Is there a diversification discount in financial conglomerates?

The basic idea behind firms such as ABN, Citi, JPM, RBS, Barclays, any multi product line firm is that a firm like that can understand a client better, it can better deploy ideas to the client, look after all its requirements from soup to nuts, better manage risk across product lines, better managerial oversight, etc. And this is not a new idea, this idea can be traced back to great trading and banking houses in the old 18th and 19th century. If that is indeed the case, how come single product firms consistently beat these giant conglomerates in their return on capital? In other words, pick any type of single product firm, purely retail banking, purely insurance, purely asset management, purely investment banking, pure broking, and it will, much more often than not, beat the return on capital of these big behemoths. Further proving this image is how you always get rumours and pushes by hedge funds who can clearly see that the worth of the individual parts is greater is the sum of the parts. And as we have seen, with ABN as well. (as an aside, this form of behaviour isnt restricted to financial institutions, the giant conglomerates like Hanson, Tyco, etc. have all been broken up, although the exception such as GE is amazing. But the reason why it is so leads to the answer).

A recent research paper came across my inbox which confirms that the reason behind the under valuation of conglomerate shares is that the managers are unable to manage (see why GE is doing well? it has a brutal approach to capital, if any of its capital deployed units is not 1st or 2nd in its industrial segment, it kicks out that unit). The authors looked at a global sample of banks from Argentina, Australia, Austria, Belgium, Brazil, Canada, Chile, Colombia, Denmark, Egypt, Finland, France, Germany, Greece, Hong Kong (China), India, Indonesia, Ireland, Israel, Italy, Japan, Jordan, Kenya, Rep. of Korea, Malaysia, Mexico, Netherlands, Norway, Pakistan, Peru, Philippines, Portugal, Singapore, South Africa, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, United Kingdom, United States, and Venezuela across 5 years, 1998 - 2002. So no criticisms on scope or coverage. Further, it covers the upside and downside of the business cycle.
The crucial factor is, they didnt find a SINGLE conglomerate bank which had a diversification premium, every diversified bank was trading on a discount.

What does this mean? well, personally speaking, I am always reminded of what my first boss told me, never invest in a bank, lol. Secondly, this provides some interesting background to why conglomerates are a target (the irony is that they are being broken up as a conglomerate to be brought up by other banks to form bigger conglomerates - who said bankers were smart and having a long term view???). Finally, it reiterates the view that in order to be successful, one has to be brutal with capital and under-performance. Welcome to the creative destruction of capitalism!

Happy reading and happy weekend (I am going to fire up the BBQ :))

"This paper investigates whether the diversity of activities conducted by financial institutions influences their market valuations. We find that there is a diversification discount: The market values of financial conglomerates that engage in multiple activities, e.g., lending and non-lending financial services, are lower than if those financial conglomerates were broken into financial intermediaries that specialize in the individual activities. While difficult to identify a single causal factor, the results are consistent with theories that stress intensified agency problems in financial conglomerates engaged in multiple activities and indicate that economies of scope are not sufficiently large to produce a diversification premium."

Journal of Financial Economics 85 (2007) 331–367,

Is there a diversification discount in financial conglomerates?$ Luc Laeven, Ross Levine