Not all eggs in the same basket? The role of sectoral specialization in the banking system

Students of systemic banking distress point to concentration in specific asset classes or sectors as one of the most important factors explaining these crises. The last two global crises are good examples: the simultaneous overexposure of several banks to the U.S. mortgage market initiated the global financial crisis `07–`08 and the overexposure of several banks to sovereign debt of distressed European countries severely deepened the European debt crisis of `11–`12. Given the importance of risk concentration in banking it is therefore surprising how little empirical evidence is available on the relationship between sectoral concentration and bank performance and stability. This absence of research is mainly explained with a lack of data. In recent work, we introduce a new methodology to measure sectoral specialization and differentiation and relate these measures to bank performance and stability (Beck, De Jonghe and Mulier, 2017).

What does theory tell us?

The traditional portfolio theory view posits that diversification largely eliminates the impact of idiosyncratic shocks on banks’ loan portfolio (Diamond, 1984; Boyd and Prescott, 1986) so that more specialized banks should be less stable and — at least in the long-run — perform worse. However, banking is not like any other sector: (sectoral) specialization can result in lower information frictions between banks and borrowers, which in turn can reduce agency conflicts. More focused banks may therefore not only experience lower default risk among their borrowers, they may also detect a deterioration of the borrower’s business earlier allowing them to mitigate risk in a timely manner, for example, by requesting additional collateral (Winton, 1999), leading ultimately to higher (risk-adjusted) returns.

Sectoral concentration, however, matters not only on the individual bank-level, but also in the aggregate; more specifically, the degree to which banks specialize in the same sectors might affect their performance and stability. We have seen an increasingly homogeneous banking system over the past decades, and this has happened only partly through increasing consolidation in the sector (De Nicolo and Kwast, 2002). This lack of diversity can be costly for society as it implies that similar institutions will more likely face problems at the same time (Wagner, 2010). In fact, banks may have ex-ante incentives to become more similar through herding, which can lead to socially very undesirable outcomes (Acharya and Yorulmazer, 2007, 2008).

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Measuring sectoral specialization and differentiation

Most papers testing these hypotheses have relied on credit registry data for one country, which limits the external validity of the findings. Furthermore, sectoral concentration of banks may come through lending, but it can be critically influenced by the use of derivatives to either hedge positions taken through lending or create long or short positions in specific sectors without even lending to these sectors. In our recent paper, we therefore draw on the mutual fund literature and use an extended factor model to relate bank stock returns in a given year to returns on 9 sectoral portfolios and a set of common factors, which include the returns on a global market index, a domestic market index, a financial sector index, a real estate index, and the Fama-French factors. We define bank sectoral specialization as the percentage variation of the bank’s stock returns that is incrementally explained by the sector-specific portfolios over and above the variation explained by the set of common factors. We define bank sectoral differentiation as the Euclidean distance between a bank’s estimated sectoral exposures and the average sectoral exposures of all other banks in the same country-year. We construct these indicators for 1,587 banks across 24 countries over the period 2002–2012, and find significant variation in these indicators across banks and over time.

We show the validity of our new indicators of sectoral concentration by comparing them with a small hand-collected database on the actual sectoral lending exposures for a subsample of the largest banks, which we derive from the notes to their annual statements.

What does the evidence tell us?

After this validity check, we relate our new market-based indicators to three indicators of bank performance and stability for our full sample. Specifically, we focus on the volatility of a bank’s stock returns (to measure total bank risk), the market-to-book value of its equity (to gauge risk-adjusted returns), and the marginal expected shortfall (to capture the exposure of a bank to systemic risk (Acharya et al., 2017)). We find that

  • Banks with more concentrated sectoral exposure (more specialization) experience a lower volatility of their stock returns and a lower exposure to systemic risk. There is also weak evidence that more specialized banks have higher franchise values. These effects are substantially stronger in the long-run than in the short-run.
  • These results are not only of statistical but also economic significance: in the long run a one standard deviation increase in sectoral specialization reduces total bank risk by 0.2 standard deviation and reduces exposure to systemic risk by 0.32 standard deviation.
  • Banks whose sectoral exposures are similar to that of their peers in the same country and same year (more differentiation) experience higher volatility and higher exposure to systemic risk.
  • A one standard deviation increase in sectoral differentiation increases total bank volatility by about 0.67 standard deviation. The positive relation between sectoral differentiation and exposure to systemic risk seems particularly driven by the crisis years 2008 and 2009.
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These ‘specialization’-findings are consistent with theories focusing on the benefit of sectoral specialization for reducing idiosyncratic and systemic risk (e.g., Winton, 1999) but not with theories that focus on the benefits of portfolio diversification (e.g., Diamond, 1984). It is important to note that the benefits of sectoral specialization come primarily through risk reduction rather than being value increasing, i.e., markets perceive more specialized banks as less risky, including during systemic shocks. Although our ‘differentiation’-results do not seem to be consistent with theories focusing on the risks of similarity of banks’ exposure profile at first sight (Acharya and Yorulmazer, 2007, 2008; Wagner, 2010), they might actually reflect underlying market expectations of bail-outs if there are too-many-banks-to-fail. Alternatively, the more adverse market reaction to more differentiated banks (especially during systemic shocks) might be due to higher information asymmetries of investors vis-a-vis banks that look more different from their peers.


The regulatory reform wave after the Global Financial Crisis has not addressed the issue of sectoral specialization and differentiation. The findings of our research show that this might be for the better, as performance and stability of more specialized banks does not necessarily correspond to standard theories of portfolio diversification. Our findings show that more specialized banks suffer less volatility and lower exposure to systemic risk, similar to banks that look more alike their peers (same country and year) in terms of sectoral exposures. However, we also find country variation in these relationships, which makes the design of one-size-fits-all regulation on sectoral exposures impossible.

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Acharya, V. V., L. H. Pedersen, T. Philippon, and M. Richardson (2017). Measuring systemic risk. The Review of Financial Studies 30 (1), 2.

Acharya, V. V. and T. Yorulmazer (2007). Too many to fail? An analysis of time-inconsistency in bank closure policies. Journal of Financial Intermediation 16 (1), 1{31.

Acharya, V. V. and T. Yorulmazer (2008). Information contagion and bank herding. Journal of Money, Credit and Banking 40 (1), 215-231.

Beck, T., O. De Jonghe and K. Mulier (2017). Bank sectoral concentration and (systemic) risk: Evidence from a worldwide sample of banks, CEPR Discussion Paper 12009.

Boyd, J. H. and E. C. Prescott (1986). Financial intermediary-coalitions. Journal of Economic Theory 38 (2), 211-232.

De Nicolo, G. and M. Kwast (2002). Systemic risk and financial consolidation: Are they related? Journal of Banking & Finance 26(5), 861-880.

Diamond, D. W. (1984). Financial intermediation and delegated monitoring. Review of Economic Studies 51 (3), 393-414.

Wagner, W. (2010). Diversification at financial institutions and systemic crises. Journal of Financial Intermediation 19 (3), 373{386.

Winton, A. (1999). Don’t put all your eggs in one basket? Diversification and specialization in lending. Working paper available at SSRN:

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