Banks’ loan portfolio diversification

Abstract

Credit Risk management within banking is continually developing. Advances in credit-scoring models have allowed banks to improve their avoidance of non credit-worthy firms. Through meticulous credit evaluation, banks attempt to minimize credit-specific risk to their ideal cost of capital. However, this practice may not sufficiently reduce the total loan portfolio risk; systematic risk. To minimize the total loan portfolio risk, banks can consider diversify-ing its loan portfolio. Yet, research indicates that the correlations between portfolio compo-nents are often unconsidered by banks. The bank is therefore exposed to low firm specific credit risk, but may be exposed to high total portfolio credit risk if the portfolio components are highly correlated. Our thesis investigates the strategy behind loan portfolio diversification at banks.

This thesis is a qualitative study about how large banks in Sweden manage their loan portfo-lios. We discuss credit risk diversification with the help of Markowitz’s Modern Portfolio Theory (1952). Furthermore, we investigate whether Swedish banks actively pursue loan port-folio diversification and what methods they use.

We found that the majority of large banks in Sweden to a certain degree intuitively diversify their loan portfolio. On the other hand, we found that due to practical complexities the banks do not manage using loan portfolio diversification. Due to the size of these large banks it is assumed that loan portfolio diversification will happen naturally.