Asset Diversification and Efficiency of Islamic Banks

Introduction

The existing literature has extensively explored the relationship between diversification and bank performance (Chen,Liang, & Yu, 2018; Gamra & Plihon, 2011; Mercieca, Schaeck, & Wolfe, 2007; Vallascas, Crespi, & Hagendorff, 2012). However, minimal evidence has been provided to support any relationship between diversification and bank efficiency, particularly for Islamic banks. This gap is counterintuitive because banks should enjoy the benefits of diversification, such as risk-diversification and economies of scope (Chen et al., 2018). These benefits should promote bank efficiency in the sense that risk and cost reduction accompanied by diversification facilitates the reduction of the cost involved when converting inputs to outputs. Importantly, the positive effect of diversification on bank efficiency should be particularly found among Islamic banks primarily because they are generally less diversified and smaller than conventional banks. That is, the former is more capable of reaping a net positive effect of diversification on bank efficiency than the latter (Chen et al., 2018). Accordingly, investigating the impact of diversification on the efficiency of Islamic banks is a worthwhile endeavor. The reason is that if the results indicate a positive effect of diversification on bank efficiency, then Islamic banks are recommended to engage in diversification to improve bank efficiency. Such a diversification could improve bank sustainability and performance. In addition, the concerned authorities are recommended to adopt regulations that encourage Islamic banks to engage in diversification to facilitate the improvement of efficiency in the banking industry. Hence, this study is conducted to fill in this research gap.

Despite the abundance of research on the relationship between diversification and bank performance, empirical evidence on such a relationship has remained mixed. Prior studies have generally provided evidence indicating that diversification negatively affects bank performance. This finding suggests that the cost of the accompanied agency problems and diseconomies of management outweighs the benefits of the accompanied risk diversification and economies of scope (Acharya, Hasan, & Saunders, 2006; Chen et al., 2018; DeYoung & Roland, 2001; Laeven & Levine, 2007). In addition, diversification’s negative (positive) effect on bank performance is frequently observed among conventional (Islamic) banks (Chatti, Kablan, & Yousfi, 2013; Čihák & Hesse, 2010; Molyneux & Yip, 2013).

Chen et al. (2018) examine the effect of asset diversification (AD) on bank performance in Indonesia, Malaysia, and Pakistan. They find that diversification positively affects asset quality and profitability of banks and that such effects are stronger for Islamic (large) banks than for conventional (small) banks. However, they also determine that diversification has a minimal impact on cost efficiency of conventional banks and no impact on Islamic banks. The possible reason is that the cost-to-income ratio may not be a good proxy for bank efficiency. Tripe (1998) explains that several underlying factors (e.g., structural differences among banks) affect such a ratio, which may not completely reflect bank efficiency.