Income Diversification and Bank Risk-Return Trade-Off: Evidence from an Emerging Economy

Abstract

This study examines the impact of bank income source diversification on risk-return trade off, of commercial banks in an emerging economy. Considering eleven commercial banks for the period from 2002 to 2015, the paper examines non-interest income and its components against the risk-adjusted returns to explore the relationships among them. Results confirmed that non-interest income is riskier than interest income, but offers potential diversification benefits to shareholders. This is followed by the negative correlation between the interest income and non-interest income. Moreover, risk adjusted return on equity is positively affected by higher non-interest income activities, indicating that a marginal increase in non-interest income improves the shareholders’ risk return trade off. However, interest income, which has a significant negative relationship with risk-adjusted return on equity indicate that increase in interest income has been associated with worsening the risk return tradeoff for shareholders. Further, comparative analysis of non-interest income and risk-adjusted returns shows that foreign exchange income and other income categories have major influence on the shareholders risk and return. However, fee based income has no explanatory power over risk adjusted return. The findings of the study have important policy implications on the regulators in the implementation of capital adequacy requirements which adjust with the bank’s risk exposure.