Should banks be diversified?: evidence from individual bank loan portfolios

Acharya, V, Hasan, I and Saunders, A (2001) Should banks be diversified?: evidence from individual bank loan portfolios. Working Paper. London Business School IFA Working Paper.

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 19931999. 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 bankbybank 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 to 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 riskreturn 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 safery for banks.