Industry Mix and Lending Environment Variability: What Does the Average Bank Face? - Economic and Financial Review, Second Quarter, 1999 - Dallas Fed

24 Behind that old proverb “don’t put all your eggs in one basket” lie the potential benefits of diversification. However, the idea that diversification is always enhanced by using more baskets can be misleading. In the world of equity investing, for example, the introduction of an additional stock to a portfolio can either increase or reduce the variability, or risk, of the portfolio’s return. The new stock is more likely to reduce portfolio variability if changes in its return over time are not closely associated with changes in the return of the original portfolio. In the same way individuals can hold portfolios of stocks, banks can be said to own a portfolio of earning assets. The most important collection of assets for most banks is their loan portfolio. And diversification in banks’ loan portfolios is just as important as diversification in individuals’ portfolios. A well-diversified loan portfolio does not eliminate all the risks banks face. But diversification can substantially limit banks’ exposure to economic shocks and help reduce the variability of bank earnings. Many banks in Texas experienced financial difficulties in the last half of the 1980s because their loan portfolios were concentrated in oil and real estate, industries that suffered severe shocks at that time. If the Texas banks had also been lending heavily in states with a significantly different industry mix, lending profits in those states may have helped offset the severe losses on loans extended in Texas. On the other hand, having additional lending operations in another heavily oil-dependent state, such as Oklahoma, would not have done much to help reduce the earnings variability of Texas banks. If the benefits of diversification are well known, why might banks not have pursued a more diversified loan portfolio? One explanation might lie in legal restrictions the U.S. banking industry faced that limited diversification opportunities. Chief among these are the longstanding restrictions on interstate banking and branching that U.S. banks operated under until fairly recently. Individual states controlled the degree of branching allowed within their own borders, as well as the degree of interstate banking allowed across their borders. Although several methods were used to partially overcome these obstacles, geographic restrictions nevertheless made it difficult for banks to spread their operations across several regions. In the late 1970s, restrictions on banks’ geographic expansion began to ease. States increasingly allowed out-of-state banking organizations to acquire in-state banks, and intrastate branching restrictions were eliminated. This proIndustry Mix and Lending Environment Variability: What Does the Average Bank Face?