SPECIALIZATION, RISK, AND CAPITAL IN BANKING

Diversification is certainly the simplest and perhaps the oldest appro ach to managing Me trade-off between portfolio risk and return. Becaus e diversification tends to reduce risk without a proportional reductio n in returns, an overwhelming majority of commercial banks have divers ified portfolios. Larger banks usually are organized into multiple spe cialized lines of business; smaller banks generally hold a higher prop ortion of marketable securities whose returns are not tied to a partic ular geographic market. A much smaller number of banks have chosen to ignore the benefits of diversification and focus on a particular asset such as credit cards, residential or commercial real estate, corporat e trust services, or small business lending. This article investigates specialization in banking and its effects on risk and return. The aut hor compares a group of banks specializing in small business micro-loa ns (loans under $100,000) with a matched set of diversified peers. The number of specialized banks is still small, but they are expected ti, become more prevalent, and the number of specialized nonbanks is large including commercial and consumer finance companies, mortgage banks, leasing companies, many thrift institutions, and some investment banks and insurance companies. The author discusses the issues that special ization creates for regulators, especially in the field of capital req uirements, and the need to revise the current approach to regulatory r isk-based capital to better distinguish between specialized and divers ified banks.