Traditionally, banking has been viewed as a pathway to reducing the frictions of transaction costs and information asymmetries. However, innovations in information technologies, deregulation, and financial deepening have deprived banks of the intermediation advantages by reducing the costs and information gaps. The emergence of shadow banking model further erodes these advantages. Banks have often responded by ameliorating their intermediation costs, through sectoral diversification. Indeed intermediation theories advocate for diversification to attain efficiency by reducing costs. However, given the nature of their operations, banks never hold sufficient balances to guarantee full liquidity. This exposes them to runs and portfolio losses if they don’t efficiently monitor and recover the advances. This scenario raises two questions that are critical to the very core of bank intermediation. First, does sectoral credit diversification enhance bank profitability; and secondly, are banks able to effectively monitor the many portfolios resulting from diversification? To answer these questions, secondary data was collected from Bank Supervision reports of the central banks in four East African Community (EAC) countries for eight firm years from 2008 to 2015 and analysed using Generalized Linear Models (GLM). A positive and significant effect of sectoral credit diversification on banking industry returns on assets was observed while a significant negative relationship between diversification and asset quality as a proxy for monitoring effectiveness was reported. This shows that sectoral credit diversification improve the monitoring effectiveness of banks. The paper recommends a diversified loan portfolio where intermediaries distribute their credit offerings across various economic sectors.
JEL classification numbers: G21, G28, G32
Keywords: Credit Diversification, Bank Performance, Monitoring Effectiveness
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