Overview
Given that the equity of company represents the share of the bank owned by the shareholders, a simple measure of bank performance is the return on equity.
ROE Breakdown
{% Return \, on \, Equity = %}
{% [ Average \, Asset \, Income \times Total \, Assets %}
{% - Average \, Interest \, Expense * Total \, Debt %}
{% - Average \, Operating \, Expense \times Total \, Assets ] %}
{% \times (1 - Tax \, Rate)/ Equity %}
Given this equation, there are a couple of levers that can be pulled to change the ROE. If we assume that average interest, average expense and average operating expense are dictated by the market that the bank operates in, and that the tax rate is also fixed, then the bank can only change the total assets, total debt, or total equity.
A very simple method to increase ROE is to decrease the total equity, by returning money to shareholders in the form of stock buybacks or dividends.
Return on Tangible Equity
An alternative to the return on equity is the return on tangible equity. Tangible equity is equity that does not include preferred shares, and does not include intangible items, such as:
- Goodwill
- Patents and Copyrights
- Trademarks
Relationship to Return on Assets (ROA)
{% ROE %} is connected to {% ROA %} through the bank's leverage.
{% ROE = ROA \times EM %}
where {% EM %}, the equity multiplier, is defined as
{% EM = \frac{assets}{equity capital} %}
The equity multiplier is essentially a measure of leverage.