Financial crisis, bank diversification, and financial stability: OECD countries

Abstract

Using a sample of commercial banks based in OECD countries, we investigate the effect of bank diversification on financial stability and find a significantly nonlinear (i.e., inverted U-shaped) relationship. These findings suggest that a moderate degree of bank diversification increases bank stability, but excessive diversification has an adverse effect. Furthermore, we find that this relationship has a temporal dimension. For example, bank diversification decreased the variance of bank stability prior to the financial crisis but increased its variance during the crisis. Thus, during crisis periods, it is better for banks to concentrate on traditional intermediation functions (i.e., deposits and loans) rather than diversifying their activities and investments. Further, the results suggest that although most regulators worldwide encourage diversification to reduce bank risk, bank diversification may exacerbate bank financial instability or increase the risk of financial market collapse when idiosyncratic events, such as financial crises occur.