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What Is the Importance of Return on Equity for Banks?

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  • Written By: Osmand Vitez
  • Edited By: PJP Schroeder
  • Last Modified Date: 11 September 2016
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    Conjecture Corporation
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Banks — like any other standard businesses — need to earn financial returns on its employed capital. The return on equity for banks is a common measurement they use to assess the returns made on the initial capital invested. Without a substantial return on this capital, a bank may suffer low income and be unable to pay for its administrative expenses or other standard costs. The money a bank earns from its initial capital can also be part of the net income earned by the bank. Investors are often quite interested in the return on equity for banks.

Many banks start like any other business; after meeting the legal requirements for stating operations, the owners then seek capital for making transactions. These funds can either come from the entrepreneur or from a group of readied investors looking to draw passive income. Equity funds represent money given to a business without a stated return date or other repayment plan. Banks's return on equity helps pay small financial returns to investors for the use of this capital. Higher equity returns, therefore, are typically more favorable than smaller returns.

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The return on equity for banks can also be a competitive advantage seen by investors. For example, a large bank with well-employed capital is often a target for investment by both individuals and other businesses. A bank can report its return on equity through management reports or other investment tools. This allows stakeholders to learn about the company and decide whether they should invest or not. Higher investment into a bank allows the institution to employ more capital than before and increase its financial returns.

The probability of loss is just as prevalent or as dangerous for banks as it is for normal companies. Failure to measure the return on equity for banks properly can result in not discovering decreasing financial returns. Low returns often turn into lower net profit, which leads to a bank’s inability to pays expenses and other financial obligations. As this occurs, the company will lose investors and equity, making it harder to make financial gains. The only way to stop this outflow is to find profitable investing options to increase the return on equity.

Banks often operate in highly regulated markets. While the return on equity for banks should be strong enough to make it a solid investment, returns that are too high can be problematic. Banks may be seen as gouging customers with high interest rates even if that is not the case. Managing substantial returns on equity with philanthropic activities may help dissuade these problems.

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