Loan Portfolio Diversification and Financial Performance of Commercial Banks in Sri Lanka with the Moderating Effect of Firm Size.

Abstract

Banks face several challenges in strategically managing their loan portfolios to maximise wealth and long-term stability. In the financial sector, firm size appears to be a powerful variable in explaining organisational profitability since it has a more diversified portfolio with a larger scale of assets. Although numerous studies have been carried out to examine the relationship between loan portfolio diversification and financial performance, their conclusions are still inconclusive and often contradictory, as those studies have been conducted across multiple countries, over various periods and using diverse methodologies. Therefore, this study aims to examine the impact of loan portfolio diversification on the financial performance of licensed commercial banks in Sri Lanka and examine the moderating effect of firm size on the relationship between loan portfolio diversification and the financial performance of licensed commercial banks in Sri Lanka. Secondary data was collected from nine licensed commercial banks in Sri Lanka from 2012 to 2023. Hirschman Herfindahl Index was used to measure loan portfolio diversification. Return on Assets and Return on Equity were used as the measures of financial performance. Capital adequacy and liquidity were deemed as control variables. Firm size was considered a moderate variable. It was measured in terms of total assets. Descriptive statistics, correlation and panel data regression analyses were used to examine the data. This study employed the Hausman, Chow, and LM tests to select the best model among fixed, random, and common effects. The study found that product- and sector-wise loan portfolio diversification has an insignificant impact on ROA. However, product-wise loan portfolio diversification has a negative and statistically significant effect on ROE. According to these findings, product-wise loan portfolio diversification should be strategically managed to enhance the financial performance of banks in terms of ROE. Firm size has a positive and significant moderate impact on the relationship between product-wise loan portfolio diversification and the financial performance of Banks measured by ROA. However, A negative and statistically significant moderating effect of firm size is observed in the relationship between product-wise and sector-wise loan portfolio diversification and the financial performance of the banks reflected in ROE. Moreover, from the perspective of the R-squared value, there is a significant increase in the model incorporating the moderating effect of firm size compared to the other models. It perfectly reveals a strong moderating effect of firm size on the relationship between loan portfolio diversification and the financial performance of the licensed commercial banks. Hence, licensed commercial banks should increase product-wise diversification by offering environmentally friendly loans like green loans in addition to overdraft, term loans, pawning, trading and leasing. Further, they must analyse the costs and benefits of pursuing diversification to enhance financial performance. According to the moderating effect of firm size, a bank with larger assets is likely to speed up diversification, particularly with better risk management strategies and customer relationships, and it will benefit from economies of scale.