Financial reporting and performance: why return on tangible equity should be a bank’s primary financial objective

An article by Shaun Taylor, CFO Americas

A recent McKinsey report illustrated that despite the strong growth in banks’ revenue and margins (thanks in part to higher interest rates) resulting in their profitability reaching a 14-year high in 2022, the capital entrusted to them from shareholders is not generating an adequate return. As a consequence, many trade below their respective book value.

In part, banks need to communicate better on how they are positioning their scarce resources to capitalise on opportunities to grow profitably and deliver shareholder value. To measure progress and aid with communication there are numerous financial metrics available which banks can use. They range from top line growth, price to book, return on risk weighted assets and efficiency ratio, among others. While no single metric can be considered perfect, the most holistic for banks to consider would be return on tangible equity (RoTE).

RoTE is simply profit post-tax, divided by the tangible equity. This measure has endured over many years and is used by analysts and investors as a benchmark across the sector. A return in excess of 10 percent is commonly expected from investors and the strong correlation between returns and share price is clear. Banks that have higher RoTE typically have higher share prices. Therefore, aligning all stakeholders – internal and external – with the mindset of optimising for RoTE is important to deliver the best financial outcomes for any bank.

The importance of internal engagement to shift mindsets

Awareness, understanding and action require change. And every organisation faces hurdles and challenges when embedding change. In a large organisation, a series of engagement techniques to get everyone aligned and on the same page are key. It cannot just be one email; the messaging and subsequent understanding must be thoroughly embedded.

Internal audiences must understand that everyone has a role to play and that the wide use of RoTE creates a level playing field by bringing everyone to a common understanding. Decisions can therefore be made more easily and consistently across multiple product lines, geographies and businesses.

Should a bank be rolling out more retail products in Asia or focusing on corporate lending in Africa? This common framework provides a level playing field to evaluate opportunities or respond to difficult decisions objectively.

But how does one ensure a workforce that adopts this mindset? Clear accountability, targets and incentivisation throughout an organisation are effective means to do so. Implementing methods such as including RoTE in financial scorecards, generating the appropriate management information to help drive decision making, and sharing the RoTE figure monthly, rather than purely during earnings, are all great motivators that can enable change.

Fully embedding this mindset requires organisations to empower people to think differently. For example, it is common for colleagues in a support function to rarely make decisions with shareholder returns and share price in mind. Unfortunately, they are likely to have never thought that they could influence them. Of course, that is not the case. How a support function is run, its cost base, how its team is organised, target operating models, etc., all feed into the cost of supporting the business and clients. This will ultimately affect profitability and thereby returns to shareholders. If colleagues are empowered to make changes that will have a material impact on RoTE, they are more likely to continue with that mindset and encourage others to do so.

Interestingly, while several would agree with the premise of using RoTE as a consistent reference, one challenge is convincing stakeholders to move away from focusing on other metrics that may appear to be more flattering for their line of business. For most, that is top line growth. But this can be impacted by several macroeconomic factors and thus is not always the most accurate picture of how a business is performing. This is especially the case if the business does not focus on highlighting its cost base and what capital it has used to generate year-on-year growth.

A level playing field

In summary, externally, RoTE is the most important metric to use in the banking sector and is well-regarded among the investment community in terms of providing a benchmark.

Internally, if banks are not already encouraging the adoption of this metric, then it should be considered. Everyone has a role to play in improving RoTE and by enabling everyone in a financial institution to understand its importance, it becomes the norm to think about it in everyday decision making, regardless of geography, sector or product. It can be applied to big strategic decisions like entering and exiting markets, just as it can be applied to smaller ones such as infrastructure spend and headcount.

RoTE makes it possible to align everyone to thinking commercially, focusing on how they can help make better or faster decisions with respect to uplifting their bank’s RoTE, and to look at it from a returns perspective with one metric, as opposed to a cost perspective with multiple metrics.

There is no perfect metric, but RoTE is robust and here to stay, which is why continuing to embed it into everyday decision making should be high on the agenda.