Should Banks Be Diversified? Evidence from Individual Bank Loan Portfolios*

TLDR

The study investigates how loan portfolio focus versus diversification affects the return and risk of 105 Italian banks during 1993–1999. It analyzes bank‑by‑bank exposure data across industries and sectors to evaluate this relationship. Results show diversification does not reliably enhance performance or safety, with high‑risk banks experiencing lower returns and higher risk, low‑risk banks seeing only marginal or inefficient trade‑offs, indicating monitoring effectiveness weakens at high risk and when lending expands into newer or competitive industries.

Abstract

We study the effect of loan portfolio focus versus diversification on the return and the risk of 105 Italian banks over the period 1993–99 using data on bank‐by‐bank exposures to different industries and sectors. We find that diversification is not guaranteed to produce superior performance and/or greater safety for banks. For high‐risk banks, diversification reduces bank return while producing riskier loans. For low‐risk banks, diversification produces either an inefficient risk‐return trade‐off or only a marginal improvement. Our results are consistent with a deterioration in the effectiveness of bank monitoring at high risk‐levels and upon lending expansion into newer or competitive industries.