Is a Uniform Hurdle Rate Relevant in a Banking Firm?

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