A False Sense of Security: Why U.S. Banks Diversify and Does it Help?

Modern U.S. banks engage into activities traditionally considered as non-core for the banking sector. Consistent with extant models of financial intermediation, which suggest banks diversify to lower risk and improve profitability, we document that banks with higher probability of financial distress and deadweight financial costs diversify more aggressively. Diversified banks appear to benefit from "coinsurance", are more profitable, less financially constrained, and supply more credit. However, diversification does not lead to real reductions in risk as its benefits are limited to "good" times. Diversified banks are more exposed to systematic risk and their lending is more sensitive to macroeconomic conditions. They are also more prone to correlation risk, the risk that diversification benefits provided by non-core activities may unexpectedly change especially when they are most needed. Our study contributes to the current debate on the optimal scope of bank activities, and highlights novel channels through which diversification impacts banks' credit supply and therefore the real economy.