Don’t Put All Your Eggs in One Basket? Diversification and Specialization in Lending

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Abstract
Should lenders diversify, as suggested by the financial intermediation literature, or specialize, as suggested by the corporate finance literature? I model a financial institution's ("bank's") choice between these two strategies in a setting where bank failure is costly and loan monitoring adds value. All else equal, diversification across loan sectors helps most when loans have moderate exposure to sector downturns ("downside") and the bank's monitoring incentives are weak; when loans have low downside, diversification has little benefit, and when loans have sufficiently high downside, diversification may actually increase the bank's chance of failure. Also, it is likely that the bank's monitoring effectiveness is lower in new sectors; in this case, diversification lowers average returns on monitored loans, is less likely to improve monitoring incentives, and is more likely to increase the bank's chance of failure. Diversified banks may sometimes need more equity capital than specialized banks, and increased competition can make diversification either more or less attractive. These results motivate actual institutions' behavior and performance in a number of cases. Key implications for regulators are that an institution's credit risk depends on its monitoring incentives as much as on its diversification, and that diversification per se is no guarantee of reduced risk of failure.
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