Productive, Geographical and Clientele Diversification of Banks, and its Effect on the Loan Portfolio Performance in Argentina

Loan diversification is a typical mechanism used by financial institutions to minimize their portfolio risk. However, diversification might not always be beneficial in response to the complex task of monitoring credit risks and the associated incentives. For instance, a highly diversified bank may monitor less intensely under the presumption that diversification and monitoring are substitutes of each other. At the same time, the expansion into new sectors or regions imposes steep learning costs about the new clients´ capacity and willingness to repay. By the same token, it is likely that initially the bank ends up lending to clients previously rejected by other, more experienced institutions. As a result, a diversification strategy might undermine, at least during its first stages, the bank´s ability to build a solvent loan portfolio. Adding to this, there might be pecuniary costs in implementing this diversification process, particularly at the geographical level. The present study examines the link between credit risk (measured by the ratio of non-performing loans) and the diversification of the corporate loan portfolio for the whole set of financial institutions operating in Argentina over 1998-2006. Three dimensions of diversification, measured by the traditional Herfindahl-Hirschmann Index, are considered: by province, by productive sector, and by client. Significant concentration levels are observed in all three dimensions, most especially by province. Anyway, a moderate tendency towards more geographical diversification is observed up to 2004, explained by the acquisition of small, regional banks by large institutions with a nationwide scope. In turn, sectoral diversification displays a negative evolution (that is, more concentration) until 2004, and a stable pattern from then on. In general, the primary and industrial sectors appear to capture a larger piece of total private credit at the expense of the services sector. Regarding client-level diversification, a strong move towards concentration is seen after the 2001-2002 crisis, which remains afterwards, which in principle reveals a preference for old and well-known borrowers. Econometric techniques were applied in order to establish whether the different levels of diversification have any independent explanatory power over the ratio of non-performing loans in our panel of banks/years. Controls included the origin of capital (public, private, and foreign), accounting indicators, and time dummies to proxy for macroeconomic developments. The traditional statement that diversification improves loan quality is not verified in our case. On the contrary, we find that specialization diminishes non-performing loans. Besides the noise introduced by the recent financial crisis, alternative storylines like those discussed above may have something to do with the evidence produced by our investigation.