«European Journal of Accounting Auditing and Fianace Research Vol.3,No.3,pp.1-20, March 2015 Published by European Centre for Research Training and ...»
European Journal of Accounting Auditing and Fianace Research
Vol.3,No.3,pp.1-20, March 2015
Published by European Centre for Research Training and Development UK(www.eajournals.org)
CAPITAL STRUCTURE AND BANK PERFORMANCE – EVIDENCE FROM SUBSAHARA AFRICA
Ebenezer Bugri Anarfo
GIMPA Business School
Ghana Institute of Management and Public Administration
P.O. Box AH 50, Achimota, Accra, Ghana
Tel: +233 21 4010681, Fax: +233 21 421 622
Cell: +233(0)267160600 ABSTRACT: This paper seeks to examine the relationship between capital structure and bank performance in Sub-Sahara Africa. This study has employed the use of panel data techniques to analyze the relationship between capital structure and bank performance. The performance variables used in the study were return on asset (ROA), Return on equity (ROE) and net interest margin (NIM). The results from Levin-Lin-Chu and Im-pesaran-shin unit root test show that all the variables were stationary in levels. The study hypothesized negative relationship between capital structure and bank performance. The results also indicate that capital structure does not determine bank performance but rather it is performance that determines banks capital structure.
KEYWORDS: Capital Structure. Bank performance, Return on Equity, Return on Asset and Net Interst margin, Total debt ratio
INTRODUCTIONRecent developments in the global economy coupled with the financial crisis and credit crunch in the last decade has made researchers developed further interests in studying the banking sector. Furthermore, due to the increasing spate of globalization, the effect of these incidents have trickled down into the African banking sector hence banks in Africa have been influenced by the changing nature of banking services worldwide (Ahmed &Rehman, 2008). Irrespective of such developments, banks are graded on the basis of their profitability, branch network and customer service. As the main functions of banks is to accumulate surplus funds and make them available to deficit sectors of the economy, they make profits through lending and borrowing activities hence, the bigger the size of the bank, the higher the expenditure.
However, competition in the banking sector has tightened due to technological advancements and major changes in the financial and monetary environment of banks (Spathis et al., 2002).
Since studies have showed an existing relationship between capital structure and bank profitability, there is the need for banks to determine their optimal capital structure to maximise their profitability and minimize losses in order to withstand the competition.
Capital structure refers to the firm's financing mix mainly debt and equity used to finance the firm. The ability of banks to carry out their stakeholders’ needs is tightly related to capital structure. Capital structure, in financial terms, means the way a firm finances its assets through the combination of equity and debt (Saad, 2010). Since the seminal work of Modigliani and Miller (1958), capital structure studies have become an important subject matter in finance theory. How a firm is been finance is of great importance to both the managers of the firm and the providers of capital. This is due to the fact that, a wrong mix of finance employed can affect European Journal of Accounting Auditing and Fianace Research Vol.3,No.3,pp.1-20, March 2015 Published by European Centre for Research Training and Development UK(www.eajournals.org) the performance and survival of the firm. This study wants to contribute to the capital structure debate on the relationship between capital structure and firm performance. This study seeks to answer the question of whether capital structure affects banks performance in Sub-Sahara Africa.
Most empirical studies that analyze the relationship between capital structure and firm performance have been done for individualcountries, thus limiting the generalizability of the results of such studies. The purpose for this study is to fill the gap related to capital structure and bank performance in Sub-Saharan Africa. Studies into capital structure and firm performance have ignored possible endogeneity of capital structure and bank performance.
Capital structure may be correlated with bank performance. Ignoring possible endogeneity may lead to inconsistent estimates (see Wooldridge, 2002 and Camaron and Trivedi, 2005).
Reverse causality has been identified by previous studies (Berger and Bonacorrsidi, 2006) as a possible cause of spurious regressions. It is possible for a firm’s performance to influences its capital structure rather than capital structure influencing firm’s performance. Therefore, this paper will test for reverse causality by performing Granger causality tests on the relationships between capital structure and bank performance in sub-Sahara Africa.The main aim of this paper is to examine the impact of capital structure on the performance of banks in Sub-Saharan Africa.
