The relationship and causality testing between diversification, risk and financial performance: Empirical examination in Taiwan's banking industry

The objective of this study is to examine the portfolio theory that suggests that diversification can potentially reduce both the return variance and the probability of failure of a portfolio. The study aims to investigate the diversification measure by means of the Hershman-Herfindahl index proposed by Berry [1], and applies the 'diversification index' proposed by Demsetz and Strahan [2,3] by scaling systematic risk with stock return variance of individual banks. It is assumed that as banking has a high diversification index (a high R²), the fraction of risk stemming from firm-specific factors will be small. Next, this study examines the effects of diversification on risk and financial performance, respectively, and finally tests the causality between diversification, risk and financial performance in Taiwan's banking industry for the period 1993-2001. Our paper provides strong evidence of a link between diversification, risk and financial performance of the banking industry in Taiwan. The empirical examinations suggest that diversification may provide an important motive for risk reduction and performance enhancement for the banking industry.