of the banking sector in the wake of a global financial crisis.

"The EU banking landscape will be transformed over the medium term" owing to turmoil that pushed the world's financial system to the brink of collapse, another part of the report forecast.

Tougher rules on bank reserves and asset standards have been proposed to the G20 group of developed and developing nations to strengthen banks' foundations and ensure the flow of credit on which modern economies depend.

The European parliament has also passed measures to create pan-European supervisors overseeing banks, insurers and markets in a bid to to prevent a new crisis.

In its report, the ECB said RoE "may be less of a performance benchmark than a communication tool in the relationship between banks and markets" and warned it could be misleading or manipulated.

"RoE is a short-term indicator and must be interpreted as a snapshot of the current health of institutions," the bank said.

"It does not take into account either institution's long-term strategy or the long-term damages caused by the crisis."

Polleit agreed that "it might be that on a risk/reward basis," a bank that offered a lower return could in fact be a better investment.

In its overview of the sector, the ECB said: "The overall shock-absorbing capacity of the EU banking sector has improved over the past 12 months," owing "in particular, to a strengthening of capital buffers to well above their pre-crisis levels."

In May, the EU's banking sector weathered a shock sparked by soaring levels of public and private debt that some forecast could devastate the 16-nation eurozone.

The ECB concluded however that "the possibility both of a setback in the recent recovery of bank profitability and of an adverse effect on the supply of credit to the economy remain important risks."

© 2010 AFP

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