McAllister, Patrick H. and Douglas A. McManus, "Diversification and Risk in Banking: Evidence from Ex Post Returns", Finance and Economics Discussion Series, No. 201, Federal Reserve Board, (June 1992), 38 pages.

Abstract: This paper examines rates of return on bank loan portfolios less than $10 billion in size. It develops nonparametric estimates of the mean and variance of the rate of return and derives a measure of insolvency risk. We find that variance declines with the size of the portfolio, a form of financial returns to scale that has been overlooked in recent studies of scale economies in banking. Our results imply that the current system of risk-based capital requirements, which does not take diversification into account, places a disproportionate burden on most larger banks.

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