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Franchise value and risk-taking in modern banks

Author

Listed:
  • Natalya Martynova
  • Lev Ratnovski
  • Razvan Vlahu

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.

Suggested Citation

  • Natalya Martynova & Lev Ratnovski & Razvan Vlahu, 2014. "Franchise value and risk-taking in modern banks," DNB Working Papers 430, Netherlands Central Bank, Research Department.
  • Handle: RePEc:dnb:dnbwpp:430
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    File URL: https://www.dnb.nl/en/binaries/Working%20Paper%20430_tcm47-309755.pdf
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    References listed on IDEAS

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    Cited by:

    1. Natalya Martynova, 2015. "Effect of bank capital requirements on economic growth: a survey," DNB Working Papers 467, Netherlands Central Bank, Research Department.
    2. Wu, Ji & Chen, Minghua & Jeon, Bang Nam & Wang, Rui, 2017. "Does foreign bank penetration affect the risk of domestic banks? Evidence from emerging economies," Journal of Financial Stability, Elsevier, vol. 31(C), pages 45-61.
    3. repec:eee:riibaf:v:42:y:2017:i:c:p:1455-1466 is not listed on IDEAS

    More about this item

    Keywords

    Banks; Risk-taking; Franchise value; Bank capital; Repo markets; Crises;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation

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