Value Creation in Banking Under Bâle III Regulation

Previous literature on finance has established that ROE leads to excessive risk-taking and does not provide an accurate measurement of a bank's performance. Despite this, for reasons relating to regulation, the nature of the business and the information available, ROE remains the primary measure of performance used within the banking sector. In this article, we propose a method for measuring bank performance that applies financial principles from the “classic” framework of financial theory to banking. We consider the concepts of “capital employed” and “economic capital” in the context of banking and measure the value created by a bank (or loan) that is subject to the Basel III regulatory framework. There are many advantages to using this measurement. Among other things, it allows us to reconcile banking investment decisions with the standard theoretical framework, renders bank leverage comparable with that of industrial companies and means that investment decisions are not based solely upon equity investment