Bank investors prize ROE as a measure of how well a financial institution uses its capital to generate profits – but industry-wide, ROE now is at levels once thought unimaginable. Is the right approach taking on more risk, or going back to basics?

Large global financial institutions and their CEOs might be forgiven for indulging in a spot of nostalgia now and then for the good old days in which they could routinely earn returns on equity (ROE) for their shareholders north of 10%, and often even above 20%. The battle to maximize ROE was intense; the higher the ROE, the better a financial institution’s managers had done at making its capital work for investors. Today, as the chart below clearly illustrates, the levels of ROE have taken a decided shift lower.

That’s bad news for banking CEOs. Conventional wisdom on Wall Street has been modified in the post-crisis environment; while an ROE of 20% or more was the gold standard, it is now generally recognized that it’s very difficult to achieve that on a sustainable basis. After all, it wasn’t until 2005 that the ROE of Goldman Sachs hit 21.9%, jumping to 33.3% the following year. And while other banks tried to replicate that kind of performance, mostly they fell short of the mark and hand to settle for an ROE in the mid-teens, with commercial banks generally posting a lower figure still because of their much larger capital bases. As the financial crisis of 2008 brought about a host of new regulations and restrictions on their activities (such as the provisions of the Dodd-Frank Act barring much proprietary trading and many investments in hedge funds and private equity vehicles), however, bankers began to worry that their returns on equity would slump lower still. The more capital they need to keep on their balance sheets and the more higher-risk but potentially profitable businesses they can no longer pursue as actively, the greater the potential for their ROE to dip. The common worry became that if their ROE fell below 10%, investors would be less willing to purchase their stock, since at that level the returns were less attractive relative to the risk and the degree of volatility in the share prices.

As can be seen in the chart above, the returns on equity of most major financial institutions in both Europe and the United States now hover somewhere between 10% and 5% — at levels that CEOs of these banks would once have considered unacceptable. Whereas an ROE of around 20% enabled a bank’s stock to trade at around three times book value, a smaller ROE would weigh on that book value ratio and thus the share price. Certainly, banks have immediate reasons to worry. As ROE levels have declined since the financial crisis, so, too has the book value of banking stocks in both the United States and Europe. European banks, in particular, appear to have a lot to worry about, with a price/book ratio, on average, of around 0.5, as seen in the chart below. Whenever a company trades at a level below its book value, it signals that it is generating on return on shareholders’ equity that is below its costs of capital – thus, instead of creating value for shareholders, it is destroying it. In theory – although it’s rarely practical in the real world – it would be better for the directors of such a company to liquidate it if they aren’t able to turn that ROE around and boost book value above 1.

The quest for ROE sets the recent headlines involving both Barclays PLC (BARC.L) and JP Morgan Chase (JPM.N) in an interesting context. At both banks, traders violated either the law or the bank’s internal policies, and ended up costing their institutions both money and reputation. At Barclays, bank employees were involved in a scheme to rig the interbank lending market by accommodating favored clients at special rates. The result: a $450 million fine that included the largest ever levied by the Financial Services Authority of Britain, and a blot on the reputation of Barclays CEO Bob Diamond that is so large that this analysis of events by Reuters Breakingviews concluded that he “has become a liability” and should step down or be fired. “Diamond’s credibility with regulators, politicians, customers and investors is so low the board should replace him,” the analysis concludes.

Life for Jamie Dimon, CEO of JP Morgan Chase, isn’t any more rosy these days. Since the bank disclosed this spring that a London-based trader had accumulated a position in a complex web of credit derivatives that had so far generated a $2 billion loss, Dimon has been left with egg on his face. After years of insisting that banks could do a good job regulating themselves, he is now focused on preserving the bank’s ROE as much as possible. There’s no evidence that he himself turned a blind eye to the trader’s activities, hoping for a big win instead of a big loss, but the risk management failure draws attention to what can happen within a financial institution that is trying to get back to generating the kind of ROE it once did for its investors. And Dimon certainly seems to have moved very rapidly to get the trade off its books, as this Reuters Breakingviews article notes. This analysis calculates that as much as 70% of the trade may have been unwound thus far, despite the fact that Dimon had earlier sought to reassure investors he would try to “maximize economic value” and could hold on to some of the assets until later in the year if need be. Now it seems as if Dimon has acted precipitately, especially if this week’s media reports that the size of that loss may reach $8 billion or more prove to be accurate.

Currently, the mean estimate by analysts for JP Morgan Chase’s ROE for the current year stands at only 9.45%. The StarMine SmartEstimate, however, which places a greater weight on the most recent forecasts by those analysts with the most accurate track records, is slightly lower, at 9.38%. At Barclays, the SmartEstimate for 2012 ROE of 6.36% is slightly higher than the mean forecast of 6.28%.

Even the mightiest Wall Street firms are struggling to post an ROE that once would have been considered barely acceptable. At Goldman Sachs (GS.N), for instance, where traders and bankers once deployed the firm’s capital so effectively that ROEs rose from the teens and north of 20%, the mean estimate forecasts a 2012 return on equity of only 8.8%, while the SmartEstimate is a notch lower, at 8.6%. And JP Morgan Chase and Goldman Sachs are far from being the worst off, by a long stretch. Among the big money-center banks that can be viewed as JP Morgan’s peers, Citigroup (C.N) has a SmartEstimate calling for the ROE to hit 6.63% this year, while Bank of America (BAC.N) may earn an astonishingly low return on equity of 2.84% this year, according to the StarMine SmartEstimate.

Ironically, after so many years in which taking big risks on the trading desk or taking proprietary positions in highly-levered deals was the ticket to a higher ROE for most financial institutions, these days it is the more “plain vanilla” institutions that can lay claim to being able to generate higher returns on equity. Wells Fargo (WFC.N) – of the biggest banks, the one that has least exposure to trading or investment banking – is the standout performer: the analysts’ mean forecast is that it will generate a 12.74% return on equity this year, while the StarMine SmartEstimate suggests a figure closer to 12.42%. That’s still double the rate at which Citigroup or Barclays will generate profits on their own sizeable balance sheets.

Indeed, Wells Fargo is one financial institution that appears to be emerging from the financial crisis in a position of relative strength. After it downgraded the debt ratings of 15 big banks last week, Moody’s Investors Service this week affirmed its ratings on Wells Fargo. Its business is expanding – it recently snapped up the $6 billion subscription finance portfolio, a real estate lending business, of German bank WestLB AG. And its StarMine ratings look relatively robust as well: while it scores only 62 on the StarMine Analyst Revisions (ARM) Model, indicating that there is a modest chance that analysts will boost their estimates for the bank’s earnings, that is significantly better than the readings for the other behemoth banks in the United States. (Bank of America scores 17, Citigroup scores 13, and J.P. Morgan Chase only 3, with the latter a clear sign that analyst sentiment is increasingly bearish.) Wells Fargo scores in the top decile on both the StarMine Value-Momentum (Val-Mo) model and the StarMine Price-Momentum (Price-Mo) model; the former combines two StarMine valuation models with two momentum models into a particularly robust stock ranking model, while the Price-Mo model reflects the tendency of long-term trends in returns to continue and that of short-term trends to revert.

It’s unlikely that any of these financial institutions will abandon the pursuit of the maximum ROE any time in the near future; this remains a metric by which investors can judge how skillfully the managers of the banks in which they invest are deploying capital. What recent trends and news events seem to suggest, however, is that the kinds of activities that once contributed to that ROE may, in a new market and regulatory climate, be less rewarding.