The Benefits of Geographic Diversification in Banking

We estimate the benefits of intrastate and interstate geographic diversification for bank risk and return, and assess whether such benefits could be shaped by differences in bank size and disparities in economic conditions within states or across U.S. states. For small banks, only intrastate diversification is beneficial in terms of risk-adjusted returns but for very large institutions both intrastate and interstate expansions are rewarding. However, in all cases the relationship is hump-shaped for both intrastate and interstate diversification indicating limits for banks of all size. Moreover, we also find geographic expansion to reduce bank risk. Our results indicate that both small banks and very large banks could still benefit in terms of risk-adjusted returns from further geographic diversification. Disparities in economic conditions as measured by the dispersion in unemployment rates either across counties or states impact the benefits of diversification. At initially low levels of intrastate diversification, expanding in new markets allows small banks to further reduce their risk in the presence of higher economic disparities. However, when they get more diversified, this effect is reduced.