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Two alternative research hypotheses concerning how small business lending affects bank profitability are tested. The specialization hypothesis argues for higher profitability than other banks due to increased focus on small business lending, whereas the diversification hypothesis asserts that small business lenders' profitability will be lower than other more diversified banks. Using the rate of return on assets as the profit measure, we find that small business exposure tends to have neutral or positive effects on bank profitability after taking into account bank risk. Using efficient frontier analyses that focus on the rate of return on equity, we find that small business lenders reap benefits from specialization, particularly in terms of reducing failure risk. We conclude that the evidence supports the specialization hypothesis.

Assessing the Profitability and Riskiness of Small Business Lenders in the Banking Industry