A Study on Capital Adequacy and Its Impact on the Banks' Performance. A Panel Data Analysis

Abstract:

In the banking industry adequate amount capital is a prerequisite to ensure financial solvency, sustainability and smooth flow of business operations. The amount of adequate capital of a bank relies on the regulations, size of the bank and economic conditions. In Bangladesh private commercial banks are playing a vital role and their contribution towards the economy is acknowledged. The challenge is to maintain their solvency through adequate capital as well as generate optimal profit. The performance needs to be maximized sustainability where solvency and maximizing shareholders' wealth both of them will be equally considers as integrated prime objects. With an intention to reasonably and statistically investigate, this paper explores whether in Bangladesh private commercial banking industry capital adequacy has any momentous impact on the profitability. This paper also exhibits the significance level of their relationship by considering latest 7 years data with the time series of 2008-2014 for 13 private commercial banks through establishing OLS regression models. The findings of this research show that capital adequacy is significantly related with profitability of private commercial banks of Bangladesh.

Keyboard: Return on asset, Return on equity, Bank size, Asset to liability ratio, Debt to total equity ratio, Regression models.

1. Introduction:

Banking industry is one of most crucial sectors of an economy. Bank is such an institution that works with people's money and works for people's money to earn more money. As banks major business operations rely on the depositors' money which is counted as debt for them, banks have to mandatorily maintain certain rules and regulations to provide protection towards banks' consumers (depositors). In such a case argument can be predominated about the restrictions that why banks must follow these regulations. One of the main reasons is as banks work with monetary unit, failure of one bank or more than one bank can be translated into negative and downward pressure towards the economy. Because of the severe effects existence, precautions are strictly and mandatorily maintained by banks. One of the most important parts of these regulations is to hold an adequate amount of capital. Adequate capital not only ensure solvency but also operate as a shield against loss which in return ensure banks' sustainable economic operations with satisfactory return. In such a case argument can be predominated based on the research where researchers found that profitability and capital adequacy is negatively related (Navapan and Tripe, 2003). However, based on the perspective of banks' solvency it is more urged that adequate capital should be maintained in a standardized level where solvency and profitability will be optimal. In such a case adequate amount of core capital relative to total asset and risk adjusted asset must be maintained as a part of the risk management as well as following the Basel framework. This combination of asset should be varied according to the bank size. Another important factor that banks must consider that is the controlled level of leverage as it is two-way sword, higher leveraged bank has more probability to entirely fail to operate business.

As Bangladesh economy is an emerging economy banking sector plays a vital role. The main concern of this research paper is to identify in what extents or regards the capital adequacy has impact on the profitability of private commercial banks of Bangladesh. For the investigation with an intention of answering the question here multiple simpler independent variables are implemented for the constructs of capital adequacy. On the other hands, for the constructs profitability, return on asset and return on equity are also implemented as multiple simpler dependent variables. Through multiple OLS regression models by considering 13 private commercial banks the research paper exhibits that capital adequacy has significant positive relationship with the profitability. However, these findings might have changed if others variables consider for the same purpose. Moreover, banks profitability also rely on many other important factors such its investment and risk management, asset quality etc. External factors also have significant impact on the profitability such as stable business environment, market condition and political stability.

