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

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