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

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 1993–1999. Specifically, we analyze the tradeoffs between (loan portfolio) focus and diversification using a unique data set that is able to identify individual bank loan exposures to different industries, to different sectors, and to different geographical regions. Our results are consistent with a theory that predicts a deterioration in bank monitoring quality at high levels of risk and a deterioration in bank monitoring quality upon lending expansion into newer or competitive industries. We find that industrial loan diversification reduces bank return while endogenously producing riskier loans for all banks in our sample, this effect being most powerful for high-risk banks. Sectoral loan diversification only produces an inefficient risk–return trade-off for banks with very high levels of risk. Geographical diversification on the other hand does result in an improvement in the risk–return tradeoff for banks with low levels of risk. Overall, our results suggest that diversification of bank assets is not guaranteed to produce more performance efficient and/or safer banks.