Bank Rent Research Articles

Bank Risk and Bank Rents: The Franchise Value Hypothesis Reconsidered

The predictive relationship between banks' Tobin Q and a theory-based measure of bank risk of insolvency is highly non-linear. Using large samples of publicly quoted banks in the US, Europe, and Asia during 1985-2017, we find that higher values of Q predict lower bank risk of insolvency up to values of Q close to 1, but higher values of Q predict higher bank risk of insolvency when Q exceeds 1 and franchise value is priced. The franchise value (FVH), postulating a negative relationship between bank rents and risk, is thus rejected in our samples. We then construct proxy measures of bank efficiency rents, loan and deposit pricing power rents, and rents due to government guarantees, and show that an increase of any of these rents is associated with higher franchise values. We provide an explanation of the rejection of the FVH using a calibration of two standard financial models of the banking firm, and illustrate a simple model that can rationalize the rejection of the quiet life hypothesis due to the positive correlations between pricing power rents, a measure of cost inefficiency, and bank risk found in the data.

Do Islamic banks need to earn extra profits?

PurposeThis paper aims to draw upon existing debate over “financial sector rent” (bank rent) to analyze the current pattern of financing of Bangladeshi and Indonesian Islamic banks during the period of 2011 and 2015.Design/methodology/approachThe empirical evidence through a comparative approach of analyzing the performance of Islamic banks with that of conventional banks in respective countries – two of the largest countries where majority of the population are Muslims – is drawn to demonstrate the objective.FindingsWhile Islamic banks in Bangladesh are primarily concentrating on the murabaha (mark-up contract) mode of financing, some transactions under musharaka (partnership/equity-based contract) are observed in the Indonesian Islamic banking sector. This anomaly in Indonesia can be explained by the nature of their musharaka financing which is not of the purely “participatory” financing type. As a result, we can observe the quasi-murabaha syndrome in Indonesian Islamic banking sector. The concentration of asset-based financing including consumers’ financing (hire purchase) in the credit portfolio gives Islamic banks relatively higher Islamic bank rent opportunity for protecting their “franchise value” as Sharīʿah-compliant (Islamic law-compliant) lenders. However, Indonesian Islamic banks share a still infant Islamic banking market, and enjoy less rent opportunity under a severe competition with conventional banks.Research limitations/implicationsThe bank rent approach suggests that the syndrome observed both in Bangladesh and Indonesia can be ironically justifiable. Moreover, the mode of profit-and-loss sharing provides, in practice, an idea of the difficulty in managing the participatory financing embedded with high credit risk. Under this scenario, it is necessary for Islamic scholars and the regulatory authority to design an appropriate financial architecture, enabling Islamic banks to avail the benefit from a wider variety of Sharīʿah-based Islamic financing.Originality/valueThis paper expands the newly emerged concept of “Islamic bank rent” to make sense of the murabaha syndrome in Bangladesh and the quasi-murabaha syndrome in Indonesia. This approach also contributes to clarifying the unique risk and cost to be compensated with the spreads that Islamic banks are expected to earn.

Islamic bank rent

Purpose – This paper aims to draw on the bank rent approach to evaluate the existing pattern of financing of Islamic banks and to propose a fairly new conceptualization of Islamic bank rent. Design/methodology/approach – The bank rent theory is adopted to generate the theoretical underpinnings of the issue. After that, empirical evidence from the banking sector of Bangladesh is used to support the arguments. Findings – Repeated transactions under murabaha are observed in the Islamic banking sector of Bangladesh. The asset-based financing gives the Bangladeshi Islamic banks relatively higher Islamic bank rent opportunity for protecting their “franchise value” as Shari’ah-compliant lenders, while responding to the periodic volatility in transaction costs of profit-and-loss sharing. Research limitations/implications – The bank rent approach suggests that the murabaha syndrome can be ironically justifiable. On the other hand, the current profit-and-loss sharing risk provides an idea of the difficulty in assuming the participatory financing with higher credit risk in practice. Islamic scholars and the regulatory authority need to design an appropriate financial architecture which can create different levels of rent opportunities for Islamic banks to avail the benefit from the variety of Islamic financing as declared by Islamic Shari’ah. Originality/value – This paper introduces a fairly new concept of “Islamic bank rent” to make sense of the murabaha syndrome. This approach also contributes to clarifying the unique risk and cost to be compensated with the spreads that Islamic banks are expected to earn. To draw empirical evidence, as far as it could be ascertained, the data of both Islamic banks and conventional banks with Islamic banking windows/branches are used for the first time.

