The Great Debate UK

from Breakingviews:

Four factors to determine bank returns

larsen.jpgWhat is an acceptable return on equity (ROE) for a bank? That question is likely to dominate the debate among executives, investors and regulators in the coming year. After the spectacular losses of the crash, there is no doubt that banks' future returns should be lower than the super-charged profits earned during the credit boom. But if ROEs fall too far, the consequences could be severe.

Returns are already on the way down: just look at Goldman Sachs. Between November 2007 and September 2009, the Wall Street bank's tangible common equity swelled by 74 percent. In 2007, its best-ever year, Goldman earned a 38 percent return on that equity. This year the bank is expected to report the second-highest profit figure in its history. But its ROE is likely to be just half its level of two years ago.

Of course, there is no good reason why banks should consistently earn 20 percent-plus on their equity, particularly when interest rates are at zero. During the 1970s and the 1980s, when interest rates and inflation were much higher, the return on tangible equity for the British banking industry averaged 10 to 11 percent, according to Credit Suisse research. This only changed in the 1990s, when looser regulations permitted large banks to increase leverage and take on more risk.

As long as central banks keep interest rates down and pump liquidity into the markets, most banks will continue to earn healthy profits, as they did in 2009. In the longer run, however, returns will be largely determined by four factors: regulation, competition, funding costs and economic growth.