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Franchise value and risk-taking in modern banks

Natalya Martynova (), Lev Ratnovski () and Razvan Vlahu ()

DNB Working Papers from Netherlands Central Bank, Research Department

Abstract: Traditional theory suggests that high franchise value limits bank risk-taking incentives. Then why did many banks with exceptionally valuable franchises get exposed to new financial instruments, resulting in significant losses during the crisis? This paper attempts to reconcile theory and evidence. We consider a setup where a bank takes risk by levering up, to invest in risky market-based instruments. High franchise value allows the bank to borrow more, so it can take risk on a larger scale. This offsets lower incentives to take risk of given size. As a result, a bank with a higher franchise value may have higher risk-taking incentives. The proposed effect is stronger when a bank can expand the balance sheet using inexpensive senior funding (such as repos), and when it can achieve high leverage thanks to better institutional environment (with more protection of creditor rights). This framework captures well the stylized patterns of bank risk-taking in the run-up to the crisis.

Keywords: Banks; Risk-taking; Franchise value; Bank capital; Repo markets; Crises (search for similar items in EconPapers)
JEL-codes: G21 G24 G28 (search for similar items in EconPapers)
Date: 2014-07
New Economics Papers: this item is included in nep-ban and nep-cta
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4) Track citations by RSS feed

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Persistent link: https://EconPapers.repec.org/RePEc:dnb:dnbwpp:430

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