Do banks diversify portfolio risk? A test of the risk-cost hypothesis

Baltensperger (1972a, b) proposes the risk-cost hypothesis that banks decid e the number of loans by considering the costs arising from diversifiable p ortfolio risk. Thus, the banks do not minimize operation costs, but total c osts including risk costs. This paper examines empirically whether the risk -cost hypothesis is valid, using financial panel data from Japanese banks f rom 1981 to 1994. Estimating the first-order condition of total cost minimi zation together with an operation cost function, we find that the hypothesi s is supported. Dividing the sample into different types of banks, it is fo und that the hypothesis is valid for city and regional banks, but not for s econd regional banks. (C) 1999 Elsevier Science B.V.