Corporate diversification has been characterized as a central topic of research in the literature with existing studies investigating various issues like its relationship with ownership, top management characteristics, information asymmetry, and organizational divisionalization, to name a few. Perhaps the most well researched strand of this literature is the one linking diversification and performance (Chatterjee and Wernerfelt, 1991; Palich et al., 2000), with early studies going back to the work of Rumelt (1982). However, this topic continues to be central in the research agenda of banking, finance, and management scholars (e.g. Chakrabarti et al, 2007; Goddard et al., 2008; Elsas et al., 2010). One potential reason is that despite the large number of studies, the literature has not yet reached maturity, as it is evident by the little agreement that exists at both the theoretical and empirical level (Palich et al., 2000).
An important issue that has been highlighted in the case of non-financial firms is that while some studies examine the association between diversification and risk-return performance, the vast majority of the literature does not take risk into account (Bettis and Mahajan, 1985). This is surprising considering the importance of risk in managerial decision making (e.g. Miller and Bromiley, 1990) and the theoretical associations between diversification and risk (see e.g. Chang and Thomas, 1989). Additionally, the few studies that investigate the risk-return performance traditionally rely on the standard deviation of return on assets as a measure of risk, an approach that has also been used in studies in banking (e.g. Stiroh, 2004; Goddard et al., 2008). While this risk metric captures the instability of returns, it fails to take into account potential trade-offs, and it does not provide an overall indicator of exposure to the various risks. Yet, the idea that gains on one dimension must be potentially sacrificed on another dimension (i.e. trade-off) is central in the analysis of financial economics and bank management (Thakor, 2014).
Some banking studies have partially improved upon this by relating diversification to risk using the Z-score index, an indicator of a bank’s probability of insolvency (e.g. Stiroh, 2004; Mercieca et al., 2007). This index takes into account not only the standard deviation of return on assets but also the average return on assets and the average equity to assets over a fixed time period. Still, the Z-score is not without its drawbacks. First, there is no guidance as for the number of years that have to be used for the calculation of the standard deviation, with many studies relying on just two or three years. Yet, as shown in Delis et al. (2014) the number of periods considered for the construction of the variance component significantly affects the results. In addition, the requirement of having data for numerous continuous years imposes some restrictions on the number of banks that can be eventually assessed with this kind of analysis. Third, and most importantly, the Z-score focuses on profitability and capitalization ignoring other aspects like liquidity, asset quality, and cost management.
In general, there appears to be limited work in integrating various categories of risk exposures and incorporating risk into performance measures, an approach that could offer the possibility to assess the firm exposures along different dimensions (Miller, 1998; Chang and Thomas, 1989). At the same time, an increasing number of studies highlight the need to take into account the multidimensionality of performance, instead of focusing on individual measures like profits (see e.g. McKiernan and Morris, 1994; Devinney et al., 2010; Kyrgidou and Syropoulou, 2013).
Motivated by the above discussion, we aim to re-examine the impact of diversification on risk and return, while proposing a methodological framework that integrates various bank characteristics into an overall indicator of financial strength. Thus, we attempt to bring together the literature on diversification and the one on the multidimensional character of firm performance, an issue that has not been properly explored, despite having been suggested as an avenue of future research for over two decades (see Nguyen et al., 1990).