Can banks provide loan accommodations to their middle-and upper-middle-market customers in the mid- to late '90s at prices that will ensure profitable performance? Are they currently providing these accommodations for sufficient compensation?
It is now understood that, in order to preserve viability, banks must earn a risk-adjusted return or equity that is at least great as, or greater than, their hurdle rate. A bank's hurdle rate is equal to Rf+b(Rm-Rf). That is, to hold on to the stock, the bank shareholder must earn the risk-free rate (Rf), plus the market price of risk, which is the return over the risk-free rate normally garnered by stock-market investors (Rm-Rf), as adjusted for the individual riskiness of the bank, or the bank's beta (b). For a bank with a beta of one (it is just as risky as the general market), the prevailing level of interest rates implies the need to earn approximately 14% to 15% after tax.