ECB vs RoE: towards a new profit paradigm?

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The European Central Bank published on Wednesday a broad review of the European Union EU banking sector and urged that a benchmark of profitability 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 in an appendix to its report on European Union banking structures.

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.

"The EU banking landscape will be transformed over the medium term" following a crisis that pushed the world's financial system to the brink of collapse, another section 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 bank 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.

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 said.

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 nonetheless concluded 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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