International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 24 (2009)

© EuroJournals Publishing, Inc. 2009
http://www.eurojournals.com/finance.htm

Internal Determinants for Diversification in Banks in India an

Empirical Analysis

Mrs. Sangeeta Arora

Senior Lecturer, Dept of commerce & Business Management
Guru Nanak Dev University, Amritsar, Punjab, India
E-mail: sukhsangeet@yahoo.com
Tel: 0183- 2258801-09(Ext.3433); Res: 0183-2501800; Mobile: 9417272600

Ms. Shubpreet Kaur

Lecturer in Commerce, Post Graduate dept of commerce & Business Management
Lyallpur Khalsa college, Jalandhar, Punjab, India
E-mail: shubhpreet.bajwa@gmail.com
Tel: 0183-2507367; Mobile: 9463650403

Abstract

Banks, the world over, are transcending their normal business operations and
diversifying their activities in response to economic and financial sector reforms. The
Indian banking industry too has been seen steadily shifting away from traditional sources
of revenue like loan-making etc, towards nontraditional activities that generate fee income,
service charges, trading revenue, and other types of noninterest income. In this paper an
attempt has been made to empirically analyze the significance of internal determinants for
diversification of banks in India across the time period of 2000 to 2007. For the purpose,
this paper uses aggregate bank level data from 2000 to 2007 consisting of foreign sector
banks, nationalized banks, private banks and SBI group. Some of the major internal
determinants forcing banks to diversify such as risk, cost of production, regulatory cost and
technological change have been analyzed. It has been found out that all the four
explanatory variables have been very significant for bringing variation in the income
structure of the banks. Variations in Foreign banks are higher followed by national banks
and private banks respectively and least is in the case of SBI group.

Keywords: Diversification, Internal Determinants

JEL Classification Codes: G21

Section I
Introduction
The last two decades, the world over have witnessed a phenomenal transformation in the operations
and objectives of financial sector in general and banking sector in particular. The deregulation,
disintermediation, emergence of advanced technologies, along with the consolidation wave in the
banking sector have been instrumental in making banks to diversify their operations. As a result the
banks are transcending their normal business operation and are venturing into insurance, investment
and other non-banking activities. One aspect of overall financial change is a shift in the pattern of
International Research Journal of Finance and Economics - Issue 24 (2009) 178

business undertaken by banks. This is thought to be manifested in a relative increase in fee and other
non-interest income vis -à-vis the net interest income. The general trend has been towards downstream
universal banking where banks have undertaken traditionally non-banking activities such as investment
banking, insurance, mortgage financing, securitization, and particularly, insurance (Jalan, 2002). The
IMF (2001) has also noted the trend toward consolidation of bank with nonbanking financial activities
and the emergence of universal banking.
As far as India is concerned, the wave of diversification became apparent in the banking sector
in the 1980’s and 1990’s. The reforms in this sector allowed the banks to undertake activities like
investment banking, leasing, merchant banking, factoring, hire purchase and mutual funds etc., through
separate subsidiaries. As a result, there has been a manifold interest amongst the foreign banks also to
expand their operations to India. For example Brussels Lambert, a subsidiary of the Dutch ING Group,
has expressed its intent to take control of Vysya Bank. It currently holds a 20 per cent stake in Vysya
Bank. The promoters of Global Trust Bank are believed to have approached ABN Amro Bank, to sell
the more than 26 per cent stake held by them in the bank.
The Indian banking industry too has been seen steadily shifting away from traditional sources
of revenue like loan-making and towards nontraditional activities that generate fee income, service
charges, trading revenue, and other types of noninterest income. It is not only the banks in the private
sector that are making a headway into diversifying their operations, it is also the public sector banks
also like Punjab National Bank, Bank of Baroda, Canara Bank etc., which are aggressively looking for
branch expansions in various countries. Mergers, amalgamations and acquisitions have been
undertaken on a large scale in order to gain size and to focus more sharply on competitive strengths.
This consolidation has produced financial conglomerates that are expected to maximize economies of
scale and scope by 'bundling' the production of financial services. In response to the increased
competition from Scheduled Commercial banks (SCBS), Kotak Mahindra, a Non-Banking financial
Companies (NBFC) has been recently converted into a Scheduled commercial bank. Ashok Leyland
Finance has too merged with a new private sector bank (IndusInd Bank) and ICICI Bank has acquired
Investitsionno-Kreditny Bank in Russia. Centurion Bank of Punjab Limited has been taken over by
HDFC bank. These are just a few examples signifying the transformation in the banking sector.

