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Specialization, risk, and capital in banking

  • Ralph C. Kimball

Diversification is certainly the simplest and perhaps the oldest approach to managing the trade-off between portfolio risk and return. Because diversification tends to reduce risk without a proportional reduction in returns, an overwhelming majority of commercial banks have diversified portfolios. Larger banks usually are organized into multiple specialized lines of business; smaller banks generally hold a higher proportion of marketable securities whose returns are not tied to a particular geographic market. A much smaller number of banks have chosen to ignore the benefits of diversification and focus on a particular asset such as credit cards, residential or commercial real estate, corporate trust services, or small business lending.> This article investigates specialization in banking and its effects on risk and return. The author compares a group of banks specializing in small business micro-loans (loans under $100,000) with a matched set of diversified peers. The number of specialized banks is still small, but they are expected to become more prevalent, and the number of specialized nonbanks is large, including commercial and consumer finance companies, mortgage banks, leasing companies, many thrift institutions, and some investment banks and insurance companies. The author discusses the issues that specialization creates for regulators, especially in the field of capital requirements, and the need to revise the current approach to regulatory risk-based capital to better distinguish between specialized and diversified banks.

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Article provided by Federal Reserve Bank of Boston in its journal New England Economic Review.

Volume (Year): (1997)
Issue (Month): Nov ()
Pages: 51-73

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Handle: RePEc:fip:fedbne:y:1997:i:nov:p:51-73
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  1. Gregory E. Elliehausen & John D. Wolken, 1990. "Banking markets and the use of financial services by small and medium- sized businesses," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Oct, pages 801-817.
  2. Mark Carey & Mitch Post & Stephen A. Sharpe, 1996. "Does lending by banks and finance companies differ?," Proceedings 508, Federal Reserve Bank of Chicago.
  3. Hannan, Timothy H & Hanweck, Gerald A, 1988. "Bank Insolvency Risk and the Market for Large Certificates of Deposit," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 20(2), pages 203-11, May.
  4. Robert A. Eisenbeis & Myron L. Kwast, 1989. "Are real estate specializing depositories viable? The evidence from commercial banks," Finance and Economics Discussion Series 88, Board of Governors of the Federal Reserve System (U.S.).
  5. Larry D. Wall & Pamela P. Peterson, 1996. "Banks' responses to binding regulatory capital requirements," Economic Review, Federal Reserve Bank of Atlanta, issue Mar, pages 1-17.
  6. Robert C. Merton & André Perold, 1993. "Theory Of Risk Capital In Financial Firms," Journal of Applied Corporate Finance, Morgan Stanley, vol. 6(3), pages 16-32.
  7. Patrick H. McAllister & Douglas A. McManus, 1992. "Diversification and risk in banking: evidence from ex post returns," Finance and Economics Discussion Series 201, Board of Governors of the Federal Reserve System (U.S.).
  8. Nellie Liang & Donald Savage, 1990. "New data on the performance of nonbank subsidiaries of bank holding companies," Staff Studies 159, Board of Governors of the Federal Reserve System (U.S.).
  9. Maximilian J.B. Hall, 1996. "Banking regulation in the European Union: some issues and concerns," Proceedings 494, Federal Reserve Bank of Chicago.
  10. Glenn Canner & Wayne Passmore, 1997. "The Community Reinvestment Act and the profitability of mortgage-oriented banks," Finance and Economics Discussion Series 1997-7, Board of Governors of the Federal Reserve System (U.S.).
  11. Donald Davis & Kevin Lee, 1997. "A Practical Approach To Capital Structure For Banks," Journal of Applied Corporate Finance, Morgan Stanley, vol. 10(1), pages 33-43.
  12. Richard W. Kopcke, 1995. "Financial innovation and standards for the capital of insurance companies," New England Economic Review, Federal Reserve Bank of Boston, issue Jan, pages 29-57.
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