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The average return on equity (ROE) for companies in the banking industry in the third quarter of 2020 was 5.31%, according to the Federal Reserve Bank of St. Louis. ROE is a key profitability ratio that investors use to measure the amount of a company’s income that is returned as shareholders’ equity.
Key Takeaways
- The average return on equity (ROE) as of the third quarter of 2020 was 5.31%.
- Most nonfinancial companies focus on growing earnings per share (EPS), while ROE is the key metric for banks.
- Bank ROEs averaged in the mid-teens for over a decade—prior to Basel III passage in 2009.
- Since 2009 banks have averaged ROEs between 5% and 10%, only recently breaking above 11%.
- Most megabanks in the U.S. have below-average ROEs, while JPMorgan (JPM) has an industry-high ROE of about 15%.
Why Return on Equity (ROE) Matters
The return on equity (ROE) metric reveals how effectively a corporation is generating profit from the money that investors have put into the business. ROE is calculated by dividing net income by total shareholders’ equity. ROE is a very effective metric for evaluating and comparing similar companies, providing a solid indication of earnings performance.
Average returns on equity vary significantly between industries, so it’s not advised to use ROE for cross-industry company comparisons. A higher return on equity indicates that a company is effectively using the contributions of equity investors to generate additional profits and return the profits to investors at an attractive level.
There is one inherent flaw with the ROE ratio, however. Companies with disproportionate amounts of debt in their capital structures show smaller bases of equity. In such a case, a relatively smaller amount of net income can still create a high ROE percentage from a more modest base of equity.
Bank Return on Equity (ROE)
While most corporations focus on earnings per share (EPS) growth, banks emphasize ROE. Investors have found that ROE is a much better metric at assessing the market value and growth of banks. This comes as the capital base for banks is different than conventional companies, where bank deposits are federally insured. As well, banks can offer interest on its deposits, which is a form of capital, that is well below rates other companies pay for capital. Banks are incentivized to focus on managing capital to maximize shareholder value versus growing earnings.
However, minimum capital requirements, such as Basel III, increased the amount of capital banks had to keep in hand. This has pushed ROEs down. As a result, average bank ROEs have been lower following the passage of the reform in 2009. From the early 1990s until the mid-2000s, banks averaged an ROE in the mid-teens. Since Basel III, ROEs have averaged between 5% and 10%, only breaking above 11% since the first quarter of 2018.
As of October 2021, many of the megabanks have ROEs below the industry average. This includes Bank of America (BAC), Citi (C), and Wells Fargo (WFC), which have ROEs of roughly 10%. Meanwhile, the largest U.S. bank, JPMorgan Chase (JPM), has an ROE of 18% as of its third quarter 2021 report.