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Impact Of Capital Adequacy Ratio On Banks' Performance:Evidence From Ghana

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This chapter of the study consists of a review of theories related to the study, empirical literature as derived from research work by other researchers, the context of this study and a conceptual framework to aid in further understanding the study.


The current study relied on two theoretical viewpoints to explain the nexus between capital adequacy and performance of banks in Ghana. They are the buffer theory and the trade-off theory

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Buffer theory

Proponents of the buffer theory postulate that as a bank approaches the minimum capital requirement, they tend to raise the capital above the minimum to avoid costs which they may incur in case of breach of set regulatory capital. Calem and Rob indicated that breaching the regulatory provisions comes with costs such as fines, penalties and even takeovers. Therefore, banks would prefer to maintain capital in excess of prudential limits to reduce the chances of falling below legally required capital limits. In support of the buffer theory, Gropp and Heider posit that buffer capital has functions which may be promotional, protective, regulatory and operational. The promotional functions of buffer capital of banks relate to how they ensure that there is enough capital to carry out business growth activities and meet expectations of stakeholders, hence promoting economic growth. The protective functions of buffer capital of banks is seen in its ability to cushion banks against unexpected losses, so as to ensure business continuity and reliability. The efforts of management of banks to hold adequate capital to absorb any unexpected loss plays a regulatory function by protecting banks from breaching regulatory capital requirements. The operational function of buffer capital lies in the use of the excess capital for undertaking volumes of banking activities which in turn generate returns for the holders of equity. The buffer theory enables banks to set their own capital benchmarks above the regulatory standard so as to ensure smooth operations, without straining the funds of depositors. The excess capital held results in increased operations, which leads to improved financial performance of banks. Similarly, the buffer capital held leads to reduction in costs which would have been incurred in penalties and fines in case of breach of regulatory capital requirements.

Trade-off theory

The trade-off theory of capital structure is of the viewpoint that firms have in place optimal capital structures determined by trading off the costs of using debt and equity. The theory points out that debt is beneficial to the owners of equity. This benefit is enjoyed when the reward for tax deduction is made because having debts offset potential bankruptcy costs. This school of thought comprise two views: the static trade-off and the dynamic trade-off. The static trade-off theory argues that firms maintain their financing structure in a way such that ensures that deviations from the optimal leverage ratio are brought back to it. This view of the trade-off theory also advocates that though debt has tax shield advantage to equity holders, it cannot be the only source of financing. This is as a result of the fact that there is a trade-off between advantages of tax shield on interest paid on debt on one hand and bankruptcy cost on the other hand. Myers indicated that a firm that is guided consistently by this theory sets a target debt level and always tries to achieve it overtime. This target is determined by weighing the tax shield on cost of debt against the cost of bankruptcy.

The dynamic view of the theory posits that firms will have no fixed optimal capital structure, but have their capital structures varying according to the risk portfolios of using a combination of debt and equity in financing projects. Mostafa and Boregodwa cautioned that too much debt leads to underinvestment, as additional debt might not be issued at the right time when a firm has an existing debt. Therefore, the firm will not be able to keep to its optimal capital structure, but will be forced to vary the ratio of debt to equity based on project risk profiles to ensure attaining the required debt or equity financing. The implication of this view of the theory is that viable projects may not be undertaken, resulting in poor financial performance. The trade-off theory seeks to explain why some firms have poor financial performance due to preference of debt rather than having more capital. It indicates that though debt has tax shield benefits, these benefits may not compensate for financial distress costs as well as covenants required by debt providers. This suggests that firms with more capital are more stable enough to take risky investments which will end up improving financial returns.

From the foregoing discussion, the trade-off theory appear to posit a positive relationship between capital adequacy and performance of banks. The trade-off theory concludes that firms maximize their value when the additional benefits (marginal benefits) that stem from debt (i.e. interest expense tax deductibility, the disciplinary role of debt, lower informational costs relative to equity) equal the marginal cost of debt (i.e. bankruptcy costs, agency costs between stake holders and bondholders).


