Income Diversification of Chinese Banks: Performance, Risk and Efficiency

Abstract

This research contributes to the debate on the effects of diversification in the banking industry, and provides a comprehensive analysis of how the diversification-performance, diversification-risk and diversification-efficiency nexus are affected when banks move into non-traditional businesses.

The research first examines to what extent income diversification can affect performance in the Chinese banking industry in terms of profitability. Results showing that in the Chinese banking sector as a whole there exists a diversification discount, suggesting that a shift from traditional banking business to mixed business lines negatively affects bank performance.

Following the discussion of profitability, we move the focus to the issue of stability. By adopting the first-differenced GMM estimator for the dynamic threshold panel data model, we get results showing that there exists an inverse U-shaped relation between diversification level and risk in the Chinese banking industry. Income diversification will reduce bank risk only after the bank has passed a certain threshold of income diversification. This pattern of relationship seems to be driven mainly by the learn-by-doing effect and the mitigation of agency problems, which result from the expansion of non-interest activities.

Finally, this thesis analyses the efficiency implications of the trend towards greater income diversification. We use a two-step approach by adopting within maximum likelihood estimation (WMLE) and dynamic Tobit model to estimate banks’ efficiency scores and regresses those scores with banks’ diversification indicators. We find that for the overall Chinese banking sector, income diversification has an efficiency-destroying effect.

This thesis provides a good reference for bank managers and policy makers to better understand and treat non-interest income in China’s banking market. Our results also have fundamental and useful implications for bank managers and policy authorities seeking to enhance the performance and efficiency of Chinese banks under the condition of maintaining financial stability in Chinese financial system.