Does Diversification Improve the Performance of German Banks? Evidence from Individual Bank Loan Portfolios

Abstract

Should banks be diversified or focused? Does diversification indeed lead to enhanced performance and, therefore, greater safety for banks, as traditional portfolio and banking theory would suggest?This paper investigates the link between banks' profitability (ROA) and their portfolio diversification across different industries, broader economic sectors and geographical regions measured by the Herfindahl Index. To explore this issue, we use a unique data set of the individual bank loan portfolios of 983 German banks for the period from 1996 to 2002. The overall evidence we provide shows that there are no large performance benefits associated with diversification since each type of diversification tends to reduce the banks' returns. Moreover, we find that the impact of diversification depends strongly on the risk level. However, it is only for moderate risk levels and in the case of industrial diversification that diversification significantly improves the banks' returns.Keywords: focus, diversification, monitoring, bank returns, bank risk JEL Classification: G21, G28, G32 Non-Technical SummaryShould banks be diversified or focused? Does diversification indeed lead to enhanced performance and therefore greater safety for banks as traditional portfolio and banking theory would suggest? In this paper we try to shed some light on these questions by empirically investigating the situation for German banks. By exploiting a unique data set of individual bank loan portfolios for the period from 1996 to 2002, we analyse the link between banks' profitability measured by ROA and their portfolio diversification measured by the Herfindahl Index across different industries, broader economic sectors and geographical regions. To the best of the authors' knowledge, this is the first paper to study the effect of all three types of diversification based jointly on micro-level data on German banks.The relevant academic literature puts forward two conflicting theories concerning the optimal degree of diversification. While traditional banking and portfolio theory recommends that banks should be as diversified as possible to reduce their risks of suffering a costly bank failure, corporate finance theory suggests that a bank should focus so as to obtain the greatest possible benefit from management's expertise and to reduce agency problems.Our results clearly support the latter theory, as the evidence we present indicates that each kind of diversification tends to lower German banks' returns, ie focusing generally increases profitability.Furthermore, the impact of any diversification on banks' return changes in line with the risk level.While the effect of sectoral focus on return declines monotonously with increasing risk, there is mixed evidence to suggest either a monotonously decreasing or a U-shaped relationship for regional focus as well as a rather distinct indication of a U-shape with respect to industrial focus. In addition, our data shows that diversification significantly improves banks' profits only in the case of mo...

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