Annals of Financial Economics

The Causal Relationship Between Bank Capital and Profitability
David E. Hutchison and Raymond A. K. Cox 1 Westwood Development Group and University of Ontario Institute of Technology

Abstract: The relationship between capital structure and return on equity is examined.
It is shown that for banks in the U.S., for the relatively less regulated 1983 to 1989 period as well as the more highly regulated 1996 to 2002 period, there is a positive relationship between financial leverage and the return on equity. The analysis is extended to determine the relationship between return on assets and equity capital. The evidence supports the hypothesis that there is a positive relationship between equity capital and return on assets.

Relevance to Practice: Previous empirical evidence for U.S. banks had indicated a perverse negative relationship between financial leverage and the return on equity for the 1983 to 1989 period. The cause of such an association was attributed to a reputation effect for large banks who adopted an aggressive capital structure. These contrary findings coupled with regulations on improving equity capital adequacy from the Basel II accord supported the efforts to promote a reduced capital structure risk posture by banks. However, these opposite results conflicted with traditional thought from the DuPont analysis wherein, when operating profitability is positive, increased financial leverage augments the return on equity. Thus, banks continue to have an incentive to ratchet up their financial leverage so as to increase the returns to stockholders albeit with increased financial risk.

Key Words: Banks, Capital Profitability JEL Classification: G21, G32

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Contact: Raymond A. K. Cox*, Faculty of Business & IT, University of Ontario Institute of Technology, Oshawa, Canada; Tel.: 905-721-8668; Fax: 905-721-3167; Email: raymond.cox@uoit.ca.

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Annals of Financial Economics The relationship between capital