Income Diversification, Credit Risk and Profitability of Ethiopian Commercial Banks

Abstract

Understanding how income diversification affects credit risk-taking behaviour and profitability in commercial banks is important for stakeholders, including bank owners, managers, and regulators. This study therefore examined the impact of income diversification on credit risk-taking and profitability of commercial banks in Ethiopia. Additionally, it investigated how bank-specific, market and macroeconomic-related factors influence the diversification, risk-taking and profitability of these banks. The analysis was based on unbalanced panel data of 19 banks from 1997 to 2022. The empirical estimation relies on the two-step Generalized Method of Moments (GMM) technique. The results indicate that commercial banks in Ethiopia tend to enhance their profitability by assuming greater credit risk. The findings also indicate that diversifying income sources toward non-traditional activities has a significant profit enhancing effect for Ethiopian commercial banks. Income diversification was also found to have credit risk-reducing benefits, but the effect is statistically insignificant. The results of the study further suggest that bank-specific characteristics, such as bank size and capitalization, and macroeconomic conditions play important roles in determining income diversification, credit risk-taking and profitability of banks in Ethiopia. In conclusion, the study recommended promoting diversification into non-traditional businesses to enhance profitability and stability within Ethiopia's commercial banking system.