Sectoral exposure and its impact on bank risk: Evidence from India

Abstract

This study investigates how banks’ sectoral loan exposures affect their risk profiles. We introduce two market-derived measures: Aggregate diversification, which gauges vulnerability to sector-specific shocks, and Differential specialization, indicating how much a bank’s sectoral focus diverges from industry average. Analyzing data from 2006 to 2022 for Indian commercial banks, we find that greater aggregate diversification significantly reduces bank risk, while higher differential specialization increases it. Specifically, a one standard deviation increase in Aggregate diversification improves bank stability by 3.4%, whereas a comparable increase in Differential specialization reduces stability by 7.2%. The stabilizing effect of diversification stems from reduced stock volatility, lower financing costs, and enhanced market valuations. Specialization conversely correlates with higher non-performing loans and diminished shareholder value. These results emphasize the importance of employing high-frequency return data to measure risk and underscore the sectoral context and institutional capacity in shaping the risk-return trade-offs between diversification and specialization.