The paper examines how loan portfolio diversification drives bank returns, mainly focusing on the conditioning roles of business models and ple of Vietnamese commercial banks from 2008 to 2019 to perform regressions in the dynamic panel models with the two-step system generalized method of moments (GMM) estimator. We find that increased sectoral loan portfolio diversification reduces bank returns, but not all banks are equally affected. Banks that adopted a business model towards non-interest activities are hurt less from loan portfolio diversification, and bank market power may mitigate the detrimental effects of loan portfolio diversification on bank returns. When such asymmetric effects are sizeable, neglecting them could miscalculate the choice of loan portfolio diversification. Our findings are robust to a rich set of bank return indicators and alternative loan portfolio diversification measures based on the Herfindahl-Hirschman (HHI)/Shannon Entropy (SE) indexes with different sectoral exposure profiles. Thus, both regulators and commercial banks should take the disadvantage of portfolio diversification into account when encouraging/pursuing a diversified strategy, which must be accompanied by the crucial caveat that the damage is most pronounced for banks with lower shares of non-interest income and less market power.

1. Introduction

Should banks diversify loan portfolios or specialize in only some economic sectors? This topic has attracted much attention from academia and regulators over the years. Fundamentally, corporate finance theory indicates that banks should specialize in only a few economic sectors to seize the comparative advantage of managerial expertise and experience (Denis et al., 1997 ). By granting loans to several sectors, banks could better evaluate and monitor their customers and collateral values, which might reduce the adverse selection problem. Furthermore, portfolio diversification seems not to be an attractive strategy for any bank as it could enhance competition with other banks (Jensen, 1986 ). In sharp contrast, traditional banking theory calls for the pursuit of loan portfolio diversification. Accordingly, banks should diversify their credit portfolio to diminish asymmetric information and further reduce financial intermediation costs (Diamond, 1984 ). This theory also argues that less diversified banks are more vulnerable to the economic downturn because of their limited exposures to only a few economic sectors. In practice, during the last decades, many banking crises have also raised the concern that bank collapse is highly associated with concentration, so commercial banks should diversify their loan portfolios to avoid idiosyncratic shocks (Chen et al., 2014 ).

Loan portfolio diversification and bank returns: Do business models and market power matter?

Though the impact of loan portfolio diversification on bank returns is a well-established concept in the banking literature, its empirical analysis has been limited in context and scope thus far. First, the cost-benefit implications of loan portfolio diversification have been mainly addressed for advanced economies. Concretely, exploring the banking sectors in Italy and Germany, many studies find portfolio concentration to be associated with more profit gains and less risk-taking, thus highlighting the diseconomies of diversification (Acharya et al., 2006 ; Behr et al., 2007 ; Hayden et al., 2007 ; Jahn et al., 2013 ). However, some competing effects dominated in other advanced ) reveal that portfolio diversification reduces bank risk and increases profit efficiency for Austrian banks. Using a sample of US banks, Shim ( 2019 ) shows that banks could promote financial stability when diversifying their loan portfolios across multiple economic sectors. Only a few papers investigate emerging markets and even exhibit mixed results. Analyzing the banking sector in Brazil, Tabak et al. ( 2011 ) encourage loan portfolio concentration as this strategy completely improves bank performance (more returns and lower risks of default). Focusing on Chinese banks, Chen et al. ( 2014 ) indicate a risk-return tradeoff of loan portfolio diversification in the way that it reduces bank profits and also mitigates bank risks simultaneously. Unlike banks in advanced economies, the available breakdown of loan portfolios is restricted at banks in emerging markets.