Managing Bank Capital: Capital Allocation and Performance Measurement, 2nd Edition

17

Determining the Cost of Capital: A Stock Market Perspective

WHAT IS A SUITABLE TARGET RoC?

The question of capital levels can be phrased either way: given a certain amount of capital, how much return should we aim for? Or given a certain amount of planned return, how much capital should we hold? The key to both questions is the required return on capital (RoC). We are here assuming that capital is synonymous with the capital employed (shareholders' investment in the business). As noted in Chapter 16, we generally treat all other forms of capital as part of the operations of the bank. Return is therefore expressed after deducting the cost of servicing these other items.

If the return required by shareholders is known, then it is possible at least to make a reasonable calculation: one can start either with a planned return (based on what can be achieved in terms of market share increases etc.—i.e. an incremental approach), or with a given level of capital and work out what sort of return needs to be generated (i.e. a zero-based approach).

One approach is to look at the returns generated by similar banks (benchmarking), and set a goal of simply beating the competition. This may be a good starting point, but if the average performance across the industry is poor, then this is probably not very ambitious, and may over time expose the bank to the risk of a takeover. Whilst most bank takeovers and mergers have been either smaller, troubled banks being acquired by their larger brethren, ...