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The Hurdle Rate and the Cost of Capital

The reference for hurdle rate is the cost of capital of the bank. The cost of capital of a bank differs from the cost of capital of a corporation. In a non-financial corporation, the cost of capital is defined as the weighted cost of equity and debt, the weights being the target weights of equity and debt. Such cost of capital, or weighted average cost of capital (" Wacc"), is the discount rate applicable to investment projects for calculating the net present value of the project.

In a bank, we do not consider debt because income is already defined in excess of cost of debt. The hurdle rate is the cost of equity, which is defined, as in non-financial corporations, as the required return on equity by shareholders.

The cost of debt remains mostly important, however. It depends on the credit rating of the bank, which influences the credit spread applicable to the bank. Also the cost of funding short-term is also critically affected by the inter-bank cost of liquidity, defined as a Libor. Such cost of liquidity includes a spread, which normally matches the average risk of the banks used as references for calculating a Libor. But the interbank rates can become much higher either because there are fears for the future of a particular bank, or because the financial system faces a liquidity crisis, such as the 2007-2008 crisis.

The hurdle rate, or cost of equity for the bank, is the equity risk premium above the risk-free rate that the market assigns to a particular bank. The cost of equity is theoretically defined by the well-known CAPM model, which adds to the risk-free rate a premium that depends on the systematic risk of the stock measured by the (3 of the stock.

When using risk-adjusted measure of performances, the cost of risk has only two components, the expected loss and the capital allocated to a transaction or a portfolio. The cost of allocated capital also has two components, the amount of capital charged and the percentage compensation, or hurdle rate, applicable to bank's capital. The cost of capital is the cost of equity for the equity portion of bank's capital. For Tier 2, or subordinated debt, there is also a cost, which is the excess spread of subordinated debt above the spread applicable to bank's debts that are senior to Tier 2. Both ROE and ROC, inclusive of Tier 2 capital, are relevant.

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