Diversification, Size, and Risk at Bank Holding Companies

By Demsetz, Rebecca S.; Strahan, Philip E. | Journal of Money, Credit & Banking, August 1997 | Go to article overview

Diversification, Size, and Risk at Bank Holding Companies


Demsetz, Rebecca S., Strahan, Philip E., Journal of Money, Credit & Banking


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. …

The rest of this article is only available to active members of Questia

Sign up now for a free, 1-day trial and receive full access to:

  • Questia's entire collection
  • Automatic bibliography creation
  • More helpful research tools like notes, citations, and highlights
  • Ad-free environment

Already a member? Log in now.

Notes for this article

Add a new note
If you are trying to select text to create highlights or citations, remember that you must now click or tap on the first word, and then click or tap on the last word.
One moment ...
Default project is now your active project.
Project items

Items saved from this article

This article has been saved
Highlights (0)
Some of your highlights are legacy items.

Highlights saved before July 30, 2012 will not be displayed on their respective source pages.

You can easily re-create the highlights by opening the book page or article, selecting the text, and clicking “Highlight.”

Citations (0)
Some of your citations are legacy items.

Any citation created before July 30, 2012 will labeled as a “Cited page.” New citations will be saved as cited passages, pages or articles.

We also added the ability to view new citations from your projects or the book or article where you created them.

Notes (0)
Bookmarks (0)

You have no saved items from this article

Project items include:
  • Saved book/article
  • Highlights
  • Quotes/citations
  • Notes
  • Bookmarks
Notes
Cite this article

Cited article

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

(Einhorn, 1992, p. 25)

(Einhorn 25)

1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited article

Diversification, Size, and Risk at Bank Holding Companies
Settings

Settings

Typeface
Text size Smaller Larger Reset View mode
Search within

Search within this article

Look up

Look up a word

  • Dictionary
  • Thesaurus
Please submit a word or phrase above.
Print this page

Print this page

Why can't I print more than one page at a time?

Full screen

matching results for page

Cited passage

Style
Citations are available only to our active members.
Sign up now to cite pages or passages in MLA, APA and Chicago citation styles.

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn, 1992, p. 25).

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences." (Einhorn 25)

"Portraying himself as an honest, ordinary person helped Lincoln identify with his audiences."1

1. Lois J. Einhorn, Abraham Lincoln, the Orator: Penetrating the Lincoln Legend (Westport, CT: Greenwood Press, 1992), 25, http://www.questia.com/read/27419298.

Cited passage

Thanks for trying Questia!

Please continue trying out our research tools, but please note, full functionality is available only to our active members.

Your work will be lost once you leave this Web page.

For full access in an ad-free environment, sign up now for a FREE, 1-day trial.

Already a member? Log in now.