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The Effects of Diversification on Banks’ Expected Returns

Author

Listed:
  • Dairo Estrada
  • Angela González Arbelaéz
  • Javier Gutiérrez Rueda

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.

Suggested Citation

  • Dairo Estrada & Angela González Arbelaéz & Javier Gutiérrez Rueda, 2008. "The Effects of Diversification on Banks’ Expected Returns," Borradores de Economia 524, Banco de la Republica de Colombia.
    • Handle: RePEc:bdr:borrec:524
    DOI: 10.32468/be.524
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    References listed on IDEAS

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    More about this item

    Keywords

    Diversification; Risk; Colombian Banking System.;
    All these keywords.

    JEL classification:

    • G00 - Financial Economics - - General - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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