Is a Uniform Hurdle Rate Relevant in a Banking Firm?

17 Pages Posted: 15 May 2006

See all articles by Tyrone M. Carlin

Tyrone M. Carlin

Southern Cross University; The University of Sydney Business School

Nigel Finch

Saki Partners

Guy Ford

Macquarie University - Graduate School of Management

Richard Petty

Macquarie University; Macquarie University, Macquarie Business School

Date Written: 2006

Abstract

In this paper we question the relevance, and assess the implications, of the practice in banking to use a uniform hurdle rate based on the cost of equity for the purposes of pricing and performance measurement. We examine three perspectives on this issue. First, we point to the potential inconsistency that arises when risk-adjusted performance measures are benchmarked against a hurdle rate based on the systematic of the bank, when these measures are typically linked to economic capital, which takes a total bank (idiosyncratic) perspective on risk. Second, we take a theoretical perspective and use an option pricing framework based on Crouhy et al (1999) to assess the ability of a bank to maintain a uniform hurdle rate and target solvency standard when leverage changes in response to changes in the volatility of bank assets. Finally, we take a practical perspective and develop a loan pricing framework to examine the impact of the uniform hurdle rate assumption on the question of whether or not an increase in the solvency standard - a higher target credit rating - is of benefit to a bank.

Keywords: cost of capital, isk-adjusted performance measures, option pricing

JEL Classification: G12, G21, G32

Suggested Citation

Carlin, Tyrone M. and Finch, Nigel and Ford, Guy and Petty, Richard, Is a Uniform Hurdle Rate Relevant in a Banking Firm? (2006). Available at SSRN: https://ssrn.com/abstract=902205 or http://dx.doi.org/10.2139/ssrn.902205

Tyrone M. Carlin

Southern Cross University ( email )

Lismore, New South Wales 2480
Australia

The University of Sydney Business School ( email )

Cnr. of Codrington and Rose Streets
Sydney, NSW 2006
Australia
+ 61 2 9036 7230 (Phone)
+61 2 9351 7471 (Fax)

HOME PAGE: http://sydney.edu.au/business/staff/tyronec

Nigel Finch

Saki Partners ( email )

Australia

Guy Ford (Contact Author)

Macquarie University - Graduate School of Management ( email )

99 Talavera Road
Sydney, NSW 2113
Australia
+61-2-9850-7813 (Phone)
+61-2-9850-9019 (Fax)

Richard Petty

Macquarie University ( email )

North Ryde
Sydney, New South Wales 2109
Australia

Macquarie University, Macquarie Business School ( email )

New South Wales 2109
Australia

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