Relationship Between Banks Capital Levels And Financial Performance Finance Essay

Although capital by and large accounts for a little part of the fiscal resources of banking establishments, it plays a cardinal function in their long-run funding, solvency place and their overall public credibleness. In the event of a crisis, the lower the purchase ratio is, the lower the chance that a bank will neglect to pay back its debts. This fact tends to warrant the being of capital adequateness ordinance in order to avoid bankruptcies and their negative outwardnesss on the fiscal system. An optimum capital construction is the 1 that maximises the houses ‘ value in the absence of regulative demand.

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Harmonizing to conventional wisdom in banking, a higher hazard plus ratio is believed to be associated with lower return on equity. This tends to back up the hypothesis that, 1 there exist a negative relationship between hazard plus ratio and fiscal public presentation. Another school of idea in banking besides believed that higher capital is straight related to fiscal public presentation. 2 This besides back up the hypothesis that there go out a positive relationship between Bankss capital degree and fiscal public presentation. This is based on the statement that a profitable bank will be able to hike its capital from retained net incomes and therefore a higher return on equity but if the statutory hazard plus ratio is high, it will suppress the ability of the bank to make liquidness and bring forth more net income. They defined capital as the parts of equity investors, retained net incomes and subordinated capital over clip while hazard plus ratio is the proportion of the capital that is set aside to buffer the consequence of inauspicious exposure to the recognition market ( recognition hazard ) . Fiscal public presentation is measured by return on equity ( ROE ) . Both school of idea nevertheless agreed on one thing, that the more equity capital nowadays in the overall capital construction of a bank, the less likely is the chance that the bank will neglect and besides that the higher the hazard plus ratio, the less likely that the bank will neglect. We so explicate another hypothesis that, 3 a positive relationship exists between capital degrees, hazard plus ratio and bank failure. This suggests that, the more the equity capital as comparison to debt capital of a bank, the less likely that the bank will neglect. Intuitively, higher hazard plus ratio will intend less likeliness that the bank will neglect. If we hold these premises to be true, we would anticipate that Bankss in the United Kingdom should hold higher returns and less likeliness of failure than Bankss in Nigeria because they are adequately capitalized and less hazardous in footings of their operating environment. In fact, it is normally assumed that the position is so obvious that the inquiry does non necessitate to be investigated. But the development between 2007 and 2008 in the industry calls for probe.

Comparing returns on equity is one manner of mensurating their public presentation relation to each other which allows a comparing of investing in Bankss portions with other investing chances while it can besides supply a step of the peril of the Bankss. A comparing of return on equity between United Kingdom and Nigeria Bankss shows that Bankss in Nigeria appear to be gaining much higher returns. The mean return on equity for five selected Bankss which dominate retail concern in Nigeria over the period 2000 to 2008 was 34 % whereas the mean return on equity for the five major United Kingdom bank for the same period was 28 % , This difference is capable to a scope of possibilities. It could be that Nigeria market is less competitory and they are able to work the market by bear downing higher involvement rate or that they are more efficient in their operations. Alternatively, it could be that it ‘s merely a map of different degrees of capital as Bankss in Nigeria are statutorily required to keep more capital than in the United Kingdom. This paper focuses on these last possibilities and looks at the extent to which difference in return on equity might be a map of degrees of equity or other explanatory variables.

This paper proceeds as follows. Following subdivision looks at old research on the subject while subdivision three focused on the information and methodological analysis

STATEMENT OF THE PROBLEM

Most existing literature on this topic focused more on capital adequateness standard CAD as a forecaster of bank ‘s failure and fiscal public presentation. They tend to direct their research energy to advanced economic systems without taking into awareness the fact of mutuality between fiscal markets of developed and developing economic systems of the universe. They besides treated hazard plus ratio in isolation as prescribed by the bank for international colony ( BIS ) in the general agreement of 1988 ( Basel II agreement ) without sing the purchase consequence of subordinated capital in the calculation of CAD criterion. If Bankss in Nigeria are statutorily required to keep 10 % of their capital as a shock absorber against their hazard assets, this is 2 % above the standard demand of CAD so Bankss in the UK should be expected to hold higher return that Nigeria Bankss.

