Academic journal article
By Demsetz, Rebecca S.; Strahan, Philip E.
Journal of Money, Credit & Banking , Vol. 29, No. 3
This paper shows that large bank holding companies (BHCs) are better diversified than small BHCs based on market measures of diversification. We find, however, that better diversification does not translate into reductions in risk. The risk-reducing potential of diversification at large BHCs is offset by their lower capital ratios and larger C&I loan portfolios. Our results suggest that diversification may provide an important motive for consolidation by allowing BHCs to pursue riskier lending while operating with greater leverage.
A fundamental implication of modern portfolio theory is that diversification reduces the return variance of a portfolio of financial assets. Applied to banking, portfolio theory suggests that diversification can potentially reduce the probability of failure. Diversification across borrower projects may also reduce the costs of providing a bank with the appropriate incentives to monitor borrowers and make payments to depositors (Diamond 1984).
The banking literature tends to presume that diversification and size go hand in hand. This paper demonstrates empirically that this presumption is valid. We measure the diversification of a sample of bank holding companies (BHCs) using stock market data and quantify a strong, positive effect of size on BHC diversification. We also show how large bank holding companies use their diversification advantage. Large BHCs, while better diversified than small BHCs, have historically been no less risky. Large BHCs have used their diversification advantage to operate with lower capital ratios and pursue riskier activities.
Our findings with respect to capital are consistent with Liang and Rhoades (1991), who find that capital ratios decline with balance sheet measures of asset diversification, and with McAllister and McManus (1993), who show that large banks realize a cost advantage over small banks because of their ability to operate with less capital. Our results regarding the pursuit of riskier activities are consistent with Akhavein, Berger, and Humphrey (1997), who show that the profit efficiency associated with large-bank mergers is at least in part attributable to a shift in outputs from low-risk securities to higher-risk loans.
Our results have policy implications particularly relevant today, as banking consolidation accelerates following the passage of the 1994 Reigle-Neal Interstate Banking and Branching Efficiency Act. Consolidation can enhance diversification, but the resulting change in risk will depend on the extent to which consolidation is accompanied by changes in banks' activities. In the past, large BHCs used their diversification advantage to increase risky lending and to operate with lower capital ratios but not to operate at lower levels of overall risk. If this pattern is indicative of the behavior of banks involved in today's merger wave, then we should not expect consolidation to reduce bank risk.
If the riskier activities pursued by large banks are profit enhancing on average, however, then growth via mergers should increase profits. This is consistent with Akhavein, Berger, and Humphrey, discussed above, and with Benston, Hunter, and Wall (1995), who model the price bid by acquiring banks in takeover deals and conclude that acquiring banks "seek earnings diversification in an effort to generate higher levels of cash flow for the same levels of total risk." Nevertheless, Boyd and Runkle (1993) find that size is not positively correlated with profits at BHCs.
We use a measure of BHC diversification derived from a decomposition of stock return variance into explained and unexplained variance, labeled "systematic risk" and "firm-specific risk." Portfolio theory tells us that a BHC's diversification will decrease its firm-specific risk but leave its systematic risk unaffected; hence, we are primarily interested in the relationship between BHC size and firm-specific risk. The problem is that diversification is not the only factor affecting a BHC's firm-specific risk. …