Sectoral credit diversification, bank performance and monitoring effectiveness; a cross-country analysis of east African banking industries
Jonathan Mwau Mulwa
Journal of Finance and Investment Analysis, 2018, vol. 7, issue 2, 2
Traditionally, banking has been viewed as a pathway to reducing the frictions ofÂ transaction costs and information asymmetries. However, innovations inÂ information technologies, deregulation, and financial deepening have deprivedÂ banks of the intermediation advantages by reducing the costs and informationÂ gaps. The emergence of shadow banking model further erodes these advantages.Â Banks have often responded by ameliorating their intermediation costs, throughÂ sectoral diversification. Indeed intermediation theories advocate for diversificationÂ to attain efficiency by reducing costs. However, given the nature of theirÂ operations, banks never hold sufficient balances to guarantee full liquidity. ThisÂ exposes them to runs and portfolio losses if they donâ€™t efficiently monitor andÂ recover the advances. This scenario raises two questions that are critical to theÂ very core of bank intermediation. First, does sectoral credit diversificationÂ enhance bank profitability; and secondly, are banks able to effectively monitor theÂ many portfolios resulting from diversification? To answer these questions,Â secondary data was collected from Bank Supervision reports of the central banksÂ in four East African Community (EAC) countries for eight firm years from 2008Â to 2015 and analysed using Generalized Linear Models (GLM). A positive andÂ significant effect of sectoral credit diversification on banking industry returns onÂ assets was observed while a significant negative relationship betweenÂ diversification and asset quality as a proxy for monitoring effectiveness wasÂ reported. This shows that sectoral credit diversification improve the monitoringÂ effectiveness of banks. The paper recommends a diversified loan portfolio whereÂ intermediaries distribute their credit offerings across various economic sectors.JEL classification numbers: G21, G28, G32Keywords: Credit Diversification, Bank Performance, Monitoring Effectiveness
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