Proposal
Proposal
Proposal
References
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Capital adequacy has become one of the most significant factors for assessing the
soundness of banking sector. Raise and utilization of funds are the primary functions
of commercial banks. As such, commercial banks collect a large amount of deposits
from general public. The depositors think that depositing their money in a bank is safe
and relaxing. But, what does happen if the bank does not have enough capital funds to
provide a buffer against future, unexpected losses? Therefore, capital must be
sufficient to protect a bank’s depositors and counterparties from the risks like, credit
and market risks. Otherwise the banks have to use all the money of depositors in their
own interest and depositors have to suffer loss (Vaidhya, 2014).
Basel III reforms are the response of the Basel Committee on Banking Supervision
(BCBS) to improve the banking sector’s ability to absorb shocks arising from
financial and economic stress, whatever the source, thus reducing the risk of spill over
from the financial sector to the real economy. Basel III reforms strengthen the bank-
level i.e. micro prudential regulation, with the intention to raise the resilience of
individual banking institutions in periods of stress. Besides, the reforms have a macro
prudential focus also, addressing system wide risks, which can build up across the
banking sector. These new global regulatory and supervisory standards mainly seek to
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raise the quality and level of capital (Pillar 1) to ensure that banks are better able to
absorb losses on both a going concern and a gone concern basis, increase the risk
coverage of the capital framework, introduce leverage ratio to serve as a backstop to
the risk-based capital measure, raise the standards for the supervisory review process
(Pillar 2) and public disclosures (Pillar 3) etc. The macro prudential aspects of Basel
III are largely enshrined in the capital buffers. Both the buffers i.e. the capital
conservation buffer and the countercyclical buffer are intended to protect the banking
sector from periods of excess credit growth (Nepal Rastra Bank, 2021).
The study is based on the capital funds of the banks which are supposed to be
adequate as per the NRB directive no. 1, which is related with the capital adequacy
norms for commercial banks. The norms basically emphasize on the basic
requirement of the capital fund that a commercial bank should possess. The
fundamental objective of the norms is to safeguard the interest of the depositors as per
these norms; bank capital has been divided into two categories which are generally
known as Tier-1 and Tier-2.
Capital adequacy generally affects all entities. But as a term, it is most often used in
discussing the position of firms in the financial section of the economy, and precisely,
whether firms have sufficient capital to cover the risks that they confront (Abba,
2013). This has forced regulators to define several control procedures and issue new
reforms in order to avoid insolvency in the banking sector. Capital adequacy ratio is
the ratio of an eligible regulatory capital (tier 1 and tier 2) to its risk weighted assets
(Apostolic, Christopher & Peter, 2009).
Athanasoglous, Brissimis and Delis (2005) stated capital is essential and critical to the
perpetual continuity of bank as a going concern. A minimum amount of capital is
required to ensure safety and soundness of the bank. It is also required to build trust
and confidence of the customers. A bank with a sound capital position is able to
pursue business opportunities more effectively and has more time and flexibility to
deal with problems arising from unexpected losses thus achieving increased
profitability. (Nepal Rastra Bank, 2021) a capital is required by a bank as a cushion
to absorb losses, which should be done by shareholder and to finance the
infrastructure of the business.
minimum total capital (MTC) of 8.5 percent of total risk weighted assets (RWAs) i.e.
capital to risk weighted assets (CRAR). Banks must maintain proper liquidity in order
to be able to pay it is obligations in the short run and maintain adequate profitability
to enhance solvency and to gain trust by customers and shareholders. Banks should
maintain it is earning assets, such as loans and advances, bonds, government
securities, stocks. As well as, banks are required to generate revenues to meet
operating costs, maximizing shareholders’ wealth, and show management efficiency
(Nepal Rastra Bank, 2021).
