Does Income Diversification Enhance Bank Efficiency and Stability in Periods of Increased Competition?

Existing literature affirms that cost and profit efficiency are critical to assessing a bank’s performance. In this regard, expansion into a wide array of businesses to boost profit efficiency has become a trend in the banking industry. Still, empirical studies are ambiguous about the effects of bank competition and income diversification on cost and profit efficiency and stability. This study aims to bring to light empirical proof that high levels of income diversification have an impact on the efficiency and stability of the Philippines’ top 20 (With regard to the total number of Philippine UKBs, the authors of this study refer to the BSP’s 2005–2021 list of 46 UKBs. From 2020 to 2021, some of these UKBs failed to submit their records, thus the BSP database totaled only 41 UKBs. As of the first quarter of 2022, 45 UKBs submitted their balance sheets to the BSP. The reduced number was due to the 2021 merger of Landbank of the Philippines and United Coconut Planters Bank). UKBs in periods of increased competition. Measuring tools will include the Lerner Index for bank market power and the Stochastic Frontier Analysis for estimating bank cost and profit efficiency scores. The GMM panel estimation has shown a negative relationship between competition and cost and profit efficiency and stability, which supports the information generation hypothesis and competition-fragility view. The results also reveal that a high level of income diversification alone is detrimental to bank efficiency and stability. On the other hand, banks become more efficient and s table when high levels of income diversification go hand-in-hand with high levels of market power. Due to this, domestic banks, particularly the dominant ones, thrive in an imperfectly competitive market despite having diverse income sources. However, a bank’s performance declines with the erosion of market power—a situation that is more evident among banks with highly diversified income sources. This implies that a high level of income diversification can worsen the negative impact of market competition on a bank’s stability and cost and profit efficiency.