Impact of Capital Structure on Banks Profitability Finance Essay

Main role of financial decision making is to "increase the wealth of shareholders" and these financial decisions can be very tricky sometimes. One of the decisions is related to capital structure which is related to its financing option (debt and equity). One basic question "proportion of debt to equity?" and there could be hundreds of options but purpose is to decide which option is best in firm's particular circumstances. It is effective to use more portion of Debt for the purpose of financing as it is less costly then equity but there are also some limitations and in the case of bank there are some restrictions imposed by regulatory authority, and after the certain limit use of debt affect company's leverage (traditional capital structure's theory). Financially troubled or risky companies could face severe consequences as they normally are charged more interest rates on debt. So there should be a balanced proportion of securities mix in firm's capital structure. Capital structure affects leverage and consequently profitability of firms. Firms with low earnings and high leverage are more exposed to risk and less attractive for investors. Most of these statements are true for banks also but capital structure of banks is a bit different from firm's perspective. So far there is no clear understanding about combination of financing options and this is because of regulations from government/ regulatory body, banks have to follow them and they have to adjust theirs source of financing accordingly.

Rationale of study

Banking sector, in all over the world (including Pakistan) is one of the most sensitive businesses. Banking sector plays a major role in current world of money and economy. Basic reason behind selecting this sector is that banks are main custodians of public money, they can motivate savings and can mobilize saving towards national economy. They have major impact on economy of Pakistan and they influence many activities distribution of public finance, poverty elimination and mobilization of resources.

Banking sector in Pakistan is now well developed, ranges from State bank of Pakistan (central bank) to commercial banks, Islamic banks, specialized banks which accommodates specific requirement of specific sector. State bank of Pakistan regulates all the banks operating in Pakistan and rules of SBP are same for all the banks, then why these banks have different levels of profitability?

In this study framework, Profitability is dependent variable which includes ROA and ROE. Profitability is affected by many factors and one the factor is capital structure (Independent variable). Capital structure is proxied by Gearing ratio and Equity Multiplier. To investigate the impact of capital structure on profitability alone, there is need to control the other factors which possibly can affect the profitability like Size, which is log of total assets, burden and efficiency ratio are some variables which also affect the profitability. For better analytical results, they are taken as control variable in this study.

This study has certain limitations.

Sample selected can be constraint to the research, data is gathered through published financial reports and data shown in the reports might or might not represent the actual picture. During the time period of 2004 to 2008, there are other factors which also affected the banks profitability, like privatization and government regulations.

According to Raghav (2004) "Capital is the engine of the economy and the financial information is the oil that keeps the engine running smoothly". For banks, Capital is the total Owned Funds available to the Institution for a reasonably long time. ICCMCS (2004) divided this capital into Core capital (basic equity) and Supplementary capital and classified in Tier I, Tier II and Tier III Capital.

Tier 1 capitalA consists of common stock and disclosed reserves like retained earnings and is the core measure of aA bank's financial strength.

Tier II capitalA is also used to measure the financial strength of a bank and is the second most reliable form ofA financial capital which includes Revaluation of assets, Undisclosed reserves (Reserves that are not burdened to any liabilities), General Provision, Hybrid instruments which are the capital instruments having the debt & equity characters and Subordinated debts. www.wikipedia.org

Tier III capital debts may include a greater number ofA subordinated issues, undisclosed reserves and general loss reserves compared to tier II capital and is used to supportA market risk, commodities riskA and foreign currencyA risk. www.investopedia.com

According to Kunt and Harry (2000) banks play a major role to allocate capital, to mobilize savings, to manage investment decisions of corporate managers and provide risk management guidance.

Capital structure is the combination of a firm's debt (long-term debt and short-term debt) and equity (common equity and preferred equity). Firm uses its various sources of funds to finance its overall operations and growth. Debt can be in the form of issuance of bonds or long-term notes payable, while equity consists of issuing common stock, preferred stock, or having retained earnings. Joshua. K stated advantages and disadvantages of each financing option and management always tries to find out the best combination to finance their capital and lower the cost of financing. As Eugene F. Brigham (2007, p440) stated, there is an optimal capital structure which is the best combination of equity and debt financing. On this level of optimization, cost of the capital is lowest and value of the firm is highest. At the same time, J. Abor (2005) believed that there is no universal theory for debt-equity choices, different combination are used in different situations to achieve the desired outcome.

