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

49 Pages Posted: 16 Apr 2002

See all articles by Viral V. Acharya

Viral V. Acharya

New York University - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); National Bureau of Economic Research (NBER)

Anthony Saunders

New York University - Leonard N. Stern School of Business

Iftekhar Hasan

Fordham University ; Bank of Finland; University of Sydney

Multiple version iconThere are 3 versions of this paper

Date Written: March 2002

Abstract

We study empirically the effect of focus (specialization) versus diversification on the return and the risk of banks using data from 105 Italian banks over the period 1993-99. Specifically, we analyse the trade-offs 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 produces an inefficient risk-return trade-off only for high-risk banks. Geographical diversification on the other hand does result in an improvement in the risk-return trade-off for banks with low levels of risk. A robust result that emerges from our empirical findings is that diversification of bank assets is not guaranteed to produce superior performance and/or greater safety for banks.

Keywords: Focus, diversification, monitoring, bank risk, bank return

JEL Classification: G21, G28, G31, G32

Suggested Citation

Acharya, Viral V. and Saunders, Anthony and Hasan, Iftekhar, The Effects of Focus and Diversification on Bank Risk and Return: Evidence from Individual Bank Loan Portfolios (March 2002). CEPR Discussion Paper No. 3252, Available at SSRN: https://ssrn.com/abstract=306768

Viral V. Acharya (Contact Author)

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

HOME PAGE: http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/~vacharya.htm

New York University (NYU) - Department of Finance

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
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1000 Brussels
Belgium

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Anthony Saunders

New York University - Leonard N. Stern School of Business ( email )

44 West 4th Street
9-190, MEC
New York, NY 10012-1126
United States
212-998-0711 (Phone)
212-995-4220 (Fax)

Iftekhar Hasan

Fordham University ( email )

45 COLUMBUS AVENUE
GBA-5TH FLOOR
NEW YORK, NY 10023
United States

Bank of Finland ( email )

P.O. Box 160
Helsinki 00101
Finland

University of Sydney ( email )

P.O. Box H58
Sydney, NSW 2006
Australia

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