Islamic banking and the Grameen mode of microcredit in Bangladesh: an institutional comparison

With diverse histories and attitudes toward risk-taking, different financial systems have a common aim: ensuring financial stability and efficiency within a geographical region. But differences exist between various financial systems as a result of their evolution and adaptation to their surrounding environment. This paper aims to analyze the incentive and sanction mechanisms of the Islamic mode of banking and the Grameen Bank model of microcredit in Bangladesh, and how they help ensure their financial stability and efficiency. We challenge the conventional explanations of their success. We point out that the informal sanction mechanisms embedded in the two modes of financial intermediation – avoiding non-compliance with Islamic Shari'ah (revealed divine law) in the case of Islamic banking, and kinship-based groupings or gushtis in the case of microcredit – play important roles in lowering the transaction costs of screening and enforcing contracts. We also point out how bank rent opportunity – the promised return from non-participatory financing and a high spread supported through low-cost funds provided by donor agencies and compulsory savings – is captured in each of the two modes, playing a further important role in maintaining their franchise values, given the specificities of the Bangladeshi financial context.

Understanding the rise and decline of the Japanese main bank system: The changing effects of bank rent extraction

This paper shows how main bank rent extraction affects corporate decisions about investment and financing during financial regulatory reform. Our model predicts that limited loanable funds can initially contain main bank controlled overinvestment, even when new equity is available to the firm. Abundant funds facilitate overinvestment to the detriment of firm profitability. A shift of control rights back to the firm due to financial deregulation produces an “equity for upside potential and bank debt for downside risk” bias against the banks. A stock market and real estate boom in Japan made it harder than ever for the banks to diversify risk. The insights from this analysis help explain why Japan’s main bank system was beneficial in the (capital constrained) postwar period but became harmful during the (capital abundant and even bubbly) 1980s, and why the adverse shocks of the post-deregulation 1990s had such severe effects on the banking system.

The Grameen Bank “Empowering the Poor” Model of Microcredit: An Institutional Comparison with the Traditional Mode of the Japanese Banking System

This paper proposes an institutional approach to understanding the success of a South Asian “empowering the poor” model of microcredit — the “Grameen Bank”. We compare the institutional settings in the model with those in the traditional mode of Japanese relation-based banking which greatly contributed to Japan's high growth, to shed an analytical light on the advantages and sustainability of Bangladesh's microcredit industry. We find that the availability of bank rent opportunities, low level of transactions costs, mainly in terms of low monitoring costs and delegation costs, together with the well-rooted protection and sanction mechanisms, which are properly aligned with both formal and informal institutions, guarantee the success of the GB mode of microcredit in the current context, as it guaranteed the success of the Japanese relation-based mode of banking during its high growth period.

A ‘bank rent’ approach to understanding the development of the banking system in Bangladesh

This paper applies the ‘bank rent’ approach to understanding the development of the banking system in Bangladesh since its independence. The paper uses the financial restraint model as an analytical framework and argues that there still remains room for creating bank rents in order to change the current dreary performance of the banking system. The paper unearths a varied level of high nominal lending rates, high nominal spreads and too low or negative real spreads as per different clusters of banks both in the pre-liberalized and liberalized regime, and concludes that this persistent varied performance is largely the outcome of a high amount of non-performing loans, inefficiencies in managing credit risks, and fragmentation and distorted competition in the banking system. This varied level of performance of the banking clusters also results from the government's intervention in the activities of nationalized commercial banks and specialized banks for mediating credits to priority sectors at a subsidized rate. The paper suggests that a more coordinated use of monetary and fiscal policies is required with a view to creating appropriate rents for banks for redressing their current dismal performance.

