Bidirectional Relationship Between Risk and Efficiency of Commercial Banks of Bangladesh. Do Bank Diversification and Market Competition Matter?

Abstract

This study undertakes a comprehensive analysis of the bidirectional relationship between risk and efficiency in Bangladeshi commercial banks, addressing a significant gap in existing research. It explores how risk-taking behaviour impacts bank efficiency and, conversely, how efficiency affects risk levels. The study also investigates the effect of market competition and diversification in this relationship nexus. Asset and revenue diversification are considered to ensure a comprehensive analysis, and the Boone Indicator (BI) is used to measure market competition. We employ System Generalised Method of Moments (GMM) estimation on an extensive dataset of 818 bank-level observations from 2000 to 2022 for empirical validation. The findings reveal several significant insights. First, banks with higher credit risk exhibit greater efficiency; however, excessive risk-taking leads to decreased efficiency over time. Second, asset diversification positively influences the risk-efficiency relationship, whereas revenue diversification has a detrimental effect on risk and efficiency. Third, the non-linear impact of competition suggests that its effect varies depending on the level of risk and efficiency, revealing a heterogeneous relationship. Furthermore, the combined effect of competition and diversification significantly alters risk and efficiency dynamics. These findings have significant practical implications for risk management, regulatory policies, and strategic decision-making in Bangladesh's banking sector. Understanding the tradeoffs between risk and efficiency can empower policymakers and bank managers to design more effective regulations and strategies. This, in turn, can enhance banking stability, performance, and financial resilience.