AIMS AND OBJECTIVES

The purpose of this research work is to utilize steadfast particular and macro economic variables to research the relationship between bank ‘s capital degrees ( tier 1 ) and fiscal public presentation within the context of developed and developing economic systems and to research the extent to which difference in fiscal public presentation of Bankss in these state can be a map of difference in capital degrees. It besides goes farther to research the possibility of utilizing conformity and non conformity with the minimal capital adequateness criterions as a forecaster of bank failure. It besides provides a trial of the capital construction theory of Modigliani and Miller ( 1958 ) , Inactive Trade-off Theory and Pecking Order Theory.

SCOPE AND LIMITATIONS

The range of this research work is limited to selected Bankss in Nigeria and the United Kingdom. The Bankss for Nigeria includes First bank of Nigeria ( FBN ) , United Bank for Africa ( UBA ) , Zenith International Bank ( ZIB ) , Guaranty Trust Bank ( GTB ) , Standard Chartered Bank ( SCB ) , Intercontinental Bank ( IB ) , Citi Bank ( CITI ) and Oceanic International Bank ( OIB ) . The pick of these Bankss stems from the fact that they represent the assumed strongest Bankss in the state with being of some over 100 ( FBN ) old ages. The full industry comprise of 24 Bankss out of which two are foreign Bankss. Two out of the locally integrated bank received authorities bailout in 2009 in order to remain afloat.

The Bankss for the United Kingdom include Barclays Bank Plc, Royal Bank of Scotland, HSBC and Lloyds TSB bank Plc. The pick besides root from the fact that they represent the most active Bankss in the state and two of them besides received authorities bailout in resent clip. All the Bankss adopted the same line of concern ( cosmopolitan banking ) so they are good braces for comparing.

THORETHICAL BACKGROUND

The modiglianig and miller capital construction theory ( 1958 ) presume a perfect capital market ( no dealing cost or bankruptcy costs ; perfect information ) ; houses and persons can borrow at the same involvement rate ; no revenue enhancements ; and investing determinations are n’t affected by funding determinations. Modigliani and Miller made two findings under these conditions. Their first ‘proposition ‘ was that the value of a company is independent of its capital construction. Their 2nd ‘proposition ‘ stated that the cost of equity for a leveraged house is equal to the cost of equity for an unleveraged house, plus an added premium for fiscal hazard. That is, as purchase additions, while the load of single hazards is shifted between different investor categories, entire hazard is conserved and therefore no excess value created.

Their analysis was extended to include the consequence of revenue enhancements and hazardous debt. Under a classical revenue enhancement system, the revenue enhancement deductibility of involvement makes debt funding valuable ; that is, the cost of capital lessenings as the proportion of debt in the capital construction additions. The optimum construction so would be to hold virtually no equity at all.

Inactive Trade-off theory. Trade-off theory allows the bankruptcy cost to be. It states that there is an advantage to funding with debt ( viz. , the revenue enhancement benefit of debts ) and that there is a cost of funding with debt ( the bankruptcy costs of debt ) . The fringy benefit of farther additions in debt diminutions as debt additions, while the fringy cost additions, so that a house that is optimising its overall value will concentrate on this tradeoff when taking how much debt and equity to utilize for funding. Empirically, this theory may explicate differences in D/E ratios between industries, but it does n’t explicate differences within the same industry.

LIERATURE REWIEW

Previous surveies on the topic can be delineated in to four ( 4 ) different classs each of which is capable of separate probe and analysis. The first group focused on the determiners of bank ‘s profitableness and some focused on determiners of bank ‘s capital degrees. Other groups focused on the determiners of hazard plus ratio and the last group focused of the relationship between the three variables. There seems to be convergence and divergency in the decisions reached.

Kyriaki et.al ( 2006 ) investigated the impact of bank-specific features, macroeconomic conditions and fiscal market construction on UK owned commercial Bankss. They used step of return on mean assets ( ROAA ) and net involvement borders ( NIM ) as a footing of analysis. They discovered that, capital strength, represented by equity to assets ratio is the chief determiner of UK Bankss net incomes. The research used panel informations set of 244 observations covering the period 1995-2002. Their survey supply support to the statement that good capitalized bank face lower costs of external funding which reduces the cost and enhance net income. Surveies for other states besides support this findings ( Berger, 1995 USA ; Demirguc-Kunt and Huizinga, 1999 ; Ben Nacuer, 2003 TUNISIA ; Pasiouras and Kosmidou, 2006 AUSTRALIA ; Pasiouras et al. , ( 2006 ) UK.

