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When banking institutions can expand into other lines of business, some think they will diversify to reduce their total risk. Others think just the opposite. In this article, John H. Boyd and Stanley L. Graham explain the reasoning behind these two views and then test to see which one best describes the behavior of U.S. bank holding companies since 1970. They find that in 1971-77, when these companies were relatively free to invest in some new lines of business, diversification was associated with greater risk of failure. But in 1977-83, when the companies were more tightly regulated, that association disappeared. These findings suggest to Boyd and Graham that, left to their own devices, bank holding companies will expand into new lines of business to increase their risk, but that regulation can control this risk-taking -- at least for the lines of business bank holding companies are currently allowed.
Boyd et al. (Sat,) studied this question.