Diversification Strategies and Performance in the Italian Banking System

The paper addresses the question of diversification in the Italian banking sector. The Italian banking system represents an ideal experimental setting since it is characterised by a quite heterogeneous type of banks. The process of deregulation, innovation and consolidation during the Nineties implied a new competitive contest forcing new managerial strategies in the attempt to find new opportunities in terms of increased profits. Theoretically, the literature suggests bank diversification policies may lead to cost savings or revenue improvements due to spreading of fixed costs, exploitation of economies of scope from using the same information and customer cost economies. Diversification implies also benefits in terms of reduced agency costs of managerial discretion by lowering cash-flow volatility. As in previous studies, rather than attempting to measure economies of scope and agency problems directly, we investigate whether two types of diversification strategies, i.e. revenue and geographic diversification, may affect bank risk adjusted performance. Using an unbalanced panel dataset of 3,002 observations relative to Italian banks for the period 2006-2011, the core question is to analyse the effect of geographic and functional diversification across and within both interest and non-interest income and their effect in terms of risk adjusted performance verifying also if the results have been affected by the financial crisis. With respect to the previous work on bank diversification, our paper represents one of the first attempt to directly assess the risk/return implications of different types of product mixes. Moreover, in our empirical analysis we investigate whether certain type of institutions are better able to reap the benefits of diversification focusing on performance implications of size. Finally, we use consolidated balance sheet when available and unconsolidated if not, since banks tend to reserve the making of non traditional innovative activities to non-banking subsidiaries whose contribution can be more precisely evaluated if consolidated financial statements are available. The main results suggest that revenue and geographical diversification play a role in determining bank performance, but the relative effects appear to be different in relation to banks’ size. Moreover, in the after crisis period banks that have been less penalized in terms of risk-adjusted profit are those characterised by a greater focus on non-interest income component and the ones more geographically diversified. The paper is structured as follows. Section 2 reviews the literature on the nexus between diversification and bank performance. Section 3 presents the econometric methodology and the data used. Section 4 describes the results. Section 5 concludes