The general objective of this study is to investigate the impact of income source diversification on financial performance of commercial banks in Ethiopia. Commercial banks in Ethiopia are currently facing competition from non-bank institutions entry into the activities which was in the past only role of banks. Therefore, banks started searching new income sources rather than focusing only traditional inter-mediation income generating activities. Thus, this study was to examine the impact of income sources diversification on bank performance in case of some selected commercial banks in Ethiopia by using panel data over the period 2010-2015. The study used secondary data collected mainly from each sampled banks annual report financial statements. Since the data is secondary in nature, quantitative approach was adopted. This data was analyzed by using STATA version 12 and Microsoft Excel. Fixed effect model was used, since this model is preferred than the random effect model based on the hausman specification test. Return on asset (ROA) was used as dependent variable while income diversification (Div) as independent variable with control variables such as bank size (BS) in terms of total assets, equity/ assets ratio (EAR), loan/asset ratio (LAR) and expense/income ratio (Exp). The findings of the study show that the level of diversification has a positive impact on financial performance of Ethiopian commercial banks. In addition, the study also revealed that EAR, LAR and BS had positive impact on financial performance while Exp had negative impact. The results of the study are important for bankers to understand how income diversification affects the performance of banks. Therefore, the study recommended that banks should diversify their sources of income into interest and non-interest as well as reduce operating expense in effective way, so as to enhance their performance (ROA).
Table of Contents
Abstract
Acknowledgement
Table of Contents
List of Tables and Figures
Acronyms or Abbreviations
CHAPTER ONE
INTRODUCTION
1.1 Background of the study
1.2 Statement of the problem
1.3 Objectives of the study
1.3.1 General objective
1.3.2 Specific objectives
1.4 Significance of the study
1.5 Scope and limitation of the study
1.6 Structure of the thesis
CHAPTER TWO
RELATED LITERATURE REVIEW
2.1 Theoretical Review
2.1.1 Definitions of diversification
2.1.2 Why Diversification?
2.1.3 Approaches to Bank Diversification
2.1.4 Financial Performance Measures
2.1.5 The Role of banks
2.1.6 History of Ethiopian banking sectors
2.1.7 Development in Ethiopian banking sector
2.2 Empirical Literature
CHAPTER THREE
RESEARCH DESIGN AND METHODOLOGY
3.1 Research Design
3.2 Sources of Data and Method of Data Collection
3.3 Target Population, Sample size and Sampling Technique
3.4 Econometric Approach
3.5 Methods Data Analysis
CHAPTER FOUR
EMPIRICAL RESULTS AND DISCUSSION
4.1 Descriptive Statistics and Trend Analysis
4.1.1 Trend analysis
4.1.2 Descriptive statistics
4.2 Correlation Analysis
4.3. Regression Analysis
4.3.1 Testing assumptions of classical linear regression model (CLRM)
4.3.2. Random versus fixed effect model
4.4 Multiple Regression Analysis
4.5 Interpretation of the Finding
CHAPTER FIVE
CONCLUSIONS AND RECOMMENDATIONS
5.1 Conclusions
5.2 Recommendations
5.3 Future Research Direction
REFERENCES
APPENDICES
DECLARATION
I hereby declare that this thesis entitled “The Impact of Income Sources Diversification on Bank Performance: A Study on Selected Commercial Banks in Ethiopia”, has been carried out by me under the guidance and supervision of Mr. Yonas Mekonnen and Mr. Mohammed Sultan.
The thesis is original and has not been submitted for the award of any degree or diploma to any university or institutions.
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CERTIFICATE
This is to certify that the thesis entitled “The Impact of Income Sources Diversification on Bank Performance: A Study on Selected Commercial Banks in Ethiopia”, submitted to Jimma University for the award of the Degree of Master of Science in Accounting and Finance (MSc) and is a record of bona fide research work carried out by Mr. Mudesir Kasim A/Gosa under our guidance and supervision.
Therefore, we hereby declare that no part of this thesis has been submitted to any other university or institutions for the award of any degree or diploma.
