Ratio Working Papers,
The Ratio Institute

Abstract: Contrary to received wisdom, two recent studies report a negative relation-ship 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 explore the sign of the relation-ship 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 relation 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 re-sults of the previous studies, a long-term “normal” positive relationship be-tween leverage and profitability is also reaffirmed.

Keywords: return-on-equity; leverage; bank capital

JEL-codes: G21; N23; N24

18 pages, January 3, 2005

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