Bank Risk and Bank Rents: The Franchise Value Hypothesis Reconsidered

Abstract

The predictive relationship between franchise value, measured by 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 this prediction is reverted when franchise value is priced and Q exceeds unity, as higher values of Q predict higher bank risk of insolvency. 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 in these rents is associated with higher market valuation and higher franchise value. Thus, an increase of any of these rents predicts a higher bank risk of insolvency. The franchise value hypothesis is thus rejected in our samples. An interpretation of these findings in light of existing theories is discussed.

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

JEL Classification: C21, E44, G21