Improving the Robustness of Diversification and Bank Performance: Empirical Evidence from Pakistan

Abstract

This study examines the impact of diversification (asset, income, and funding) on the financial performance of banks, measured through Return on Assets (ROA), Return on Equity (ROE), and Net Interest Margin (NIM). The study employs a system GMM approach to estimate the parameters by collecting data from Pakistani banks over the period from 2011 to 2023. The findings reveal that asset and funding diversification reduces the profitability of Pakistani banks while the income diversification enhances it. The findings reveal that diversification's effectiveness varies across bank capitalization levels, with income diversification positively influencing performance in well-capitalized banks, while undercapitalized banks experience mixed results due to inefficiencies. Macroeconomic factors, including economic growth and inflation, significantly influence the relationship between diversification and performance. The study underscores the importance of tailoring diversification strategies based on bank-specific characteristics and economic conditions. Policy recommendations include enhancing capital adequacy, promoting risk management frameworks, and aligning diversification strategies with macroeconomic stability. These measures can strengthen the resilience and efficiency of the banking sector.