Diversification by U.S. Banks: True Safety or a False Sense of Security?

Abstract

U.S. banks have increasingly diversified into activities traditionally considered as non-core for the banking sector. This paper investigates whether diversification influences banks’ investment (credit) policy and profitability. Diversified banks appear to benefit from “coinsurance,” supply more credit, and seem more profitable. However, diversification does not lead to real reductions in risk as its benefits are limited to “good” times. Diversified banks are more exposed to systematic risk and their credit supply is more sensitive to macroeconomic conditions, and monetary policy changes. Our study contributes to the current debate on the optimal scope of bank activities, and highlights novel channels through which diversification may impact banks’ credit supply and therefore the real economy.

Keywords: Bank diversification, Non-interest income, Systemic risk, Financial crisis

JEL Classification: G01, G21, G28