Does Diversification Lead to the Financial Stability and Efficiency of Commercial Banks in Ethiopia? A Simultaneous Equation Approach

The purpose of this study is to investigate the impact of diversification on the financial stability and efficiency of commercial banks in Ethiopia. The data was obtained from a sample of 17 banks from both the public and the private sector operating in Ethiopia for more than a decade. The balanced panel presented operational and financial stability and efficiency metrics for the decade starting from 2013. A seemingly unrelated regression model was used to estimate the impact of diversification on bank stability and efficiency by controlling endogeneity between diversification, stability, and efficiency. The study found that geographic, asset, and sectoral credit diversification, as well as intellectual capital efficiency, significantly improvebank stability, while investment diversification has mixed effects, and income and deposit diversification have negligibly positive effects. The study further found that geographic, asset, sectoral credit, and deposit diversifications have a significant negative effect on the efficiency of commercial banks. The results of this study provide valuable insights. Bank managers can better understand the impact of diversification on banks’ financial stability and efficiency. This study encourages policymakers and the top management of respective banks to pursue strategic geographic, asset, and sectoral credit portfolio diversification to maintain their financial stability and efficiency. To the best of our knowledge, this is one of the rare studies to investigate the effect of diversification on the financial stability and efficiency of commercial banks in Ethiopia.