Bank and Diversification Improve Bank Essay

Does Diversiﬁcation Improve Bank Efﬁciency?
Chris D’Souza and Alexandra Lai*

Introduction
In 1952, Nobel Laureate Harry Markowitz, . . . , demonstrated mathematically why putting all your eggs in one basket is an unacceptably risky strategy and why diversiﬁcation is the nearest an investor or business manager can ever come to a free lunch. That revelation touched off the intellectual movement that revolutionized Wall Street, corporate ﬁnance, and business decisions around the world; its effects are still being felt today. Bernstein (1996, 6) The choice of focus or diversiﬁcation in the business activities of ﬁrms is the subject of a large body of literature in corporate ﬁnance. The evidence seems to indicate that diversiﬁcation is value-destroying, leading to what is known as the “diversiﬁcation discount.” Theoretical explanations for this include managerial risk aversion, agency problems between managers and shareholders, inefﬁciency of internal capital markets, and power struggles between different segments of a ﬁrm. Diversiﬁcation is particularly important for a bank, given its nature as a ﬁnancial intermediary. Since risk management is an integral part of a

* We thank Alejandro Garcia for technical assistance. We also thank Jim Armstrong, Younes Bensalah, Dave Bolder, and Eric Santor for helpful comments and suggestions.

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ﬁnancial ﬁrm’s business, the ability to gain from diversifying risks is important for such ﬁrms. However, in addition to reasons that limit the gains from diversiﬁcation that apply to other types of ﬁrms, ﬁnancial institutions also face regulations that create incentives to focus or diversify their portfolios. For example, capital requirements based on predetermined weights on different asset classes can distort portfolio decisions. Moreover, each source of ﬁnancing that a bank can raise implies a different degree and type of market discipline. Equity-holders care about returns to their equity and might prefer a riskier portfolio than would debt-holders. Subordinated debt holders are considered effective monitors of banks, since they bear all the downside risks associated with a bank’s portfolio and can exert more (though not necessarily optimal) pressure for banks to diversify. Thus, diversiﬁcation per se is no guarantee of a reduced risk of failure or for better performance. We investigate whether Canadian banks hold optimally diversiﬁed balance sheets, both in terms of their asset portfolios and their liabilities (ﬁnancing). Speciﬁcally, we ask whether Canadian banks can beneﬁt from the diversiﬁcation of their loan portfolios to more industries and geographic regions and from diversiﬁcation in banking activities (business lines) and ﬁnancing sources. Acharya, Hasan, and Saunders (2002), henceforth referred to as AHS, study the effect of diversiﬁcation in loan portfolios on the performance of a sample of Italian banks. They test the following two hypotheses: (i) diversiﬁcation improves bank returns, and (ii) diversiﬁcation reduces the risk of banks. They ﬁnd that diversiﬁcation reduces bank returns while producing a riskier portfolio. Furthermore, banks with higher risk are more likely to improve their returns with focus. Their test relies on showing that as focus increases, either returns rise and risk falls, or returns fall and risk rises. The outcome is unambiguous for a bank when risk and return move in opposite directions. However, in the event that both risk and return move in the same direction, the implications are ambiguous. We ﬁnd this to be the case for Canada’s Big Five chartered banks: the Bank of Montreal, the Bank of Nova Scotia, the Royal Bank of Canada, the Canadian Imperial Bank of Commerce, and Toronto Dominion Canada Trust. Hence, the AHS framework does not indicate whether the Big Five are better off focusing or diversifying their portfolios and activities. To address this indeterminacy, we construct an efﬁciency measure that accounts for

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