The Effect of Loan Portfolio Diversification on Banks’ Risks and Returns: Evidence from an Emerging Market.

Abstract

Purpose: This paper tests 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 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 towards 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.