Corporate Control, Portfolio Choice, and the Decline of Banking




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    • Gorton is from The Wharton School, University of Pennsylvania and the National Bureau of Economic Research (NBER). Rosen is from Indiana University. Thanks to Stephen Buser, Charles Calomiris, Frank Diebold, Mark Flannery, Javier Hidalgo, Chris James, Myron Kwast, David Llewellyn, Max Maksimovic, Pat McAllister, George Pennacchi, Steve Prowse, Rene Stulz, Greg Udell, an anonymous referee, and participants of seminars at the London School of Economics, Stockholm School of Economics, the Board of Governors Lunchtime Workshop, the Penn Macro Lunch Group, the University of Chicago, the Chicago Fed Bank Structure Conference, Cornell University, University of Florida, University of Michigan, the NBER Corporate Finance Group, the Maryland Symposium, the Office of Thrift Supervision, and the San Francisco Federal Reserve Bank for suggestions and discussion. Much of the work on this paper was done while Rosen was at the Board of Governors of the Federal Reserve System. The views expressed in this paper represent the authors' views only and do not necessarily represent the views of the Federal Reserve System. Part of this paper was previously part of a paper entitled “Overcapacity and Exit From Banking.”


In the 1980s, U.S. banks became systematically less profitable and riskier as nonbank competition eroded the profitability of banks' traditional activities. Bank failures rose exponentially during this decade. The leading explanation for the persistence of these trends centers on fixed-rate deposit insurance: the insurance gives bank equityholders an incentive to take on risk when the value of bank charters falls. We propose and test an alternative explanation based on corporate control considerations. We show that managerial entrenchment played a more important role than did the moral hazard associated with deposit insurance in explaining the recent behavior of the banking industry.