Volker et.al ( 2004 ) examined how Bankss determine their capital ratio utilizing information from German Bankss from 1992 to 2001. They found out that about all German Bankss capital ratios is in conformity with the capital to plus ratio determined based on the Basel ll agreement of 1988.They found grounds in favor of capital buffer theory, which claims that reasonably capitalized Bankss try to keep their regulative buffer capital because of possible regulative cost. As expected, bank ‘s profitableness has a positive important impact on the mark capital ratios.

Berger ( 1995 ) researched on the relationship between capital and net incomes in banking utilizing information from 80,000 Bankss in the mid-80s. The consequences reported a positive relationship between capital and net incomes ‘ and that each variable positively cause others. That is, an addition in capital tends to be followed by an addition in net incomes and frailty versa. He defines bank ‘s capital demands as the capital ratio that maximizes the value of a bank in the absence of regulative capital demands. If a bank is less capitalized, that is less than the optimum capital demand, its greater possible hazard of insolvency will deter investors from farther investing and the market value will diminish. If the bank on the other manus have more than the optimum sum of capital, the returns to the investors will worsen as available net income get distributed comparatively more thinly across that expanded capital. This proposition is clearly consistent with the conversional wisdom that the return on equity as a step of fiscal public presentation and capital to plus ratio should be negatively related to each other. This besides justify the proposition that higher capital implies lower hazard, which should in bend imply lower returns ( Berger, 1995 )

An extension of his work to 1990s, provide a contrary position. He found that the positive Granger -causality from capital to net incomes of the 1980s does non use to the 1990s-1992 clip period. The negative causality during this period suggests that Bankss may hold overshot their optimum capital ratio because of lower hazard and record net incomes in 1992 and perchance a higher regulative capital demand every bit good. This nevertheless is consistent with the expected bankruptcy hypothesis, which postulate a positive causality from capital to net incomes when capital is below its optimum degree and a negative causality when capital exceed its optimum degree ( Berger, 1995 )

Berger decision is based on a individual state ( USA ) clip series informations but Kobpong and David, ( 2003 ) explore the relationship by doing comparism between Bankss in New Zealand and Australia utilizing informations set for the period 1996 to 2002. Their decision tends to be more realistic interms of acceptableness in the sense that they make comparism between different Bankss in two different states. They still went farther to explicate possible cause of fluctuations in the return on equity among Bankss in these states. They found some relationships between return on equity and ratio of capital to assets for both Australia and New Zealand Bankss. They look at Australia market as a whole but, can non corroborate the being of a relationship, but looking at merely the five largest Bankss, fluctuation in the ratio of capital to assets explains a moderate proportion of fluctuation in return on equity. The result for the New Zealand is non different in that, looking at the banking sector as a whole, there was a weak relationship with 20 % of the variableness in return on assets explained fluctuation in ratio of capital to assets.

A farther determination from their research was that, other macro economic factors might be expected to impact on bank profitableness i.e. the general degree of involvement rate and alterations in GDP. Some consequence was found for involvement rate in the New Zealand market, but it was ill-defined that there is a causative relationship. The alternate reading being that the general degree of involvement rates is correlated with other factor, which might be existent cause of the fluctuation in return on equity. The deficiency of consequence from GDP alterations may be as a consequence of comparatively new concern environment, which has meant that, Bankss have by and large merely had limited exposure to bad and dubious debts which are common subscribers to volatility in bank profitableness.

