Bank Diversification and Overall Financial Strength: International Evidence

Abstract

There are many studies in the finance and management literature that examine the impact of diversification on performance. Yet, the literature remains inconclusive as for the potential benefits in terms of risk and return. The present study aims to re‐examine this issue, while proposing a methodological framework that integrates various bank performance and risk indicators into a single measure of financial strength. Using an international sample of commercial banks, we find that diversification in terms of income, earning assets, and on‐ and off‐balance sheet activities influences positively their financial strength. We also find that income diversification can be more beneficial for banks operating in less developed countries compared to banks in advanced and major advanced economies. However, we observe the opposite in the case of diversification between off‐balance sheet and on‐balance sheet activities. Furthermore, the results reveal that income and earning assets diversification can mitigate the adverse effect of the financial crisis on bank financial strength. We continue to find a positive relationship between diversification and financial strength when we account for nesting effects, endogeneity, as well as when using an alternative approach for the construction of the financial strength indicator.

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