Capital structure is very important for any firm. It not only helps in determining theA returnA a company earns for its shareholders and also shows how a firm will behave inA recessionA or depression (Joshua K).

One of the financing options is Equity financing which is composed of funds that are raised by the business itself. This financing can be raised by the owners of the firm or by adding more peoples in the ownership i.e. issuing the shares of the company. There is certain amount paid against these share and the shareholders get dividend against those shares or against that money they have invested in the company. It depends on the company's policy that how much capital they need and how much of that capital should be raised through shares. Mostly companies with high growth rate use equity financing because they can give high return to the investors. Equity capital is considered to be the expensive type of capital because its "cost" is the return the firm must earn to attract investment (Joshua K)

Debt financing, second choice of financing means borrowing money to run the business. The amount of debt that a firm uses to finance its assets is also called leverage. Debt financing constitutes of long term debt and short term Debt based on the type of money one borrows. Interest rates for long term debt and short term are different and vary from situation to situation and firm to firm.

Long term debt refers to the money one borrows for financing the assets which can be used by the firm for longer periods. E.g. Purchase of Assets, machinery, land etc. The scheduled payment of long term loan is usually extended for more then 1 year. In the case of Banks their sub-ordinate loans and fixed deposits are long term in nature because they are held for more then one year depending on their nature.

Short term debt is the debt taken for meeting the daily basis business requirements like purchasing of inventory or paying the wages. Its scheduled payment takes place within the year. Usually short term loan is taken for some days or 3-6 months. Banks usually take loan from other financial institutions for very short period just to fulfill their daily requirement.

There are different theories of capital structure, traditional theory of Capital Structure says that use of more proportion of debt in capital structure can be effective as it is less costly then equity but it also has some limitations and after the certain limit it will affect company's leverage. According to Trade off theory, Debt financing also has an advantage of tax benefits, and this is choice of company in which combination debt: equity financing is used to balance the cost and benefits. www.wikipedia.org

Stewart MyersA & Nicolas M (1984) stated that companiesA prioritizeA their sources of financing (FromA internal financingA toA equity) according to theA Principle of least effort. According to them, internal funds are used first, and when there are no more benefits from internal funding thenA debtA should be taken, and as a last option equity should be issued as explained by Pecking Order Theory. www.wikipedia.org

In the light of these theories and literature there are pros and cons for both debt and equity financing. With debt financing company can retain maximum control over their business and debt financing has tax benefit as interest on debt financing is tax deductible but too much debt can cause problems if company begin to depend on it and do not have the amount to pay it back. High proportion of debt will make the company unattractive to investors because of leverage problem and cost of issuing debt will increase.

While talking about equity financing, this appears to be "easy money" because there is not debt involved it and no need to worry about scheduled repayment of loan, when business will makes profit the lenders will be repaid. Problem with this option is that company can lose its complete control and autonomy, now investors can have participation in decision making. High amount of equity in capital structure is indication for potential funders that company is willing to take the necessary personal risks, which could be a sign of lack of confidence in your own business venture.

Banks and financial institutions are specialized and unique businesses whose capital structure decision is affected by the factors specific to the banking industry like central bank's regulations. If government lowers the discount rate then according to tradeoff theory, banks will try to get loan from state bank and their debt portion will rise, so to handle this situation central bank enforces banks to hold more capital to balance the position. If central bank makes change in regulations like decrease in SLR and CRR requirements then more money will be available for lending and it will affect capital structure and profitability accordingly. Capital structure theories help the banks to make choices for raising capital during the financial crisis. According to pecking order theory, to overcome undervaluation problem, banks should choose to issue debt before equity if they have private information about their assets. But, during the financial crisis, financial information about the bank's assets is readily available so instead of debt, equity could be issued at discount. In this situation, if debt is issued then there will be high probability of default and issuing common stock at discount will transfer the wealth from existing shareholders to new one, so preferred stock should be issued because unlike debt repayments, preferred stock dividends can be suspended without causing bankruptcy.

To raise capital, from any source there is some cost associate with it which helps in determining how the capital should be financed? Separate option of debt and equity or combination of these two. Cost of raising money can be reduced with the best combination of equity and debt financing.

In the case of banks there are some regulations from the central bank related to the minimum requirement of holding the capital. Despite of the cost of holding that capital banks have to fulfill that requirement.

