Financial Risk, Income Diversification, Firm Characteristics and Performance of Commercial Banks in Kenya

Abstract

The study investigated the influence of financial risks, income diversification, and firm characteristics on the financial performance of commercial banks in Kenya, motivated by the need to understand how these factors impact profitability and stability in an emerging market context. The general objective of the study was to assess the relationship among financial risks, diversification, firm characteristics, and financial performance. Specifically, the study sought to examine the effects of financial risks on performance, determine how income diversification mediate the relationship between financial risks and performance, assess the moderating role of firm characteristics (size, growth, and age), and evaluate the joint effect of these factors on profitability. The study utilized a population of 39 commercial banks in Kenya, gathering secondary data from financial reports over a seven-year period (2016–2022) to analyze key variables, including credit, liquidity, market, capital, and operational risks; income diversification; firm characteristics, and financial performance. Panel regression analysis, specifically fixed-effects modelling, was employed to test the hypotheses. Findings revealed that market, capital, and operational risks significantly negatively affected financial performance, while credit and liquidity risks showed no significant effect. Income diversification emerged as an effective mediating factor in mitigating the negative impacts of specific risks. Firm characteristics, particularly bank size and age, significantly moderated the relationship between certain financial risks and performance, suggesting that larger and more established banks exhibit greater resilience to financial risks. The study concluded that targeted management of specific financial risks, coupled with strategic income diversification and leveraging firm characteristics, is essential for enhancing bank performance. Recommendations include policy measures to strengthen regulatory guidelines on risk management, incentives for income diversification, and an integrated approach combining risk management, diversification, and firm characteristics to optimize performance. For further research, the study suggests exploring qualitative insights from bank managers, conducting comparative studies across countries, examining additional diversification strategies and firm attributes, extending the time frame, and employing advanced econometric methods to capture dynamic relationships. These findings extend the Modern Portfolio Theory by demonstrating that, in the context of Kenyan commercial banks, diversifying revenue streams across interest and non-interest income sources yields superior risk–return optimization compared to asset diversification alone. This implies that managers and regulators should prioritize income diversification strategies such as expanding fee-based services and investment income to enhance resilience and profitability under varying risk conditions.