Abstract
This paper examines whether the choice of bank loan diversification and market concentration are associated with a bank's financial stability. This study also investigates how the effect of loan diversification on bank stability varies depending on the level of the concentration or the competitiveness of the banking market. We find that increased loan diversification has a positive impact on the bank's financial strength. We show that market concentration is negatively associated with bank insolvency risk, consistent with the “concentration-stability” view. The results using interaction terms between loan portfolio diversification and market concentration indicate that diversifying banks operating in highly concentrated markets are more financially stable compared to those in less concentrated markets.
1. Introduction
The number of bank closures has sharply risen particularly during the most recent financial crisis in the United States. The Federal Deposit Insurance Corporation (FDIC) reports that 465 insured U.S. commercial banks failed between January 2008 and December 2012, while only 27 banks closed from October 2000 to December 2007. Politicians and regulators claim that the lack of competition in the banking industry may have played a significant role in the financial crisis period (e.g., Akins et al., 2016). Cole and White (2012) and Government Accountability Office (2013) report that the concentration on commercial real estate loans is among the contributing factors that led to an increased likelihood of recent bank closures across all states. The latest banking failure reports and collapse of large financial institutions (such as Lehman Brothers, Washington Mutual and Bear Stearns) during the financial crisis raise the following questions: Do banks reduce or increase financial fragility from diversification of their loan portfolios? Are banks in highly concentrated markets more financially stable than those in less concentrated markets or vice versa? Does the competitive nature of the market where the bank operates influence the relationship between diversification of activities and bank fragility? What are the important bank and economic characteristics that significantly influence a bank’s financial stability? In this paper, we address these unanswered questions by undertak ing an empirical investigation using the samples of U.S. commercial banks over the period 2002:Q1–2013:Q3.
