Corporate Control, Portfolio Choice, and the Decline of Banking

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Abstract
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
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