Diversification and Bank Performance: International Evidence from 66 Countries

Abstract

The deregulation in the financial services industry makes commercial banks around the world face increased competition and change their managerial activities tremendously. A banks’ typical reaction to the new environment is to widen the range of their products and services, i.e., diversification of income sources. As a result, the ratio of bank’s non-interest income to operating revenue increases in many countries. Many studies question the implications of this change on bank’s performance and risk. Especially, supervisory authorities concern about this issue for the safety and soundness of the banking system. Prior studies, mostly based on US banks, on the effect of the increase in non-interest income on bank’s performance and risk show mixed results. Some studies show that the improvement of performance and a potential for risk reduction can be obtained by non-bank activities, but others report that there exists some increase in volatility of accounting returns and risk. This paper examines the effects of diversification on bank performance and risk by analyzing 3,220 banks from 66 countries. We find that diversification may improve bank’s capital adequacy, and earnings performance, but deteriorate the asset quality and increase the volatility of earnings and default risk. It appears that the non-interest income from various activities may be more volatile than interest income and banks may be less cautious to manage their asset compared to the interest focused activity.