The Effects of Focus versus Diversification on Bank Performance: Evidence from Chinese Banks

TLDR: This article investigated the effects of focus versus diversification on bank performance using data on Chinese banks during the 1996-2006 period and found that diversification is associated with reduced profits and higher costs.

Abstract: This paper investigates the effects of focus versus diversification on bank performance using data on Chinese banks during the 1996-2006 period. We construct a new measure, economies of diversification, and compare the results to those of the more conventional focus indices, which are based on the sum of squares of shares in different products or regions. Diversification is captured in four dimensions: loans, deposits, assets, and geography. We find that all four dimensions of diversification are associated with reduced profits and higher costs. These results are robust regardless of alternative measures of diversification and performance. Furthermore, we observe that banks with foreign ownership (both majority and minority ownership) and banks with conglomerate affiliation are associated with fewer diseconomies of diversification, suggesting that foreign ownership and conglomerate affiliation play an important mitigating role. This analysis may provide important implications for bank managers and regulators in China as well as in other emerging economies.

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Table 2 Summary statistics of economies of diversification measures for loan portfolios Table 2 presents summary statistics of the profit premium and cost discount measured by economies of diversification for loan portfolios. The definitions of the decompositions of the portfolios are the same as in Table 1. Profit premium is defined as the proportional difference in predicted profits between the observed diversified bank and a hypothetical quasi-focused bank with the same total amount of output, while a hypothetical quasi-focused bank is defined in our paper as the hypothetical focused bank which produces at least the minimum in each of the products. Cost discount is defined as the proportional difference in predicted costs between a hypothetical quasi-focused bank and the observed diversified bank.

Table 12 presents the ordinary least squares (OLS) regressions of cost efficiency on Focus Indices, ownership variables, conglomerate affiliation dummy (equal to 1 if the bank is affiliated with a conglomerate, 0 otherwise), the interaction terms between Focus Indices and ownership variables, between Focus Indices and conglomerate affiliation dummy, and control variables including size (including both ln(assets) and squared term of ln(assets)), and hyper-regulated period dummy (equal to 1 for period 1996-2001, 0 otherwise). Majority Domestic private ownership and the less-regulated period are considered omitted variables in the regressions. The Focus Index in the first paired columns represents the loan Focus Index, and the same Focus Index is also used to construct the interaction terms between Focus Indices and other variables. The Focus Indices in the second, third, and fourth paired columns represent deposit Focus Index, asset Focus Index, geographic Focus Index. Absolute values of t statistics (based on White heteroskedastic-consistent standard errors) are presented in brackets. *, **, and *** represent significance level of 10%, 5%, and 1% respectively.

Table 6 Summary statistics of Focus Indices of loan, deposit, asset, and geographic portfolios Table 6 presents the summary statistics of Focus Indices, and decompositions of loan, deposit, asset and geographical portfolios follow the same definitions as in Table 1. Summary statistics of subsamples of Chinese banks by size are also presented.

Table 1 Summary statistics of firm-level characteristics variables Table 1 presents summary statistics of ROA, cost ratio, decomposition of loan, deposit, asset, and geographical portfolios, and also some firm-level characteristics variables, including risk proxies and size variables. The disaggregated loan decomposition is based on each bank's loans to industry loans, commercial loans, real estate loans, agriculture loans, and consumer loans. The disaggregated deposit decomposition is based on each bank’s customer demand deposits, customer savings deposits, non-bank corporate deposits, deposits by other banks, and other deposits. The disaggregated asset decomposition is based on each bank’s total loans, deposits in other banks, financial investments (including investment in government securities, trading securities, and other financial assets), total fixed assets, and other assets. The disaggregated geographical decomposition is based on each bank’s loans on various regions in China, including northern, central, eastern, southern, and western regions. Conglomerate affiliation equals to 1 if the bank is affiliated with a conglomerate, 0 otherwise. Hyper-regulated period equals to 1 during 1996-2001 period, 0 otherwise. All the financial items, except ln(assets, in thousand $US), are in billions of $US, and inflation-adjusted to the price level of year 1996.