Rationale for Diversification

During the second half of the 1990s many Indian banks have indeed adopted universal banking
structures (in different forms and degrees) as a strategic response to increased competition in both
domestic as well as global market. Diversification helps a bank in eliminating the unevenness of
geographical reach, product-process innovation, exploit economies of scale and scope, reap benefit of
advanced technology, diversify risk along with mobilization of additional capital.Diversification has
opened the door for commercial banks to earn fee income from investment banking, merchant banking,
insurance agency, securities brokerage, and other nontraditional financial services. Ali-Yrkko (2002),
classifies the banks’ motive to diversify as synergy (or economic) motive, managerial motive, value
maximization motive, increased market power motive, capital strength and risk diversification motives
etc. Determinants of diversification can be categorized into two categories. External determinants such
as Economies of Scale and Scope, Dynamics of bank Competition, Global presence of Financial
Conglomerates and Disintermediation in banking activities. While the internal determinants include
risk reduction motive, decline in interest margin, cost of production, low cost of capital, technology
upgradation etc
In this paper an attempt has been made to empirically analyze the significance of internal
determinants for diversification of banks in India across the time period of 2000 to 2007. For the
purpose, this paper uses aggregate bank level data from 2000 to 2007 consisting of foreign banks,
nationalized banks, private sector banks and SBI Group and its associate. Several internal determinants
like risk, cost reduction, regulatory cost and technology change etc., forcing banks to diversify are
examined empirically to find out significance of these factors for bringing variation in the income
structure of the bank.
179 International Research Journal of Finance and Economics - Issue 24 (2009)

The paper has been structured as follows. Section I entails brief introduction and rationale for
diversification in banks, In Section II, various studies on the determinants of diversification of banking
sector have been reviewed briefly. Contribution of these factors in making banks to diversify is
empirically analyzed in section III. This is followed by results and implications for the banking sector.

Section II
Review of Literature
Diversification has been one of the most frequently researched topics in strategic management
literature and to some extent in finance. Numerous studies have been conducted on determinants of
diversification and its financial implications. Some relevant studies on the determinants of
diversification and financial performance of diversified banks have been reviewed in brief in the text
that follows.

Year and Author Inputs Outputs period Methodology Finding

1.Landi And Venturelli intermediation ratio net revenues the 1990 - 1997 OLS Diversification is
(2002) (IR), intermediation banks obtain regression, positively related to
growth (IG), interest from “spread” efficiency. An
margin (IM), and “fee-based” impressive growth of
concentration ratio activities bank revenue from
(C5), branch density, security and insurance
relative interest margin business has observed.
(RIM), total assets The X-efficiency score,
(TA), capital ratio in terms of both cost and
(CR), fixed assets ratio profit, show a strong
(FA) positive correlation with
the diversification
2.Lepetit, Nys, Rous, non-interest 1996, -2002 Mean, T- Banks which have
Tarazi, (2005) income/ net statistic expanded into non-
trading income/ interest income
ROA, ROE activities present a
higher level of risk than
banks which principally
supply traditional
intermediation
activities.
3.DeYoung, P. Roland, asset size revenue from 1988-, 1995, OLS the banks earning grow
(1999) fee-based regressions, more volatile as banks
service, Mean, std. dev. tilt their product mixes
investment median towards fee based
share, trading activities and away from
share, deposit traditional
share intermediation
activities.
4 Jixin Xu, (1996) Bank Domestic asset, Rate of return 1978-1985 Analysis of banks benefits from
International asset Variance model diversification through
(ANOVA) the increasing stability
of their asset returns. It
was revealed that
international banking
with diversification of
the banks assets escapes
systematic risk.

