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The Potential for Portfolio Diversification in Financial Services
Alan K. Reichert and Larry D. Wall
Less effective over time as financial firms used advances in information processing and financial technology to avoid the rules by offering products that were functionally equivalent to those that they could not legally provide. The effectiveness of the rules was further diminished assympathetic regulators reinterpreted prior law to allow their regulates to enter other parts of the financial services industry.
Nevertheless, the old rules imposed costly restrictions on a bank ability to provide investment banking and insurance activities. Moreover, they often had the effect of preventing investment banking and insurance firms from owning a commercial bank.
TheGramm-Leach-Bliley act removes most of the impediments to the affiliation of commercial banks with investment banks and insurance companies.
Although the G-L-B act largely eliminates the barriers to affiliation within the financial services industry, it dies not necessarily follow that financial supermarkets will come to dominate the financial services industry, as some had predicted.
Any financialconglomerates that emerge must be at least as profitable as firms that focus in specific market segments, and the conglomerates must earn higher risk-adjusted rate of the return if they are to dominate. Berger (forthcoming) surveys a large number of existing studies of cost and profit efficiency in the financial services industry to assess the prospect fir such financial conglomerates. While pointing out thatthe available evidence is incomplete in a number of important ways, he concludes that the largest possible gains appear to exist from the greater risk-diversification potential of conglomerates. Conglomerates may exploit the gains from diversification by increasing the proportion of their portfolio invested in higher-return assets – for example, by holding proportionately more loans and fewersecurities- without increasing the potential of diversification to reduce risk is a potentially important issue in understanding the effect of the G-L-B act on financial conglomeration.
The potential for diversification has been considered in a number of studies. Wall, reichert, and Mohanty (1993) survey prior studies in this area. They also provide an analysis of the strengths and weaknesses ofalternative methodologies, which is adapted her in the box on page 8. In addition, they present new evidence using internal revenue service (IRS) data on industry- level return on assets. They find and emerging consensus that pairwise combinations of individual firms provided insignificant gains for diversification at best and an increase in risk at worse. However, following Litan (1985) andusing IRS data over the 1974-89period, they find gains from forming portfolio of bank and nonbank activities whe using IRS rather than individual bank data. Certain portfolios of bank and nonbank activities showed substantially higher returns for lower risk. However, wall. Reichert, and Mothanty (1993) also find that their results were time-dependent.for example, they find that life insurance was thelowest risk portfolio in the 1974-80 sub period whereas it was a relatively small part of those portfolios in the 1981-89 sub period.
The article updates the contribution of Wall, Reichert, and Mohanty (1993) in several ways. It begins with a brief review of the literature since 1993. Next, it summarizes the legal changes resulting from the recent passage of the G-L-B. The article then extendsthe earlier empirical analysis, first by updating the analysis of the potential gains from diversification using IRS data on return on assets through 1997 and the by extending the diversification analysis to consider profitability as measure by retur on equity using IRS data from 1990 to 1997. The article concludes with some speculation about the potential impact of recent technological change on...