Geographic diversification and risk in banking

Abstract

Tests of the hypothesis that geographic diversification affects bank risk are conducted on large samples of banking organizations (1976–1985) and focus on intrastate geographic diversification experience. Three composite measures of risk are included iin the tests along with the individual components of these measures. Results show that while composite measures of risk are reduced by geographic diverisification, some inidividual components of these measures increase. Importantly, the results show lower financial risk (the variation in earnings), which is predicted by portfolio theory. However, we also observe lower levels of earnings and capital with greater diversification implying, ceteris paribus, higher risk. This effect is not predicted by portfolio theory, but is predicted by our notion of operating risk. There is apparently more than pure financial risk involved with diversification by firms.