Portfolio diversification, bank size and financial performance of commercial banks in Kenya

Abstract

Financial institutions can benefit from understanding how portfolio diversification affects bank performance, stability, and risk exposure. Risk reduction through portfolio diversification affects bank performance and clientele. Despite its popularity as a risk management tool, the effect of portfolio diversification on bank performance is unclear. Diversification may not improve financial performance due to increasing costs and depleted economies of scale. The purpose of this study was to establish the moderating effect of bank size on the relationship between portfolio diversification and financial performance of commercial banks in Kenya. The specific objectives guiding this study were to determine the influence of sectoral credit, to assess the effect of bancassurance, to establish the effect of deposits portfolio, to analyse the of effect of investments portfolio and to examine the effects of bank size on the financial performance of commercial banks in Kenya. Additionally, the study sought to establish the moderating effect of bank size on the above relationship and financial performance of commercial banks in Kenya. Modern portfolio theory, organizational lifecycle theory and growth of firm theory provided the theoretical foundation for the study. Utilization of an explanatory research design with a longitudinal approach. The unit of analysis consisted of all 42 commercial banks registered in Kenya. From the annual financial statements of the institutions and the annual reports of the Central Bank of Kenya, 210-year observations of secondary data were extracted for the study spanning 2017-2021. The study's data were analysed using descriptive and inferential statistics, as well as statistical techniques such as the Pearson correlation coefficient and regression analysis. All analyses were conducted using STATA version 13. The hypotheses were evaluated using a hierarchical multiple regression model at a significance level of 0.05. The findings of this study were presented in table format. The study determined that sectoral credit diversification had a statistically significant negative effect on the financial performance of Kenyan commercial banks (β = -0.113, p < 0.05). The study found that bancassurance had no statistically significant impact on the financial performance of commercial banks (β = 0.002, p > 0.05). Diversification of deposit portfolios had a negative and statistically insignificant impact on the financial performance of commercial banks (β = -0.107, p > 0.05). Diversification of investment portfolios had a positive and statistically significant impact on the financial performance of commercial banks (β = .153, p < 0.05). Further, bank size ad a positive and significant effect on financial performance (β = 0.414, p < 0.05). Bank size moderated the relationship between sectoral loan diversification and the financial performance of commercial banks in Kenya (ΔR 2 = 0.716, β= 0.018, p< 0.05). The findings of the study indicated that bank size does not moderate the relationship between investments portfolio diversification and financial performance of commercial banks (ΔR 2 =0.716, β= -0.002, p> 0.05). The relationship between bancassurance and financial performance was negative and significantly moderated by the size of the bank (ΔR 2 =0.721, β =-0.018, p< 0.05), as well as the relationship between deposits portfolio diversification and financial performance (ΔR 2 = 0.721, β=0.069, p< 0.05). The study has managerial and practical implications for commercial banks to ensure they diversify their credit targets and avoid over-reliance on the domestic sector. The study revealed that bancassurance has no bearing on the financial success of commercial banks. The study contributes by demonstrating that portfolio diversification and firm size jointly influence the financial performance of banks, a combined effect not previously documented. Commercial banks are advised to diversify their investment portfolios to ensure their financial stability and to take advantage of low-risk government securities. Policymakers and regulators in Kenya's commercial banking sector, such as they should formulate policies and regulations that encourage mergers, acquisitions, and portfolio diversification.