By: Tom Hannagan

I was hoping someone would ask about this. Return on Equity (ROE) is generally net income divided by equity, while Return on Assets (ROA) is net income divided by average assets. There you have it.

The calculations are pretty easy. But, what do they mean? ROA tends to tell us how effectively an organization is taking earnings advantage of its base of assets.  This used to be the most popular way of comparing banks to each other — and for banks to monitor their own performance from period to period. Many banks and bank executives still prefer to use ROA…though typically at the smaller banks.

ROE tends to tell us how effectively an organization is taking advantage of its base of equity, or capital. This has gained in popularity for several reasons and has become the preferred measure at larger banks. One huge reason for the growing popularity of ROE is, simply, that it is not asset-dependent. ROE can be applied to any line of business or any product. You must have “assets” for ROA, since one cannot divide by zero.

This flexibility allows banks with differing asset structures to be compared to each other, or even for banks to be compared to other types of businesses. The asset-independency of ROE also allows a bank to compare internal product line performance to each other. Perhaps most importantly, this permits looking at the comparative profitability of lines of business like deposit services. This would be difficult, if even possible, using ROA.

If you are interested in how well a bank is managing its assets, or perhaps its overall size, ROA may be of assistance. Lately, what constitutes a good and valid portrayal of assets has come into question at several of the largest banks. Any measure is only as good as its components. Be sure you have a good measure of asset value, including credit risk adjustments.

ROE on the other hand looks at how effectively a bank (or any business) is using shareholders’ equity. Many observers like ROE, since equity represents the owners’ interest in the business. Their equity investment is fully at risk compared to other sources of funds supporting the bank. Shareholders are the last in line if the going gets rough. So, equity capital tends to be the most expensive source of funds, carrying the largest risk premium of all funding options. Its deployment is critical to the success, even the survival, of the bank. Indeed, capital allocation or deployment is the most important executive decision facing the leadership of any organization. If that isn’t enough, ROE is also Warren Buffet’s favorite measure of performance.

Finally, there are the risk implications of the two metrics. ROA can be risk-adjusted up to a point. The net income figure can be risk adjusted for mitigated interest rate risk and for expected credit risk that is mitigated by a loan loss provision. The big missing element in even a well risk-adjusted ROA metric is unexpected loss (UL). Unexpected loss, along with any unmitigated expected loss, is covered by capital. Further, aside from the economic capital associated with unexpected loss, there are regulatory capital requirements. This capital is left out of the ROA metric. This is true at the entity level and for any line-of-business performance measures internally.

Since ROE uses shareholder equity as its divisor, and the equity is risk-based capital, the result is, more or less, automatically risk-adjusted. In addition to the risk adjustments in its numerator, net income, ROE can use an economic capital amount. The result is a risk-adjusted return on capital, or RAROC. RAROC takes ROE to a fully risk-adjusted metric that can be used at the entity level and that can also be broken down for any and all lines of business within the organization. As discussed in the last post, ROE and RAROC help a bank get to the point where they are more fully “accounting” for risk – or “unpredictable variability”.

Sorry about all of the alphabet soup, but there is a natural progression that I’m pointing to that we do see banks working their way through. That progression is being led by the larger banks that need to meet more sophisticated capital reporting requirements, and is being followed by other banks as they get more interested in risk-adjusted monitoring as a performance measurement. The better bank leadership is at measuring risk-adjusted performance, using ROE or RAROC, the better leadership can become at pricing for all risk at the client relationship and product levels.