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Corporate Control, Portfolio Choice, and the Decline of Banking

  • Gary Gorton
  • Richard Rosen

The authors focus on the persistence of bank unprofitability during the 1980s. A large literature in banking, following Merton (1977), concentrates on the incentives of shareholders to maximize the value of the (fixed rate) deposit insurance subsidy provided by the government by taking on risk inefficiently, so called moral hazard' risk. This paper takes issue with this moral hazard explanation for the performance of the banking industry. The moral hazard view assumes that shareholders make the lending decisions and can take on risk to maximize the value of insurance if they desire. The authors assume bank managers, who may own a fraction of the bank, make the lending decisions. If managers have different objectives than outside shareholders and disciplining in managers is costly, then managerial decisions may be at odds with the decisions outside shareholders would like them to take. When investment opportunities are declining, managers behave differently than in healthy' industries. This is particularly true in banking, where asymmetric information and deposit insurance allow banks resources to invest even if there are few good lending opportunities. The risk-avoiding behavior of managers stressed in the corporate finance literature presumes that conservative behavior is sufficient for job and perquisite preservation. When bad managers predominate, conservative behavior may not allow most managers to keep their jobs and perquisites. These managers may find it optimal to take excessively risky actions. The paper sets out a game between a bank manager and shareholders and solves for a sequential Nash equilibrium. A bank manager chooses either risky or safe loans based on the quality of the loan opportunities available to the manager (the manager s type). The choice of loan portfolios is observed by shareholders, but the manager s type is not. If the manager is fired, shareholders decide whether to invest in new bank assets (hire a new manager) or move their capital out of banking (liquidate capital). In any period that they are employed, managers receive a private benefit. Using data on the equity ownership structure of large bank holding companies, the authors test the predictions of the corporate control model of banking against an alternative model based on moral hazard problems between banks and regulators. With respect to the choice of loans made, the authors findings are consistent with corporate control problems playing an important role, but are inconsistent with moral hazard playing a dominant role in banking. None of the results are what a moral hazard model would predict. However, the analysis is done for adequately-capitalized banks. Thus, if the value of bank equity is low enough, the interests of inside and outside owners are aligned, so there are no corporate control problems of the sort modeled by the authors. It may be accurate to say that, for large U.S. banks, corporate control problems have been the cause of the conditions of which moral hazard may be an accurate characterization. The presence of agency costs suggests that the underlying trends that reduced profitability in the 1980s may persist, despite high bank earnings in the early 1990s. That banking is regulated does not appear to be a sufficient countervailing force. To the extent that chartered banks must transform themselves into nonbanks as they seek nonlending and deposit-taking activities which are profitable, the authors suggest that banking' is in decline. Their conclusions concern the difficulties that outside equityholders face during the transition period.

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Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 95-09.

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Date of creation: Jul 1994
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Handle: RePEc:wop:pennin:95-09
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