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JIMMA UNIVERSITY
COLLEGE OF BUSINESS & ECONOMICS
DEPARTMENT OF ACCOUNTING AND FINANCE
MSc PROGRAM
Board of Examination Thesis
Approval Sheet
Members of the Board of Examiners
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JUNE 2016
JIMMA
Abstract
Commercial banks in Ethiopia are currently facing competition from non-bank institutions entry into the activities which was in the past only role of banks. Therefore, banks started searching new income sources rather than focusing only traditional inter-mediation income generating activities. Thus, this study was to examine the impact of income sources diversification on bank performance in case of some selected commercial banks in Ethiopia by using panel data over the period 2010-2015. The study used secondary data collected mainly from each sampled banks annual report financial statements. Since the data is secondary in nature, quantitative approach was adopted. This data was analyzed by using STATA version 12 and Microsoft Excel. Fixed effect model was used, since this model is preferred than the random effect model based on the hausman specification test. Return on asset (ROA) was used as dependent variable while income diversification (Div) as independent variable with control variables such as bank size (BS) in terms of total assets, equity/ assets ratio (EAR), loan/asset ratio (LAR) and expense/income ratio (Exp). The findings of the study show that the level of diversification has a positive impact on financial performance of Ethiopian commercial banks. In addition, the study also revealed that EAR, LAR and BS had positive impact on financial performance while Exp had negative impact. The results of the study are important for bankers to understand how income diversification affects the performance of banks. Therefore, the study recommended that banks should diversify their sources of income into interest and non-interest as well as reduce operating expense in effective way, so as to enhance their performance (ROA).
Key words: Income diversification, Bank performance, ROA, Commercial banks, fixed effect
Acknowledgement
First of all, I thank Allah for giving me the strength in all way. I am especially indebted to my advisor Mr. Yonas Mekonnen, Assistance professor, Jimma University for his patience and dedication in providing his continuous, valuable and constructive comments throughout in development of research paper.
I would also like to extend my heartfelt appreciation to my Co-advisor Mr. Mohammed Sultan, Lecturer in Jimma University in Department of Accounting and Finance for his full-fledged assistance and constructive comments in each parts of my research paper developments. Lastly but not the least, I would like to thank my families and friends for their appreciation in my work.
List of Tables and Figures
Table 1.1 Net Interest Income (NII) and Non Interest Income (NONII) sampled Ethiopian commercial banks for five years (in million)
Table 2.1 List of banks operating in Ethiopia
Table 4.1 Descriptive Statistics of Dependent, Independent and Control Variables
Table 4.2 Correlation matrix among dependent and independent variables
Table 4.3 Hausman test fixed or random model
Table 4.4 ROA Model: Fixed Effects Regression Results
Figure 4.1 Average trend of diversification (DIV), NONII and NII during 2010 to 2015...
Acronyms or Abbreviations
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CHAPTER ONE
INTRODUCTION
1.1 Background of the study
The portfolio theory of the Markowitz (1952) points out that diversification can decrease risk when individual assets are not fully correlated. Theory of bank diversification suggests the existence of several types of diversification which include; income diversification, assets diversification, credit diversification, geographical diversification and international diversification. Banks can diversify by investing in financial securities, participating in Fed funds and other securities in addition to making loans. Commercial banks can diversify not only their lending portfolio but also their investments. Income source diversification of bank is an expansion of new income earning financial services other than the traditional intermediation services. It involves the shift of reliance from the interest income sources associated with traditional intermediation activities to innovative non-interest income earning activities (Kiweu, 2012). Income diversification can be measured using the Herfindahl Hirschman Index and the Entropy Index which accounts for the variations in the breakdown of net operating income into interest income and non-interest income (Stiroh and Rumble, 2006).
The financial industry in developed as well as in developing countries has experienced major changes (Crouzille, et al, 2013). Deregulation and increased competition has led banks to expand their activities and to develop new lines of businesses beside their traditional interest activities (Edwards & Mishkin, 1995). Banks have diversified their income sources by performing new activities, such as underwriting and trading securities, brokerage and investment banking and other activities, which generate non-interest income (Crouzille, et al, 2013). Banks are transcending their normal business operations and diversifying their activities in response to economic and financial sector reforms. In recent years, deregulation and technological innovation has permitted almost all financial institutions to capture an increasing share of their income stream from noninterest sources. According to DeYoung and Rice (2003), in US commercial banks an amount of non-interest income increase due to diversification into lines of business such as investment banking, venture capital and insurance underwriting, growth in fee-paying and commission-paying services linked to traditional retail banking services has also been significant.
