Bank leverage and return on equity targeting: intrinsic procyclicality of short-term choices

We find evidence that banks target return on equity (RoE) and make active use of leverage to affect the speed of adjustment towards RoE targets. That holds for both the pre- and post-2007 periods and especially for banks that tend to operate with above median leverage among their peer group. As a result, RoE targeting could affect leverage dynamics and amplify cyclical fluctuations as banks take on more leverage to achieve high returns when risk premia are low, while ‘rush for the exit’ and delever to contain losses when the cycle turns. Therefore, recent proposals that aim to align executive pay with long-term performance by restricting the use of profitability metrics such as RoE from remuneration schemes seem to be in the right direction.