Does Diversification Increase or Decrease Bank Risk and Performance? Evidence on Diversification and the Risk-Return Tradeoff in Banking

56 Pages Posted: 2 Aug 2010

See all articles by Allen N. Berger

Allen N. Berger

University of South Carolina - Darla Moore School of Business; Wharton Financial Institutions Center; European Banking Center

Iftekhar Hasan

Fordham University - Gabelli School of Business; Bank of Finland

Iikka Korhonen

Bank of Finland - Institute for Economies in Transition (BOFIT)

Mingming Zhou

University of Colorado, Colorado Springs - College of Business

Date Written: June 21, 2010

Abstract

Conventional wisdom in banking argues that diversification tends to reduce bank risk and improve performance, but the recent financial crisis suggests that aggressive diversification strategies may have resulted in increased risk taking and poor performance. This paper addresses this important question by evaluating the empirical relationship between diversification strategies and the risk-return tradeoff in banking. Our data set covers Russian banks during the 1999-2006 period and finds somewhat mixed results. Specifically, we find that banks’ performance tends to be non-monotonically related to their diversification strategy. The marginal effects of focus indices (inverse measures of diversification) on performance are nonlinearly associated with the level of risk and foreign ownership. A focused strategy is found to be associated with increased profit and decreased risk only up to a certain threshold. Additionally, when foreign ownership is either very high or very low, banks tend to benefit more from being diversified. This analysis provides important strategic and policy implications for bank managers and regulators in Russia as well as in other emerging economies.

Keywords: banks, diversification, focus, Russia, foreign ownership, scope economies

JEL Classification: G21, G28, G34

Suggested Citation

Berger, Allen N. and Hasan, Iftekhar and Korhonen, Iikka and Zhou, Mingming, Does Diversification Increase or Decrease Bank Risk and Performance? Evidence on Diversification and the Risk-Return Tradeoff in Banking (June 21, 2010). BOFIT Discussion Paper No. 9/2010. Available at SSRN: https://ssrn.com/abstract=1651131 or http://dx.doi.org/10.2139/ssrn.1651131

Allen N. Berger (Contact Author)

University of South Carolina - Darla Moore School of Business ( email )

1705 College St
Francis M. Hipp Building
Columbia, SC 29208
United States
803-576-8440 (Phone)
803-777-6876 (Fax)

Wharton Financial Institutions Center

Philadelphia, PA 19104-6367
United States

European Banking Center

P.O. Box 90153
Tilburg, 5000 LE
Netherlands

Iftekhar Hasan

Fordham University - Gabelli School of Business ( email )

Rose Hill Campus Bronx
New York, NY 10458
United States

Bank of Finland ( email )

P.O. Box 160
Helsinki 00101
Finland

Iikka Korhonen

Bank of Finland - Institute for Economies in Transition (BOFIT) ( email )

P.O.Box 160
Helsinki 00101
Finland

Mingming Zhou

University of Colorado, Colorado Springs - College of Business ( email )

1420 Austin Bluffs Parkway
Colorado Springs, CO 80933-7150
United States
1-719-255-5153 (Phone)

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