Does Skin in the Game Help? Bank Franchise Value, Managerial Incentives and ‘Going for Broke’

Abstract

The roles of bank franchise value (“skin in the game”) and CEO ownership play in determining bank risk are studied for large United States Bank Holding Companies. We find robust evidence of a U-shaped relationship between bank risk and each of CEO ownership and franchise value, indicating that increases in each are initially risk decreasing but as franchise value and CEO ownership increases so too does bank risk. Further, we find that low levels of franchise value combined with high CEO ownership results in managerial incentives aligning with those of shareholders, resulting in increased bank risk (“going for broke” or asset substitution (Harris and Raviv 1991)). We argue that these results are consistent with those of Merton (1977), but in the context of franchise value rather than bank capital, and accordingly offer some policy recommendations for regulatory monitoring of bank risk that are consistent with these results.

Keywords: Bank risk-taking, Managerial incentives, CEO ownership, Franchise value, Bank holding companies

JEL Classification: G21, G28, G30, G32, G38