Section –III
An analysis of some of the Major internal determinants for diversification
Data base and Research methodology
Sample
International Research Journal of Finance and Economics - Issue 24 (2009) 180

The sample encompasses of foreign banks, the nationalized banks, the private sector banks and the SBI
Groups in India. Table (1.0) gives an overview of the sample size by year basis.

Table 1.0: Number of Banks under study for each period (Sample size )

Banks 2000 2001 2002 2003 2004 2005 2006 2007

FSB 41 42 40 36 33 31 29 29
NBS 19 19 19 19 19 19 19 19
PVTBS 32 31 31 29 30 29 28 25
SBI GROUP 8 8 8 8 8 8 8 8

FSB stands for Foreign Sector banks, NBS for Nationalized banks, PVTBS for Private banks,
SBI Group for State bank of India and its associates.

Time Period
Data has been used for the period of 8 years from 2000 to 2007.

Data and Data Source

The main data source for the analysis comes from the published documents of Reserve bank of India,
database of Capitaline and the report on trends and progress in banking sector in India.

Research Methodology
To analyze the significance of four internal determinants (explanatory variables) of diversification
namely risk, cost of production, regulatory control and technological change, the multiple regression
has been used. Various ratios have been analyzed over the time period of 2000 to 2007. Regression
Coefficient and T values have been calculated for four explanatory variables by taking the Net Interest
Margin (NIM) and Non Interest Margin (NOM) as dependent variable.
These are defined as the ratio of NII (net interest income) and NOI (non-interest income) to
total assets, respectively. Significance of these four explanatory variables in bringing variation in NIM
and NOM has been computed.
The purpose is to identify factors across the banking industry that is driving NIM and NOM and
also to know if certain factors are significant determinants for diversification in banks or not.

NIM (Net Interest Margin)

Table 1.1: Net Interest Margin (NIM)

Year 2000 2001 2002 2003 2004 2005 2006 2007

FBS 10.25 10.26 9.07 7.85 7.12 6.33 6.96 7.55
NBS 9.68 9.64 9.30 8.86 8.00 7.38 7.17 7.56
PVTBS 9.89 9.67 7.68 8.66 7.71 6.61 7.05 7.77
SBI GROUP 9.38 9.20 9.09 8.66 7.85 7.49 7.48 7.52
181 International Research Journal of Finance and Economics - Issue 24 (2009)

NOM (Non Interest Margin)

Table 1.2: Non Interest Margin (NOM)

Year 2000 2001 2002 2003 2004 2005 2006 2007

FBS 2.70 2.72 3.05 2.69 3.18 2.67 3.04 2.91
NBS 1.27 1.21 1.58 1.77 2.00 1.42 1.00 0.88
PVTBS 1.90 1.40 1.98 2.57 2.30 1.60 1.62 1.69
SBI GROUP 1.55 1.45 1.41 1.70 2.09 1.61 1.44 1.04

The explanatory variables

On theoretical grounds, the first two variables that might be expected to drive banks’ NIM and NOM
are risk and return.
• Risk
In finance theory, the most important relationship is between risk and return. Since NIM and
NOM are close proxies for banks’ rate of earnings, it is used to find that variations in risk
between banking sectors as well as variations in the dependent variables.
Denoting risk of banking sector k in year j by the symbol risk we define it as:
risk = ROAjk / ROAmeank
where
ROAjk = return on assets of banking sector k in year j
ROAmeank = mean return on assets in banking sector k across all years
= average return on assets in banking sector k
and ROA is defined as (Profit before tax)/(Total assets).

Table 1.3: Risk (Risk)

Banks 2000 2001 2002 2003 2004 2005 2006 2007

FBS .85 0.73 0.92 1.05 1.17 0.90 1.14 1.26
NBS .57 0.43 0.89 1.26 1.55 1.15 1.04 1.12
PVTBS 1.08 0.82 0.87 1.09 1.11 0.94 1.05 1.04
SBI GROUP .98 0.68 0.92 1.09 1.22 1.09 1.02 1.00

The higher the average measured deviations for a banking sector over time, the more ‘risky’ it’s
banking sector returns are by world standards. Higher risk implies the greater NIM and NOM. It seems
that on an average return of foreign sector banks are more risky followed by private sector banks and
state bank group respectively.

