No. 20 - The asset diversification and market value of banks

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by Federica CiocchettaFebruary 2020

The price-to-book ratio (PTB) - defined as the ratio of the market value of a listed company's shares over its book value - is a measure of the expected value that a company can create given the composition of its assets and liabilities (franchising value). Differences between the market value and the book value, i.e. when the PTB is other than 1, stem from investors' risk assessments and profit expectations that differ from those reflected in the financial statements. In Europe, a large number of banks have a PTB below 1, though the ratio varies greatly among intermediaries within the same country.

One of the factors that may explain the difference in bank PTB values is how banks diversify their assets between loans and other components. A high degree of diversification may have both positive and negative effects. This depends on whether the benefits associated with operational synergies and more efficient risk management outweigh the risks that stem from greater organizational complexity and from investments in riskier assets than traditional activities.

An empirical study on a sample of 92 listed European banks during the 2011-17 period demonstrates that the disadvantages of diversification outweigh the benefits. The study found the existence of a negative relationship between asset diversification - alternatively measured by an asset diversity index or by a concentration index - and the market value of European banks, controlling for other factors deemed significant in the literature, such as profitability, operational efficiency, credit quality, asset opaqueness and size. The relationship is particularly negative for larger, more complex intermediaries, among which global systemically important banks (G-SIBs). A reduction in asset diversification of one standard deviation in the diversity index would result in an increase of 0.06 in the PTB, equal to 7 per cent of the sample's average value. Results of a similar magnitude are obtained using the concentration index. The negative relationship between the PTB and the diversity index is also confirmed when the scope of the analysis is limited to Italian intermediaries.

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