Banks with Something to Lose: The Disciplinary Role of Franchise Value

Rebecca S. Demsetz · Marc R. Saidenberg · Philip E. Strahan

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Banking stability, regulation, efficiency Corporate Finance and Governance Banking Sector Performance and Management

Abstract

As protectors of the safety and soundness of the banking system, banking supervisors are responsible for keeping banks' risk taking in check. The authors explain that franchise value--the present value of the stream of profits that a firm is expected to earn as a going concern--makes the supervisor's job easier by reducing banks' incentives to take risks. The authors explore the relationship between franchise value and risk taking from 1986 to 1994 using both balance-sheet data and stock returns. They find that banks with high franchise value operate more safely than those with low franchise value. In particular, high-franchise-value banks hold more capital and take on less portfolio risk, primarily by diversifying their lending activities.

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References

1994The Benefits of Lending Relationships: Evidence from Small Business Data 1995Relationship Lending and Lines of Credit in Small Firm Finance 1997Diversification, Size, and Risk at Bank Holding Companies 1984Deregulation and bank financial policy 1995The Decline of Traditional Banking: Implications for Financial Stabilityand Regulatory Policy

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