Hortlund ( 2005 ) explore long term relationship between capital and net incomes in Swedish commercial Bankss utilizing informations from 1870 to 2001. He surprisingly found a negative relationship between purchase and profitableness in banking. The capital plus ratio lessening from degrees around 20 per centum at the bend of the nineteenth century, to degrees around 5 per centum today. The trickle occurred peculiarly during WW1 and in 1940-1980. In the same period, return on equity more than doubled, from about 5 per centum to about 13 per centum in existent footings. This postulates a positive relationship between return on equity and the debt equity ratio. This was officially tested and a strong positive linear relationship was found to be over the period 1871 to 1980 but non in 1980 to 1990. Consequences are hence supportive of those of the old surveies. At the same clip, a long term positive relationship between purchase and profitableness in banking was reaffirmed. Over the centuries, at least, the economic Torahs seem to be working.

Terhi ( 2009 ) research on the one-dimensionality between bank ‘s capital and charted values opened a new page for this treatment. The paper through empirical observation explores the predicted long-run relationship for a set of United States ( US ) Bankss between 1986 and 2008 and the consequence reveals that, the relationship is extremely non-linear and bulge shaped which is rather different from what was predicted by old research. In peculiar, they found that, one time Bankss have a charter value above the average threshold, their capital buffer is held changeless. The analysis adopted two different attacks to get at this decision. First, they modeled yak value as a map of bank ‘s gross mix, loan portfolio and sedimentation composing. The predicted values from the equation were so used as inputs in the 2nd equation that target the relationship between capital and profitableness. It was further assumed that functional signifier to be unknown so as to cognize the exert relationship. The first attack shows a considerable line drive relationship but under the 2nd attack, the estimated movable value demonstrates a quadratic signifier. Each approached was estimated utilizing pooled time- series cross-sectional observations. The concluding consequence showed that the relationship between capital and charted values is extremely non-linear as predicted by theory. It was further showed that, higher Bankss do non needfully keep more capital. The account to this they said is that beyond certain profitableness degree, it is easier for Bankss to raise new equity thereby cut downing the demand for them to pull off big capital buffer. The consequences further assert that, as the profitableness starts falling, Bankss will get down edifice more capital in an effort to protect their falling net income. This action shows that falling net income react to the impression expected net incomes react to the demand for more capital. Their consequences indicate that the charter value in itself does move as a disciplining mechanism for bank capital direction. Banks with a valuable adequate charter will pull off capital so as to keep a shock absorber for protection against negative dazes.

Unomoibhi ( 2004 ) examined company-level determinates of bank profitableness in Nigeria utilizing information on 33 Bankss between 2000 and 2003.The research work goad from the action of the Central Bank of Nigeria ( CBN ) directing all Bankss to recapitalised to the melody of 25 billion as against the bing regulation of 250 million. The determination was in reaction to the systemic jobs encountered by the state fiscal sector. This remarkable action led to series of amalgamations and acquisitions within that period. The believe by the apex bank was that good capitalised bank will be able to defy inauspicious economic conditions and bring forth more net income to hike the capital over clip. Based on the consequences of the empirical analysis, capital size, size of recognition portfolio, and ownership concentration significantly determines bank profitableness in Nigeria. Therefore, in order to maximise net incomes, directions of Bankss in Nigeria should concentrate on keeping a ample sum of militias, bettering the quality of their recognition portfolios and griping up the concentration of their ownership. In the same vena, to prevent hurt and heighten the stableness of all the Bankss presently runing in the Nigerian banking industry, the CBN should orient its policies and ordinances toward guaranting that they are all headed in this way.

Old ages subsequently, he besides explores the relationship utilizing macroeconomic indexs and his consequence concluded that existent involvement rates, rising prices, pecuniary policy via liquidness ratio, and exchange rate government significantly determine bank profitableness in Nigeria. By deduction, these variables besides impact bank stockholders ‘ public assistance. Therefore, in order to maximise the profitableness and stableness of Bankss in Nigeria, the CBN should pay considerable attending to these macroeconomic indexs. Through the uninterrupted acceptance and application of sound macroeconomic rules, the CBN should endeavor to ever carry through its primary duty of supplying a sound macroeconomic environment for all aspects of economic activities, particularly banking.

