Bank profits: tangible benefits

You cannot turn a sow's ear into a silk purse. But with a little effort you might make it vaguely presentable. And so banks, whose plain old returns on equity are far from silky, are turning to returns on tangible equity as they lay out their targets. ROTE typically excludes goodwill built up through acquisitions. UBS is the latest to make the switch. A year ago it pulled back from its earlier aim of a 2015 return on equity of 15 per cent. Its latest target is a 2016 adjusted ROTE of 15 per cent. On that basis it returned 8.9 per cent in 2014, so there is a way to go. Other banks, including JPMorgan and Santander, also use ROTE targets.

There are some sound reasons for the shift. When a bank teeters, only tangible equity is available to absorb losses and save it from ruin. The Basel III rules exclude goodwill and intangible assets in their calculation of capital ratios. And many banks incentivise senior staff using ROTE.

It makes some sense to use a variety of measures when reporting progress to shareholders. But it pays to be suspicious of metrics that tend to produce rosier results. By using the same profit figure but a lower equity base, ROTE can render higher numbers than ROE. A 9 per cent ROE looks weak. An 11 per cent ROTE seems somehow healthier.

Balance sheet valuations reflect management's more or less educated guesses at the value of the business. So the use of ROTE raises the question of what belongs on the balance sheet in the first place. If the directors think that tangible equity is a better measure of what shareholders really own, then they ought to be considering writing off intangible assets and taking impairment charges.

There are much worse return measures to use than ROTE. Return on risk-weighted assets, for example, is an appallingly opaque measure that is too frequently used. ROE, however, forces banks and their investors to scrutinise balance sheets in their totality - and retains the advantage of simplicity.

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