Targeting Return on Equity: Banks’ Ownership Structure and Risk Taking

Based on a unique hand-collected data on the strategy of targeting return on equity (ROE) by 224 public commercial banks in Europe from 1995 to 2016, we conduct the first study on banks’ actual practice of targeting ROE. Our results show that banks with concentrated controlling ownership are more likely to target ROE. Among the banks with ROE target, the banks with higher insider holdings are less likely to publish the exact number of the target. This reviews that ROE targeting is more in line with agency theory rather than the theory of signalling, similar to the dividend payout policy. How would the management acts to achieve the goal and what is the actions’ implication on banks’ risk taking in the following year? Our evidence shows that banks, which become more likely to target ROE, are riskier, in terms of return-on-assets volatility and Value-at-Risk in the coming year. Yet, for banks paying dividends, levering up their balance sheets becomes a short cut to achieve a high return on equity. However, dividend-paying banks become less likely to default within a year. As targeting ROE is a managerial strategy for the interests of stockholders, our study contributes to our understanding of not only the targeting itself, but also the link between bank ownership structure and risk taking.