Concept of capital adequacy

There are varied views on the role of capital adequacy in the banking industry. Some researchers have indicated that capital adequacy enables banks to absorb shocks on their balance sheets while others see it as a buffer against deposit withdrawals. Mekonnen intimates that capital adequacy promotes the efficiency and stability of the financial system and protects depositors. Similarly, it is argued in Masood & Ansari that banks’ survival rests on their ability to maintain sufficient capital to act as buffer during a liquidity crunch. Chowdhury, on the other hand, finds no significant evidence of sufficient equity capital serving as buffer and shock absorber in the UAE banking industry. Thus, meeting the requirement of keeping high bank capital does not necessarily mean that better capitalised banks are well-positioned to withstand the unfavourable impact of financial crisis.

Other researchers believe that the generally known reasons for the capital adequacy requirements are not entirely beneficial. Ensuring safety and soundness has been one of the reasons for the imposition of higher capital requirements on banks by regulators. This reason is however dispelled by the findings of Berger and Bouwman which suggests that even though regulators may be able to accomplish this purpose, the benefit of the action may bring about a decline in small banks’ liquidity creation and an increase in same for large banks. This implies that the small banks’ ability to generate and retain profits to boost their capital base ends up being threatened. Similarly, Blum indicated that in some cases, regulations that seek to increase capital may reduce bank profits and increase risks. The reality is that banks generate most of their revenue through financial intermediation which includes liquidity transformation and part of this revenue may be retained as reserves to supplement capital.

Goddard, Molyneux and Wilson also argue that a high capital adequacy ratio may be an indication of a bank operating over-cautiously and does not take advantage of prospective profitable activities within its environment. In this regard, a bank becomes risk averse as it tries to eschew any risk associated with productive ventures thereby missing avenues for growth.

Capital adequacy is measured in different ways. For example, equity to total assets ratio, shareholder equity to risk-weighted assets, and eligible capital to total risk-weighted assets proposed in the Basel III accord. Among the known measures of bank solvency, the Basel III proposed measure is said to provide more protection for banks than the rest, following the 2007/2008 financial crises. The eligible capital comprises Tier 1 capital and Tier 2 capital while the total risk-weighted assets is composed of credit RWAs, market RWAs, and operational RWAs.

Tier 1 capital is made up of equity capital, permanent preference shares (irredeemable non cumulative preferred stock), loan loss reserves, and disclosed reserves.

Tier 2 capital, on the other hand, has the following elements: subordinated term debt, hybrid capital, revaluation reserves and undisclosed reserves. The former measures banks’ ability to absorb losses while in operation. That is why the ‘core capital’ ratio, as it is commonly known, seems to be providing more protection for depositors than the ‘secondary’ or Tier 2 capital. Banks usually cater for losses with earnings first, and beyond earnings, the reserves in Tier 1 capital. This means that depositors are not affected at this stage as their deposits remain intact.

Tier 2 capital on the other hand helps to absorb losses only when the bank is winding up. In the event of losses extending beyond Tier 1 capital, the bank has to wind up. In that case, Tier 2 capital comes in to mop excess losses.

The Tier 2 capital is temporary in nature relative to Tier 1 and contains more debt than Tier 1 capital. Demirguc-Kunt et al found that Tier 1 capital is significant to market participants as they concentrate more on the constituent of capital that is available to absorb losses while the bank is still in operation. Tier 1 capital has to represent at least 50% of the total eligible capital. It is seen as the only element of banks’ capital base that is common to the banking systems of all countries in the world.

In order to specify how much risk-covering capital banks require in sustaining their operations in difficult times, bank regulators express the capital base as a percentage of the total risk-weighted assets. The risk weighting of assets varies according to each asset’s default prospect and the likely associated losses in the event of default. For instance, an unsecured commercial loan is considered riskier than a mortgage secured with the property. Thus, the former attracts a higher multiplier than the latter.

If capital adequacy ratio is high, it means the banks are capable of absorbing losses resulting from their operations. The reverse is the case where the ratio is low. The benchmark for determining whether the ratio is low or high is the minimum capital adequacy ratios set by the central banks of a particular country. Countries, such as Ghana, which have subscribed to the Basel Accords, set the ratio at 10%. The 10% implies that a bank can lose up to 10% of its assets without becoming insolvent. As indicated earlier, bank losses are catered for with earnings. However, where there are larger unexpected losses beyond earnings, they are absorbed with capital. This implies that losses from bank operations affect capital in two ways; one is where banks make large advances out of capital and they go bad. The other is where normal earnings are insufficient to take care of large losses. To cushion themselves against the losses, banks sometimes maintain more capital than what regulation imposes on them so that they can be more resilient during crises if they cannot avoid the crises in the first place. They also do so to avoid the high transaction cost of raising new equity on short notice.

