The optimal size of a bank: Costs and benefits of diversification

This paper provides a theory of diversification and financial structure of banks. It shows that by diversifying the bank portfolio and financing it wi th debt, the bank can commit to a higher level of monitoring. By linking th e benefits of diversification to the costs, the paper derives an optimal si ze of the bank, which is bounded. The costs of diversification lie in the h igher overload costs with which the banker is faced by monitoring more proj ects. The benefits of diversification lie in increasing the bank's owner's incentives to monitor the lenders, (C) 2000 Elsevier Science B.V. All right s reserved. JEL classification: D82: G21; G32.