Main Hypothesis The following main hypothesis will be tested;
Ho: there is no relationship between capital structure and bank performance in Sub-Sahara Africa.
H1: there is a relationship between capital structure and bank performance in Sub-Sahara Africa The motivation of this study is to fill a gap in the literature. Most capital structure studies havebeen done for developed countries. Examples of such studies include the work of Rajan and Zingales (1995) done for G-7 countries; Bevan and Danbolt (2000 and 2002) also utilize data from UK and France; and Hall et al. (2004) used data from European SMEs. There are a few studies that provide evidence from developing countries; for example, Boot et al. (2001) analyze data from only ten developing countries. Among all studies on capital structure, some have used cross-country studies, or a study on a particular region or country. However there is little or no work done on the capital structure of banks and how banks capital structure affects their performance in Sub-Sahara Africa. This study seeks to bridge the gap by analyzing capital structure and bank performance; evidence from Sub-Sahara Africa.
By analyzing capital structure and bank performance, there is the possibility of endogeneity problem between capital structure and bank performance.This study shall also address the endogeneity problem if it exists. Studies into capital structureand performance have ignored possible endogeneity of capital structure and bank performance. Capital structure may be correlated with bank performance. Ignoring possible endogeneity may lead to inconsistent estimates (see Wooldridge, 2002 and Camaron and Trivedi, 2005). The main objective of this study is to examine the relationship between capital structure and bank performance.
Many studies have developed theoretical frameworks and conducted empirical tests to explain how firms chose between debt and equity and their relative proportion in firm financing (Baker and Wurgler, 2007), (Meier and Tarhan, 2007), and (Dittmar and Thakor, 2007). Others like Guedes and Opler, (1996) and Krishnaswami, Spindt, and Subramanian (1999) analyse debt issues from the perspective of agency theory and costs stemming from moral hazard problems.
The point is that debt, arguably, can resolve agency problems between the shareholders and bondholders on one hand, and shareholders and managers on the other (Jensen and Meckling, 1976 and Jensen, 1986). Managers are believed to have no option other than being efficient where their organizations are significantly leveraged. This implies that firms leverage level can constrain and monitor managerial behaviour. Moreover, the use debt financing do not dilute shareholders voting right. The use of debt financing has the potential of increasing the risk of financial distress. The use of debt financing minimizes the problem of adverse selection unlike equity financing (Meier and Tarhan, 2007).
Some studies have concluded that the relationship between capital structure and firm performance is both positive and negative (Tian,et.al,) 2007;Tsangyaa,et.al.2009; Saeedi and Mahmoodi,2011;Abor,2005;Oke and Afolabi,2008),others concluded that the relationship is negative (Narendar,et.al.2007; Pratheepkanth, 2011;Shah,et.al.2011; Onaolapo and Kajola, 2010).Yet,other studies have documented a positive relationship (Shoaib and Siddiqui,2011;
Aman,2011; Chowdhury and Chowdhury,2010; Omorogie and Erah, 2010; Akintoye, 2008).With these mixed and conflicting results, the quest for examining the relationship between capital structure and firm performance has remained a puzzle and empirical study continues.
THEORETICAL LITERATURE REVIEW ON CAPITAL STRUCTURE
Trade-Off Theory of Capital Structure The trade-off theory of capital structure states that a firm’s choice of its debt – equity ratio is a trade-off between its interest tax shields and the costs of financial distress.The trade-off theories suggest that firms in the same industry should have similar or identical debt ratios in order to maximize tax savings. The tax benefit among other factors makes the after-tax cost of debt lower and hence the weighted average cost of capital will also be lower. Brigham and Gapenski (1996) argue that an optimal capital structure can be obtained if there exist tax benefit which is equal to the bankruptcy cost. It can be concluded that, there is an optimal capital structure where the weighted average cost of capital is at its minimum.