Effect of capital adequacy on performance of banks

Kosmidon et al., investigated the impact of banks characteristics, macroeconomic conditions and financial market structure on banks net interest margin and return on average assets in the UK commercial banking industry over the period of 1995-2002. The results showed that capital strength was one of the main determinants of UK banks performance providing support to the argument that well capitalized banks face lower costs of going bankrupt which reduces cost of funding or that they have lower needs for external funding which results in higher profitability.

According to Attanasoglou et al, a bank with a sound capital position is able to pursue business opportunities more effectively and has more time and flexibility to deal with problems arising from unexpected losses thus achieving increased profitability. This view is shared by Naceur who studied the effects of capital regulation on cost of intermediation and profitability and concluded that capital adequacy ratio contributed positively to banks profitability. White and Morrison also argued that capital requirements ensure that banks have enough of their capital at stake. Bichsel and Blom sided with the researchers named above by arguing that capital regulations help in reducing negative externalities (e.g. general loss of confidence in the banking system) in addition to boosting the GDP.

Additionally, Cotter asserted that where shareholders’ interests are controlling, capital is an important managerial decision variable and the capital position of the wealth maximizing bank theoretically will affect its capital structure and the loan policy. To the extent that capital does affect lending, it has implications for the performance of banks as financial intermediaries and hence for the allocation of real resources within the economy.

Moreover, in a study by Hassan, which examined the performance of Islamic banks during 1994-2001, a variety of internal and external banking characteristics were used to predict profitability. The result indicated that high capital leads to high profitability. Breu also found that highly capitalized banks face lower expected bankruptcy costs and thus lower funding costs resulting into better profitability.

In a study, Haron measured the impact of some determinants of profitability and named variables such as asset structure, inflation, deposit items, liquidity and money supply as some of the factors affecting profitability of the banks. Demiurge-Kunt in his research into bank profitability found that there was a positive relationship between capitalization and profitability. He however found that there was a negative relationship between reserves and profitability.

Margarida and Mendes carried out a related study and observed in their findings that those banks that, well-capitalized banks faced lower expectancy costs and thus lower funding costs in addition to higher interest margins on assets. They also found that stiffer minimum capital adequacy ratios are associated with stronger revenue generation. In their conclusion, they pointed out that the health of a bank is cushioned by higher capital to Asset ratio.

In a like manner, Gordard investigated the profitability of European banks against the capital – asset ratio and in his findings he concluded that a positive relationship exists between the profitability of the banks and capital-Asset ratio. Mwega also found that capital requirements help to lessen the chances that banks will become insolvent if sudden shocks occur. He concluded that the higher the risk weighted capital adequacy ratio, the lower the probability that a commercial bank will be exposed to the risk of insolvency. and therefore a negative relationship exists between the risk weighted adequacy ratio and insolvency of commercial banks.

In a closely related study of factors affecting the growth of SME’s in rural Kenya, Wanjohi and Mugure focused on a number of profitability variables such as capital, interest rate, liquidity, asset base among others. They found out that the financial institutions with high capital base were more profitable than those with lower capital base relatively.

In sharp contrast to the conclusions of the above-named researchers, findings of other studies have suggested that capital adequacy has negative effect on banks’ performance. Majnoni argued that the introduction of higher capital requirements induced an aggregate slowdown or contraction of bank credit. Bank credit being the major source of banks income implies that its contraction consequently affects negatively the bank’s performance. Javapan and Tripe asserted that the proposition that there should be a negative relationship between a banks ratio of capital to assets and its return on equity may seem to be self-evident as to not need empirical evidence. Similarly,Kim and Santamero using a mean variance framework to compare the bank portfolio choice with and without solvency regulation show that capital requirements will introduce changes in the composition of the risky part of the banks’ portfolio in such a way that risk is increased and the possibility of failure may be higher.


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