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 1989period 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 IIaccord 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 thereturns to stockholders albeit with increased financial risk.
Key Words: Banks, Capital Profitability JEL Classification: G21, G32
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: email@example.com.
Annals of Financial Economics The relationship between capitalstructure and return on equity is of considerable importance to all firms. The banking industry is especially sensitive to changes in financial leverage due to their low level of equity capital to total assets. In addition, the capital structure of banks is highly regulated. One such regulator is the Federal Deposit Insurance Corporation (FDIC) insuring the retail deposits of banks. This makes theFDIC the bank’s largest potential credit risk holder. Prior to the passage of the Federal Reserve Deposit Insurance Corporation Improvement Act (1991) deposit insurance was a flat rate. Subsequently, deposit insurance pricing was tied to a reserve standard reflecting past bank performance as opposed to a forward-looking risk measure. Thus, banks have an incentive to increase their risk throughboth riskier loans and greater financial leverage to increase their return to equity. The purpose of this paper is to examine the relationship between bank capital and operating returns, specifically return on equity and return on assets. Marcus (1984) noted that regulatory changes raising (reducing) barriers to competition can increase (decrease) the value of bank charters. To the extent bankcharter value is lost when a bank fails the bank has an incentive to lessening the likelihood of bankruptcy by strengthening its capital structure using infusions on equity capital. Keeley (1990) argued that the high failure rate of banks during the 1980s can be attributed to risk-taking incentives provided by fixed-rate deposit insurance. Berger (1995) examines the relationship between bank equitycapital and accounting return on equity from 1983 to 1989. He found an anomalous positive causal relationship attributed to bankruptcy costs reflected in borrowing rates. Several recent studies including Flannery and Sorescu (1996), Jagtani, Kaufman and Lemieux (2002), Morgan and Stiroh (2001), Evanoff and Wall (2001) and Sironi (2001) found evidence that subordinated debt credit spreads reflect...