Shareholder value is a centric component used while measuring business performance, banking sector in particular is required to calculate the precise capital requirement and cost allocation for each of its businesses. In general capital allocation would be a result of differences in risk and regulatory mandates, and traditionally banks allocate cost of capital as a circumstance and do not distinguish between performing and non-preforming business lines.

Arguably capital is allocated based on how much risk is endured by the business line and highest return on equity (RoE), which will subsequently maximize the overall RoE; hence the allocation of capital should be calculated as a function regulatory mandates and internal capital requirements. Therefore the cost of capital has to be distinguished amongst businesses in a practical manner that will avoid inconsistent pricing and reduction in the overall shareholder value.

The current practice in capital allocation is based on risk insensitive measures that safeguard the consistency between the allocated capital and the actual required amount. However its eminent the cost of capital will vary amongst business lines, such practices can yield in imprecise conclusions on the shareholder value generated by each business line. Furthermore regulatory capital mandate changes will be an additional challenge faced by the bank while assessing performance of each business line.

Distinguishing between business lines while allocating cost of capital not propositional to risk, will result in distorted risk adjusted profitability and pricing decisions, therefore its curtail to allocate capital based on contending capital needs. By adopting such strategy the banks will be able to tailor capital need per business line, in addition to that it will allow to calculate the cost of capital on the allocated amount and the actual leverage. Banks should be in a position to sustain a positive shareholder value added by gauging the risk adjusted coast of capital and ensuring that profit on invested capital exceeds it, at the same time carry out regular comparative analysis on the short-term vs. long- term investments to include revenue, earnings, growth, margins and liquidity.

Huge efforts are required while calculating the cost of capital, arriving at a precise returns and correlations with inaccurate or no data is fraught. In the absence of data from individual business lines the capital cost estimation will be at firm level, yet fine-tuning the cost of capital per business and calculate leverage is basic step. In my opinion banks can look at the economic capital and stress testing to overcome the calculation constrains of cost of capital per business line, adopting such strategy can arrive to correct adjustments of cost per business line. In conclusion factors determining the cost of capital are not trivial and how to accurately estimate the cost of capital of banks and their business lines in practice clearly warrants further research.