Revenue Diversification, Technical Efficiency, Size and Financial Performance of Commercial Banks in Kenya

Abstract

Banks interlink each other closely as well as financial market system players that make the sector systemic important to the larger economy. Therefore, the assessment of a banks’ financial performance becomes a concern to the bank management, shareholders, market players, regulators and scholars. Commercial banks generate revenue mainly from traditional banking activities constrained by the related expense and the wider the interest spread the better financial performance. However, the banking sector across the world is sensitive to financial shocks and heavily regulated. This in effect destabilizes the banking revenue structure and in the end, weakens returns earned and capital base, with the net effect of limiting the banking funded activities. As a reaction, banks have drastically embraced diversification and ventured into non-traditional banking activities, aimed at complementing the dwindling traditional banking activities. Thus, it is of curiosity to know how such a paradigm shift in the banking business model affects the perceived profitability challenges in the sector. The objective of this study was to assess the relationships between revenue diversification, technical efficiency, size and financial performance of commercial banks in Kenya. Specifically, the study assessed the effect of revenue diversification on financial performance, the mediation effect of technical efficiency on the relationship between revenue diversification and financial performance, the moderation effect of size on the relationship between revenue diversification and financial performance, and the joint effect of revenue diversification, technical efficiency and size on financial performance. The study inclined towards positivism philosophical orientation and adopted a longitudinal descriptive research design. The resource-based theory guided the study and supported by the market-power and agency-problem theories. The study collected and utilized unbalanced panel data sourced from the central bank of Kenya database and across registered commercial banks spanning 2009 to 2018. The study used the Hirschman-Herfindahl index to generate revenue diversification levels while data envelopment analysis was used to generated technical efficiency indices. The study used a weighted composite index to capture size while the financial performance ratio was measured using profits before tax and exceptional items, over the total assets. The panel least square fixed-effect model evaluated the directions of the relationship between variables, while Baron and Kenny 1986’s model assessed both the mediation and moderation effects. The results revealed that on average commercial banks were moderately diversified in revenue, and that financial performance related significantly with both interest(Ṝ2 = .37, β1 = 6.27, p = .00) and non-interest (Ṝ2 = .36, β1 = 5.16, p = .00) diversification. Technical efficiency exhibited no mediation effect on the relationship between revenue diversification and financial performance while size moderated the relationship between non-interest (not interest) diversification and financial performance (β3 = -.68, p = .02). Jointly revenue diversification, technical efficiency and size significantly affected financial performance (Ṝ2 = .46, F (N (4, 416) = 8.52, p = .00)). These results demonstrated that financial performances of commercial banks in Kenya improve with revenue diversification level and size size-dependent. The finding has important policy implication to scholars, policy-makers and bank manager in respect to the enactment of possible congruent policies that embraces banking activities mix in the intermediation process as well as optimal banking scope and scale targeted measures aimed at enhancing the financial performance of commercial banks in Kenya.