However, as a firm leverage ratio rises, tax benefits will eventually be offset by increases bankruptcy cost. The trade-off theory sought to establish an optimal capital structure where the weighted average cost of capital will be minimized and the firm value maximized. At the optimal level of capital structure, tax benefit will be equal to bankruptcy costs. Despite the theoretical appeal of debt financing, researchers of capital structure have not found the optimal capital structure (Simerly& Li, 2002).
Agency Theory of Capital Structure The agency cost theory of capital structure emanates from the principal-agent relationship (Jensen and Meckling, 1976). In order to moderate managerial behavior, debt financing can be used to mediate the conflict of interest which exists between shareholders and managers one European Journal of Accounting Auditing and Fianace Research Vol.3,No.3,pp.1-20, March 2015 Published by European Centre for Research Training and Development UK(www.eajournals.org) hand and also between shareholder and bondholders on the other hand. The conflict of interest is mediated because managers get debt discipline which will cause them to align their goals to shareholders goals.
Jensen and Meckling (1976) and Jensen and Ruback (1983) argue that, managers do not always pursue shareholders interest. To mitigate this problem, the leverage ratio should increase (Pinegar and Wilbricht, 1989). This will force the managers to invest in profitable ventures that will be of benefit to the shareholders. If they decide to invest in non-profit tax businesses or investment and are not able to pay interest on debt, then the bondholders will file for bankruptcy and they will lose their jobs. The contribution of the Agency cost theory is that, leverage firms are better for shareholders as debt can be used to monitor managerial behavior (Boodhoo, 2009). Thus, higher leverage is expected to lower agency cost, reduce managerial inefficiency and thereby enhancing firm and managerial performance (Jensen 1986, Koehhar 1996, Aghion, Dewatnipont and Rey, 1999).
Pecking Order Theory of Capital Structure From the foregoing analysis, the focus on the use of debt has been on only the economic gains and benefits of the formation of optimal capital structure. The pecking order theory is geared towards the signaling effect of the use of debt financing. According to the pecking order theory firms prefer financing their operations from internally generated funds, because the use of such funds does not send any negative signal that may lower the stock price of the firm. If internal finance is required, firms prefer to issue debt first before considering the issue of equity. This pecking order occurs because issuing debt is less likely to send a negative signal to investors.
If a firm should issue equity it sends a negative signal to investors that the firm’s share prices are overvalued that is why the managers are issuing equity. This will cause investor to sell their shares leading to a fall in the stock price of the firm. A share issue is thus interpreted by the market as a bad omen but debt is less likely to be interpreted this way. Firms therefore prefer to issue debt rather than equity if internal finance is insufficient. The pecking order theory is therefore a competing theory of capital structure that says firms prefer internal financing.
THEORETICAL FRAMEWORK AND METHODOLOGYA number of firm-level characteristics have been identified in previous empirical studies examining capital structure and these include; firm size, asset tangibility, profitability and growth. These are discussed in turn.
Debt Ratio (DR) The dependent variable used in this paper is the Debt Ratio (DR). According to the agency cost theory of capital structure, high leverage is expected to reduce agency cost, reduce inefficiency and eventually leads to improvements in firm’s performance. Berger 2002 argues that an increase in the leverage ratio should result in lower agency costs outside equity and improve firm’s performance, all other things being equal. From the analysis above an inverse relationship is expected to be between leverage (DR) and firm performance.
Firm Size The size of the firm is a very important determinant of its profitability that is why it is included as a controlled variable. Firm size has a positive relationship with short-term debt ratio (Abor J. 2008). According to Penrose (1959), larger firms enjoys economies of scale and economies European Journal of Accounting Auditing and Fianace Research Vol.3,No.3,pp.1-20, March 2015 Published by European Centre for Research Training and Development UK(www.eajournals.org) of scope and this has the tendency to impact its profitability, larger firms can also increase their market power and this will have an impact on its profitability and performance. Larger firms can take on more debt or increase leverage since their profits are high enough to service their debt Shepherd (1989).