Q.38 Smart Bank (SB) recently launched a successful takeover of AC Bank. After post-acquisition analysis, senior management at SB strongly feels some of the AC’s business lines do not justify their huge capital allocations. Of key concern is AC’s Small and Medium Businesses Lending Division (SMBL), which has a Loan portfolio worth $150 million. The division relies heavily on deposits to satisfy its funding needs. After extensively analyzing the division’s credit risk, analysts at SB determine that the probability of default is 7% and the loss given default is 60%. What’s more, the exposure at default is 100% of the loan exposure. Senior management requests a review of SMBL’s capital allocation in an attempt to establish exactly how efficient the division is in its use of funds compared to other divisions. The bank applies a 1-year horizon to measure the parameters outlined in the exhibit below:

Item	Value
SMBL division
Economic capital	$120 million
Operating direct costs	$1.25 million
Interest costs	$6 million
Cost of debt capital	5%
Return on risk capital	2%
Return on the loan portfolio	12%
Further Details
Hurdle rate	4.6%
Equity market return	6%
Risk-free rate	2%
Equity beta	1.08
Effective tax rate	30%

Assume that the effective tax rate and hurdle rate span all business lines, there are no transfers, and that correlations between the various divisions are the same. Furthermore, all divisions have a mandate to maximize shareholder wealth. Which of the following recommendations of SB’s analysts would be correct?