Batiz-Lazo and Woldesenbet, (2006) in their study suggest that financial performance is a measure of how sound financial health of a bank is and how is a guarantee to its depositors, shareholders, employees and the economy at large. Due to this fact, efforts have been made from time to time, to measure the financial position of each bank and manage it efficiently and effectively. Financial institutions have been increasingly generating income from “off-balance sheet” business and fee income (Allen & Santomero, 2001). The decline in interest margins, had forced banks to explore alternative sources of revenues, leading to diversification into trading activities, other services and non-traditional financial operations. The concept of revenue diversifications followed the concept of portfolio theory which states that individuals can reduce firm-specific risk by diversifying their portfolios (Albertazzi and Gambacorta; 2006, Uzhegova, 2010).
The study related to the relationship between income source diversification and financial performance in empirical findings ambiguous because the result of those finding indicate either positive, negative or even no relationship between the two. For example, the study conducted by Ousman et al. (2013), suggest that diversification of income sources in a bank should lead to a lower risk level and a higher risk-adjusted performance. Since service fees, net trading profits and other non-interest income are uncorrelated or imperfectly correlated with net interest income, diversification of income sources should make net operating income of a bank more stable. Similarly to diversify across income sources is desirable for risk management and efficiency which bring profitability enhancement (Chiorazzo, Milani, &Salvini, 2008).
In contradiction, the study on the relationship between income source diversification and financial performance by Lepetit et al. (2008) noted that an increased non-interest income resulting in higher bank risk. This study is conducted by exploiting detailed income data; they concluded that increased risk is due to commission and fee activities for small banks rather than trading activity. Their conclusions are related to that of Laeven and Levine (2005), indicating that diversification across lending and non-lending activities did not add value and was likely to increase agency costs. Diversification is better for the performance of the bank than focusing on non interest income activities (Ramadhani; 2015)
Abera (2012) suggested that capital strength, income diversification, bank size and gross domestic product have statistically significant and positive relationship with banks’ profitability. This study examines the bank-specific, industry-specific and macro-economic factors affecting bank profitability for a total of eight commercial banks in Ethiopia, covering the period of 2000-2011. He concluded that income source diversification was a vital driver of the performance of Commercial banks in Ethiopia. That means in the Ethiopian banking industry for the last twelve years revenue generated from non-traditional activities were one of the relevant drivers of their performance in general and profitability in particular. Furthermore, the highest positive coefficient that existed between income diversification and profitability compared to other variables clearly indicates as the Ethiopian banks profitability is highly determined by earnings other than interest.
A study conducted by Boru (2014) on the determinants of Ethiopian banks performance considering bank specific and external variables on selected banks’ profitability for the 1990-2012 periods. The study finds that bank specific variables by large explain the variation in profitability by using accounting measure Return on Assets (ROA) to represent Banks’ performance. High performance is related to the ability of banks to control their credit risk, diversify their income sources by incorporating non-traditional banking services and control their overhead expenses. He concluded that income source diversification is one of the key drivers of the Ethiopian Banks performance. Hence, banks should divert their attention towards maintaining the proper mix of non-interest bearing assets which can generate fee incomes and their loan exposures. The focus to introduce fee based services which are less exposed to credit risk should be one of the areas that Ethiopian banks need to work for in the future if they need to sustain their profitability performance.
There are various studies conducted in our country related to the determinants or factors affecting the profitability or performance of commercial banks in Ethiopia. Most of these studies classify factors in to two; internal profitability determinants and external determinants. However, to the researcher’s knowledge, none of these studies specifically focus on investigating the impact of income source diversification on financial performance of commercial banks in Ethiopia. Therefore, the focus of this research is to examine the impact of income source diversification of commercial banks in Ethiopia during the period of 2010 to 2015G.C.
