Bank Risk and Bank Rents: The Franchise Value Hypothesis Reconsidered

41 Pages Posted: 6 Nov 2020 Last revised: 4 Apr 2021

See all articles by Gianni De Nicolo

Gianni De Nicolo

Johns Hopkins University - Carey Business School; CESifo (Center for Economic Studies and Ifo Institute)

Viktoriya Zotova

Georgetown University - Department of Accounting and Business Law

Date Written: March 31, 2020

Abstract

The predictive relationship between banks' Tobin Q and a theory-based measure of bank risk of insolvency is highly non-linear. Using large samples of publicly quoted banks in the US, Europe, and Asia during 1985-2017, we find that higher values of Q predict lower bank risk of insolvency up to values of Q close to 1, but higher values of Q predict higher bank risk of insolvency when Q exceeds 1 and franchise value is priced. The franchise value hypothesis (FVH), postulating a negative relationship between bank rents and risk, is thus rejected in our samples. We then construct proxy measures of bank efficiency rents, loan and deposit pricing power rents, and rents due to government guarantees, and show that an increase of any of these rents is associated with higher franchise values. We provide an explanation of the rejection of the FVH using a calibration of two standard financial models of the banking firm, and illustrate a simple model that can rationalize the rejection of the "quiet life hypothesis" due to the positive correlations between pricing power rents, a measure of cost inefficiency, and bank risk found in the data.

Keywords: Tobin Q, Bank Risk of Insolvency, Bank Rents

JEL Classification: C21, E44, G21

Suggested Citation

De Nicolo, Gianni and Zotova, Viktoriya, Bank Risk and Bank Rents: The Franchise Value Hypothesis Reconsidered (March 31, 2020). Available at SSRN: https://ssrn.com/abstract=3708927 or http://dx.doi.org/10.2139/ssrn.3708927

Gianni De Nicolo (Contact Author)

Johns Hopkins University - Carey Business School ( email )

100 International Drive
Baltimore, MD 21202
United States
(410) 234-4507 (Phone)

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

Viktoriya Zotova

Georgetown University - Department of Accounting and Business Law ( email )

McDonough School of Business
Washington, DC 20057
United States

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