How Does Diversification Impact Bank Stability? The Role of Globalization, Regulations, and Governance Environments

• DOI: http://doi.org/10.1111/ajfs.12032
• Author: Pei‐Fen Chen,Meng‐Fen Hsieh,Shih‐Jui Yang,Chien‐Chiang Lee
• Published date: 01 October 2013
• Date: 01 October 2013

How Does Diversification Impact Bank

Stability? The Role of Globalization,

Regulations, and Governance

Environments*

Meng-Fen Hsieh

Department of Finance, National Taichung University of Science and Technology

Pei-Fen Chen

Department of International Business Studies, National Chi Nan University

Chien-Chiang Lee**

Department of Finance, National Sun Yat-sen University

Shih-Jui Yang

Department of Finance, National Sun Yat-sen University

Received 18 February 2013; Accepted 6 July 2013

Abstract

This paper examines the impact of bank diversification on stability, using bank-level data for

22 Asian countries over the period from 1995 to 2009. We empirically investigate whether

country characteristics, economic structure, regulatory and governance environments, and

globalization have affected the degree of banking stability in Asia. This study takes on two mea-

sures for banking diversification - asset and income diversities - and adopts a broad set of vari-

ables as a proxy for bank stability. We apply dynamic panel data techniques and show different

results from the U.S. and Europe. Our results first reveal that in Asia asset diversity is not suffi-

cient enough to improve bank stability. However, bank stability can be enhanced through a

strategy of income diversity. Second, a higher degree of globalization decreases bank stability

through income diversity, but stability rises through asset diversity. Third, a country with a

higher level of corporate governance reduces the agency problem, thus further increasing

*Acknowledgements: We would like to thank Editor Dr. Chang-Soo Kim, Associate Editor,

and two anonymous referees for their highly constructive comments. Chien-Chiang Lee is

grateful to the National Science Council of Taiwan for financial support through grant NSC

102-2410-H-110-007-MY2. The usual disclaimer applies and the views herein are the sole

responsibility of the authors.

**Corresponding author: Chien-Chiang Lee, Department of Finance, National Sun Yat-sen

University, Kaohsiung 804, Taiwan. Tel: +886-7-5252000 ext 4825, Fax: +886-7-5254899,

email: cclee@cm.nsysu.edu.tw.

Asia-Pacific Journal of Financial Studies (2013) 42, 813–844 doi:10.1111/ajfs.12032

©2013 Korean Securities Association 813

stability through diversity. Finally, a country with a higher level of economic development will

support asset diversity so that banks can obtain higher profit accompanied by lower risk.

Keywords Banking diversification; Bank stability; Regulations; Globalization; Dynamic panel

JEL Classification: C23, G21, O16

1. Introduction

The overall development trend in financial markets is liberalization. Financial institu-

tions are being encouraged to develop new financial products with the goal of meetin g

the demand from the development of markets, upgrading competitiveness, expanding

business scale, and promoting liberalization and diversification of financial markets.

Theoretically, the question of whether a greater diversification of business activities

improves the performance (or risk) of financial intermediaries is still a puzzle. Park

and Pennacchi (2009) develop a competition model and analyze the U.S. retail market

over a seven-year period from 1998 to 2004. Their results show that a greater presence

of large, multi-market banks tends to promote competition in retail loan markets, but

harms competition in retail deposit markets. Nevertheless, to our knowledge, no

extant studies consider the diversification-stability relationship to vary across coun-

tries through country specific characteristics, economic structure, regulatory and gov-

ernance environments, and the role of globalization for Asia’s banking industry.

