Are banks using leverage to target return on equity? Evidence from the US and the EU

Abstract

Abstract We find evidence that banks actively use leverage to attain RoE targets and that leverage adjustments are primarily driven by capital distributions to shareholders. Using a large group of publicly-traded commercial banks from the US and the EU for the period 2001–2013, we demonstrate that this effect particularly holds for large banks before the crisis. Such behaviour may have led banks to enter the crisis with insufficient capital buffers to absorb losses, requiring unprecedented support by the public sector to maintain their solvency. Therefore, recent policies restricting the use of RoE as a metric in remuneration schemes and introducing constraints to capital distributions unless banks maintain certain buffers above the regulatory minimum, are in the right direction.