Don't Put All Your Eggs in One Basket? Diversification and Specialization in Lending

43 Pages Posted: 2 Sep 1999

See all articles by Andrew Winton

Andrew Winton

University of Minnesota - Twin Cities - Carlson School of Management; Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF)

Date Written: September 27, 1999

Abstract

Should lenders diversify, as suggested by the intermediation literature, or specialize, as suggested by the corporate finance literature? I model a financial institution's ("bank's") choice between these two strategies in a setting where bank failure is costly and loan monitoring adds value. All else equal, diversification across loan sectors helps most when loans have moderate downside risk and the bank's monitoring incentives are in doubt; when loans have low downside, diversification has little benefit, and when loans have sufficiently high downside, diversification may actually increase the bank's chance of failure. Also, it is likely that the bank's monitoring effectiveness is lower in new sectors; in this case, diversification lowers average returns on monitored loans, is less likely to improve monitoring incentives, and is more likely to increase the bank's chance of failure. Diversified banks may sometimes need more equity capital than specialized banks, and increased competition can make diversification either more or less attractive. These results motivate actual institutions' behavior and performance in a number of cases. Key implications for regulators are that an institution's credit risk depends on its monitoring incentives as much as on its diversification, and that diversification per se is no guarantee of reduced risk of failure.

JEL Classification: G11, G21, L20

Suggested Citation

Winton, Andrew, Don't Put All Your Eggs in One Basket? Diversification and Specialization in Lending (September 27, 1999). Available at SSRN: https://ssrn.com/abstract=173615 or http://dx.doi.org/10.2139/ssrn.173615

Andrew Winton (Contact Author)

University of Minnesota - Twin Cities - Carlson School of Management ( email )

321 19th Avenue South
Department of Finance
Minneapolis, MN 55455
United States
612-624-0589 (Phone)
612-626-1335 (Fax)

Shanghai Jiao Tong University (SJTU) - Shanghai Advanced Institute of Finance (SAIF) ( email )

Shanghai Jiao Tong University
211 West Huaihai Road
Shanghai, 200030
China

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