The recent rise in problem loans extended by banks in the United States and the decline in profitability faced by Japanese banks are a source of concern for policymakers, who associate these events with a significant decline in the franchise value of wholesale banks in those countries.
In contrast with the conventional view that the franchise value of banks stems from their informational advantage over other financial institutions, this paper identifies the franchise value of a bank with the business of providing liquidity and payments services to bank customers. In this regard, the decline in the franchise value of wholesale banks in Japan and the United States is attributable to a reduction in corporate demand for bank liquidity. This paper also maintains that the decline in franchise value has led to increased risk taking on the part of American wholesale banks and to a decline in earnings at Japanese wholesale banks.
An important conclusion is that proposals to reform the banking industry that concentrate on broadening the powers of banks may not solve the fundamental problem of wholesale banks because they do not deal with the origin of the problem. Instead, wholesale banks are faced with two choices: First, banks could reduce the scale of their business to a level consistent with the reduced demand for liquidity of their customers. A second option may lie in the expansion of businesses that permit banks to exploit better their traditional skill of reducing the cost of liquidity. The building of swap markets is a case in point.