Diversification, Collateral and Economies of Scale in Banking : Lessons from a Continuous-Time Portfolio Approach

Adopting a continuous-time portfolio framework with endogenous financial intermediation, this paper analyzes diversification in bank lending. First, an increase in the number of independent credits in a loan portfolio is shown to enhance intermediation activities. This supports the hypothesis of financial deepening in a growing economy. Second, diversification may reduce a bank's collateral requirements, giving rise to a kind of scale economy in lending. If competition among banks is driven by collateral, big banks get a competitive edge vis-agrave;-vis less diversified small banks, which should lead to a natural monopoly outcome in the banking market