Income diversification patterns and their impact on bank risk

Abstract

This study focuses on the crucial topic of income diversification and its implications for bank risk, using the context of India's public and private Sector banks. The research spans the years 2005–2021, investigating the influence of varying degrees of non-interest income on the risk profiles of Indian banks. Employing a program impact evaluation methodology, the study employs the generalised propensity score-fractional dose–response function technique to ascertain the impact of different levels of non-interest income on bank risk. The outcomes underscore the diverse effects of diversification contingent upon factors like bank size and ownership type, including large and small banks as well as public and private sector institutions. Notably, the aftermath of the Global Financial Crisis introduced distinctive dynamics to income diversification's impact. By segmenting the study timeline into two periods—2005–2013 and 2014–2021—it emerges that income diversification lowered bank risk in the earlier period, while conversely amplifying risk in the latter phase. These insights bear significance as an early warning mechanism for bank executives, policymakers, and regulatory authorities, enabling them to navigate strategic transitions associated with non-interest income. Employing a novel approach, this research contributes to the literature by evaluating the interplay between income diversification and bank risk across diverse levels of non-interest income mix. In contrast to conventional econometric methods, the use of the generalised propensity score method stands out as a robust technique to mitigate confounding biases inherent in non-experimental inquiries.