The Optimal Size of a Bank: Costs and Benefits of Diversification

This paper provides a theory of diversification and financial structure of banks. It shows that by diversifying the bank portfolio and financing it with debt, the bank can commit to a higher level of monitoring. By linking the benefits of diversification to the costs, the paper derives an optimal size of the bank, which is bounded. The costs of diversification lie in the growing size of the organization needed to achieve diversification, that is, the costs of hiring more managers and providing them with the incentives to monitor. The benefits of diversification lie in increasing the bank's owner's incentives to supervise managers and thereby increase the overall level of monitoring in the bank. 

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