Should Banks Be Diversified? Evidence from Individual Bank Loan Portfolios
Posted: 8 Jun 2004
We study the effect of loan portfolio focus vs. diversification on the return and the risk of 105 Italian banks over the period 1993-1999 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 tradeoff 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
JEL Classification: G21, G28, G31, G32
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