According to a FT article last week, Lloyds’ bank has a target return on equity of 14.5 per cent. Banks like to argue that this is the level of return on equity they need to earn, in order to gain funding from the markets. Naturally, remuneration is linked to achieving such objectives. The question, however, is whether such objectives make any sense. The brief answer is: no.
[...]Indeed, it is perfectly obvious that these cannot be sustainable safe returns in economies growing at 2 per cent a year, for such a large and well-established industry. At a 15 per cent real return, the value of cumulative retained earnings would double in five years and increase 16-fold in 20 years. Pretty soon, bank equity would be the only real asset in the world!If you were confident banks could earn 15 per cent real returns, you would not ask for distributions, since the returns would be so much higher than you could plausibly earn anywhere else. Thus, the example of compound growth of bank equity, under reinvestment of profits, is not unreasonable if the returns were themselves plausible. But they are not. Incidentally, if these really were plausible returns, there would also be no problem in obtaining much higher capital in banks, very quickly: just prevent distributions for a few years.
The important point, then, is that these desired returns must represent the result of extreme risk-taking.
[...]If a bank says it needs a real return on equity of 15 per cent, to obtain funds from investors, it is telling you that it is running an enormously risky business. The question you need to ask yourself is this: can we afford to have financial institutions that are both so large and so essential and yet run such huge risks?