Berger (1995) found evidence for a positive relationship between the ratios of capital
to assets and returns on equity. The study further, argued that a higher capital ratio
(with reduced risk of bankruptcy) should reduce a bank’s cost of funds, both by
reducing the price of funds and the quantity of funds required, thus improving a
bank’s net interest income and hence profitability. Smirlock (1985) found a positive
and significant relationship between size and bank profitability. Additionally,
Pasiouras and Kosmidou (2007) also found that larger banks might have a higher
degree of production and loans diversification than smaller ones. Naceur and Goaied
(2008) studied the banking performance of twelve Tunisian deposit banks over the
period of 1995-2005 and found a significant positive relationship between size and
return on assets. Similarly, Sinkey and Greenawalt (1991) concluded that larger banks
are more profitable than smaller ones.
Banks with higher capital are capable of absorbing any negative shocks and assumed
to possess less insolvency. Higher capital may also incentivize shareholders to
monitor management activities; therefore lower the probability of taking an excessive
risk by managers. On the other hand, the risk-return hypothesis states that there is a
direct relationship exist between risk and return; a higher capital ratio decreases the
risk of the firms and leads to lower performance of the banks (Budathoki & Rai,
2020).
The management efficiency is measured by how much they gain profits. The bank
may expose into insolvency if it fails to generate profits. Profitability is a key target
for all financial institutions as banks must keep adequate liquidity amounts so as to
maintain the continuity. They are one of the most important sources Key to generate
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capital. Without profits banks are not be able to attract external capital to strengthen
its investments and co-existence with the competition (Shrestha & Niraula, 2021).
In the context of Nepal, Pradhan and Bhattarai (2016) revealed that there is negative
impact of financial leverage on return on assets, return on equity as well as net interest
margin of banks. Debt to equity has negative relationship with return on equity and
net interest margin. Udas (2007) revealed that there was significant impact of NRB
directives of capital adequacy on the various aspects of the commercial banks and it
also helped in maintaining the stability of commercial banks in the financial market
and to uplift the banking sectors in Nepal to international standard.
Marahatta et al. (2016) indicated that higher the quality of assets, bank size and
liquidity of banks, higher would be the return on assets. Further, Joshi (2004)
analyzed financial performance through the use of appropriate financial tools and to
show the cause of change in cash position of the two banks. The study found that
liquidity and banks loan are positively related to bank profitability. Karki (2004)
found the positive relationship between capital adequacy and profitability. Joshi
(2004) found that liquidity and banks loan are positively related to banks profitability.
Similarly, Maharjan (2007) revealed that the capital adequacy and liquidity is
positively related to the bank profitability.
The above discussion reveals that there is no consistency in the findings of various
studies concerning capital adequacy, cost income and banks performance. Therefore,
this study has been conducted to analyze the capital adequacy position and its impact
on profitability of Nepalese commercial banks. This study has the following issues;
What is the level of capital adequacy of commercial banks in Nepal?
What is the level of profitability of commercial banks in Nepal?
How capital adequacy affect the profitability of commercial banks?
The main objective of this study is to examine the effect of capital adequacy into the
profitability of commercial banks, so as to highlight the role played by these banks to
strengthen the profitability of the Nepalese banking system. So, this thesis will be a
new study in the field of banking sector. Thus, the thesis has of course presented some
results which reflect the capital structure and position of commercial banks of Nepal.
Only the effect of capital adequacy of the bank is evaluated in this study and
the qualitative and external variables that affect the performance of the bank
have not been considered in the study.
For analysis purpose, secondary data is used through published reports of the
banks are used and the reliability of the data depends on the report.
