Return on Equity for the Banking Industry

In the last thirty years, the banking industry has seen significant regulatory changes, new business development, and several business cycles. One quantitative metric that can summarize the complicated universe of events over that time is profitability.

Return on Equity for the banking industry

The chart above shows return on equity for the banking industry. Return on equity, calculated as net income (profit) divided by average equity on an annualized quarterly basis, is one of the most important banking ratios as it standardizes the bottom line of the income statement with equity to create a profitability ratio that is comparable across time and between banks.

After calculating this standardized time series measurement of profitability for the industry from 1990 to 2018, a few stories emerge:

  1. Although the Savings and Loan Crisis of the early 1990's was a significant loss event at the time, the next fifteen years would be extremely profitable for the banks that survived.
  2. The 2001 recession was somewhat of a non-event for industry profitability. The stock market took a major hit but for those years and several after, times were good.
  3. The financial crisis took profits and threw them off a cliff. Not only was it a swift and sudden fall with seemingly no warning but the entire industry barely saw any positive bottom line for almost three years.
  4. Post-crisis profits never returned anywhere close to the former glory of ten to fifteen percent ROE. As banks have dealt with new regulation and reduced risk-taking, profitability has hovered around five percent.
  5. Don't be scared by the drop in 2017Q4! It's just an accounting response to the tax cuts.

Looking holistically at the industry, it's easy to understand why 2008 was a banking crisis and why the 2001 recession was certainly not a banking crisis. It is always helpful to remember that not all recessions are the same. In fact, the post-crisis period has also shown that recoveries or the "new normal" can also be very different than expected.

Turning toward the future, the industry will likely see increased profitability due to the 2017 tax cuts. In terms of spotting the next recession, keep a watch on profitability, which dropped leading up to the three recessions in the last thirty years. While things will of course be different next time, not everything will be.

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