On the riskiness of banks: A two-sided story of functional diversification

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This study investigates the implication of functional diversification on bank’s risk. Under Diversification-Stability Channel, the combine of different activities reduce the total risk of the diversified banks. Under Diversification-Fragility Channel, if the diversified activity is inherently riskier than traditional banking business, and these activities are highly correlated, the cost of diversification could outweigh the benefit, leading a higher risk for banks. Using a large sample of 13,500 US banks from 1986:Q1 to 2013:Q4, our results show the dark side of diversification, consistent with Diversification-Fragility Channel that banks with relative-ly high share of noninterest income become riskier with a moving toward noninterest-generating activities. The findings also lend support, although weakly, to the Diversification-Stability Channel – that banks with relatively low share of noninterest income enjoy the net gains from diversification with an increase of noninterest income activities. Interestingly, the data provides support to the Diversification-Stability Channel during the financial crises. Our main findings are robust with a battery of robustness tests. This study also yields an insight into why banks diversify under agency problems framework. Finally, the evidence has different implications for regulators, managers and investors.

Author(s):

Viet Dung Tran    
Univ Grenoble Alpes
France