Dynamics of Diversification and Risk-Taking: Empirical Evidence from South Asia

Abstract

This study examines the impact of bank diversification on risk and stability in South Asian countries, focusing on three key types of diversification: income, funding, and asset diversification. Utilizing an unbalanced panel dataset of commercial banks over the period from 2001 to 2023, the analysis employs the system generalized method of moments (GMM) regression technique to explore how different diversification strategies influence bank performance. The findings reveal that income and asset diversification positively affect bank stability, while funding diversification appears to introduce instability. Additionally, the study shows that larger banks benefit more from income and asset diversification compared to smaller banks. The results underscore the complex and context-specific nature of diversification’s impact on bank stability and risk, providing valuable insights for policymakers and financial institutions. Based on these findings, the study proposes several policy recommendations, including encouraging strategic income diversification, closely monitoring funding diversification, promoting asset diversification with caution, and tailoring policies to the needs of smaller banks. Moreover, it emphasizes the importance of strengthening regulatory frameworks and fostering financial innovation to enhance the resilience of the South Asian banking sector.