Effect Of Financial Soundness Indicators on The Degree of Diversification in Commercial Banks in Kenya

Abstract

Commercial banks are essential to global economies, with Kenyan banks contributing significantly, holding 78.55% of total savings. However, challenges in Kenyan commercial bank performance have led to a consideration of diversification as a means to boost returns and manage risks. This study explored how financial soundness indicators impact diversification in Kenyan commercial banks, examining metrics like capital, high-quality assets, effective management, and liquidity. It drew on four theoretical frameworks—agency theory, buffer capital theory, financial intermediation theory, and stakeholders' proposition—to provide a structured understanding of the situation. The research focused on 36 licensed commercial banks operating in Kenya as of December 2022, analyzing data from 2016 to 2021. Data was sourced from the Central Bank of Kenya's website and banks' annual financial reports, analyzed using STATA software and various tests including heteroscedasticity, correlation, autocorrelation, multicollinearity, and normality tests. Findings showed that capital adequacy, asset quality, and liquidity management significantly influenced diversification levels, with a notable decline in 2018 attributed to political instability following elections. Recommendations include establishing a clear framework for banks to implement financial soundness indicators, especially in asset quality, capital adequacy, management efficiency, and liquidity management. Ensuring bank efficiency is vital for financial sector stability and safeguarding savings. In summary, this study finds that capital adequacy, asset quality, management efficiency, and liquidity management play significant roles in diversification among Kenyan commercial banks. Political instability in 2018 exposed potential risks in banks' diversification strategies. To enhance diversification, effective implementation of financial indicators is crucial, though this study's focus on commercial banks and reliance on secondary data were mitigated through thorough analysis.