This research is the first regionally-focused paper with Asian data that deals with

risk-taking issues and investigates two main hypotheses - the “regulatory enhance-

ment hypothesis” and the “regulatory deterioration hypothesis” - while analyzing the

impacts from diversification. We examine the case of the Asian banking industry

with the latest and a wider range of panel data over 1995–2009 and totaling 1585

banks - a period covering the 1997 Asia financial crisis and the global financial tsu-

nami of 2008–2009. This study augments the existing literature through the following

five ways: (i) It adopts a panel of 22 Asian countries, as opposed to a smaller set of

countries that mainly focuses on the U.S. (Liang and Rhoades, 1988; Rose, 1996; Shi-

ers, 2002; Stiroh and Rumble, 2006; Deng et al., 2007; Deng and Elyasiani, 2008) or

on European banking (Acharya et al., 2006; Baele et al., 2007; Mercieca et al., 2007;

Chiorazzo et al., 2008; Lepetit et al., 2008; De Jonghe, 2010; Fiordelisi et al., 2011).

(ii) It examines two measures for banking diversification: asset and income diversi-

ties. (iii) It sets up five variables as the proxy for bank stability. (iv) It considers an

extensive array of interaction terms (conditional factors):

1

globalization, law and reg-

ulation, corporate governance, and economic development. Indeed, if related “condi-

tional factors” play an important role in influencing the effects of diversification on

stability, then one can expect countries with the same degree of banking diversifica-

tion to have very different outcomes in terms of bank stability. (v) It econometrically

adopts dynamic panel data techniques. An important feature of our generalized

1

We will describe the relationship in terms of each condition in the next section.

M.-F. Hsieh et al.

814 ©2013 Korean Securities Association

method of moments (GMM) approach is that we control for possible endogeneity of

the measures for the degree of diversification (Lee and Hsieh, 2013).

Research on Asian banks is sparse,

2

but very important, because the rapid

expansion of East Asian corporations through entry into new business segments is

seen as an important contributing factor to the East Asian Miracle (World Bank,

1994). Asia is also the predominant source of capital financing for businesses in this

continent’s private sector (Deesomsak et al., 2004). On the other hand, excessive

diversification of corporations contributed in part to the Asian financial crisis

(Claessens et al., 2003). Banks in this region have experienced their own banking

crises, and bank restructuring programs presently continue in several Asian coun-

tries (Agusman et al., 2008).

After the Asian financial crisis of 1997–1998, the concentration ratio increased

in Asian banks, due to a decline in the number of banks following bank closures

and the creation of mega banks through bank consolidation. However, Asia’s expe-

rience in bank mergers is different from that of the United States. For instance,

bank mergers in South Korea were the result of horizontal mergers among banks

with overlapping geographical markets, which is contrary to the market extension

history of interstate banking in the United States. An increase in market concentra-

tion has resulted in less competition over time in the Korean banking system.

Another notable case is China. Through economic reform, the Chinese government

authorized four state-owned commercial banks between 1979 and 1984 with limited

competition among them. Since then, the government has allowed many joint

equity banks and private banks in order to mobilize needed financial resources for

economic development. Furthermore, China authorized several policy banks and

city banks in the 1990s as a measure of financial liberalization ahead of its entry

into the World Trade Organization. All these developments have contributed to a

continuous decrease in market concentration in the Chinese banking industry

(Park, 2013).

Member countries of the Association of Southeast Asian Nations (ASEAN) have

had to adopt international standards in banking supervision and regulations (i.e.

capital adequacy, loan classification, and loan loss provisioning) and had to remove

2

However, studies on diversification and Asia focus on manufacturing firms, generally exclud-

ing the banking sector. For example, Claessens et al. (2003) examine the relationship between

diversification and performance in the corporate sector of nine East Asian economies over

the 1991–1996 pre-crisis period. They find that, relative to complementary diversification,

vertical integration is more complex and involves higher short-term learning costs and higher

probabilities of capital misallocation. Kruse et al. (2007) look at the operating performance

of 69 mergers of manufacturing firms listed on the Tokyo Stock Exchange during 1969 to

1999. They note that improvements in performance are greatest among the diversifying merg-

ers. Bae et al. (2011) investigate the valuation effects of diversification activities for publicly

traded manufacturing firms listed on the Korea Stock Exchange during 1994–2003. They offer

evidence that unrelated diversification by Korean firms erodes firm value, but their related

diversification does not decrease firm value.

Diversification Impact on Bank Stability

©2013 Korean Securities Association 815