Impact of income diversification strategy on credit risk and market risk among microfinance institutions

Purpose: This study explores the effect of income diversification strategy on credit risk and market risk of microfinance institutions (MFIs) in Ghana as an emerging market. Design/methodology/approach: The study is based on quarterly data of averagely 271 MFIs that have operated from 2016 to 2018. The dataset is unbalanced and pooled cross-sectional with 3,259 data points. The study measures the diversification strategy using income diversification indices, and accounting ratios to measure the other variables. We utilised the weighted least squares (WLS) approach to explore the nexus. Findings: The findings show that income diversification is associated with better loan quality and credit risk management. Market risk increases with the level of income diversification of microfinance firms. It is evident that large MFIs can manage their credit risks well and can have a low default rate, depicting an overall U-shaped nexus. On the other hand, the effect of size on market risk is an inverted U-shaped. The effect of asset tangibility on credit risk is positively significant while the effect on market risk is negatively significant. High profitability enhances credit risk management leading to lower loan losses while in the case of diversified and profitable MFIs, they tend to invest more in government securities. The results suggest that MFIs that hold more cash and cash equivalents tend to have high loan loss provision and more government securities suggesting much attention should be paid to optimal cash management. Practical implications: The results throw light on the credit risk and market risk profile of the firms and the effect of diversification strategies on them. The findings are relevant for effective macroprudential regulation, market regulation and prudential regulation of the microfinance sector. Social implications: The findings reveal the nature of income diversification strategy of MFIs in emerging markets such as Ghana, pointing out how they affect the risk exposure of MFIs that lend to the pro-poor population. Originality/value: This is a premier formal assessment of the nexus between income diversification strategies and risk management among MFIs that serve the pro-poor population in the emerging market context.