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.
Should financial institutions (FIs) and banks be focused or diversified? Does the extent of focus or diversification affect the quality of their loan portfolios? Does diversification, based on traditional portfolio theory wisdom, lead to greater safety for FIs and banks? In this paper, we undertake an empirical investigation of these questions. The evidence we present suggests that, in contrast to the recommendations of traditional portfolio and banking theories, diversification of bank assets is not guaranteed to produce superior return performance and/or greater safety for banks.
There are several reasons why the focus vs. diversification issue is important in the context of FIs and banks. First, FIs and banks face several (often conflicting) regulations that create incentives either to diversify or focus their asset portfolios, such as the imposition of capital requirements that are tied to the risk of assets, branching and asset investment restrictions, etc. Hence, from a policy standpoint, it is interesting to ask if FIs and banks benefit or get hurt from diversification of their loan portfolios.
In addition, the very nature of an intermediary’s business activities makes the question of focus versus diversification an interesting economic issue to explore. FIs and banks act as delegated monitors in the sense of Diamond (1984), and acquire proprietary information about the firms they lend to, as noted by Fama (1980, 1985), and James (1987), and as modelled by Rajan (1992) and Sharpe (1990). The quality of monitoring and information acquisition is however an endogenous choice of FIs and banks. This choice is governed by the extent of agency conflict between equity holders (bank owners) and creditors of an FI. As explained below, this agency conflict is affected by the “downside riskiness” or insolvency risk of the FI and by the extent of the FI’s focus or diversification.
We define portfolio “downside risk” or insolvency risk to mean the likelihood that the FI’s asset returns will be lower than a given threshold (i.e., the level of deposits in the bank’s capital structure), an event that constitutes a “default” or an economic insolvency. For the sake of illustration, consider the extreme case where the FI’s insolvency risk is extremely high, then on an expected basis most benefits from monitoring accrue only to its creditors (uninsured depositors and providers of borrowed funds). In this case, bank owners have little incentive to monitor. All else being equal, the FI’s under-investment in monitoring will be more severe the greater is its risk of failure. Under such an incentive structure, can FIs and banks monitor their loans effectively as they expand into different industries and segments of the loan markets? How does the decision to be focused or diversified affect their monitoring incentives and the endogenous quality (i.e., the risk and the return) of their loans?
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Should Banks Be Diversified
