Franchise Value Matters: The Drivers of Bank Risk-Taking in the Post-Basel III Era

We examine banks’ risk-taking in lending to small and medium-sized enterprises under the prolonged low interest rate environment in Japan. Specifically, we identify “low-return borrowers,” whose borrowing interest rates are low relative to their financial soundness. Using bank-firm level data for millions of Japanese small and medium-sized enterprises, we find that bank loans to low-return borrowers have increased more than those to other normal firms in recent years and such risk-taking by banks has been driven by the low interest rate environment as well as the increase in competition among banks. In addition, we show that highly capitalized banks with low profitability increased loans to such vulnerable borrowers more than lowly capitalized banks. These findings suggest that under the post-Basel III regulatory framework, future franchise value of banks, rather than the current capital of banks, is the key driver of banks’ risk-taking.