Abstract
This paper provides a theory of diversification and financial structure of banks. It shows that by diversifying the bank portfolio and financing it with debt, the bank can commit to a higher level of monitoring. By linking the benefits of diversification to the costs, the paper derives an optimal size of the bank, which is bounded. The costs of diversification lie in the higher overload costs with which the banker is faced by monitoring more projects. The benefits of diversification lie in increasing the bank's owner's incentives to monitor the lenders.
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