Effects of Income Source Diversification on Financial Performance of Commercial Banks in Kenya

Abstract

Financial institutions generate increased portion of their income from non-intermediation activities (DeYoung & Rice, 2004) and this could be associated to financial liberalization policies. Commercial banks exist to inter-mediate the transactions between demanders and suppliers of money at a given consideration. Earnings from these transactions form commercial banks traditional income generating activities. However, critical analysis of financial statements for commercial banks reveal a different trend, where over 40% of their net operating income comes from non-intermediation income generating activities (Stiroh, 2004a). By engaging in these non-interest sources, banks have been able to diversify their income source. Shaped by structural forces of change, banking in emerging markets has recently experienced a decline in its traditional activities, leading banks to diversify into new business strategies. Generally, it is believed that diversification of income sources should reduce total risk, as diversification should stabilize operating income if income streams are negatively or imperfectly correlated. Financial performance of an organisation is of utmost importance in determining its success. The objective of this study was to establish the effects of revenue diversification into non-interest income on financial performance of commercial banks in Kenya. This research adopted descriptive design as the information was collected from secondary sources. The population of interest was drawn from the commercial banks in Kenya for the period 2008 to 2012. In pursuance of the objective of the study, the study sampled 6 largest (most profitable) commercial banks in Kenya in terms of market share. The study used secondary data which was collected using audited financial statements of commercial banks in Kenya. Both descriptive and inferential statistics were used with the aid of Statistical Package for Social Science (SPSS) programme at 95% confidence level. The researcher employed regression model to study the relationship between the commercial banks financial performance and income diversification into non-interest incomes by banks. HHI was used to measure diversification while bank performance was measured by ROA. The study utilized chi-square test in testing the significance of variables in the study which showed significant relationship of variables with financial performance of commercial banks. According to the results, each of the independent variables which are fees and commissions on loans and advances, foreign exchange earnings, government securities income and sales and lease of assets income contribute positively to financial performance of commercial banks in Kenya. It is evident from the study that without diversification of income sources by commercial banks in Kenya most of them would have struggled with their objective of maximizing profit. The study recommends that CBK should offer environment where the commercial banks operations are not interfered with so as to attain diversification of income sources.The study recommends another study be done to establish the other non-interest incomes that the banks diversified into that influenced financial performance of the commercial banks in Kenya. Further research to augment the study findings on the sustainability of each of the non-interest income source could add value to the profitability of commercial banks and academic literature.