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Should Banks Be Diversified? Evidence from individual bank loan portfolios

by Viral V. Acharya of the London Business School,
Iftekhar Hasan of the Rensselaer Polytechnic Institute, and
Anthony Saunders of New York University

May 2006

Abstract: We study the effect of loan portfolio focus versus diversification on the return and the risk of 105 Italian banks over the period 1993-99 using data on bank-by-bank exposures to different industries and sectors. We find that diversification is not guaranteed to produce superior performance and/or greater safety for banks. For high-risk banks, diversification reduces bank return while producing riskier loans. For low-risk banks, diversification produces either an inefficient risk-return trade-off or only a marginal improvement. Our results are consistent with a deterioration in the effectiveness of bank monitoring at high risk-levels and upon lending expansion into newer or competitive industries.

JEL Classification: G21, G28, G31, G32.

Keywords: Focus, Diversification, Monitoring, Bank risk, Bank return.

Published in: Journal of Business, Vol. 79, No. 3, (May 2006), pp. 1355-1412.

Previously titled: The Effects of Focus and Diversification on Bank Risk and Return: Evidence from Individual Bank Loan Portfolios

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