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The Economic Research Institute, Stockholm School of Economics SSE/EFI Working Paper Series in Economics and Finance

No 611:
The Long-Term Relationship between Capital and Earnings in Banking

Per Hortlund ()

Abstract: Contrary to received wisdom, some recent studies report a negative relationship between leverage and profitability in banking in the 1980s and early 1990s. This study presents new data on the leverage and profitability of Swedish commercial banks in 1870–2001, and explores the sign of the relationship in the long term. In the studied period, the capital-asset ratio decreased by a factor four, while return-on-equity more than doubled. The “leverage formula” postulates a positive linear relationship between return-on-equity and the debt-equity ratio. A strong positive linear relationship was found over the period 1871–1980, but not in 1980–2001. Thus, while supporting the results of the previous studies, a long-term “normal” positive relationship between leverage and profitability is also reaffirmed.

Keywords: Return-on-equity; Leverage; Bank capital; (follow links to similar papers)

JEL-Codes: G21; N23; N24; (follow links to similar papers)

25 pages, November 17, 2005, Revised November 17, 2005

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