Mishkin (2000) stated that most of the bank managers want to hold less capital than is required by the regulatory bank, because high cost is associated with holding capital.

There are many variables that can be used to investigate the relationship between Capital Structure and Profitability of Banks. J. Abor (2005), Chin & A. Fu (1997) used Gearing ratio and Equity multiplier to measure capital structure. Kunt & Harry (2000) took Return on Asset to measure the profitability of banks. Chin & Ai FuA (1997) while finding the connection between capital structure and profitability focused on Debt to equity and Return on Investment. During the analysis of financial ratios of major commercial banks, conducted in Oman, Murthy (2003) focused on Return on Equity, Return on Assets (to find profitability) and burden ratio (to measure performance). These ratios are linked with the financing decision of the Bank i.e. Capital Structure

According to Athanasoglou et al (2005) expanses of the bank are very important factor to measure profitability.

Choice of capital structure influences Return on Assets because of the behavior of interest in calculating taxes. Company with low debt pays high taxes (due to lowA interest expense) compared to a company with more leverage. www.wikinvest.com

ROA also resolves a major shortcoming ofA return on equityA (ROE). ROE is the most commonly used ratio to analyze profitability but it doesn't show the true picture as the company can have excessive debt and is using debt to drive returns. This information can be gathered through ROA. Since ROA is divided by total assets and Asset is equal toA debtA plusA shareholder equity. So lower the debt, higher the ROA.

This equation also shows that if a company carried no debt, their ROE and ROA would also be the same because its shareholders' equity and its total assets would be the same.

As the company start taking debt, it increases its assets because of the cash inflow but at the same time equity shrinks, and since equity is the ROE's denominator, ROE will rise.

ROE is subjected to capital structure decision. According to DuPont, ROE is linked with Equity Multiplier and Capital Structure. So if there is any change occurs in the proportion of debt and equity, this measure will be affected.

Efficiency Ratio is metric used for analyzing the interest expanses and interest earnings. This is typically applied to banks as they are interest based businesses, their income and expanses both are related to amount of interest.

www.wikipedia.org

Michealas, Chittenden & Poutziouris (1998) consider various non-financial and behavioral causes which persuade capital structure decisions. Interviews are conducted for collection of the concerned data. They found that there are some factors like need for control, knowledge (experience), mind perception and social model etc which made certain belief about debt and this belief make their approach toward use of debt in their capital composition. There are also huge numbers of small firm owners who choose to rely on internal generated funds rather than raising external finance.

Groth & Anderson (1997) described capital structure and observed its influence on the cost of capital and the value of a company. There is no equation exist to determine the optimal capital structure for firm. Proper use of debt and equity in capital structure lowers the weighted cost of capital and this low weighted cost of capital helps in increasing the value of the firm.

Upneja & Dalbor (2001) studied the capital structure decisions of restaurant firms in USA. Pecking-order theory and position of the firm in the financial growth cycle are the basis for their study. Their results showed that both pecking-order and financial growth cycle influence capital structure decision of the restaurant firms. They found some separate factors which influence long term and short term debt decisions of the restaurant firms

Amidu (2007) focused on the factors involved in determining the capital composition of banks in Ghana. The variables covered by him are profitability, growth, tax, asset structure, risk and size. This study highlighted the association between long and short forms of debt while making capital structure choice. It is found that long-term debt structure is positively and statistically related to operating assets. While short-term debt and leverage are positively correlated, they move in the same way. The study suggested that profitability, size of the bank, their asset structure and corporate taxes are important variables to influence capital composition of banks.

Chaganti & Damanpour (1991) tried to answer two main questions. One, what is the relationship between outside institutional shareholdings and a firm's capital structure and performance? And secondly, does the size of stockholdings by corporate executives, family owners, and insider-institutions modify those relationships? They have collected data from forty pairs of manufacturing firms and found that the size of outside institutional stockholdings has a significant impact on the firm's capital structure and family and inside institutional owners' shareholdings moderate the linkage between outside institutional shareholdings and capital structure.

Jamal (1994) examined the influence of capital structure, particularly in the presence of market imperfections on firm's profitability. He analyzed the effect of corporate taxes, interest expense, debt level and equity size. The findings of this research paper are that higher debt level results in a lower profitability and higher profitability have positive connection with taxation but negative with interest expense.

