How Diversification Helps Banks Lend More, Cut Risk, and Boost the Economy

A new study reveals manifold benefits of banks growing their footprint geographically and across business segments, amid fears that such diversification increases financial fragility and systemic risk.

Banks in the U.S. that expanded beyond their geographical roots and into new business segments were able to lend more (especially to small businesses), reduce risk, and stabilize their revenue streams, according to a new paper, titled “Bank Diversification and Lending Resiliency.” Such diversification increased the resilience of banks, allowing them to maintain lending even during economic downturns, eventually benefitting local economies with higher employment levels, the paper noted.

“Diversification gives banks more stability and more resilience, and they can respond to shocks better,” said Wharton finance professor Itay Goldstein, who co-authored the paper with Michael Gelman, finance professor at the University of Delaware’s Alfred Lerner College of Business and Economics and Andrew MacKinlay, finance professor at Virginia Tech. “The lending function of banks is better served by diversification.”

Bank diversification has not always been viewed favorably. Regulatory relaxations over the past three decades allowed banks to operate across state lines and invest in different business segments such as insurance and securities underwriting. But they also brought fears bank diversification could increase fragility and systemic risk (which affects all asset classes), especially after the 2008 financial crisis, the paper noted.

Goldstein and his coauthors embarked on their paper because they wanted to promote a balanced view of the outcomes of bank diversification. “People always tend to think about the negative effects of diversification, such as how a bank becomes too entangled with the economy and that it generates contagion and systemic risk,” he said. “But there are some positive effects that are maybe not often emphasized. We don’t try to dispute the problems that diversification might generate. Rather, we highlight a counterforce that is an important one to consider in the broader debate.”

One big benefit of diversification is that it enables banks “to lend more without increasing their risks to excessively high levels,” according to the paper. Diversified banks [not only] lend more in normal times, but they are also able “to maintain credit supply during negative shocks, when credit availability is paramount,” it asserted.

Bank diversification is not a zero-sum game, the paper pointed out. “The lending resiliency of more diversified banks does not come at the expense of other banks. Instead, geographically diversified banks help promote overall economic activity,” it stated. The study’s design controls for size to ensure that the effects it captured are purely from diversification and not from size.

“It is not a mechanical channel where a bank lends more just because it is bigger,” Goldstein said. “If you take two banks that have exactly the same size and are similar in other dimensions, then the one that has more activities spread out rather than being concentrated will lend more.” Also, areas with more diversified banks see a boost to employment and other such spillovers to the economy, he pointed out.

How Diversification Brought New Gains

In order to test its main hypothesis of the positive spillovers from diversification, the study analyzed bank lending trends between 1997 and 2017, notably those after the 2008 financial crisis, noting that it was “an unanticipated shock to lending opportunities.” Its key findings highlighted the growth in both overall lending and small business lending:

• Between 1997 and 2017, a one standard deviation increase in geographic diversification produced a 1.4% quarterly increase in lending.

•  The most geographically diversified banks had 6.7% more total lending than the least diversified banks after the 2008 financial crisis.

• Banks with an established insurance subsidiary increased their small business lending by 38%, compared to similar banks.

•  In 1997, the average bank conducted small business lending across eight states, which by 2017 had expanded to 15 states.

•  In a given county and year, the most geographically diversified banks maintain twofold higher levels of small business lending during the financial crisis, compared to the least diversified bank.

•  Counties with a one standard deviation higher share of diversified banks experience 4.2% higher aggregate small business lending in the crisis.

•  Banks that expanded lending to new states (enabled by deregulation) increased small business lending by nearly 17% over that of other banks that did not take advantage of deregulation to expand.

The paper also looked at the outcomes of banks diversifying into “non-lending activities” such as insurance, securities broker-dealer, and investment banking, securitization, non-deposit trust subsidiaries such as fiduciaries, and trading activity. They found that bank diversification was most visible in insurance, which improved their lending resiliency during the financial crisis.

In 2017, 54% of the banks covered by the study had at least one domestic insurance subsidiary. They also grew in other business segments such as setting up securities broker-dealer subsidiaries (22%), non-deposit trust subsidiaries that engage in fiduciary activities (12%), and subsidiaries linked to securitization (4%).

Some of those new business lines such as insurance provide more resilience to banks than others that were perhaps perceived as “riskier and adversely affected by the 2008 financial crisis,” Goldstein said.

Takeaways for Regulators

The recent collapse of Silicon Valley Bank and the regional banking crisis it sparked off underscored the risks of being overly concentrated in one geographic market or asset category. “It highlighted the costs of banks being very localized and focused on one type of depositor and one type of borrower,” Goldstein said. According to Goldstein, regulators might find it useful to incorporate the effects of diversification in bank stress tests.

“It will be useful to see how different banks could be affected by different scenarios, depending on their level of diversification.

That is important to know for policymakers when they are deciding on how best to regulate the banking system.”