Should Banks be Diversified? Evidence from Individual Bank Loan Portfolios

Abstract

We study empirically the effect of focus (specialization) vs. diversification on the return and the risk of banks using data from 105 Italian banks over the period 1993-1999. Specifically, we analyze the tradeoffs between (loan portfolio) focus and diversification using data that is able to identify loan exposures to different industries, and to different sectors, on a bank-by-bank basis. Our results are consistent with a theory that predicts a deterioration in the effectiveness of bank monitoring at high levels of risk and upon lending expansion into newer or competitive industries. Our most important finding is that both industrial and sectoral loan diversification reduce bank return while endogenously producing riskier loans for high risk banks in our sample. For low risk banks, these forms of diversification either produce an inefficient risk-return tradeoff or produce only a marginal improvement. A robust result that emerges from our empirical findings is that diversification of bank assets is not guaranteed to produce superior performance and/or greater safety for banks.JEL Classification: G21, G28, G31, G32

The Impact of Public Guarantees on Bank Risk-Taking: Evidence from a Natural Experiment*

“…As we potentially face a simultaneity problem among our set of variables we lag our independent variables Z Score(i, t − 1), Loan size(i, t − 1), Interest rate spread(i, t − 1), and T otal bank assets(g, t − 1) by one year and include them as further independent variables (Acharya et al, 2006). 15 We estimate all specifications using OLS with cluster robust standard errors at the savings bank group level, thus allowing for unobserved correlation between observations from the same savings bank group (Froot, 1989).…”

What drives investment bank performance? The role of risk, liquidity and fees prior to and during the crisis

“…Thus, the positive effect of raising fee-income on bank performance via risk diversification would be stronger for banks with low levels of noninterest income. Moreover, De-Young and Roland (2001) argue that the substitution of traditional operations with fee-income activities is related to an instability of earnings, while Acharya et al (2006) show that banks with higher inclusion of non-interest income activities in their portfolio perform less efficiently than banks with lower involvement in fee-income operations. In the same manner, Stiroh (2004) and Lepetit et al (2008) find a positive association between fee-based revenue and bank risk.…”

The effects of focus versus diversification on bank performance: Evidence from Chinese banks

“…Acharya et al (2006) provide results suggesting that there are diseconomies of scope that arise through weakened monitoring incentives and a poorer-quality loan portfolio when a risky bank expands into additional industries and sectors, complementing the agency-theoretic analysis of the boundaries of a bank's activities as proposed in Cerasi and Daltung (2000). Laeven and Levine (2007) find that financial conglomerates engaging in multiple lending activities have lower market values than they would if they were broken into separate financial institutions, and their results are consistent with theories that stress intensified agency problems in financial conglomerates that engage in multiple activities and indicate that any economies of scope are not sufficiently large to produce a diversification premium.…”

“…We measure the Focus Index by employing a Herfindahl-Hirschman Index (HHI) measure following Acharya et al (2006). The Focus Index is the sum of squares of the proportions of portfolios in each classification.…”