RISK, REGULATION, AND SAVINGS-AND-LOAN DIVERSIFICATION INTO NONTRADITIONAL ASSETS

Risk exposure is a central issue in the debate over allowing savings a nd loan associations (S&Ls) to expand into nontraditional activities, This paper examines the relationship between risk and portfolio compos ition of three distinct groups of S&L lenders based on their investmen t strategies: real estate specialized (RES) S&L lenders with high hold ings of adjustable-rate mortgages (ARMs), RES S&L lenders with low ARM s, and not real estate specialized (NRES) S&L lenders. The major findi ngs of this paper suggest that diversification into nontraditional ass ets leads to lower risk and higher average returns for RES firms with low ARMs, but for NRES firms it leads to higher risk and (in some case s) lower average returns, This latter group of institutions appears to be using nontraditional assets as a means to increase their risk expo sure and not necessarily their average stock returns. In addition, we find that risk increases for RES S&Ls with high ARMs as additional adj ustable-rate mortgages are added to their portfolios. This is not the case for the low ARMs group and may indicate that at some level the in crease in credit risk dominates the decrease in interest rate risk ass ociated with additional ARMs, relative to fixed-rate mortgages. These results strongly suggest that while additional diversification provide s risk reduction opportunities for some S&Ls, it also provides opportu nities for other S&Ls to increase their risk exposure.