Banks/FIG ROE Question

Does ROE improve when a bank grows deposits more than loans? For a non-financial institution, it would make sense that increasing liabilities while holding assets and (for purposes of example) profit constant would be akin to levering up and would improve ROE that way.

But for a deposit-taking institution like a bank, increasing leverage is growing lending more relative to deposits. Even under the assumption that the bank will have to pay some interest to depositors (therefore hurting their profit), equity still declines faster than profit.

Mechanically, I understand this, but practically, it just doesn't seem to make sense. Any thoughts?

 

PacioliBoss, pure crickets, that's where I come in. Any of these useful?

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No promises, but maybe one of our professional members will share their wisdom: mbamfinquestions do1012 Bandara89

I hope those threads give you a bit more insight.

I'm an AI bot trained on the most helpful WSO content across 17+ years.
 

Deposit rates tends to be low (5 bps at the large banks) even at 100 bps, you can park the money at the fed at IOER rate of 175 bps. That’s essentially free cash you’re getting. Your return on average assets might drop because you’re not getting loan-level yields but your ROE will rise.

 
Best Response

As a practical matter, the answer is 'probably'?

It appears you're asking two questions here, one where you're still growing balance sheet (i.e. loans) while your other one is holding the balance sheet flat and changing the composition (i.e. more deposits, less equity, flat assets).

In the case of a growing balance sheet, assuming the underwriting is not too aggressive and the deposits are core, you're probably going to see some improvement in ROE. This is not necessarily the case for numerous reasons (regulatory or if the bank was running at a low capital ratio to begin with), but it probably would. Specifics would be needed to dive in deeper here.

In the case of a flat balance sheet, all else equal, you'd probably be right in assuming that ROE would improve (assuming away regulatory restrictions and such). The reason this makes sense is the cost of equity is generally higher than the cost of deposits. Pull up the 10-k of any bank, large or small, and go to the average balance sheet disclosure. They also disclose the cost of interest bearing and interest earning balances. For deposits, it should be some fairly low number.

While equity is obviously not there because it's not an interest bearing liability, any reasonable estimate would suggest a number that is many multiples of whatever you see for deposits.

As a parting thought, you'd probably want to view ROE in conjunction with ROA. It's not perfect, but it does roughly show how efficient a bank is with all its sources of capital as opposed to one that is primarily levering up to improve returns.

 

I think that’s generally right.

The question I still have is with regards to the mechanics of ROE. If we assume ROE is just net income / equity, a bank’s assets are its loans and its liabilities are its deposits, then wouldn’t it make sense to load up on deposits, minimize equity and then ROE would go through the roof? In other words, the denominator would get increasingly smaller relative to the numerator? Again, putting aside any regulatory requirements for purposes of example.

The flip-side being, if a bank lends like crazy and keeps its deposits broadly stable, then net income might improve, but equity would rise faster, leaving the denominator growing faster than the numerator, thus eating into ROE?

 
PacioliBoss:
I think that’s generally right.

The question I still have is with regards to the mechanics of ROE. If we assume ROE is just net income / equity, a bank’s assets are its loans and its liabilities are its deposits, then wouldn’t it make sense to load up on deposits, minimize equity and then ROE would go through the roof? In other words, the denominator would get increasingly smaller relative to the numerator? Again, putting aside any regulatory requirements for purposes of example.

The flip-side being, if a bank lends like crazy and keeps its deposits broadly stable, then net income might improve, but equity would rise faster, leaving the denominator growing faster than the numerator, thus eating into ROE?

Yes. It's no different than any other company. Holding RoA and cost of funds constant, higher leverage = higher RoE. Not sure why you're so confused.

As with any business, if you reinvest all of your earnings into the business and don't increase debt, your leverage will decrease and ROE will be reduced.

ROE isn't a perfect metric. This is why people also look at ROIC and EPS.

 

The question is not clear and further assumptions are required.

Scenario 1: Assuming a bank adds 100 in deposits and 50 in loans to a balance sheet (per your example where deposits grow more). Assuming no change to net interest income for the bank, cash increases by 50 and loans by 50. Liabilities (deposits) increases by 100, balance sheet balances. ROE has no change as equity has not changed and net income has not changed. Note that ROA falls as overall asset base increases but net income is constant. 

Scenario 2: Same as above, but net interest income increases. Since equity is the same, ROE increases. ROA change could go either way depending on the magnitude of net income increase vs asset increase.

Scenario 3: Total assets remain constant but deposits take up a larger share and equity decreases. Clearly in this case, ROE improves. 

 

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