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Class 10

# The level of capital affects the return on equity

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-- The level of capital affects the return on equity. Measures of bank profitability Two measures of bank profitability are known as the Return on Assets and the Return on Equity. They are defined and measured as follows. Return on assets (ROA): is a measure of the amount of profit generated by each dollar of assets held by the bank. It is measured as ROA = net profit after taxes . assets Return on equity (ROE): is a measure of the amount of profit generated by each dollar of equity capital. It is measured as ROE = net profit after taxes equity capital The ROE and ROA are linked through something known as the equity multiplier. Equity multiplier (EM): the value of assets per dollar of equity capital. The equity multiplier is defined as EM = assets equity capital From the above equations, we can obtain the following identity: ROE = ROA x EM. This states that the return on equity is the product of the return on assets and the equity multiplier. Verify for yourself that this equation holds. 98

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Econ 350 U.S. Financial Systems, Markets and Institutions Class 10 An increase in equity capital increases the denominator of the equity multiplier, so the equity multiplier declines. For a given return on assets, a decrease in the equity multiplier leads to a decline in the return on equity. So an increase in equity capital leads to a decline in the return on equity. In deciding on the amount of capital, a bank always faces tradeoffs between safety and the return to equity holders. In examining these four principles of bank management, we showed that there are always competing interests in trying to run a bank efficiently. Overall, the objective of the bank is to earn as high a profit as possible. It does this by managing credit risk, or reducing the likelihood that loans will default, and through managing interest rate risk, or reducing the exposure of the bank to changes in interest rates. Managing Credit Risk Credit risk: is the likelihood that a borrower will default on his loan. As we saw in Class 8, the problems of adverse selection and moral hazard help to explain why borrowers may be likely to default on loans. In managing credit risk, banks try to minimize the problems of adverse selection and moral hazard. Techniques of reducing exposure to credit risk include: -- screening and monitoring of potential loan applicants, through such tools as credit scores or bond ratings. -- specialization in lending to geographic area or type of lender. -- monitoring and enforcement of restrictive covenants. -- developing long-term customer relationships. -- loan commitments to commercial customers. -- collateral requirements. -- compensating balances in other accounts accessible to the lender. -- credit rationing in the amounts, quantities, or types of loans. Managing Interest Rate Risk
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The level of capital affects the return on equity Measures...

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