The effect of loan portfolio diversification on banks’ risks and return

Abstract

Purpose The purpose of this paper is to test whether diversification of credit portfolios across economic sectors leads to improved profitability and reduced credit risks for Ghanaian banks that have been characterized by high non-performing loans in recent times (IMF, 2011). Design/methodology/approach Static and dynamic estimations, namely Prais-Winsten, fixed and random effect estimators, feasible generalized least squares as well as the system generalized methods of moments are employed on the annual data of 30 Ghanaian banks that operated between 2007 and 2014 to determine the effect of loan portfolio diversification on bank performance. Findings The study shows that loan portfolio diversification does not improve banks’ profitability nor does it reduce banks’ credit risks. Research limitations/implications The study focuses on a single banking system in Africa largely as a result of data limitation. Practical implications The study emphasizes the need for banks to perform a careful assessment of the effects of their lending policies geared toward increased sectoral diversification on their monitoring efficiency and effectiveness. A further investment in loan screening and monitoring is necessary to minimize credit risks. Originality/value This study is the first to present empirical evidence on the effects of loan portfolio diversification on bank performance in an emerging banking market in Africa.