How To Manage The Cost vs. Diversification Trade Off

Is there an advantage to banks in diversifying loan portfolios by geography? As we learned during the last downturn, geography can have a significant negative impact on banks. In fact, geography is the largest single factor driving profitability (largely due to credit performance) composing about 16% of a bank’s return. However, banks are often criticized for making out of area loans. While out of area loans do afford some diversification, they also come with presumably less understanding and a higher transaction costs. In this article, we explore the benefits and costs of diversification and ask the question – is diversification worth it?


Geographic Diversification


Economists and regulators have argued that geographic diversification may reduce the risk of insolvency through business cycle troughs. To this point, it is important to clarify, that geographic diversification is about spreading assets over locations with low behavioral covariance. If you are lending in two different areas and they both happen to be suburban hubs of a major metro center, both are likely to react in the same manner during a credit shock. Despite being 30 miles apart, lending in those two areas offers little diversification. True geographical diversification can means that the areas tend to move in non-correlated fashion as it pertains to credit, volatility, growth, labor, real estate and population composition.


Getting geographical diversification is hard to find and it is getting harder. As can be seen below in the credit map of FL, most counties have relatively the same risk profile. As transportation costs decrease and the world becomes more homogenous, the benefits of diversification go away. In days of yore, a rural center and a suburban center would be separated only by a span of five miles. Now, given the interstate highway system, public transportation, and the internet, that interface is much larger so a bank needs to go farther out in area to achieve the same diversification.


FLorida Credit



When it comes to geography, what really matters is the diversification of the industries and the reliance on the local economy. The more businesses and households rely on the local economy the higher probability of being very positively correlated. For example, in Florida, Duval, and Polk counties, despite being different local economies and 200 miles apart, are highly (86%) correlated. Portfolio diversification between the two counties doesn’t help much. In comparison, the county of New York, with its high concentration of multinational companies and dense urban centers offers very low correlation while San Francisco, with its stable real estate and technology focus, offers negative correlation. As can be seen, banks have to try really hard to achieve geographical diversification. 


Correlated Credit Risk





Another facet of this equation is scale, the wider the service area of a bank, the greater the cost. Scale is the ability to spread operating costs over larger fixed factors of production and is a complex equation in itself. Generally, as banks expand, their cost margins increase so the goal is to create savings from scale at a faster rate than cost increase.


Luckily, the diversification argument has been studied extensively.  Important research on this subject was conducted by Kevin J. Stiroh in 2005 (“Bank Risk and Revenue Diversification: An Assessment of Using Equity Returns”). Stiroh concluded that size-related diversification does create benefits to the bank, but the relationship was non-linear. Diversification increases performance for a given level of risk but when banks approach approximately $4B in assets, this benefit disappears.


Meslier, Morgan et. al in 2014 (The Benefits of Intrastate and Interstate Geographic Diversification in Banking) also inspected the benefits of balance sheet diversification for banks. They further considered the effects of increasing geographic diversification versus an increase in asset size, or scale to account for potential diversification benefits.


The above and other studies consistently conclude that the average large bank (over $50B in assets) does not benefit from any further geographic diversification. However, smaller banks (under $10B in assets) can benefit from geographic diversification. We point out that there is a very important caveat. Spreading across geographic markets has substantial costs.


Geographic diversification often leads to higher costs and diminishes the benefits of diversification.  Opening branches in new locations are expensive. These costs can be particularly high for specialized relationship lending (especially for community banks) such as medical finance. As banks grow geographically, the cost of collecting soft data becomes more costly as the distance between the lender and the borrower increases. Furthermore, increasing distances between principals (executives and owners) and agents (management) creates higher agency costs.


What is The Answer?


Thus, the answer to the question is - banks should diversify in cases where geographic risks are higher than the administrative costs of going out of market. Banks need to weigh the advantage of being close to a borrower or property with reduction of risk in diversification. The more volatile asset prices are, the more likely diversification helps. Diversification helps more in FL and TX than it does in New York. Diversification always helps, it is just a question of how much and is it more than the increased administrative cost and potentially the extra risk from the lack of information.


It is also important to add, that diversification can be achieved in a number of ways and usually loan type and industry concentration are more inexpensive ways to achieve greater diversification than compared to geographical diversification.


In order to enjoy the benefits of diversification and diminish the costs, banks need to rely more heavily on banking technologies and partnerships to allow cheaper geographical diversification. For example, wholesale lending platforms that provide immediate access to geographically distant borrowers is one way to increase geographic diversification without the attendant costs. 


A bank with all of its offices in one community or one metropolitan area is vulnerable to local market risk. The risk is especially great during business cycle downturns. In these cases, banks should focus their pricing, sales and marketing dollars to bank companies that derive their revenue from sources outside the geography while making sure they have a good mix of non- or negatively correlated industries (such as technology, agriculture, consumer products, energy, etc.)


Finally, tactics may include creating partnerships with other banks, equipment manufacturers, trade associations or similar in order to reach different geographies in a cost-efficient manner while gaining the advantage of expertise. In this manner, banks can keep costs low, credit diversification high and satisfy the regulators that they understand the credits they are getting into despite an increased geographic span.