Question

If the Chief Executive Officer (CEO) of a financial institution finds ways to increase the asset-capital leverage of the institution during the boom years, how can we use the relationship between the return on assets, the return on capital and the asset-capital leverage for banks and financial institutions to explain how this would affect the share price and hence the shareholders' return?

If the CEO's bonus is linked with the institution's profit in that year, how would this affect the CEO's bonus? How would this affect the risk of the financial institution in the long run?

Answer 1

when the chief executive officer is increasing the Asset capital leverage during boom years, it will mean that the relationship between the return of asset and return of capital and asset capital leverage for bank will be decreasing to a large extent in the adverse economic conditions and it will be improving in the boom years because these are the factors which are employed by the financial managers in order to maximize the rate of return by taking additional leverage during the time of of easy credit and boom period

if the market is efficient, the share price is going to decrease because additional leverage is putting more risk to the organisational solvency.

I think the rate of return of the shareholders are also going to decrease and if the chief executive officer of bonus is linked to the institutional profit then the bonus will not be provided to the chief executive officer because of his lack of understanding of additional debt at the time of easy credit because it can lead to ripple effect when the economy will be going through adverse phase and a very high amount of leverage is always risky.