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The study examines bank risk by investigating the equity and loan portfolio characteristics of publicly-traded bank holding companies. It finds that the reduced ability of small banks to diversify forces them to either pick borrowers whose assets have relatively low credit risk or make loans that are backed by relatively more collateral.
The paper has presented strong circumstantial evidence that regulators place a limit on the total volatility of each bank’s assets regardless of size.
Small banks have more risk inherent in their loan portfolio because they cannot diversify away idiosyncratic volatility as well as large bank. However, they do make loans with less credit risk than large banks. This has the effect of reducing idiosyncratic volatility and also reducing the beta of each loan.
These results suggest a possible explanation for the co-existence of large and small banks. Small banks are able to secure loans with lower credit risk but at the cost of less diversity in their loan portfolio.