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

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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.