The relationship and causality testing between diversification, risk and financial performance: empirical examination in Taiwan's banking industry

The objective of this study is to examine the portfolio theory that suggests that diversification can potentially reduce the return variance and the probability of failure of a portfolio. The current study is to investigate the diversification measure by means of Hershman-Herfindahl index, and applies the " diversification index " proposed by Demsetz & Strahan (1997) by scaling systematic risk with stock return variance of individual bank, which implies that as the banking with a high diversification index (a high R 2), the fraction of risk stemming from firm-specific factors is small. Next, this study examines the effects of diversification on risk and financial performance respectively, and finally tests the causality between diversification, risk, and financial performance in Taiwan's banking industry during 1993~2001. The empirical results shows that the average diversification measures based on Hershman-Herfindahl index between stated-owned banking and new-private banking are 26.61% and 25.18% respectively. It shows that the state-owned banking is better diversified than new-private banking. However, better diversification does not translate into reductions in risk for state-owned banking. Besides, this study also demonstrates a positive relationship between systematic risk and stock return variance of banking industry in Taiwan. Furthermore, the empirical results show that the more diversification, the less volatility of ROA and possibility of failure. In addition, the effects of diversification on five kinds of financial performance show that the more of diversification, the more of ROA, EPS, NIS, PIS, and ROE. The results show that the diversification and the financial performance of banking industry exist positive relationship significantly; it implies that the diversity nonbank activities are benefited to the financial performance of banking industry. On the side of the relationship between risk and financial performance, the empirical results show that the return variance and the five kinds of financial performances exists negative relationship significantly. That is, the results show that the more of market risk, the less of financial performance for banking industry. The results of Granger causality testing between diversification and risk shows that the diversification of past period does cause the risks of the banking industry; there ii exist the time lag effect between diversification and risk. Besides, the results of Granger causality testing between diversification and financial performance shows that causality testing between diversification and five kinds of financial performance shows that the diversification of past period does cause the financial performance of the banking industry, and vice versa; there exist …