Tier 1 capital is the core measure of a bank's financial strength which includes only permanent shareholders' equity (issued and fully-paid ordinary shares/common stock and perpetual non-cumulative preference shares) and disclosed reserves (created or increased by appropriations of retained earnings or other surplus, e.g. share premiums, retained profit, general reserves and legal reserves) [3]
Tier II capital is used to measure the financial strength of a bank and is the second most reliable form of financial capital [4] . It includes Revaluation of assets (a reserve created when a company has an asset revalued and an increase in value is brought to account), Undisclosed reserves (Reserves that are not burdened to any liabilities), General Provision (shelter against those losses whose actual impact is not known), Hybrid instruments which are the capital instruments having the debt & equity characters and Subordinated debts (includes conventional unsecured subordinated debt capital instruments with a minimum original fixed term to maturity of over five years and limited life redeemable preference shares) [5]
Tier III capital is used to support market risk, commodities risk and foreign currency risk.. Tier 3 capital debts may include a greater number of subordinated issues, undisclosed reserves and general loss reserves compared to tier 2 capital [6] .
Banks play a leading role in mobilizing savings, allocating capital, overseeing investment decisions of corporate managers, and providing risk management vehicles (Asli Demirgiu-Kunt, Harry DHuizIi) [7]
Capital structure is the combination of a firm's debt (long-term debt and short-term debt) and equity (common equity and preferred equity). So the Capital structure is the firm's various sources of funds used to finance its overall operations and growth. Debt is in the form of bond issues or long-term notes payable, while equity consists of common stock, preferred stock, or retained earnings. Each financing option has its own advantages and disadvantages and management always tries to find out the best combination to finance their capital. (Joshua Kennon) [8]
There is an optimal capital structure which is the best combination of equity and debt financing, on this level of optimization cost of the capital is minimum and value of the firm is maximum (Eugene F. Brigham) [9] .
The concept of capital structure is very important for any firm. It not only helps in determining the return a company earns for its shareholders and also shows whether or not a firm survives in a recession or depression (Joshua Kennon).
Equity financing is composed of funds that are raised by the business itself. This financing can be raised by the owners of the firm or by adding more peoples in the ownership i.e. issuing the shares of the company. There is certain amount paid against these share and the shareholders get dividend against those shares or against that money they have invested in the company. It depends on the company's policy that how much capital they need and how much capital should be raised through shares. Mostly those companies use equity financing which have high growth rate because they can give high return to the investors and can be attractive for the investors
Many consider equity capital is the expensive type of capital because its "cost" is the return the firm must earn to attract investment (Joshua Kennon)
Debt financing means borrowing money to run the business. The amount of debt that a firm uses to finance its assets is also called leverage. Debt Financing constitutes of Long term debt and Short term Debt based on the type of money one borrows. Interest rates for long term debt and short term are different and vary from situation to situation and firm to firm.
Long term debt means the money one borrows for financing the assets which can be used by the firm for longer periods. e.g.; Purchase of Assets, machinery, land etc. Long term debt is commonly called Long term loans or long term liability of the firm. The scheduled payment of long term loan is usually extended for more then 1 year. In the case of Banks their Sub-Ordinated Loans are Long term in nature because they are mostly for more then 1years depending on the nature on loan.
Short term debt is the money that is used for daily basis business operations like purchasing of inventory or paying the wages. Short term financing is referred to operating loan or short term loan and its scheduled payment takes place within the year. Usually short term loan is taken for some days or 3-6 months. Banks usually take loan from other financial institutions for very short period just to fulfill their daily requirement.
There are different theories of capital structure, traditional theory of Capital Structure says that use of more proportion of Debt in capital structure can be effective as it is less costly then equity but it also has some limitations. After the certain limit it will affect company's leverage. [10] Trade off theory [11] states that there is an advantage to finance with debt, the tax benefits of debt and it refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits
Stewart C. Myers and Nicolas Majluf (1984) [12] states that companies prioritize their sources of Financing (from internal financing to equity) according to the Principle of least effort, According to them, internal funds are used first, and when there are no more benefits from internal funding debt should be issued and as a last option equity should be issued. (Pecking Order Theory)
In the light of these theories and literature there are advantages and disadvantages for debt as well as equity financing [13] . Benefits attached with debt financing are, company can retain maximum control over their business and the interest on debt financing is tax deductible which means that debt financing has tax benefit.
There are also some disadvantages for debt financing. Too much debt can cause problems if company begin to rely on it and do not have the revenue to pay it back. Also too much debt will make the company unattractive to investors who will view you as "high risk" and will charge more while issuing the debt.
While talking about equity financing, this appears to be "easy money" because it involves no debt and there is no need to worry about repayment in the traditional way. As long as your business makes a profit, the lenders will be repaid and with the help of investors, your business becomes more credible and may win new attention from the lenders' networks. Disadvantage is that company can lose its complete control and autonomy, now investors will also have part in decision making. Too much equity may indicate to potential funders that company is willing to take the necessary personal risks, which could signify a lack of belief in your own business venture.