F. Voulgaris et al (2004) investigate the determinants of capital structure; they focused on manufacturing sector of Greek and took Large Size Enterprises (LSEs) for their study. The findings show that asset utilization, total assets growth and net profitability have a major impact on the capital structure of LSEs. Greek LSEs will face higher debt levels in the future that will arise mainly from higher short-term debt ratios. The ratios such as return on equity, asset profitability, asset structure, inventory turnover and liquidity which came out as major determinants of capital structure while other empirical studies did not show significant results.

Guorong Jiang et al (2003) have tried to answer the question of "whether both bank-specific as well as macroeconomic indicators are main factors influencing bank's profitability" and "A profitable banking sector is better to oppose against financial distress and contribute towards the solidity of the financial system or not". They conclusion of their study is that a profitable banking sector can oppose better against negative shocks and can help in secure financial structure. In terms of bank-specific factors, operational efficiency is the key factor in explaining differences in profitability, and macroeconomic developments have also significant effect on bank's profitability.

Chiang Y. H et al (2002) showed the connection between cost of capital, capital structure and profitability. Focus of their study was on property developers and contractors in Hong Kong. The analysis of this paper showed that gearing is generally higher among contractors than developers and capital gearing is positively linked with asset but negatively with profit margins.

Panayiotis P. et al (2005) found the determinants of profitability in banking sector. According to their study, size of the bank, operating expense, financial strength, ownership status and cost decisions of bank's management are the major factors which influence the profitability of Banks.

Methodology

20 Sample Banks

Alfalah bank limited

Allied bank limited

Askari bank limited

Bank al-Habib ltd

Bank of Punjab

Faysal bank limited

First Women bank limited

Habib bank limited

Habib Metropolitan bank ltd.

Khushhali bank limited

MCB bank limited

Meezan bank ltd.

My bank ltd.

National bank of Pakistan

NIB bank limited

Pak-Kuwait investment company

Saudi-Pak commercial bank ltd

SME bank limited

United bank limited

Zarayi tariqiyati bank ltd.

Top 10 tier banks

Alfalah bank limited

Allied bank limited

Askari bank limited

Faysal bank limited

Habib bank limited

MCB bank limited

Meezan bank ltd.

National bank of Pakistan

NIB bank limited

United bank limited

This study sampled 20 banks, mostly from private sector. Top 10 tier banks are also included in this study separately, to see the same relationship. This is for the purpose of better understanding where these banks stand now. This study is based on quantitative data analysis. Financial data was collected from annual reports of the banks. The proposed period is from 2004 to 2008. Independent variable is Capital structure which is analyzed through gearing ratio and equity multiplier. Gearing ratio and equity multiplier are used to investigate the relationship of long term liabilities and total assets with shareholder's equity. Profitability is dependent variable which is measured through commonly used Return on Assets and Return on Equity. Expanses of the bank are very important factor to measure profitability according to Panayiotis P. Athanasoglou (2005). Efficiency ratio, burden ratio and Size of the bank are taken as control variable in this research.

Most of the banks have different level of profitability just because of their size, their efficiency level and their ability to take burden. These factors must have impact on the profitability of the banks and because of this reason and to refine more concrete results these variables are taken as control variables.

In the first phase financial data is collected from the annual reports of banks and is analyzed through above mentioned ratios in the second phase. Collected data was in the form of panel data which allows the use of panel data methodology. Panel data refers to cross sectional data containing observations on multiple phenomena observed over multiple time periods. This dataset have data on i cases, over t time periods, for a total of i Aƒ- t observations. Third phase is comprised of analysis of this panel data with the help of regression tool.

Fixed affect model has been used to find the relationship between dependent and independent variable. This model is selected in against of variable affect model and pooled regression model. To decide which model is better, first Breusch-Pagan test was run on the panel data and Pagan test denied the use of random affect model. Then Houseman test was run on the panel data for the final selection of model and the result shows that fixed affect model is better option in this scenario, as level of significance was higher in fixed affect model.

Descriptive statistic shows that average gearing ratio for the sample study is 7.53, which ranges from 0.0547 to 30.216. This huge variance in sample's gearing is because of the structure of banks. During the time period of 2004- 2008 most of the banks have changed their structure to private sector banks. Same is the case with equity multiplier; mean of equity multiplier is 13.50 with huge variance between minimum and maximum values.

