The effect of diversification across businesses and within lending activities on risks of commercial banks' portfolios: evidence from South Korea

Abstract

This paper investigates the effects of diversification across interest and non-interest activities, as well as, the effects of diversification within lending activities on banks' risk and return measures. Aggregate and panel data from the restructured (after 1997 crisis) banking industry of South Korea for the period 2002-2006 are used. Our results indicate that high level of diversification across interest and non-interest activities, as well as, across broad type of loans (i.e., corporate, household and other loans) is negatively significantly correlated with insolvency risk and positively significantly correlated with risk-adjusted returns, providing evidence for the market-discipline hypothesis. Concerning bank loan portfolio risks, less diversified across industries, loan portfolios are correlated with higher non-performing loan ratio. A shift from manufacture lending towards real estate and lease business lending can reduce the risk of bank loan portfolio. Therefore, bank regulations that focus on stable profitability and bank soundness should provide incentives for diversification.