1.2 Statement of the Problem
Following the fall of the Dergue regime, in 1991 the Ethiopian People's Revolutionary Democratic Front (EPRDF) declared a liberal economic system. Subsequently, the Monetary and Banking proclamation No. 83/1994 and the Licensing and Supervision of Banking Business No. 84/1994 was issued in 1994 which lead to the introduction of many new private banks in our financial markets. According to NBE report as of December 2015, the number of banks including Development Bank of Ethiopia reached 19 (16 private and 3 state-owned banks) in the country. The number of banks existing in our country is small as compared to other developing countries, but competition among them and from non financial institution is increased. The traditional role of commercial banks has centered on intermediation and the generation of net-interest income through two core activities; namely, the collection of deposits on which banks pay interest and the issuing of loans for which they receive interest income.
According to Chiorrazzo et al (2008) and Uzhegove, (2010), diversification should stabilize operating income and give rise to a more stable stream of profits. Diversification made it cheaper for institutions to achieve credibility in their role as screeners or monitors of borrowers (Diamond et al, 1986). Ousman et al; 2013, suggest that diversification of income sources in a bank should lead to a lower risk level and a higher risk-adjusted performance. Similarly to diversify across income sources is desirable for risk management and efficiency which bring profitability enhancement (Chiorazzo, Milani, &Salvini, 2008). Income source diversification was a vital driver of the performance of Commercial banks in Ethiopia (Abera, 2012).High performance of Ethiopian commercial banks are related to the ability of banks to control their credit risk, diversify their income sources by incorporating non-traditional banking services and control their overhead expenses (Boru, 2014).
In Ethiopia, due to the country’s monetary police and economic condition banks income from traditional activities may become small as compared to non interest income. However, commercial banks have gradually expanded beyond their traditional role and sources of income to encompass more activities that generate non-interest income. Depending on the above facts we can say if banks diversify their sources of income, their profitability’s are not only depending on loan interest. This means if the banks fall to collect the loan interest, they may cover their expenditure and maintain their performance by other non-interest income sources. Most of the studies above suggest that bank can diversify income sources into interest and non-interest income to increase profitability or performance. As table below indicate that most commercial banks of Ethiopia generate almost more than half of their total operating income from non-interest income activities like local and foreign transaction commission and service charge, other income etc. This implies that there are income source diversifications in commercial banks of Ethiopia.
Table1.1 Net Interest Income (NII) and Non Interest Income (NONII) sampled Ethiopian commercial banks for five years (in million).
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Source: Annual reports of sampled banks available on their web sites and magazines.
Several researchers mentioned above have explored relationships between diversification of income sources and risk adjusted financial performance (Ali Ousman et al; 2013, DeYoung and Rice, 2003; Stiroh, 2004; Stiroh, 2006; Stiroh and Rumble, 2006; Laeven and Levine, 2007; Lepetit et al., 2007 ;). However, the studies related to this issue in developing countries are scarce especially country like Ethiopia. In our country, there are various studies conducted related to the determinants or factors affecting the performance of commercial banks in Ethiopia. However, to the researcher’s knowledge, there are no studies that had been done specifically to close the gap of knowledge in investigating the impact of income source diversification on financial performance of commercial banks in Ethiopia. Therefore, the aim of this research is to examine the impact of income source diversification on performance of commercial banks in Ethiopia during the period of 2010 to 2015G.C.Research questions that the study attempt to answer are:
- What the trend of income source diversification of Ethiopian commercial banks looks like?
- Is there a relationship between income source diversification and bank performance?
- Does income sources diversification affect the performance of commercial banks?
- What are the impacts of control variables on commercial banks performance?
1.3 Objectives of the Study
1.3.1 General Objective
The general objective of this study is to investigate the impact of income source diversification on financial performance of commercial banks in Ethiopia.
1.3.2 Specific Objectives
- To shows trends of income sources diversification in Ethiopian banking industry during sample period
- To analyze the relationship between income diversification and profitability of Ethiopian commercial banks
- To investigate the effect of income source diversification on profitability of commercial banks of Ethiopia.
- To examine the impact of other control variables used in this study on profitability of commercial banks.
[...]
- Citation du texte
- Mudesir Kasim (Auteur), 2016, The Impact of Income Sources Diversification on Bank Performance, Munich, GRIN Verlag, https://www.grin.com/document/535024
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