Expected costs associated with financial distress takes a substantial bite out of a firm
value providing an opposing force to the tax advantage of additional debt. On the
other hand, it is argued that capital is very costly. Investors demand a premium to
compensate for increased bankruptcy risk associated with the probability of financial
distress and proportionately low capital ratio. In order to generate an “adequate”
return on equity, commercial banks have to incur higher risks to receive higher risk
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premium on their investments the higher the level of capital. Thus, increased risk
requires greater proportions of equity in the firm’s capital structure to prevent an
inefficient cost of capital. The net effect of this negative incentive effect and the
buffer effect is ambiguous. It is possible that the default risk increases as the level of
capital is increased (Brealey & Myers, 2003).
indicates that higher the cost income ratio and liquidity ratio, lower would be the
return on equity. The regression results show that bank size has positive impact on
bank performance. However, the study reveals that capital adequacy ratio, cost
income ratio, and equity capital to total assets has negative impact on return on assets.
Okoye, Ikechukwu, Leonard, Chinyere and Christian (2017) analyzed effect of capital
adequacy on financial performance of quoted deposit money banks in Nigeria. the
objective of this study was to ascertain the effect of capital adequacy on financial
performance with a focus on selected quoted deposit money banks in nigeria. the data
were subjected to statistical analysis using pearson coefficient of correlation, multiple
regression analysis, variance inflation factors, multicollinearity, heteroskedasticity test
and hausman test. The result of this study revealed that there is a positive and
significant relationship between capital adequacy and financial performance. it was
also empirically verified that capital adequacy has a statistically significant effect on
financial performance on deposit money banks at 5% level of significance.
Ramadhanti, Marlina and Hidayati (2019) examined the effect of capital adequacy,
liquidity and credit risk to profitability of commercial banks. The stduy was
conducted to determine the effect of capital adequacy, liquidity and credit risk toward
profitability. The sample for this study was selected using the method of purposive
sampling and obtained 27 banks. Data analysis was done using Microsoft Excel and
hypothesis testing in this research using Data Panel Regression Analysis with the E-
Views program. This study found that capital adequacy (CAR) has a significant
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positive effect on profitability (ROA), liquidity (LDR) has a positive and significant
effect on profitability (ROA), credit risk (NPL) has a negative effect and significant to
profitability (ROA).
Chalise (2019) examined the impact of capital adequacy and cost-income ratio on
performance of Nepalese commercial banks. This study aimed to analyze the impact
of capital adequacy and cost-income ratio on performance of Nepalese commercial
banks. The descriptive research designs have been adopted for the study. The study is
conducted using panel data of 10 commercial banks operated in Nepali economy with
100 observations for the period 2007/8 to 2016/17. The dependent variables is return
on asset which measure bank performance while the independent variables are bank
size, Debt-equity ratio, cost-income ratio, Equity ratio, Total capital adequacy. For the
purpose of this study, the secondary data have been used. Fixed Effect Model (FEM)
of panel data analysis is used as a major tool of analysis the regression results
revealed that Cost-income ratio has negative significant impact on banks performance
and total capital adequacy has negative insignificant impact with bank performance
(ROA) whereas debt-equity ratio and bank size has positive insignificant impact with
bank performance and equity ratio has positive significant impact on bank
performance which indicates that higher equity ratio the higher would be bank
performance. This study concludes that there is negative impact of cost-income and
capital adequacy on bank performance.
position of the banks through average value, standard deviation, maximum and
minimum which describe the characteristics of data of sample banks and casual
research design supports to analyze the effect of capital adequacy on profitability of
banks in the study.
Bank Size
(Source: (Pradhan & Parajuli, 2017; Gautam, 2019; Shrestha & Noraula, 2021)
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Bank Size
Bank size is generally used to capture potential economies or diseconomies of scale in
the banking sector (Bhattarai, 2017). Larger banks tend to be more active in markets,
have a greater product and have better possibilities for diversification (Lehar, 2005).
Natural logarithm of total assets of the banks is used as a proxy for bank size. It is
expected to have positive relationship with banks profitability.