CAPITAL STRUCTURE IN BANKING
Banks and other depository institutions are specialized businesses whose capital structures are affected by a number of conditions unique to the banking industry, such as government regulation and access to a federal safety net that includes deposit insurance and borrowing. Capital structure theories can help explain the choices banks made on raising capital during the financial crisis. Under the pecking order theory, when banks have private information about their assets, they would choose to issue debt before equity to minimize the undervaluation problem. But, during the financial crisis, banks needed to raise equity to refill useless capital. At that time though, the information asymmetry regarding bank asset portfolios was so severe that equity could generally be issued only at a substantial discount. In that environment, issuing preferred stock may have been a reasonable strategy because it avoided diluting common equity while restoring the balance of equity and debt financing and meeting regulatory capital requirements. Issuing new common equity at a discount would have transferred wealth from existing to new shareholders. And, issuing new debt would have increased the probability of default, with the associated risk of losing control rights. Unlike debt service payments, preferred stock dividends can be suspended without triggering bankruptcy. Because preferred stock claims are junior to debt claims, investors would demand a higher rate of return. In order to lower dividends, banks could issue convertible preferred stock, which gives holders the right to convert preferred shares into common stock at a pre specified price. In effect, the issuing firm is giving the preferred stockholders a call option on the firm's common stock in return for a lower dividend rate.
The cost of capital determines how a company can raise money (through a stock issue, borrowing, or a mix of the two). Cost of raising money can be reduced with the best combination of equity and debt financing.
In the case of banks there are some regulations from the central bank related to the minimum requirement of holding the capital. Despite of the cost of holding that capital banks have to fulfill that requirement.
"Because of the high costs of holding capital bank managers often want to hold less bank capital than is required by the regulatory authorities. In this case, the amount of bank capital is determined by the bank capital requirements (Mishkin, 2000, p.227)." [14]
To investigate the relationship between Capital Structure and Profitability of Banks there are many variables that can be used. To measure the capital structure Gearing ratio and Equity multiplier are used as used by "Joshua Abor" [15] and "Chin, Ai Fu" [16] and profitability is measured by variables like ROA, ROE and NIM (Joshua Abor, Demirgiu-Kunt and Harry DHuizIi [17] ).
Variables are selected after going through different papers like Asli Demirgiu-Kunt and Harry DHuizIi took ROA and NIM to measure the profitability of banks. Chin, Ai Fu (1997) while finding the relationship between capital structure and profitability focused on Debt to equity, Return on Investment. There are also some variables that are used to consider while measuring the profitability of the banks like Efficiency ratio, burden ratio, earning base ratio and interest spread ratio etc. These profitability ratios are linked with the financing decision of the Bank i.e. Capital Structure
If we talk about ROA, choice of capital structure influence this ratio because of the treatment of interest in calculating taxes and a company with a high debt pays less taxes (due to higher interest expense) compared to a company with no debt [18] .
ROA also resolves a major shortcoming of return on equity (ROE). ROE is the most widely used profitability metric but it doesn't tell us if a company has excessive debt or is using debt to drive returns. This information can be gathered through ROA, in a sense that denominator in ROA is total assets which also includes liabilities like debt (Assets = liabilities + shareholder equity). So lower the debt, higher the ROA [19] .
This equation assets = liabilities + shareholders' equity also shows that if a company carried no debt, its shareholders' equity and its total assets would be the same which means that their ROE and ROA would also be the same.
But if that company took on financial leverage, ROE would rise above ROA. Reason is because shareholders' equity = assets - liabilities. By taking on debt, a company increases its assets because of the cash that comes in. But since equity equals assets minus total debt, so when debt increases, equity shrinks, and since equity is the ROE's denominator, ROE will get a boost [20] .
This measure is also influenced by capital structure decision. There are three main drivers of ROE: profitability, productivity, and capital structure [21] . The finance department at DuPont identified these components as profit margins, asset turnover, and financial leverage. So if there is any change occurs in the proportion of debt and equity, this measure will be affected because according to DuPont equation ROE is linked with Equity Multiplier and Capital Structure. Denominator of ROE is Shareholder's equity and if company raises debt the portion of equity will shrink and if that portion shrinks this will results in high ROE.
