Banks’ Portfolio Diversification on Financial Performance of Commercial Banks in Kenya

Abstract

It is complicated to efficiently manage bank’s portfolio, simultaneously maximize returns and minimize risks while being subject to managerial and regulatory constraints. This paper has discussed pertinent issues in bank portfolio diversification in the banking industry while focusing on elimination of existing classes of risk. Banks’ portfolio diversification as a strategy in the context of a country like Kenya is assessed on fundamentals of available theoretical literature supported by empirical literature with the focus being commercial banks in Kenya. Taking the current balance sheet position as the starting point, this thesis aims at constructing a multi-objective approach for attaining an optimal balance sheet whereas at the same time bringing into consideration constraints that banks in Kenya encounter. This study was guided by five specific objectives; to assess the effect of sectoral credit, income streams, deposit types and investment portfolio diversifications on the financial performance of commercial banks in Kenya. The study in addition sought to ascertain the moderating effect of bank size on the relationship between banks’ portfolio diversification and commercial banks’ financial performance in Kenya. The study embraced descriptive and correlational research design. The forty-three institutions of commercial banking officially licensed by Central Bank of Kenya by December 2018 made up the population targeted by this study. Data subjected to analysis in this study was secondary unbalanced panel data with time series and cross sectional attributesand was gathered from published accounts on websites of individual banks, statistical reports by Kenya National Bureau of Statistics, World Bank website, Central Bank of Kenya supervision reports, and the Banking survey publications for a timely scope ranging from 2003 to 2018. The five hypotheses were estimated using Panel data techniques of fixed effect and random effect models. Generalized Method of Moments (system GMM) was utilized to estimate short run model and to purge unobserved firm specific time–invariant effects and also to help in mitigating presence of endogeneity problems. The study carried out pair-wise correlations existing between the study variables. Wald and F- tests were employed in the study to estimate the significance of the regression whereas coefficient of determination and R- square estimate were thereby adopted to explain extent of variation in dependent variables was accounted for by the explanatory variables. GMM revealed short run significant effect of lagged return on equity and lagged return on assets on financial performance. Sectoral credit diversification, income streams diversification, deposits diversification and investment diversification had significant positive effect on financial performance respectively. Bank size in both dynamic and static models revealed a positive moderating effect on the effect of banks portfolio diversification and financial performance. The study concluded that spreading a portfolio over multiple, unrelated investments reduce the risk of a sudden, unexpected outcome and in a diversified portfolio, a loss or risk in one investment is offset by gains from another investment. The study recommended that there should exist risk mitigation measures set aside through portfolio management. Commercial banks should focus their activities to promote confidence, develop marketing policies that encourage diversity and establish the best assets combination that can yield an efficient portfolio through portfolio diversification.