Mathuva ( 2009 ) examined the relationship between capital adequateness, fiscal public presentation and cost to income ratio. The survey provides grounds that supports the Central Bank of Kenya`s move to bit by bit raise bank capital degrees by 2012 and to tightly supervise the operations of Bankss so as to guarantee that Kenyan Bankss are more efficient in their operations while at the same clip being profitable. With the present planetary recognition crunch, capital adequateness and the cost-income ratio being critical for Bankss, the survey examines the relationship between these variables and profitableness. Using the return on assets and the return on equity as placeholders for bank profitableness for the period 1998 to 2007, the survey finds that bank profitableness is positively related to the nucleus capital ratio and the tier 1 risk-based capital ratio. This implies that an addition in capital may raise expected net incomes by cut downing the expected costs of fiscal hurt, including bankruptcy. The survey besides establishes that there exists negative relationship between the equity capital ratio and profitableness. The survey besides finds out that Kenyan Bankss are non competitory plenty globally in footings of their efficiency as measured by the Cost-Income Ratio ( CIR ) . The survey reveals that the CIR is reciprocally related to both bank profitableness steps. The survey besides reveals that the CIRs of Kenyan Bankss are higher than those of developed states. This means that Kenyan Bankss should endeavor to maintain their CIR to a minimal degree, if possible below the 50 % threshold for them to be more efficient so as to be globally competitory.

David et.al ( 2000 ) examined the relationship between capital construction and return on equity. It is shown that for Bankss in the U.S. , for the comparatively less regulated 1983 to 1989 period every bit good as the more extremely regulated 1996 to 2002 period, there is a positive relationship between fiscal purchase and the return on equity. The analysis was extended to find the relationship between return on assets and equity capital. The grounds supports the hypothesis that there is a positive relationship between equity capital and return on assets. Meanwhile, old empirical grounds for U.S. Bankss had indicated a perverse negative relationship between fiscal purchase and the return on equity for the 1983 to 1989 period. The cause of such an association was determined to be attributable to a repute consequence for big Bankss who adopted an aggressive capital construction. These contrary findings coupled with ordinances on bettering equity capital adequateness from the Basel II agreement supported the attempts to advance a decreased capital construction hazard position by Bankss. However, these opposite consequences conflicted with traditional idea from the DuPont analysis wherein, when runing profitableness is positive, increased fiscal purchase augments the return on equity. Therefore, Bankss continue to hold an inducement to rachet up up their fiscal purchase so as to increase the returns to shareholders albeit with increased fiscal hazard.

Methodology

For the intent of analyzing this subject. Two methods of analysis shall be adopted based on attached information from bankscope database. The ordinary least square methods ( OLS ) and the logit /probit theoretical account.

OLS MODEL

ROE = ?0 + ?1CAR + ?2IR + ?3?GDP + ?4RAR+ ?5CTI+ ?6LR+ ?7LD + ? ( 1 )

Where:

ROE= is return on mean equity for the relevant clip period

CAR =is the ratio of capital to assets at the terminal of the clip period

IR =is the general degree of involvement rates

GDP= is existent gross domestic merchandise, measured here as quarterly alteration.

RAR =is hazard plus ratio

CTI =is cost to income ratio

LR =is purchase ratio

LD =is loan to lodge ratio

? =is the mistake term

The thought is to run a correlativity trial between return on equity and capital degree between selected Bankss and run a arrested development to cognize if there are other explanatory variables that are relevant in explicating the dependant variable and so do comparism. I will besides utilize Granger causality trial to cognize which of the explanatory variables grander cause each other.

LOGIT MODEL

Z = ?0 + ?1X + ? …………………………………………………………………………… ( 1 )

Where:

?0=the changeless term

?1= the vector of coefficients of the explanatory variables

X=the vector of the explanatory variables

= the mistake term

The methodological analysis will be borrowed from the literature on corporate bankruptcy, where the basic point is that insolvency is a discreet result at a certain point in clip. The result is binary: either the bank fails or does non. The logit theoretical account has a binary result. Either the bank fails or it does non. So if:

P=1, if Z0

P=0, if Z

Z=log [ p/ ( 1-p ) ]

DATA RESENTATION

Attached informations file contains informations for the period 2001 to 2008 which is what is presently available on bankscope but I intend to scroll rearward to widen the figure of old ages to cover pre ordinance period.

DATA ANALYSIS

To come

RESULT PRESENTATION

CONCLUSION AND RECOMMENDATIONS

x

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