Table 5: OLS Regressions of cost economies of diversification (cost discount) on firm-level characteristics Table 5 presents the ordinary least squares (OLS) regressions of cost economies of diversification (cost discount) on ownership variables, risk proxies, size variables (including both ln(assets) and squared term of ln(assets)), conglomerate affiliation dummy (equal to 1 if the bank is affiliated with a conglomerate, 0 otherwise), and hyper-regulated period dummy (equal to 1 for period 1996-2001, 0 otherwise). Domestic private ownership and the less-regulated period are considered omitted variables in the regressions. The cost discounts in the first, second, third and fourth paired columns are calculated based on decompositions of loan, deposit, asset, and geographical portfolios, respectively, and these decompositions follow the same definitions as described in previous tables. Absolute values of t statistics (based on White heteroskedasticconsistent standard errors) are presented in brackets. *, **, and *** represent significance level of 10%, 5%, and 1% respectively.

Table 4: OLS regressions of profit economies of diversification (profit premium) on firm-level characteristics Table 4 presents the ordinary least squares (OLS) regressions of profit economies of diversification (i.e., profit premium) on ownership variables, risk proxies, size variables (including both ln(assets) and squared term of ln(assets)), conglomerate affiliation dummy (equal to 1 if the bank is affiliated with a conglomerate, 0 otherwise), and hyper-regulated period dummy (equal to 1 for period 1996-2001, 0 otherwise). Domestic private ownership and the less-regulated period are considered omitted variables in the regressions. The profit premiums in the first, second, third and fourth paired columns are calculated based on decompositions of loan, deposit, asset, and geographic portfolios, respectively, and these decompositions follow the same definitions as described in previous tables. Absolute values of t statistics (based on White heteroskedastic-consistent standard errors) are presented in brackets. *, **, and *** represent significance level of 10%, 5%, and 1% respectively.

Full text

Center for Economic Institutions
Working Paper Series
Center for Economic
Institutions
Working Paper Series
Institute of Economic Research
Hitotsubashi University
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Tel:+81-42-580-8405/Fax:+81-42-580-8333
http://cei.ier.hit-u.ac.jp/English/index.html
No. 2009-9
“The Effects of Focus Versus Diversification on
Bank Performance: Evidence from Chinese Banks”
Allen N. Berger, Iftekhar Hasan
and Mingming Zhou
November 2009

The effects of focus versus diversification on bank performance:
Evidence from Chinese banks
Allen N. Berger
a
, Iftekhar Hasan
b,*
, Mingming Zhou
c
a
University of South Carolina, Columbia, SC 29208 U.S.A.
a
Wharton Financial Institutions Center, Philadelphia, PA 19104 U.S.A.
a
CentER, Tilburg University, The Netherlands
b
Lally School of Management & Technology, Rensselaer Polytechnic Institute, Troy, NY 12180 U.S.A.
b
Bank of Finland, Helsinki, Finland
c
College of Business and Administration, University of Colorado at Colorado Springs, Colorado Springs,
CO 80918 U.S.A.
Abstract
This paper investigates the effects of focus versus diversification on bank performance using data on
Chinese banks during the 1996-2006 period. We construct a new measure, economies of diversification, and
compare the results to those of the more conventional focus index, which is based on the sum of squares of
shares in different products or regions. Diversification is captured in four dimensions: loans, deposits, assets,
and geography. We find that all four dimensions of diversification are associated with reduced profits and
higher costs. These results are robust regardless of alternative measures of diversification and performance.
Furthermore, we observe that banks with foreign ownership (both majority and minority ownership) and banks
with conglomerate affiliation – are associated with fewer diseconomies of diversification, suggesting that
foreign ownership and conglomerate affiliation play an important mitigating role. This analysis may provide
important implications for bank managers and regulators in China as well as in other emerging economies.
JEL classification: G21; G28; G34
Keywords: Diversification; Focus; Efficiency; Chinese Banking
The authors thank the anonymous referees and the participants in the Conference on Performance Measurement
in the Financial Services Sector: Frontier Efficiency Methodologies and Other Innovative Techniques for
helpful comments.
*
Corresponding author. Tel: +1 518 276 2525; Fax: +1 518 276 8661; hasan@rpi.edu (I. Hasan).

