Diversification

One of the reasons that the Canadian banking system survived the carnage associated with the global credit crunch precipitated by the collapse of the Asset Backed Commercial Paper(ACBP)market was the scope and scale of financial regulation in this country. A system now being looked at by other countries. There is plenty of material written on this topic, so we will not.

Another reason is the geographic diversity in this country. Unlike the United States that uses a unit banking system - lots of small, geographically isolated banks with few branches, Canada uses a branch banking system - a relativel small number of banks with a multitude of branches. Canada has six dominant banks that operate from coast to coast. This allows then to diversify their loan portfolios across different geographic regions.

Portfolio theory tells us that adding assets to a portfolio reduces the riskiness of the portfolio provided that the returns on the additional assets are less than perfectly correlated. The probability of a loan default in Halifax is independent of a loan default in Calgary. This is because the economies of the two regions are independent of each other. Canadian banks are large and geographically diversified thus reducing the default risk of their loan portfolios.

The idea of diversification applies to other areas as well. Firms can choose unrelated product lines to diversify their revenue streams. Look, for example, at Canadian Tire's purchase of Mark's Work Warehouse. (Some will argue that shareholders can adequately diversify their own portfolios so firms need not venture too far from their core business - but we digress).

This brings us to an article that appeared in this morning's Globe and Mail. In an upscale night club in South Africa, you will not be admitted if you are wearing running shoes. There is, however, a local hot dog vendor that will rent you a pair of dress shoes for the evening. Now that is diversification.

Would you like mustard with those stilletos?