Effect of Diversification on Financial Performance of Commercial Banks in Kenya

Abstract

Kenyan banks have diversified their revenue streams by expanding into non-traditional banking services such as insurance, asset management, and mobile banking. This diversification has helped them to mitigate risks and stabilize their income streams, even during times of economic uncertainty. Similarly, Kenyan banks operate in a highly competitive market, which requires them to be innovative and adaptive to changing market trends. This has led to the development of new financial products and services, which have contributed to their overall financial performance. This study aimed to investigate the impact of diversification on the financial performance of commercial banks in Kenya, drawing on modern portfolio theory, the capital asset pricing model, and the market power theory. The study utilized secondary data extracted from the annual financial reports of 35 licensed commercial banks in Kenya over a five-year period (2018-2022). The key variables included the degree of diversification (measured by the Herfindahl-Hirschman Index), asset quality (non-performing loans to total loans ratio), liquidity (liquid assets to total assets ratio), and firm size (natural log of total assets). Financial performance was represented by Return on Assets (ROA). Descriptive statistics, correlation and regression analysis were applied to provide a comprehensive understanding of the relationships between these variables. The findings reveal that diversification and liquidity do not exhibit statistically significant relationships with ROA, while asset quality and firm size emerge as significant predictors. A negative correlation between non-performing loans and ROA implies that deteriorating asset quality corresponds to reduced financial performance. Conversely, a positive correlation between firm size and ROA suggests that larger banks achieve higher returns. The overall model was deemed statistically significant, explaining approximately 36.8% of the variability in ROA. The study concludes that asset quality and firm size significantly influence financial performance of commercial banks in Kenya while diversification and liquidity are not significant determiners. The study recommends that regulators continue to monitor and evaluate diversification strategies while emphasizing the importance of maintaining robust asset quality management practices. Furthermore, policymakers should balance the encouragement of growth with measures to prevent concentration risks associated with larger firm sizes. For future research, a more in-depth exploration of specific types of diversification and the inclusion of additional variables, such as management quality.