1
1. Introduction
Should banks diversify across different products and geographic regions, or should they
specialize? The focus versus diversification literature is well established in corporate finance, although
there is not a general consensus as to whether conglomerates tend to perform better or more poorly
than focused firms. Moreover, the findings in the general corporate finance literature may or may not
apply to the banking sector, because banks are different from other firms.
1
Although there are some studies on the link between diversification and performance of banks,
there is no consensus thus far, with evidence supporting both arguments. Proponents of diversification
suggest that diversified banks can benefit from leveraging managerial skills and abilities across
products and geographic regions (Iskandar-Datta and McLaughlin (2005)), gaining economies of scope
through spreading fixed costs over products and regions (Drucker and Puri (2009)), and providing a
financial supermarket to customers who demand multiple products.
Sometimes banks also face
conflicting regulation and supervision that create incentives to either focus or diversify. Branching,
entry, and asset investment restrictions often encourage focus, while supervisors tend to encourage
diversification to reduce risks.
2
1
Important differences between banks and firms in other industries are that banks are delegated monitors (Diamond, 1984)
and proprietary information acquirers of the borrowers (Fama (1980, 1985), James (1987), Sharpe (1990), Rajan (1992)),
and banks, by their very nature, are designed to diversify (Winton (1999), Acharya et al. (2006)).
On the other side, proponents of
focus argue that diversified banks can suffer from diluting the comparative advantage of management
by going beyond their existing expertise (Klein and Saidenberg (1998)), diversification-inducing
competition (Winton (1999)), and increased agency costs resulting from value-decreasing activities of
2
Diversified financial institutions may also reduce the expected costs of financial distress or bankruptcy by lowering risks
through spreading operations across different products or economic environments (Boot and Schmeits (2000)). In addition,
geographically diversified firms may obtain tax benefits by transferring income from high tax areas to low tax areas
(Iskandar-Datta and McLaughlin (2005)).

2
the managers who have lowered their personal risk (Amihud and Lev (1981), Deng and Elyasiani
(2007), Laeven and Levine (2007)).
3
Besides the inconclusive findings in the literature, the empirical evidence documented on
banking diversification to date is primarily based on the U.S. market and other developed countries,
with much less insight and discussion on the banking industry in emerging or transitional economies
(Odesanmi and Wolfe (2007) may be one of the few exceptions). When considering the size and
impact of some emerging markets such as China on the world economy, one might be surprised to
notice that there is a big gap in the banking literature: there are no empirical studies documenting the
effects of diversification strategies on performance of Chinese banks.
China boasts one of the biggest and fastest-growing emerging economies in the world, with an
average of about 10% GDP growth per year in real terms over the last two decades, and is projected by
some to become the world’s largest economy in the coming decades. Chinese banks have been playing
a big role in channeling the financial resources between the savings of households, government
deposits and transfers, and the financing of the Chinese enterprises, as the Chinese stock market did
not exist until 20 years ago and has been only serving limited number of companies which are favored
by the government. At the same time, however, Chinese banks have been heavily influenced by policy
makers. For example, although most of the national banks in China enjoy more freedom to spread
their businesses and services across the nation, most of the regional and city commercial banks face
strict geographical restrictions, and throughout the last few decades, the commercial banks have faced
limited degrees of freedom in terms of the products and services they can offer.
4
3
Furthermore, diversification of banking activities across international borders can lead to increased political risk, foreign
exchange risk, and difficulties of dealing with different languages, laws, and cultures, which can destroy shareholder value
(Miller and Parkhe (2002), Fauver et al. (2004), Deng and Elyasiani (2007)).
But these strict
regulations and limitations are becoming more relaxed, especially since China became a member of the
4
For example, the People’s Republic of China (PROC) issued 'Regulations on Credit Cards Business' (effective on April 1,
1996), which applies to commercial banks, institutions and individuals which hold, use, or accept credit cards in China. In
Chapter I of this regulation, the fifth clause says "Commercial banks, without the permission from PROC, cannot issue
credit cards..."