2. Literature Review:

With an intention to determine the crucial impact of capital adequacy over the bank Ahmed (2007) claimed that higher amount of capital reduces the exposure towards insolvency by lowering borrowings requirement and also enable banks to take adequate risk in order to maximize the profitability. Pringle (1971) also claimed that banks with lower amount of capital face difficulties by requiring more borrowings during the tight monetary period. Khaled (2013) observed that adequate amount of capital has a significant influence in maintaining the liquidity risk in a minimum level. In another similar study Abdioglu (2012) proved that the urgency of capital adequacy is more urged in order to maintain sustainable level of liquidity and enhances profitability in the same time. Aspal et al., (2014) argued that adequacy of capital ensures financial stability of banks. Consistent with this results Berger et al., (1995) and Ghosh et al., (2003) postulated that capital adequacy has significantly positive relationship with the profitability of banks. Amjad and Tufail (2013), Bokhari et al., (2012), Mathuva (2009), Ozcan and Asarkaya (2007), Oluitan (2014) all of these scholars argued that inadequate capital significantly and negatively affect banks' financial health and profitability. Based on the study conducted in Nigeria Onaolapo (2012) also revealed that banks with inadequate capital makes them unable to make sufficient business trades and to overcome from this shortfall these banks required 6 billion of additional capital. Based on another study conducted in Nigeria, Ebhodaghe (1994) explained that inadequate capital negatively affects the overall financial conditions of the banks. Santomero and Watson (1989) claimed that optimal amount of capital determine satisfactory return which in return provide a downward pressure towards the bank failure. Consistent with this research paper based on a study conducted in Uganda, Mpuga (2002) argued that lower amount of capital is one of the most important reason behind the bank failure. He also emphasized that larger banks even fail to operate their banking operations by maintaining lower amount of capital than required by the regulation authority. Based on an extensive study Jackson et al., (1999) postulated that in the developed countries like Canada, Japan, England, Holland United States, Switzerland and Germany banks' profitability is strongly related with the higher capital requirement that is required by the regulation authority. By considering 24 banks as through the qualitative and quantitative approach Karles (1989) found that there is significant negative relationship between banks' loss and adequate amount of capital. By conducting a comprehensive research in Saudi- Arabia, Alazmari (2013) focused on the relationship of banks' capital adequacy and profitability. He measured the profitability in term of return on asset and return on equity. The research results show that in Saudi-Arabia capital adequacy has positive impact on the banks' profitability. Oyeten (1997) postulated that financial condition and the performance of the banks directly rely on the adequate amount of capital and its asset quality. Supportive to that results Ebhodaghe (1994) and Olutian (2004) both argued that inadequate capital most severely affects the financial health of a bank. On the other hand, Modigliani and Miller (1958) stated that in the world of the perfect financial markets capital regulations which are imposed by the regulation authority is not required at all. Opposed to that statement Hahn (1966) proved the mandatory importance of the adequate amount of capital for commercial banks to successfully operate. The findings show the significant relationship between capital adequacy as independent variable and banks profitability as dependent variable. Jeff (1990) claimed that banks should be heavily capitalized as strongly capitalized banks are more benefited than weakly capitalized banks which give away their asset in order to raise their capital when higher capital requirement is strongly forced by the regulators. Based on the Korean banking industry Yu (2000) argued that large bank maintain lower capital adequacy ratio which in return has significant negative impact on their performance in the long run. One of the main scope of lowering the amount of capital was found in another study by Tanaka (2002) who postulated that when the bank regulators and their regulation get weekend the bank finds an incentive to maintain inadequate amount of capital. Based on another study conducted in China Cheen (2003) strongly argued that maintaining adequate amount of capital is always desired and it is the most feasible way to be a better performer among the competitors in the banking industry. Opposed to that argument Goddard et al., (2004) postulated that because of the required amount of adequate capital banks may become more cautious which may influence them to ignore investment in the profitable sectors which explicitly exhibit the negative relationship between capital adequacy and bank profitability. But opposed to this argument Pasiouras and Kosmidou, (2007) stated that with an adequate amount of capital banks require lower amount of external funds which eventually enhances the profitability of the banks.

To measure the banks' portability based return on asset, Nvapan and Tripe (2003) argued that return on equity determine the return for each monetary unit invested by shareholders relative to the business risk. Moreover, return on asset exhibits ratio of net income to total asset originated from the total asset of the firm. Ozcan and Asarkaya (2007) explained that bank with higher amount of capital has sustainable economic growth and higher return on equity. Another research which is consistent with this result and conducted by Stegall (1966) postulated that adequate amount of capital is the fundamental indicator of the sustainable rate of return. Oppose to that research results koach (2010) claimed that lower level of capital enhance banks' ability to make more investment by providing greater financial leverage which will in return generate satisfactory returns for shareholders. To some extent by supporting these results Berger et al., (1995) argued that the bank which has lower amount of capital than equilibrium has more exposure towards the insolvency but their return on equity is higher. On the other hand, banks with capital higher than equilibrium have more solvencies but less return on equity. Based on a empirical study of Turkish bank Buyuksalcarci and Abdioglu (2011) opposed to that results by explaining that higher capital has significant negative relationship with return on asset while significant positive relationship with return on equity. In another interesting research which was conducted with a timeline of 2005-2010 through regression model Yuanjua and Xiao (2012) exhibit that capital adequacy has positive relationship with return on asset but return on equity is negatively related with capital adequacy. Nacuer and Goaied (2001) claimed that any banks can only achieved its optimal performance in term of profitability when it holds required amount of capital. But Myers and Mahluf (1984) postulated that most of the banks never hold the amount of adequate capital required by the regulators. Ojo (1992) and Oluyemi (1995) found that the capital adequacy is one of the most important indications in order to measure the financial condition and stability of a bank. Shaikh and Jalbani (2008) strongly claimed that return on equity and capital adequacy has strong positive relationship in the Islamic and commercial banks. This positive relationship ensures profitable business operations with solvency in a sustainable level.

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