The Effects of Diversification on Banks´ Expected Returns

In financial theory, the optimal allocation of assets and its relationship withprofitability has been one of the main concerns; the question has always been ifbanks should focus or diversify their assets. In our case, we would like to answerthis question focusing in diversification of the loan portfolio, presenting a theoreticalmodel that considers the possible gains from diversification, while taking intoaccount the effects of monitoring. Additionally, we present empirical evidence onthis matter for the Colombian banking system. According to the model, we findthat once the banks have chosen its optimal level of monitoring, expected return isalways higher when the bank decides to focus. Additionally, the empirical resultssuggest that there are no possible gains form diversification in bank´s cost and that,on average, the effects of focusing the loan portfolio reduces bank´s return whileshowing positive effects of focusing on an specific sector.