Efficiency implications of diversification by firms and banks

Sturgess, Jason (2008) Efficiency implications of diversification by firms and banks. Doctoral thesis, University of London: London Business School.

Abstract

This dissertation examines how diversification in firms and banks affects the efficiency of capital allocation. In the first chapter, I focus on multinational firms and geographical diversification. I show that there are important differences between industrial and geographical diversification with associated efficiency effects. Using a unique sample of 212 UK multinational firms and 4,676 subsidiaries, I show that multinational firms attract, on average, a global diversification premium of approximately 16% compared with local non-multinational firms, and that on average better corporate governance practices explain roughly one-third of the value premium. The results suggest that multinational firms are compensated for exporting good corporate governance through global diversification. In the second chapter, I examine how banks’ ability to diversify affects the efficiency of allocation in the real economy. I document that the deregulation of bank branching restrictions in the United States triggered a reallocation across sectors. In particular, the reallocation can be explained by mean-variance portfolio theory applied to sectoral returns: the realized sectoral allocation of output at the state level converges towards this benchmark allocation, at a rate that is hastened following the deregulation. The result is particularly strong in sectors characterized by young, small and external finance dependent firms, and for states that have a larger share of such sectors. The results suggest that improving bank access to branching affects sectoral specialization (or diversification) of output. The final chapter is a theoretical investigation into the allocation of capital within a multidivisional firm. I show that ex-post efficient capital allocation in an internal capital market may destroy incentives, resulting in value destruction. Specifically, even where agents are assumed to behave efficiently, competition for resources may decrease efficiency where divisions are sub-optimally grouped together. The implication is that firms that exhibit a diversification discount may not be inefficient in the traditional sense, but that even when the firm is being run optimally a diversification discount persists.