3
World Trade Organization (WTO) in 2001. Given the changing regulations and their relative new
experience to the business freedom and different options they have, banks in China may not
necessarily know their optimal product and geographical strategies. This paper therefore brings
evidence on the potential benefits of being focused versus diversified.
Based on the economies of diversification framework, we measure the differences in predicted
profits and costs between diversified and hypothetical focused banks. Diversification is captured in
four dimensions: loans, deposits, assets, and geography. We find that all the four dimensions of
diversification decrease profits and increase costs for the Chinese banks after controlling for risks, and
these results maintain regardless of different alternative measures of diversification and performance.
Additionally, we find that foreign ownership and conglomerate affiliation play an important mitigating
role in the diversification discount of the Chinese banks, in the sense that the banks with foreign
ownership (either majority foreign or minority foreign) or conglomerate affiliation experience fewer
diseconomies of diversification, i.e., suffer less loss of profits and less increase in costs when they
diversify.
This paper contributes to the existing literature in the following ways. First, we provide a new
measure of economies of diversification and apply it to the banking sector. Second, our paper fills the
gap in the existing banking diversification-performance literature which is heavily focused on the
developed markets. By presenting and discussing evidence of the diversification premium/discount in
the Chinese banking industry, our paper provides important insights into one of the largest emerging
and transitional economies. In this regard, this paper should not only provide practical implications for
Chinese bank managers, but also lend some perspectives to the policy makers in China and other
emerging economies as well, who set rules that encourage and/or discourage the diversification of
banking. Finally, our paper presents evidence on the effects of foreign bank ownership and

Frequently asked questions

Q1. What are the contributions in "“the effects of focus versus diversification on bank performance: evidence from chinese banks”" ?

This paper investigates the effects of focus versus diversification on bank performance using data on Chinese banks during the 1996-2006 period. This analysis may provide important implications for bank managers and regulators in China as well as in other emerging economies. Furthermore, the authors observe that banks with foreign ownership ( both majority and minority ownership ) and banks with conglomerate affiliation – are associated with fewer diseconomies of diversification, suggesting that foreign ownership and conglomerate affiliation play an important mitigating role. 

Q2. What are the variables that could explain the performance volatility?

In the second-stage regressions, the test is applied to the absolute values of the residuals of the first regression, which are now treated as the dependent variable, and the independent variables are the variables that could potentially explain theperformance volatility. 

Q3. What is the meaning of the negative means of profit premiums and cost discounts?

The negative means of profit premiums and cost discounts suggest that more focus is associatedwith higher profits and lower costs. 

Q4. What is the effect of foreign ownership on the profit premiums?

This suggests that foreign owners are able to at least partially mitigate the diseconomies of diversification, making banks suffer fewer profit losses and fewer cost increases associated with diversification. 

Q5. What are the results of the robustness test?

Their robustness test tables showthat both majority and minority foreign ownership dummies are associated with the better profit and/or economies of diversification, higher ROA and/or lower costs, lower risk, and higher profit and cost efficiency measures. 

Q6. What is the effect of the central and local governments on the diversification of the banks?

The intensity of influence from the central and local governments is expected to follow a downward trend in the forthcoming years, though the influence might still be quite substantial for those majority stateowned banks. 

Q7. What is the effect of foreign ownership on ROA?

the interaction terms between the foreign ownership and Focus Indices are negative and significant, implying that foreign ownership may play a mitigating role when banks diversify, in the sense that the diversified banks are not penalized as much in terms of ROA if they are associated with more foreign ownership. 

Q8. What is the ratio of the bank's equity to its assets?

Equity/assets: capital ratio of the bank measured as equity (book value)/assets, theapproximate equivalent of the bank's tier 1 capital ratio.