By Ahmed M El-Wahsh
Return on Equity (RoE) is an internal performance measure of a bank’s profitability from the shareholder’s point of view, typically measured by the ‘Net Income’ per dollar of ‘Equity Capital’. It is often considered as the most popular measure of performance, as it is easily available to the analysts, proposes a direct assessment of the financial return of the equity holder’s investment, relies upon public information and allows for comparison between different companies or different sectors. The owners of a bank do not want to hold a lot of capital, as given the Return on Asset, the lower the bank capital, the higher the return for the owners of the bank. Managers must decide how much of the increased safety that comes with higher capital (the benefit) they are willing to trade off against the lower RoE that comes with higher capital (the cost). Investors expect a RoE at or near previous level. Banks usually try to reach a benchmark RoE or try to restore any element to prevent the drop in RoE through cost savings, modification of pricing or raising the hurdle rate for the investment.
After the financial crisis of 2008, one of the toughest challenges in the banking industry was restoring the RoE – the best indicator of whether the industry can sustainably deliver profits exceeding the cost of capital.
From the graphs, it is easily noticeable that US banks performed much better than their UK and European counterparts. Average RoE of American banks has steadily trended upwards since 2009. By contrast, European banks’ RoE initially recovered faster from the financial crisis but in 2011 there was a sharp decline in the banks’ RoE, creating a widening gap between European and US banks. If we examine the trends a bit further, we observe that in the European banking industry, universal banks and investment banks have shown a different evolution with regard to RoE, with investment banks experiencing higher volatility than the universal banks.
Bank managers in European Banks have mainly reacted to the negative trend by implementing cost-cutting programmes and downsizing. These techniques have been useful to improve RoE in the short run with the pitfall of a decline of earnings in the long run. Since the crisis, most of the UK’s banks have introduced structural changes in pay, cutting a lot of bonuses they used to pay on top of the base salary. The situation in the UK improved a little bit when the business bounced back in 2009, but by the end of 2010, banks cut tens of thousands of jobs as new capital rules and other regulations started to dent the returns again.
In Germany, corporate loans business has been stigmatised as a value-destroyer as it did not earn the cost of capital with an additional profit margin for a long time. Managers were downsizing credit volumes to improve RoE of the corporate loans business by lay-offs and reducing the ‘Loan Loss Provisions’. For universal banks, the main factor behind the downslide of RoE was loan loss provision that materialised during the crisis. However, for investment banks, the fall in asset turnover and sinking profit margin were thought to be the cause of the falling RoE.
In conclusion, since RoE is the most widely used performance indicator, targeting RoE has exposed banks to a higher unexpected risk. During a crisis, as was the case of the 2008 financial crisis, most banks had undertaken actions such as re-structuring and cost-cutting to enable themselves to be in a position where they could generate value in the long run.
However, these actions had negative effects in the long run and entailed further pressures on RoE. Moreover, RoE is not risk sensitive and does not take leverage into account when measuring the profitability. Thus a ‘Risk Adjusting Pricing’ strategy should be incorporated to improve earnings. If high RoE comes with higher risk investors should adjust accordingly. Banks with little equity that strive for high returns are clearly riskier than banks with more equity in the mix. The cost of capital should therefore be higher for the highly leveraged and lower for the better capitalised. This approach is logical as the successful investor is not interested in high RoE producing enterprises but in high risk adjusted returns.
Egypt is often seen as the ancestry of the Pharaohs and land of opportunities. Especially when it came to opportunities, the nation excelled in terms of being 2014’s pleasing destination for returns in the stock market. The return of equity, being a measure of the internal performance of entities profitability from the shareholders perspective, is typically coined by the net income per dollar of the equity capita invest. And with that being said, majority shares in the EGX30 and EGX100 markets increased thirty per cent [both with respect to dividends and each share price] in a year, in which the United States guided and led equity conventions and protests in first world economies.
Furthermore, even with the political volatility in affairs and ongoing turmoil throughout the nation; the Morgan Stanley Capital International [MSCI] index – which is mainly utilised by institutional investors globally as the benchmark to allocate funds across asset classes and regions – has also tripled to 29.35 from the previous year of 8.18. The leading sectors that were accounted for in the MSCI index were the financial and telecommunication services, 78.11% and 21.89% respectively. And in addition the top four constituents were the Commercial International Bank, Global Telecom Holding, TMG holding and Telecom Egypt and these institutions accounted for a total of $9.42bn.
Leading on to an average daily gain between EGP 1.04bn to EGP 6.04bn in the first two weeks of 2015, Egypt has proved time and time again that it will continue to prosper and excel in all economical aspects even while political uncertainty is always a stone throw away. In conclusion, all the more after the financial crisis in 2008, one of the most perplexing challenges most globally flourished economies had to deal with were restoring the return on equity percentages with bitter executions; but on the contrary Egypt had been able to ricochet negative externalities and sustained minimal financial damage caused by the butterfly effect.
Ahmed El-Wahsh holds a masters degree in Banking and Finance from Queen Mary, University of London. He works as an assistant portfolio manager at QUMMIF Investment Hedge Fund