Understanding the Rise and Decline of the Japanese Main Bank System: The Changing Effects of Bank Rent Extraction

Understanding the Rise and Decline of the Japanese Main Bank System: The Changing Effects of Bank Rent Extraction

Does competition from new equity mitigate bank rent extraction? Insights from Japanese data

Previous research shows that bank information production mitigates asymmetric information problems. However, this literature has ignored the concern that firms with better growth prospects are more vulnerable to bank rent extraction. This paper points out that funding competition from new equity as an effective natural mechanism solves this important concern. Using Japanese data from 1983 to 1997, we show that the relationship between loan-to-debt ratio and growth, while starting significantly negative (consistent with holdup theory), turns significantly positive towards the high end of the growth spectrum. We confirm that high-growth firms raise more new equity than do low growth firms and use more equity relative to bonds in external finance. This is consistent with a generalized Myers–Majluf framework. These results suggest that for high growth firms, when competition from public debt lessens due to increased growth-based valuations, competition from new equity steps in to restrain bank rent extraction.

Understanding the Rise and Decline of the Japanese Main Bank System: The Changing Effects of Bank Rent Extraction

This paper shows how main bank rent extraction affects corporate decisions about investment and financing and then the banking system itself under changing contracting conditions. Interestingly, during the transition from a relationship-oriented financial system to a transaction-based competitive system, an market boom can ominously increase bank risk. More precisely, our model predicts that main bank control tends to produce overinvestment by the client firm. This overinvestment, however, is initially contained by the shortage of bank capital, even when new is available to the firm. Abundant bank capital facilitates overinvestment to the detriment of firm profitability. The shift of control rights back to the firm thanks to the financial deregulation undercuts the bank influence only to erode its loan quality, because the ex ante rational bank is left financing projects with higher downside risk. The high-flying market further lowers the asymmetric information costs of new and aggravates the equity for growth and bank debt for downside risk bias. This makes the bank harder than ever to diversify its risk. The insights of this paper in a dynamic perspective help shed light on why Japan's main bank system was beneficial in the postwar (capital constrained) period, but became harmful during the (capital abundant and bubble-laden) 1980s, and why the adverse shocks of the post-deregulation 1990s had such severe effects on the banking system.

Understanding the Rise and Decline of the Japanese Main Bank System: Corporate Investment and Financing under Bank Rent Extraction

While a close firm-bank relationship mitigates market imperfections, recent research has suggested that insider banks often impose 'holdup' costs. This paper presents a model of how main bank rent extraction affects corporate decisions about investment and financing, and how the high-flying equity market during financial deregulation breeds trouble for the main bank system mainly through unfavourable investment risk profile but not necessarily through overinvestment. Our model predicts that main bank control tends to produce overinvestment by the client firm. This overinvestment, however, is contained by the shortage of bank capital, even when new equity is available to the firm. Abundant bank capital aggravates overinvestment to the detriment of firm profitability. The shift of control rights back to the firm thanks to the financial deregulation undercuts main banks only to erode banks' investment quality. The ex-ante rational bank is left financing projects with less upward potential but higher downside risk. The high-flying equity market aggravates the situation, making the bank's assets more sensitive to shocks. The model is able to show how changes in corporate governance affect investment efficiency and risk profiles especially related to ways of financing, shedding light on why Japan's main bank system was beneficial in the postwar (capital constrained) period, but became harmful during the (capital abundant and bubble-laden) 1980s, and why the adverse shocks of the post-deregulation 1990s had such severe effects on the banking system.