Should Banks Be Diversified? Evidence from individual bank loan portfolios
by Viral V. Acharya of the London Business School,
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.
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