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Hypothesis 3: The positive impact of income diversification on profitability in the form of non-interest income differs across bank size groups.

Hypothesis 4: The positive impact of income diversification on profitability in the form of non-interest income differs across ownership types.

According to economic theory, if revenue stems from various financial activities and those are less than perfectly correlated it should increase the bank profitability. The conventional industry wisdom suggests that banks with greater diversification through non-traditional sources of income are capable of reducing income volatility substantially. To disentangle the question of whether diversification enhances profitability has been explored comprehensively both theoretically and empirically (e.g., Stiroh, 2004; Acharya, Hasan and Saunders, 2006; Stiroh and Rumble, 2006; Mercieca, Schaeck and Wolfe, 2007; Elsas, Hackethal and Holzhäuser, 2010).

The underlying findings of these systematic studies are mixed and mostly based on developed market economies (e.g., US and Europe). The empirical studies that find positive impact of diversification on profitability are by Baele, De Jonghe and Vander Vennet (2007) on 17 European countries, Chiorazzo, Milani and Salvini (2008) on the

Italian banking industry and Elsas, Hackethal and Holzhäuser (2010) on nine developed countries’ banking markets. Well-diversified banks can materialise many benefits through non-intermediation activities. Among the identified benefits, Elsas, Hackethal and Holzhäuser (2010) cite efficiency gains through economies of scale and scope, superior resource allocation through internal capital markets, and bank-specific competitive advantage. Goddard, McKillop and Wilson (2008) cite the reduction of idiosyncratic risk, and the strengthening of the financial system as the motives for diversification.

Recent literature embarks on the inherent differences between large and small banks and their capability of adopting diversification strategies to enhance profitability. It is argued that due to superior technological infrastructure, expertise and economies of scale and scope, large banks tend to outperform small ones in diversifying investments. Mercieca, Schaeck and Wolfe (2007) examine the impact of diversification on the performance of small European banks for 15 countries for the period 1997-2003. They did not find any direct diversification benefits for the small banks either within or across business lines. On the other hand, for the Italian banking sample, Chiorazzo, Milani and Salvini (2008) find a stronger relationship between diversification and profitability for the large banks. For US credit unions, Goddard, McKillop and Wilson (2008) and Goddard et al. (2008) suggest that similar diversification strategies are not appropriate for the large and small credit unions. They advocate that small credit unions should limit diversification towards non-interest sources of income because they lack sufficient scale and requisite expertise in order to diversify away from traditional interest activities. Lepetit, Nys, Rous and Tarazi (2008) argue that larger banks tend to have more non-traditional activities. We, therefore, formulate hypothesis 3 to examine whether bank size has any significant influence on the impact of income diversification to enhance profitability.

However, the theoretical underpinnings against income diversification seem to suggest that hypothesis 3 might not hold. The implicit costs which are associated with

diversification can overshadow the benefits. Among the identified costs, Elsas, Hackethal and Holzhäuser (2010) cite agency problems related to diversifying investments, inefficient resource allocation problem due to malfunctioning of internal capital markets, asymmetric informational problem due to miscommunication between head office and divisional managers and the reckless rent-seeking attitude of managers. The agency problem arises when managers pursue growth through diversification by taking excessive risk, in excess of what is required by shareholders (Goddard, McKillop and Wilson, 2008). It is worth mentioning that a large portion of the Indian banking sector is controlled by the Government of India, where the principal-agent problem is eminent. Therefore, diversification can have a negative impact on profitability. In addition, Stiroh and Rumble (2006) argue that if commercial banks have an investment banking window and some fee- based income stems from investment banking activities, those earnings are more volatile than traditional lending activities, and thus banks with a higher portion of non-traditional income streams would be less profitable. DeYoung and Roland (2001) argue that it is less costly for the bank-clients of non-traditional fee-based activities to switch banks compared to bank-clients of traditional financial activities because in the latter case switching a bank requires establishing a new relationship with a bank, and it turns out to be costly for customers. The empirical studies that find a negative impact of diversification on profitability are by DeYoung and Roland (2001), Stiroh (2004) and Stiroh and Rumble (2006) for US financial holding companies. Acharya, Hasan and Saunders (2006) find that diversification of loans does not typically enhance profitability or reduce risk in Italian banks.

Pennathur, Subrahmanyam and Vishwasrao (2012) find that ownership types have a definite impact on non-interest income for Indian banks. They mention that bank size and management quality are deemed to be significant forces for banking profitability. They also argue that the pursuit of non-interest sources of income is risky for Indian banks due

to lack of prior experience, limited financial networks and unsophisticated technological infrastructure, especially at the small public and private sector domestic banks. However, with the RBI’s indication of enhancing non-interest sources of income, state-owned banks are no less cogent than private domestic or foreign banks on fee-based income (RBI, 2003). It has been acknowledged in the recent papers (e.g., Das and Ghosh, 2009; Tabak and Tecles, 2010) that the state-owned banks are more efficient by highlighting that these banks undertake most of the government sponsored programs, such as personal provident fund collection, tax collection, etc., which are likely to generate substantial fee-based income. Therefore, we develop hypothesis 4 to test whether the impact of income diversification on profitability differs across ownership types.

The existing empirical literature on the impact of income diversification on profitability is heavily concentrated on US and European banking markets, while little attention has been paid to emerging markets especially India. Comprehending the significant effect of income diversification on profitability and how this effect differs depending on bank size or ownership types has immense importance to regulators for both Indian and other emerging Asian countries in order to maintain the desired level of bank stability.