Optimal diversification, bank value maximization and default probability

Abstract

This study argues that the optimal level of diversification for the maximization of bank value is asymmetrical and depends on the business cycle. During times of expansion, systematic risks are relatively low; hence, the effect of raising systematic risks from portfolio diversification is slight. Consequently, the benefit of reducing individual risks dominates any loss from raising systematic risks, leading to a higher value for a bank by holding a diversified portfolio of assets. On the contrary, during times of recession, systematic risks are relatively high. It is more likely that the loss from raising systematic risks surpasses the benefit of reducing individual risks from portfolio diversification. Consequently, more diversification leads to lower bank values. Finally, some empirical evidence from the banks in Taiwan is provided.

Keywords:

• diversification
• default probability
• systemic risk
• banking
• business cycle

JEL Classification:

• G34
• L22
• G21
• G24

Additional information

Funding

This work was supported by Asia University [grant number 101-asia-10] and the National Science Council [grant number NSC 103-2410-H-032-024].