Measuring returns to investment banks

I noted a Bloomberg report that said that four out of the five top investment banks - Merrill Lynch, Morgan Stanley, Bear Stearns and Lehman Brothers- suffered a decline in market value of $83 bn last year. That cut the annual average rate of return for those firms in the past nine years fro 16.8% to 9.7%. Presumably, this refers to the returns that investors in stocks of these firms made.

What about the return on equity of the firms themselves? Investment banks have enjoyed a return on equity that is the envy of their peers in other businesses. Long term on equity for the top investment banks has been 16%- there have been periods when RoE has been as high as 48%. It would be interesting to see what the returns look like over a typical business cycle- say, after taking into account RoE in 2007 and 2008. The RoE would fall quite a bit.

This suggests that RoE figures for investment banks at any given point in time are deceptive because they don't quite factor in risk. We need really to measure risk-adjusted return on equity for investment banks. Or return on risk adjusted capital. Investment banks must put out these numbers so that market valuations can be based on these.

True, investment banks and banks are perceived to be riskier than the broader market which is why they trade at a discount to the market multiple. But these discounts may not be taking into account risks at a given point in time. More importantly, these discounts may not be taking into account institution-specific risk. The only this can happen is if these institutions are valued and compared on the basis of returns to risk adjusted capital.

Valuing investment banks on the basis of RoE can lead to huge distortions and inflated values at any given point because the underlying risks are not quite taken into account