The conundrum of bank capital structure: Empirical evidence from Pakistan

Abstract

This paper aims to analyze factors explaining the capital structure puzzle in the banking sector of Pakistan. Capital Adequacy Ratio (CAR) is used as a proxy for bank capital structure. Secondary data has been collected from the publications of the State Bank of Pakistan and the annual reports of banks from 2006–2017. The data is analyzed by applying the pooled OLS, fixed effect, and the GMM estimator. The determinants are grouped in (i) bank financial performance (ii) bank risk-based and (iii) industry level. Using bank financial performance indicators, the alternate cost of capital is significant, and management quality is an insignificant determinant of capital structure. Similarly, using bank risk-based variables, default risk, and credit risk is statistically significant whereas, bank risk index is statistically insignificant in explaining capital structure. Furthermore, using the industry-specific variables, both the average CAR of the banking sector and the market competitiveness proxied by the Herfindahl-Hirschman Index (HHI) is significantly predicting capital structure. Overall the bank risk-based and the industry-specific indicators are explaining bank capital structure more significantly compared to other indicators in the study. Finally, this paper included the financial crisis to observe any exogenous shocks while studying capital structure which is found to be significant in the current study.

Keywords:

• capital adequacy ratio
• dynamic panel estimation
• generalized method of moments
• scheduled commercial banks

PUBLIC INTEREST STATEMENT

This research empirically investigates explore the relationship of numerous bank-specific as well as industry-specific characteristics with banks’ capital adequacy in Pakistan. Scheduled banks are divided into conventional banks charging interest on loans and Islamic banks potentially interest-free but sharing profits and risk with borrowers. Pakistan has witnessed a transition by giving way and transforming policies to allow private commercial banks in the last two decades. Despite some challenges and inconsistent policies, the banking industry of Pakistan is one of the top growing sectors of the economy. Following internationally recognized standards and being part of the global banking community, the Pakistani banking sector needs to know and get familiarity with the determinants of its capital structure. The findings indicate the Pakistani banking sector should consider the alternate cost of capital, the risk that borrowers may not pay in time or cannot pay for its loans, and market competition from other banks.

Notes

1. Meezan Bank Limited was the first Islamic bank of Pakistan established in 2002.

Additional information

Funding

The authors received no direct funding for this research.

Notes on contributors

Bilal Sarwar

Dr. Bilal Sarwar is a Ph.D. in Finance and currently working as an Assistant Professor at the Department of Management Sciences Balochistan University of Information Technology, Engineering and Management Sciences (BUITEMS) Quetta, Pakistan. His areas of interest include Banking and Finance, Financial Econometrics, and Corporate Finance. (Email: [email protected]).

Dr. Noor Muhammad earned his Ph.D. in Finance from The University of Waikato, New Zealand. He is currently working as an Associate Professor at the Department of Management Sciences, BUITEMS, Quetta, Pakistan. He has published research papers in renowned journals like the Journal of Cleaner Production, Journal of Business Ethics, Corporate Social Responsibility & Environmental Management, and Financial Innovation.

Dr. Nadeem Uz Zaman is an Assistant Professor at the Department of Management Sciences, BUITEMS, Quetta, Pakistan.

Zia Ur Rehman is an Assistant Professor at the Department of Management Sciences, BUITEMS, Quetta, Pakistan.