Average return on equity and average return on assets during the study time frame is 10.88% and 0.98% respectively. Variation during this time frame for ROA is less than ROE. ROE in this time frame ranges from -2.7625 to 0.4873 (MCB in 2005). Skewness of profitability is more inclined towards left side of normal distribution curve.

Here, ROE is negatively affected by all the variables but significant relationship is shown by size, equity multiplier and efficiency. Equity multiplier and efficiency shows highly significant negative relationship at confidence interval of 1%. Significance of relationship is shown by P-Value, as P-Value is less than 0.05 for Alpha= 5% and less than 0.01 for alpha = 1 %.

Here, ROE is negatively affected by all the variables but highly significant relationship is shown with gearing and efficiency at confidence interval of 1%. Size shows significant negative relationship at confidence interval of 5%. Significance of relationship is shown by P-Value, as P-Value is less than 0.05 for Alpha= 5% and less than 0.01 for alpha=1 %.

Results showed that ROA is negatively affected by Gearing, which means with increase of gearing, ROA is decreasing. These results are showing high level of significance at confidence interval of 1%. Burden, which is taken as control variable shows significant negative relationship at confidence interval of 5%. Negative relationship of size and efficiency is shown with ROA but result is not significant.

Here, ROA is negatively affected by all the variables but significant relationship is shown by Burden and equity multiplier. Equity multiplier and burden is showing significant negative relationship at confidence interval of 5%. Significance of relationship is shown by P-Value, as P-Value is less than 0.05.

While focusing on top 10 tier banks, results showed that they are not on that stage where gearing affects the profitability. Here gearing is having positive affect on ROE and this relationship is shown at confidence interval of 1 %. This shows that they are well managing their long term liabilities and able to convert it into profits. Fitness of this model is 84% which is quite high level with P-value almost 0 also showing significance.

Relationship of size of bank and efficiency of bank is also negative with return on equity which means, it is not necessary that bank's having larger size and efficiency are also profitable, though coefficient of size is low but it is negative. Average return on equity for the top 10 tier banks is 21.11 %. Same is the case when ROE is taken with Equity multiplier. Significant positive relationship of return on equity is shown with equity multiplier on confidence interval of 1%.

Conclusion of the results is that overall bank's profitability is negatively affecting by the gearing and equity multiplier. This shows that banks are not able to utilize their long term debt to generate substantial profits. Control variables, which are size of the bank, efficiency of bank and burden capability of banks, are also having negative relationship with profitability. Banks are increasing their size, they are becoming more efficient but still their profitability level is low. They are unable to use their assets properly to increase profitability.

Increasing equity multiplier ratio shows that banks are increasing their risk and becoming more leveraged and this might lead to financial problem because of excessive debt portion. As the gearing of the banks increases it is hard for the banks to pay legal obligations of interest payments which increases bank's risk and decreases its profitability. Banks still needs to have debt to finance their assets because as discussed it is cheap source of financing but there are some limitations after that limit it is harmful for the company's capital structure. Here apparently it seems that banks have crossed that level that's why they are now negative effecting by debt proportion. As far as top 10 tier banks are concerned, they have not achieved that level. This is indication for them to control and focus on their leverage, because as they will cross that limit their profitability will be negatively affected by this debt proportion as other banks.

Banks can control their debt portion to increase their profitability as MCB did. Gearing ratio of MCB for the year 2004 was 15.44 and now they are on 4.7, and this decrease helps them to achieve higher ROE and ROA. Banks can analyze their previous performance to forecast in the future that which amount of debt should be use in their capital structure. There should be maximum use of cheapness of debt and at the same time keeping an eye on the leverage of the bank.

It is recommended, as banks are increasing their long term liabilities, they should also use them in such activities from where they can have some profits to minimize the increasing risk of their bank. From the results it is shown that size of the banks (log of total assets) is also negatively affecting their profitability which means just to increase the quantity of assets should not be the purpose. Proportion of earning assets should be higher and there should be some substantial earnings from those resources.

Size of the banks, burden capacity and efficiency are also negatively affecting the profitability which means that there are some other factors which affects and control the profitability, and this might be the regulation of State bank of Pakistan. Reason could be that, banks are under the obligation of holding a specific amount of equity and for tradeoff purpose banks have to use debt. Now establishment of Banking Sector Strategies (BSS) from State Bank of Pakistan, can help the banks to retain their profitability level while less exposure to risk.

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