Bank and Diversification Improve Bank Essay

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Does Diversification Improve Bank Efficiency?
Chris D’Souza and Alexandra Lai*

In 1952, Nobel Laureate Harry Markowitz, . . . , demonstrated mathematically why putting all your eggs in one basket is an unacceptably risky strategy and why diversification is the nearest an investor or business manager can ever come to a free lunch. That revelation touched off the intellectual movement that revolutionized Wall Street, corporate finance, and business decisions around the world; its effects are still being felt today. Bernstein (1996, 6) The choice of focus or diversification in the business activities of firms is the subject of a large body of literature in corporate finance. The evidence seems to indicate that diversification is value-destroying, leading to what is known as the “diversification discount.” Theoretical explanations for this include managerial risk aversion, agency problems between managers and shareholders, inefficiency of internal capital markets, and power struggles between different segments of a firm. Diversification is particularly important for a bank, given its nature as a financial intermediary. Since risk management is an integral part of a

* We thank Alejandro Garcia for technical assistance. We also thank Jim Armstrong, Younes Bensalah, Dave Bolder, and Eric Santor for helpful comments and suggestions.



D’Souza and Lai

financial firm’s business, the ability to gain from diversifying risks is important for such firms. However, in addition to reasons that limit the gains from diversification that apply to other types of firms, financial institutions also face regulations that create incentives to focus or diversify their portfolios. For example, capital requirements based on predetermined weights on different asset classes can distort portfolio decisions. Moreover, each source of financing that a bank can raise implies a different degree and type of market discipline. Equity-holders care about returns to their equity and might prefer a riskier portfolio than would debt-holders. Subordinated debt holders are considered effective monitors of banks, since they bear all the downside risks associated with a bank’s portfolio and can exert more (though not necessarily optimal) pressure for banks to diversify. Thus, diversification per se is no guarantee of a reduced risk of failure or for better performance. We investigate whether Canadian banks hold optimally diversified balance sheets, both in terms of their asset portfolios and their liabilities (financing). Specifically, we ask whether Canadian banks can benefit from the diversification of their loan portfolios to more industries and geographic regions and from diversification in banking activities (business lines) and financing sources. Acharya, Hasan, and Saunders (2002), henceforth referred to as AHS, study the effect of diversification in loan portfolios on the performance of a sample of Italian banks. They test the following two hypotheses: (i) diversification improves bank returns, and (ii) diversification reduces the risk of banks. They find that diversification reduces bank returns while producing a riskier portfolio. Furthermore, banks with higher risk are more likely to improve their returns with focus. Their test relies on showing that as focus increases, either returns rise and risk falls, or returns fall and risk rises. The outcome is unambiguous for a bank when risk and return move in opposite directions. However, in the event that both risk and return move in the same direction, the implications are ambiguous. We find this to be the case for Canada’s Big Five chartered banks: the Bank of Montreal, the Bank of Nova Scotia, the Royal Bank of Canada, the Canadian Imperial Bank of Commerce, and Toronto Dominion Canada Trust. Hence, the AHS framework does not indicate whether the Big Five are better off focusing or diversifying their portfolios and activities. To address this indeterminacy, we construct an efficiency measure that accounts for