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

Abstract

As protectors of the safety and soundness of the banking system, banking supervisors are responsible for keeping banks ’ risk taking in check. On-site examinations, off-site surveillance, and capital requirements are some of the tools that supervisors use to achieve this goal. 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 risk. In banking, sources of franchise value include efficiency, access to markets protected from competition, and valuable lending relationships. Franchise value can help reduce excessive risk taking because banks with high franchise value have much to lose if a risky business strategy leads to insolvency.