Experienced investors know that diversification is good for their portfolio: spreading your money over several investment opportunities minimizes the risk of huge losses. Does this also apply for the geographical expansion of banks? There is no agreement about this question in academia. Some studies say: yes, geographical expansion of banks does reduce their risk. When a bank is doing business in several regions which are each exposed to different economic risks, then geographical diversification can reduce the bank’s overall risk. What is more, geographically diversified banks are often larger and mostly work more cost efficient which also increases their stability. Other studies, however, suggest the opposite: a large number of new, and mostly far away, subsidiaries raise complexity and make it more difficult to control quality and manage risk. From this point of view, geographical diversification could be bad for stability. So far, several empirical studies have not delivered clear results.
Martin Götz, Professor of regulation and stability of financial institutions at the Research Center SAFE at Goethe University Frankfurt, has approached this question again in a now published paper* joined with Luc Laeven (ECB) and Ross Levine (Berkeley). In order to find out to what extent geographical diversification, in fact, contributes to bank risk and, at the same time, to take into account aspects such as cost efficiency and complexity, they used changes in regulation of US banks. Between the 1980s and 1990s, more and more US states began to permit banks from other states to open subsidiaries. These changes allowed the researchers to carry out a number of analyses on the basis of data from US banks in different metropolitan areas and, thus, to measure how much geographical diversification contributes to bank risk. They came to the conclusion that geographical diversification reduces bank risk and does not have a negative impact on lending quality.
According to Martin Götz, this result is of great importance for banking regulation. “Regulatory measures are the outcome of weighing up different motives and objectives. From the regulator’s perspective, you can pursue the intention to restrict geographical diversification of banks because it is easier to supervise a smaller bank than a larger. However, against the background of our results, the regulator has to take into consideration that, by doing so, banks are not able anymore to use the risk reducing potential of diversification.”
Nevertheless, Götz warned to generally attribute a higher risk to small banks, such as German savings banks, on basis of his results. “There are many other aspects apart from diversification that play a role for the overall risk of a bank. German savings banks, for example, are indeed independent and do business only in a small area, but they belong to a large liability scheme that ensures that all savings banks support each other and, thus, limit the risk.” However, it definitely needs to be considered that a single savings bank is exposed to the risk of its region to a higher extent than a bank that is doing business in more than one area.
* Götz, M., Laeven, L., Levine, R. (2015): „Does the Geographic Expansion of Banks Reduce Risk?“, forthcoming in the Journal of Financial Economics.