Targeting Return on Equity: Banks' Controlling Ownership and Risk

Abstract

Since the 2008-09 global financial crisis, banks are criticized for levering up their balance sheets to reach for return on equity (ROE) target. We conduct the first systematic study on banks' actual practice of targeting ROE, based on a unique hand-collected data for 188 publicly listed commercial banks in Europe from 2000 to 2018. The results show that the increasing holding of large controlling owners is positively and significantly linked to the propensity of targeting ROE. This finding is in line with the agency theory that these owners monitor the management to reduce the principle-agent conflicts. Differently we also find that, stock-based compensation is positively linked to managers' tendency to publish the explicit target numbers. However, contradict to the criticism on banks' excessive risk taking, the higher the probability of targeting ROE is, the marginally lower the probability of default is in the following year. Furthermore, this risk reduction is mainly driven by the significant increase of regulatory capital reserve rather than return on assets or equity ratio. Our study contributes to the understanding of not only the targeting itself, but also the implicit linkage between bank ownership and risk taking. In addition, it offers insights to policy makers in terms of bank regulation.

Keywords: Banks; targeting return on equity; agency theory; controlling ownership; default risk; regulatory capital

JEL Classification: G21; G28; G32; G34