Should bank loan portfolio be diversified under government capital injection and deposit insurance fund protection?

- We study the effect of loan diversification on the return and risk of a bank.
- Loan portfolio focus produces superior return but less safety for the bank.
- Loan diversification with government capital injection produces superior return but less safety.
- Increased return and decreased risk are attenuated as the deposit insurance fund increases.

The barrier option theory is applied to the contingent claims of a regulated bank under multiple loan portfolio diversifications and government capital injections. An increase in capital injection increases the bank's interest margin and decreases the default risk. With increased government capital injection, profitability is increased and stability is reduced when the diversification degree increases. The increased return and the reduced risk are attenuated as the deposit insurance fund protection increases. Although the bank faces the two conflicting capitalization policies, we may suggest that loan portfolio should be as diversified as possible, producing better profitability and greater safety for the bank.