Impact of Income Diversification on the Financial Stability and Performance of Banking Sector.

Abstract

The evolving banking landscape in Sri Lanka necessitates the strategic diversification of income sources to enhance resilience and sustain profitability. Nevertheless, there is scant empirical research in the context of domestic licensed commercial banks regulated by the Central Bank of Sri Lanka. Thus, this paper investigates how bank income diversification impacts the risk-adjusted performance and financial stability among banks. The study employed a quantitative research method using secondary data from 13 banks from 2015 to 2024. The study is supported by modern portfolio theory, resource-based theory, and risk-return trade-off theory. The three measures used are the Herfindahl-Hirschman Index, financial performance and its risk-adjusted versions (RAROA and RAROE), and financial stability (Z-score). The results indicate that diversification of income positively influences financial performance. In contrast, these findings indicate that income diversification among domestic licensed commercial banks in Sri Lanka has a significant negative impact on financial stability during the study period. This suggests that greater income diversification is associated with a higher likelihood of banks defaulting on their financial obligations. These findings explain the rationale for having a balanced and well-measured approach to diversifying the income of bank managers, regulators, government authorities and policymakers.