• Cost of production
The cost of production of a banking sector is the second important factor effecting
diversification. If a banking sector is relatively inefficient then it needs to charge higher interest
and/or fees to recover its production costs.
In what follows, cost of production of banking sector k in year j is denoted by cop and is
measured as:
Cop = Operating expenses /Total assets
of banking sector k in year j.
International Research Journal of Finance and Economics - Issue 24 (2009) 182
Table 1.4: Cost of Production (COP)

Banks 2000 2001 2002 2003 2004 2005 2006 2007

FBS 0.0312 0.03054 0.03027 0.02792 0.02752 0.02875 0.0293 0.02784
NBS 0.0255 0.02757 0.02397 0.02333 0.02193 0.02060 0.0193 0.01668
PVTBS 0.0185 0.01870 0.01449 0.01985 0.02018 0.02027 0.0210 0.02055
SBI GROUP 0.0246 0.02663 0.02110 0.02111 0.02206 0.02138 0.0227 0.01984

The sign of the coefficient on the productivity variable is expected to be positive: the lower the
operating cost ratio, the lower should be the NIM and NOM in that banking sector, other things equal.
According to this parameter, private sector banks are better as compared to their counterpart foreign
sector banks.
• Regulatory cost
Although the Basel/BIS capital adequacy and risk provisioning guidelines are a worldwide
phenomenon, differences in the precise application exist from one banking sector to the next. In
some countries, the authorities apply stricter capital requirements, and this amount to a
differential impost on the cost of doing business in that banking sector that puts its banks at a
competitive disadvantage internationally.
To correct this banking sector-by-banking sector variation in regulatory cost,this variable is
defined as REGCOST and is measure it as follows:
REGCOST = total bank capital/ total bank assets
for banking sector k in year j, where bank capital equals total net capital.
If REGCOST is high in a banking sector, is accordingly this reflected in higher NIM and NOM.
So the sign on the coefficient of this variable should be positive.
REGCOST

Table 1.5: Regulatory Cost (REGCOST)

Banks 2000 2001 2002 2003 2004 2005 2006 2007

FBS 0.0290 0.02622 0.03190 0.03864 0.03407 0.04564 0.04484 0.04675
NBS 0.0237 0.02155 0.02002 0.01660 0.01479 0.01263 0.00853 0.00696
PVTBS 0.0144 0.01149 0.01015 0.00969 0.00817 0.00786 0.00688 0.00555
SBI GROUP 0.0038 0.00257 0.00230 0.00209 0.00188 0.00165 0.00149 0.00128

• Investment in technology
Over the course of the past decade, banks have invested huge amounts in new technology such
as ATMs. The cost expended on this is high and needs to be recouped by banks from their
customers. Further, the rate of investment in technology varies between different sectors needs
to be accounted for.
This is proxy by fee income. Defining the variable TECCHG and measuring the technology
effect by:
TECCHG = non-interest income/net interest income for banking sector k in year j.
As fee income rises in importance, this correlates to rising use of electronic and other non-
traditional means of product delivery. It signifies a changing mix between traditional and non-
traditional business. So a higher value of TECCHG should imply a lower NIM (negative sign) and
higher NOM (positive sign), as banks start to earn more of their revenue from fee-for-service. The
coefficients are expected to be negative and positive, respectively.
183 International Research Journal of Finance and Economics - Issue 24 (2009)
Table 1.6: Technological change (TECCHG)

Banks 2000 2001 2002 2003 2004 2005 2006 2007

FBS 0.2632 0.26534 0.33612 0.34230 0.44734 0.42153 0.4370 0.38499
NBS 0.1315 0.12567 0.16958 0.20013 0.25054 0.19279 0.1397 0.11695
PVTBS 0.1925 0.14480 0.25794 0.29666 0.29800 0.24241 0.2297 0.21743
SBI GROUP 0.1654 0.15743 0.15528 0.19570 0.26659 0.21520 0.1932 0.13843

