Diversification and the Banks' Risk-Return-Characteristics - Evidence from Loan Portfolios of German Banks

Abstract

Banks face a tradeoff between diversifying and focusing their loan portfolio. In this paper we carry out an empirical study for the German market to shed light on the question whether or not the benefits of risk sharing outweigh those of specialization.We use data from the Bundesbank's quarterly borrowers statistic to determine the degree of diversification in the banks' loan portfolios and combine this data with the banks' balance sheets and audit reports. The unique database comprises data from all German banks during the period from 1993 to 2003.Our main results can be summarized in three statements: i) Specialized banks have a slightly higher return than diversified banks. ii) Specialized banks have lower relative loan loss provisions and lower shares of non-performing loans, iii) However, the standard deviations of the loan loss provision ratio and the non-performing loan ratio are lower for diversified banks.Keywords: bank lending, loan portfolio, portfolio theory, diversification, riskreturn analysis JEL classification: G11, G21, C23, C43 Non technical summaryShould a bank diversify its loan portfolio as much as possible or should it concentrate its lending to those industries in which it has special expertise? If the expected return and the risk of a loan were completely exogenous, the answer would clearly be in favour of the risk diversification as we know it from the stock markets. However, to some extent a bank can influence the risk-return-characteristics of its loans. For instance, the bank determines the effort for screening and monitoring of its debtors. The results of our empirical study can be summarized as follows: more specialized banks tend to have a slightly higher return, measured as profits over equity and total assets, respectively, than more diversified banks. However, the slightly higher return comes along with a slightly higher risk, which we measure as the serial volatility of the non-performing loans ratio. To sum up, focused banks enjoy a slightly better return performance, but their non-performing loans ratio is a bit more volatile. Nicht-technische Zusammenfassung

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