Franchise Value, Capital Requirements and Closure Rules in a Dynamic Model of Bank Portfolio Management

Abstract

In a dynamic framework where franchise value is determined endogenously, we show how different sources of rents (underpriced deposit insurance, super-normal returns on loans, and imperfect competition for deposits) affect banks' risk taking behaviour, the probability of default and the value of deposit insurance liability. The model predicts that bank behaviour will depend on the sources of its rents. The paper also analyzes the implications for bank risk taking of current capital requirements and the new framework proposed by the BIS. Bank closure rules also have important implications for risk taking, in particular when shareholders are allowed to replenish capital in the event that asset value falls below the value of desposit liability. In this case the disciplinary effect of the loss of the franchise value disappears and, in general, the value of the deposit insurance liability increases because the bank fails less often but with a large deficit. Capital requirements potentially mitigate the effects generated by the option to re-capitalize on the value of deposit insurance liability.