The testing equations

The equations that are tested can now be summarized as follows:
Equation one: Net Interest Margin
NII
= NIM = α1 + α2 [ risk ] + α3 [cost of production]
TA + α4 [regulatory cost]
+ α5 [technological change]
= α1 + α2 (RISK) + α3 (COP) + α4 (REGCOST)
+ α5 (TECCHG) + ε
where the αi are estimated coefficients (α1 is the intercept, a constant) and ε is the error term.
Equation two: Non-Interest Margin
NIO
= NOM = β1 + β2 [ risk ] + β3 [ productivity ]
TA + β4 [regulatory cost]
+ β5 [technological change]
= β1 + β2 (RISK) + β3 (COP) + β4 (REGCOST)
+ β5 (TECCHG) + μ
where the βi are estimated coefficients (β1 is the intercept, a constant) and μ is the error term

The results and implications

The regressions reported below use data of foreign sector banks, nationalized banks, private sector
banks and the SBI Group over the time period of 2000 to 2007. to explain movements in the net
interest margin and non-interest margin, respectively.

Results of regression for NIM and NOM.

Table 1.7: Results of regression for NIM and NOM.

Dependent variable NIM Dependent variable NOM

Coefficient of variation R square Coefficient of variation R square
FBS 0.0356 0.8890 0.0356 0.8890
NBS 0.0394 0.9911 0.0394 0.9911
PVTBS 0.1070 0.8868 0.1070 0.8868
SBI GROUP 0.0362 0.9850 0.0362 0.9850

Let us consider the individual results for the explanatory variables.

International Research Journal of Finance and Economics - Issue 24 (2009) 184

Regression coefficient and T value

Table 1.8: Regression coefficient and T value

Dependent variable NIM Dependent variable NOM

Explanatory variables Explanatory variables
Regression coefficient
Banks Risk COP REG TEC Risk COP REG TEC
COST CHG COST CHG
FBS 2.5019 3.27 -7.32 -13.69 1.07 8.50 -2.3 2.78
NBS 3.762 2.09 1.82 -0.027 0.83 4.60 3.35 2.57
PVTBS 3.0132 -8.17 2.96 0.1078 0.89 9.92 5.81 6.43
SBI GROUP -2.96 -1.93 2.964 0.0270 -0.42 3.28 2.57 8.24
T VALUE
FBS 3.153 3.147 -4.650 -6.980 3.12 1.82 2.83 2.97
NBS 2.869 1.907 3.712 -3.292 2.64 1.57 2.71 1.36
PVTBS 0.557 -0.029 1.698 -0.883 1.44 0.154 0.722 2.73
SBI GROUP -1.952 -2.09 2.075 0.774 4.87 1.43 -1.136 7.35

Risk measured by the coefficient of banking return (ROA) from the average is significant and
positive in all equations except in respect of SBI GROUP. The highest is in respect of private banks
indicating that risk diversification have been a significant factor responsible for variation in noninterest
income of bank group. It says the more risky a banking group, the higher will be noninterest margin of
the banks.
Cost of production measured by operating cost to total asset is positive and significant in
respect of foreign banks followed by national banks. Although this variable is subject to managerial
control, it has significant influence on banks net interest margin as well as non interest margin as
depicted by T value.
Regulatory Control reflects the cost of supervision,measured by the capital ratio to total asset is
significant with a positive co-efficient and T value in national banks followed by private sector banks
while it is insignificant with negative value in case of foreign banks.
Technological change, measured by the shifting mix of bank income between traditional and
nontraditional is insignificant in equation, when net interest margin (NIM) is taken as dependent
variable which shows that change in technology factor has not brought variations in the trend of net
interest margin. The coefficient and T value is negative in all the banking groups. but when we take
noninterest margin as dependent variable in the equation, the results are vice-versa showing that
changes have been instrumental in increasing noninterest income of the banks.
To summarize, in this paper multi regression technique have been used beside ratios across the
banking sector in India over the time period of 2000 to 2007 to analyze the significance of four
determinants in bringing variations in NIM and NOM supported by coefficient and T values. It is
found that all the four explanatory variables risk reduction, cost of production, regulatory control and
technological change have been instrumental in bringing out variations in the structure of income of
the banks. Variations in Foreign banks is highest followed by national banks and other scheduled banks
respectively.
185 International Research Journal of Finance and Economics - Issue 24 (2009)

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