Revenue Stream Diversification and Returns on Assets of Commercial Banks in Kenya

Abstract

Purpose: This paper examines whether revenue diversification index significantly affects returns on assets of commercial banks in Kenya and establish the presence of a long run and the speed of adjustment to equilibrium/disequilibrium between the variables.

Methodology: The study used balanced panel data sourced from the central bank of Kenya database, across 42 commercial banks from 2009 to 2018. The Hirschman-Herfindahl model was used to assess the diversification index, while returns on assets were captured using earnings before interest over total assets. Regressions analysis was used to evaluate the direction and magnitude of the relationship as guided by the resource-based theory while autoregressive distributed lag (ARDL) was adopted to establish the presence of a stable long-run relationship between the variables. The paper adopted a 2-tailed test, both at 95 percent (α = 0.05) and 99 percent (α = 0.01) confidence level.

Findings: The results revealed that on aggregate, commercial banks in Kenya were moderately diversification in both interest (HHIII = .36) and noninterest (HHINII = .63). The study found a statistically significant (P < .05) positive relationship between returns on assets and both in interest (R2 = .3237, β = 3.029, P = .049) and noninterest (R2 =.062, β = 4.432, P = .027) diversification indices. Further, the study established the existence of a long-run relationship with a speed of adjustment to the equilibrium of 89% (-.889) in the period. The paper concluded that diversification index influences became plausible up to a certain threshold (40%) when the weighted exposure sets in to outweigh the benefits and the relationship with returns decline. Therefore, the study demonstrates the existence of a stable long-run U-shaped relationship between revenue diversification and return on assets.

Implication: This implies that bank can apply consolidation as a mechanism to achieve activities diversification in order to improve returns. The study shows that returns on assets move in a similar direction with both interest and noninterest diversification index and therefore the growth of return on asset is associated with the diversification levels of revenue streams and thus the stability of returns in commercial banks is associated with revenue diversification stability.

Value: The study adds value to the theory building and extend knowledge frontier in diversification-performance relationships, while providing an evidence-based integrated theoretical framework, linking the concepts together through the resource-based theory. Provides policymakers with a scale of opportunities and understanding of issues and constraints that affect the banking sector’s performance.