Essays on bank diversification
This thesis, which consists of four studies, investigates bank diversification in the context of bank stability, banks’ market power, and bank competition, by constructing new diversification indicators to capture the degree of diversification at the market and country levels. The first essay empirically tests a theory regarding the influence of diversification on bank systemic risk and investigates whether this effect is different for bank standalone risk. I construct a new country-level diversification measure to reflect the risk distribution among banks, which makes my study more suitable to evaluate the mechanical reasons behind the theory tested than traditionally used bank-level diversification indicators. My results confirm the Wagner’s theory according to which diversification leads to more systemic risk but less bank standalone risk. The second essay investigates the role of the regulatory environment, bank size, and capital in the diversification-bank stability nexus, which extends my findings in the first essay. I find that the negative relationship between diversification and bank systemic stability becomes weaker in countries with greater supervisory power of regulatory agencies, higher stringency of capital regulations, more restrictions on the scope of banks’ activities, and more private monitoring. Moreover, I show that bank size and capital alleviate the negative diversification-systemic stability relationship, which implies that larger and well-capitalized banks are less subject to systemic risk when the degree of diversification in a country is high. To the best of my knowledge, my study is the first to confirm the moderating role of cross-country regulatory environments and banks’ essential characteristics in the relationship between diversification and bank stability. The third essay investigates how diversification influences banks’ market power, which fills the gap in the literature regarding the lack of analyses showing whether diversification can be a determinant or source of banks’ market power. Diversification may enable banks to gain market power from obtaining new sources of revenues but could also weaken market power by inducing new costs. I find an inverse U-shaped relationship between revenue diversification and banks’ market power in both lending and funding markets. This implies that diversification is an important determinant or source of banks’ market power and potentially affects market power by changing banks’ output prices and marginal costs of production, or a combination of both. In addition, this inverse U-shaped relationship is much more manifest in large banks than in small banks, which indicates that it is dominated by large banks. The last essay investigates the role of market diversification in the relationship between competition and bank stability in the dimensions of individual bank stability and systemic stability, by constructing novel market-level diversification measures. My study is important to reconcile the mixed conclusions regarding the competition-stability nexus in the literature by considering the potential changing associations between competition and bank stability conditional on different degrees of diversification in the market. I find that the negative relationship between competition and systemic stability is exacerbated when the market diversification is high while this negative competition-systemic stability relationship turns to be positive when the market diversification is low. However, I do not find a significant interacting effect of market diversification on the competition-individual bank stability relationship. Lastly, I show a positive association between competition and diversification, which suggests that restrictions in banks’ diversification activities in a competitive environment may help in maintaining systemic stability. My research provides useful implications for bank managers and policymakers. First, it offers bank managers knowledge of how diversified activities are related to banks’ standalone and systemic risks and suggests the feasibility of managing banks’ market power by formulating an appropriate diversification strategy. Second, from the policymaking perspective, my study proposes that promoting diversification would be beneficial to bank standalone stability if banks’ diversification strategy is well formulated and executed but could bring additional costs to banks and exacerbate systemic stability.