Thursday, April 26, 2012

Leverage and executive compensation


FT quotes Andrew Haldane's work that shows how the increased focus on return on equity (as against return on assets) as the metric for measuring executive performance drove executives into over-leveraging and thereby amplifying risk,
For most of the 20th century the long-run return on equity in UK banking moved in line with the underlying growth rate of the UK economy. Then from 1986 to 2006 the return on equity jumped from 2 per cent to an annual average of 16 per cent. Yet the return on assets was largely stagnant over the period. In effect, the managers of banks took to the roulette wheel. They juiced up rotten returns by shrinking their equity capital and taking on more risk. This pattern was repeated across much of the developed world.

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