Diversification, Efficiency and Risk of Banks: New Consolidating Evidence From Emerging Economies

Abstract

This working paper was written by Bang Nam Jeon (Drexel University), Ji Wu (Southwestern University of Finance and Economics), Limei Chen (Fudan University) and Minghua Chen (Southwestern University of Finance and Economics).

This paper examines the impact of business diversification of banks on their risk, with efficiency taken into consideration as a conduit. Using bank-level data from more than 1400 commercial banks in 39 emerging economies during 2000-2016, we find that increased business diversification exerts two competing effects on bank risk, and overall reduces bank risk. The direct effect of increased diversification bolsters the stability of banks, but this is offset partially by the indirect effect of lowered efficiency, which increases the riskiness of banks. This provides a consolidating evidence on the competing arguments on the diversification-efficiency nexus in banking — the “diversification-premium” argument vs. the “diversification-discount” argument — with its extended implications on bank risk. In addition, we also present evidence that the diversification-bank risk nexus is heterogeneous on the bank size, market power and the ownership of banks, which provides useful policy implications for diversification strategies by bank managers as well as for the effective surveillance by bank regulators.

Keywords: Diversification, Bank Efficiency; Bank Risk-taking; Emerging Economies

JEL Classification: G21; G15; L25