Effect of Loan Portfolio Diversification on Financial Performance: Evidence from Licensed Commercial Banks in Sri Lanka

Sazna MIF

doi:10.31961/ijaaf.v5i2.15318

Authors

Sazna MIF Assistant Lecturer

DOI:

https://doi.org/10.31961/ijaaf.v5i2.15318

Keywords:

Capital Adequacy, Hirschman-Herfindahl Index, Loan Portfolio Diversification, Loan Portfolio Concentration, Non-Performing Loan

Abstract

This study investigates the impact of loan portfolio diversification on the financial performance of licensed commercial banks in Sri Lanka from 2014 to 2023. While portfolio theory emphasizes diversification as a tool to reduce risk, its effect in the Sri Lankan context remains unclear. The study distinguishes between product-wise and sector-wise diversification to address this gap. Secondary data from 13 domestic licensed commercial banks were analyzed using purposive sampling. Loan portfolio diversification was measured through the Herfindahl–Hirschman Index (HHI), with Pearson’s correlation and panel data regression applied. Control variables included capital adequacy, non-performing loans, liquidity, and bank size. Results reveal that product-wise diversification negatively affects financial performance, while sector-wise diversification shows a significant positive effect. Capital adequacy ratio and non-performing loan ratio negatively influence performance, whereas liquidity has an insignificant positive impact. Bank size demonstrates a significant negative effect. Findings suggest that banks can improve profitability through product concentration while enhancing stability via sector diversification, offering useful insights for managers and regulators.

Downloads

Download data is not yet available.

References

Adzobu, L. D., Agbloyor, E. K., & Aboagye, A. (2017). The effect of loan portfolio diversification on banks’ risks and return: Evidence from an emerging market. Managerial Finance, 43(11), 1274-1291.

Al-Ali, S. M. (2020). The effect of dividends on the market share price: An applied study on Jordanian islamic financial companies for the 2010-2018. International Journal of Economics and Financial Issues, 10(3), 24.

Berger, A. N., & Bouwman, C. H. (2009). Bank liquidity creation. The review of financial studies, 22(9), 3779-3837.

Berger, A., Hasan, I., & Zhou, M. (2010). The Effects of Focus Versus Diversification on Bank Performance: Evidence from Chinese Banks. 2-1 Naka, Kunitachi, Tokyo, 186-8603.

Diamond, P. (1984). Money in search equilibrium. Econometrica: Journal of the Econometric Society, 1-20.

Edirisuriya, P., Gunasekarage, A., & Perera, S. (2019). Product diversification and bank risk: evidence from South Asian banking institutions. Applied Economics, 51(5), 444-464.

Ekanayake, E. M. N. N., & Azeez, A. A. (2015). Determinants of non-performing loans in licensed commercial banks: Evidence from Sri Lanka. Asian Economic and Financial Review, 5(6), 868.

Hayden, E., Porath, D., & Westernhagen, N. (2007). Does Diversification Improve the Performance of German Banks? Evidence from Individual Bank Loan Portfolios. J Finan Serv Res (2007) 32:123–140.

Huynh, J., & Dang, V. D. (2021). Loan portfolio diversification and bank returns: Do business models and market power matter? Cogent Economics and Finance, 9(1). https://doi.org/10.1080/23322039.2021.1891709

Kashian, R. D., & Tao, R. (2014). Off-balance sheet activities and community bank performance. Journal of Economic Studies, 41(6), 789-807.

Kumanayake, M. S., Gunarathne, Y. M. C., & Deyshappriya, R. (2019). Impact of loan portfolio diversification on performance of commercial banks in Sri Lanka. Journal of Management and Tourism Research, 2(1), 32-48.

Lakmali, K. H., & Disanayake, T. D. S. H. (2021). Impact of Loan Portfolio Diversification on Financial Performance of Banks: Evidence from Banking Sector in Sri Lanka.

McCarthy, J. F. (2010). Processes of inclusion and adverse incorporation: oil palm and agrarian change in Sumatra, Indonesia. The Journal of peasant studies, 37(4), 821-850.

Menike, M. G. P. D. (2024). The impact of portfolio diversification on the profitability of licensed commercial banks in Sri Lanka. Journal of Accounting and Finance, 11(2), 110-120.

Mrindoko, A. E., Macha, S., & Gwahula, R. (2020). Effect of operational risk on the financial performance of banks in Tanzania. International journal of business management and economic review, 3(6), 115-151.

Nyanyuki, M. N., Nyanga’u, A., & Onwonga, M. (2022). Evaluation of the effects of capital adequacy on financial performance of commercial banks in Kenya. International Academic Journal of Economics and Finance, 3 (7), 113, 126(2).

Redmond, W. (2013). A marketing systems view of the US housing crisis. Journal of Macromarketing, 33(2), 117-127.

Ruwanthika, W. M. T., Wijekoon, W. M. H. N., & Gunathilaka, R. C. (2022). Determinants of Banks’ Profitability: Empirical Evidence from Sri Lanka. International Journal of Accountancy, 2(2).

Shim, J. (2019). Loan portfolio diversification, market structure and bank stability. Journal of Banking & Finance, 104, 103-115.

Singh, K. M. (1991). Nowhere to Hide: Judicial Assistance in Piercing the Veil of Swiss Banking Secrecy. BUL Rev., 71, 847.

Sittichobtham, K. (2019). How does loan portfolio diversification affect bank profitability?.Chulalongkorn University.

Stiroh, K. J. (2004). Do community banks benefit from diversification?. Journal of Financial Services Research, 25(2), 135-160.

Stiroh, K. J. (2010). Diversification in banking. The Oxford handbook of banking, (1), 146.

Tah, K. A., & Martinez, O. (2016). The effects of securitized asset portfolio specialization on bank holding company’s return, and risk. Studies in Economics and Finance, 33(4), 679-687.

Waldron, R., & Redmond, D. (2017). “We’re just existing, not living!” Mortgage stress and the concealed costs of coping with crisis. Housing studies, 32(5), 584-612.

Winton, A. (1999). Don't put all your eggs in one basket? Diversification and specialization in lending. Diversification and Specialization in Lending (September 27, 1999).