Net Interest Margin is a performance metric that examines how successful a firm's investment decisions are compared to its debt situations. A negative value denotes that the firm did not make an optimal decision, because interest expenses were greater than the amount of returns generated by investments. [22]
Efficiency Ratio is a ratio that is typically applied to banks, in simple terms is defined as expenses as a percentage of revenue (expenses / revenue), with a few variations. A lower percentage is better since that means expenses are low and earnings are high. It is related to operating leverage, which measures the ratio between fixed costs and variable costs. [23]
A bank with a low burden ratio is better. An increasing trend would show lack of burden bearing capacity [24]
Interest spread is the difference between the average lending rate and the average borrowing rate for a bank or other financial institution. It is:
(Interest income ÷interest earning assets) - (interest expense ÷interest bearing liabilities)
This is very similar to interest margin. If a bank's lending was exactly equal to its borrowings (i.e. deposits plus other borrowing) the two numbers would be identical. In reality, bank also has its shareholder's funds available to lend, but at the same time its lending is constrained by reserve requirements. [25]
Changes in the spread are an indicator of profitability as the spread is where a bank makes its money.
ARTICLES
Nicos Michealas, Francis Chittenden and Panikkos Poutziouris [26] (1998) consider diverse non-financial and behavioral factors which influence capital structure decisions. They used exploratory method of conducting interviews for their study. They found that there are some factors like need for control, experience, mind perception and social norms etc made certain belief about debt and this belief make their attitude toward using of debt proportion in their capital structure. There are also large numbers of small firm owners who prefer to rely on internal generated funds rather than raising external finance.
John C. Groth and Ronald C. Anderson [27] (1997) defined capital structure and examined its influence on the cost of capital and the value of a company. There is no equation exist to determine the optimal capital structure for firm. Proper use of debt and equity in capital structure lowers the weighted cost of capital and that low weighted cost of capital helps in increasing the value of the firm.
Arun Upneja and Michael C. Dalbor [28] (2001) examined the capital structure decisions of restaurant firms in USA. Pecking-order theory and position of the firm in the financial growth cycle are the bases for their study. Their result showed that both pecking-order and financial growth cycle influence capital structure decision of the restaurant firms. They found some separate factors which influence long term and short term debt decisions of the restaurant firms
Mohammed Amidu [29] (2007) investigates dynamics involved in the determination of capital structure of banks in Ghana. The variables that are covered in this research article are profitability, growth, tax, asset structure, risk and size. This study highlighted the links between long and short forms of debt while making capital structure decisions. It is found that long-term debt structure is positively and statistically related to operating assets. While short-term debt and leverage move in same direction. The study suggests that profitability, corporate tax, growth, asset structure and bank size are important variables to influence banks' capital structure.
Rajeswararao Chaganti and Fariborz Damanpour [30] (Oct., 1991) tried to answer two main questions. One what are the relationships between outside institutional shareholdings, on the one hand, and a firm's capital structure and performance? And secondly does the size of stockholdings by corporate executives, family owners, and insider-institutions modify those relationships? They have collected data from 40 pairs of manufacturing firms and found that the size of outside institutional stockholdings has a significant effect on the firm's capital structure and family and inside institutional owners' shareholdings moderate the relationship between outside institutional shareholdings and capital structure.
Mohamad Khan Bin Raji Jamal [31] (1994) examined the influence of capital structure, particularly in the presence of market imperfections on firm's profitability. The effect of corporate taxes, interest expense, debt level and equity size was also analyzed by him. The findings of this research paper are that higher debt level results in a lower profitability and higher profitability associates positively with taxation expense but negatively with interest expense.
F. Voulgaris, D. Asteriou and G. Giomirgianakis [32] (2004)investigate the determinants of capital structure of Large Size Enterprises (LSEs) in the Greek manufacturing sector. The findings show that asset utilization, gross and net profitability and total assets growth have a significant effect on the capital structure of LSEs. Greek LSEs will face higher debt levels in the future that will arise mainly from higher short-term debt ratios. The ratios such as asset profitability, asset structure, return on equity, inventory turnover and liquidity which came out as significant determinants of capital structure in other empirical studies did not prove to be significant in this study.
Guorong Jiang, Nancy Tang, Eve Law and Angela Sze [33] (2003) have tried to answer the question of "whether both bank-specific as well as macroeconomic factors are important determinants in the profitability of banks" and "A profitable banking sector is better to resist against negative shocks and contribute to the stability of the financial system or not". They conclusion of their study is that a profitable banking sector can better resist against negative shocks and can help in stable financial system. In terms of bank-specific factors, operational efficiency is the most important factor in explaining differences in profitability and macroeconomic developments have also an important effect on bank's profitability.
Chiang Yat Hung, Chan Ping Chuen Albert, Hui Chi Man Eddie [34] (2002) shows the inter-relationship between profitability, cost of capital and capital structure among property developers and contractors in Hong Kong. The data for this research paper was collected from Datastream, an electronic financial database. The analysis of this paper shows that gearing is generally higher among contractors than developers and capital gearing is positively related with asset but negatively with profit margins.
Panayiotis P. Athanasoglou, Sophocles N. Brissimis, Matthaios D. Delis [35] (2005) found the determinants of profitability in banking sector. According to their study size of the bank, financial strength, ownership status, operating expanse, cost decisions of bank's management are the major factors influencing the profitability of Banks.
