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Does the Geographic Expansion of Banks Reduce Risk?

Economic theory provides conflicting views on a basic question in banking: does the geographic expansion of a bank’s activities reduce risk? Textbook portfolio theory suggests that geographic expansion will lower a bank’s risk if it involves adding assets whose returns are imperfectly correlated with existing assets. In addition, diversified banks might enjoy cost-efficiencies that can enhance stability. And, if diversification makes a bank too big or too interconnected to fail, implicit or explicit government guarantees can lower the risk of investing in the bank. Other theories, however, stress that expansion can increase bank risk

We find that geographic expansion materially reduces bank holding company risk. This finding holds after controlling for a wide array of time‐varying bank holding company characteristics, such as size, growth, profitability, stock market valuation, operating income, the degree of non-lending activities, and the capital‐to-asset ratio. Across an array of specifications and robustness tests, we find an economically large effect.

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