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The Effects of Diversification on Banks’ Expected Returns

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Author Info
Dairo Estrada ()
Angela González Arbelaéz ()
Javier Gutiérrez Rueda ()

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Abstract

In financial theory, the optimal allocation of assets and its relationship with profitability has been one of the main concerns; the question has always been if banks should focus or diversify their assets. In our case, we would like to answer this question focusing in diversification of the loan portfolio, presenting a theoretical model that considers the possible gains from diversification, while taking in to account the effects of monitoring. Additionally, we present empirical evidence on this matter for the Colombian banking system. According to the model, we find that once the banks have chosen its optimal level of monitoring, expected return is always higher when the bank decides to focus. Additionally, the empirical results suggest that there are no possible gains form diversification in bank’s cost and that, on average, the effects of focusing the loan portfolio reduces bank’s return while showing positive effects of focusing on an specific sector.

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Paper provided by Banco de la Republica de Colombia in its series Borradores de Economia with number 524.

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Handle: RePEc:bdr:borrec:524

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Related research
Keywords: Diversification; Risk; Colombian Banking System. Classification JEL: G00; G21; G30.;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Kevin Stiroh, 2004. "Do Community Banks Benefit from Diversification?," Journal of Financial Services Research, Springer, vol. 25(2), pages 135-160, April. [Downloadable!] (restricted)
  2. Winton, Andrew, 1997. "Competition among Financial Intermediaries When Diversification Matters," Journal of Financial Intermediation, Elsevier, vol. 6(4), pages 307-346, October. [Downloadable!] (restricted)
  3. Degryse, Hans & Ongena, Steven, 2006. "The impact of competition on bank orientation," Discussion Paper 68, Tilburg University, Center for Economic Research. [Downloadable!]
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  4. Ferrier, Gary D. & Lovell, C. A. Knox, 1990. "Measuring cost efficiency in banking : Econometric and linear programming evidence," Journal of Econometrics, Elsevier, vol. 46(1-2), pages 229-245. [Downloadable!] (restricted)
  5. Holmstrom, Bengt & Tirole, Jean, 1993. "Market Liquidity and Performance Monitoring," Journal of Political Economy, University of Chicago Press, vol. 101(4), pages 678-709, August. [Downloadable!] (restricted)
  6. Cerasi, Vittoria & Daltung, Sonja, 2000. "The optimal size of a bank: Costs and benefits of diversification," European Economic Review, Elsevier, vol. 44(9), pages 1701-1726, October. [Downloadable!] (restricted)
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  7. Viral V. Acharya & Iftekhar Hasan & Anthony Saunders, 2006. "Should Banks Be Diversified? Evidence from Individual Bank Loan Portfolios," Journal of Business, University of Chicago Press, vol. 79(3), pages 1355-1412, May. [Downloadable!]
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  8. Dairo Estrada & Poldy Osorio, 2004. "Effects Of Financial Capital On Colombian Banking Efficiency," ENSAYOS SOBRE POLÍTICA ECONÓMICA, BANCO DE LA REPÚBLICA - ESPE. [Downloadable!]
  9. Allen Berger & Robert DeYoung, 2001. "The Effects of Geographic Expansion on Bank Efficiency," Journal of Financial Services Research, Springer, vol. 19(2), pages 163-184, April. [Downloadable!] (restricted)
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  10. Dairo Estrada & Poldy Osorio, 2004. "Effects Of Financial Capital On Colombian Banking Efficiency," BORRADORES DE ECONOMIA 002432, BANCO DE LA REPÚBLICA. [Downloadable!]
  11. Berger, Allen N. & Hancock, Diana & Humphrey, David B., 1993. "Bank efficiency derived from the profit function," Journal of Banking & Finance, Elsevier, vol. 17(2-3), pages 317-347, April. [Downloadable!] (restricted)
  12. Evelyn Hayden & Daniel Porath & Natalja von Westernhagen, 2006. "Does Diversification Improve the Performance of German Banks? Evidence from Individual Bank Loan Portfolios," Working Papers 110, Oesterreichische Nationalbank (Austrian Central Bank). [Downloadable!]
  13. Hancock, Diana, 1986. "A model of the financial firm with imperfect asset and deposit elasticities," Journal of Banking & Finance, Elsevier, vol. 10(1), pages 37-54, March. [Downloadable!] (restricted)
  14. von Westernhagen, Natalja & Porath, Daniel & Hayden, Evelyn, 2006. "Does diversification improve the performance of German banks? : Evidence from individual bank loan portfolios," Discussion Paper Series 2: Banking and Financial Studies 2006,05, Deutsche Bundesbank, Research Centre. [Downloadable!]
  15. Dairo Estrada & Poldy Osorio, . "Effects of Financial Capital on Colombian Banking Efficiency," Borradores de Economia 291, Banco de la Republica de Colombia. [Downloadable!]
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  16. Carletti, Elena & Cerasi, Vittoria & Daltung, Sonja, 2007. "Multiple-bank lending: Diversification and free-riding in monitoring," Journal of Financial Intermediation, Elsevier, vol. 16(3), pages 425-451, July. [Downloadable!] (restricted)
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  17. Clark, Jeffrey A, 1996. "Economic Cost, Scale Efficiency, and Competitive Viability in Banking," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(3), pages 342-64, August. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. David Pérez-Reyna, . "Una aproximación para analizar la estabilidad financiera por medio de un DSGE," Temas de Estabilidad Financiera 040, Banco de la Republica de Colombia. [Downloadable!]
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