Franchise Value and Risk-Taking in Modern Banks

41 Pages Posted: 17 Jul 2014

See all articles by Natalya Martynova

Natalya Martynova

De Nederlandsche Bank - Research Department

Lev Ratnovski

International Monetary Fund; European Central Bank, Financial Research Division

Razvan Vlahu

De Nederlandsche Bank

Date Written: July 16, 2014

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

JEL Classification: G21, G24, G28

Suggested Citation

Martynova, Natalya and Ratnovski, Lev and Vlahu, Razvan, Franchise Value and Risk-Taking in Modern Banks (July 16, 2014). De Nederlandsche Bank Working Paper No. 430, Available at SSRN: https://ssrn.com/abstract=2467024 or http://dx.doi.org/10.2139/ssrn.2467024

Natalya Martynova (Contact Author)

De Nederlandsche Bank - Research Department ( email )

P.O. Box 98
1000 AB Amsterdam
Netherlands

Lev Ratnovski

International Monetary Fund ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

HOME PAGE: http://ratnovski.googlepages.com

European Central Bank, Financial Research Division

Germany

Razvan Vlahu

De Nederlandsche Bank ( email )

P.O. Box 98
Amsterdam, 1000 AB
Netherlands
+31205242483 (Phone)
+31205242506 (Fax)

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