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Return on Assets
Return on Assets is the yield or return on total assets invested in the operations of an
organization. It measures organization profitability, equal to a fiscal year’s earnings
divided by its total assets expressed as a percentage. Investors usually look for banks
with higher return on assets. In this study the bank performance is only measure by
return on assets (Chalise, 2019). For banks with similar risk profiles, ROA is a useful
static for comparing bank profitability as it avoids distortions produced by differences
in financial leverage (Sinkey and Joseph, 1992). It is more suitable for comparing the
banks in the same industry than other measures of performance. Thus, return on assets
(ROA) is chosen as the performance measure for this study.
Return on Equity
The ROE is said to measure the rate of return on the bank's shareholders equity
and it is calculated by dividing banks net income after tax by total equity capital
which includes common and preferred stock, surplus, undivided profits, and
capital reserve (Molyneux & Thornton, 1992). ROE is what the shareholders
look in return for their investment. A business that has a high return on equity is
more likely to be one that is capable of generating cash internally. Thus, the
higher the ROE the better the company is in terms of profit generation. ROE
reflects how effectively a bank management is using shareholders’ funds
(Khrawish, 2011).
Arithmetic Mean
The arithmetic mean or simple mean of set of observations in the sum of all the
observation divided by the number of observations. It is the best value, which
represent to the whole group mean is the arithmetic average of a variable. Arithmetic
mean of a series is given by:
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Mean ( – ) =
Where,
– = denotes arithmetic mean, n denotes the no. of periods and x1, x2
…… x are the individual observations.
Standard Deviation
Standard deviation is defined as the positive square root of the mean of square of the
deviation taken from the arithmetic mean. It indicates the ranges and size of deviance
from the middle or mean. It measures the absolute dispersion. Higher the standard
deviation higher will be the variability and vice versa. Dispersion measures the
variation of the data from the central value. In other words, it helps to analyze the
quality of data regarding its variability. It is calculated as:
Standard Deviation (SD) =
Co-efficient of Variation
Standard deviation is the absolute measure of dispersion. The relative measure of
dispersing based on the standard deviation is known as the measurement of coefficient
of standard deviation. The percentage of measure of co-efficient of so is called co-
efficient of variation. Less CV is the more uniformity and consistency and vice versa.
Only standard deviation is not appropriate to compare two pairs of variables but also
CV is capable to compare two variables independently in terms of their variability. It
is calculated as under:
Coefficient of Variation (C.V.) = 100%
Coefficient of Correlation
Correlation coefficient is defined as the association between the dependent variable
and independent variable. It is a method of determining the relationship between these
two variables. If the two variables are so related change in the value of independent
variable cause the change in the value of dependent variable then it is said to have
correlation coefficient.
Correlation Coefficient (r) =
For this study, t-test for significance of an observed and sample correlation coefficient
is used. Set up Hypothesis
Null hypothesis (H₀); ρ = 0 i.e. the correlation between the considered variables are
not significant in the population.
Alternative Hypothesis (H₁); ρ ≠ 0 i.e. the correlation between the considered
variables are significant in the population.
Test statistic under H₀;
t=
Where,
r = Sample correlation between two variables
n = No of Pair of observations
Level of significance: Level of significance is ∝ = 5% and
Decision: If p-value for the calculated correlation coefficient is less than the
significance level the null hypothesis is rejected concluding the coefficient is
significant in the population and if p-value for the calculated correlation coefficient is
greater than the significance level null hypothesis is accepted concluding that the
coefficient is not significant in the population.
Regression Analysis
In statistical modeling, regression analysis is a set of statistical processes for
estimating the relationships among variables. It includes many techniques for
modeling and analyzing several variables, when the focus is on the relationship
between a dependent variable (ROA and ROE) and one or more independent variables
(bank size, loan and advance to total deposit ratio, total debt to total equity ratio and
capital adequacy ratio). More specifically, regression analysis helps one understand
how the typical value of the dependent variable (or 'criterion variable') changes when
any one of the independent variables is varied, while the other independent variables
are held fixed (Yadav, Dhakal, Tamang, Shrestha, & Panta, 2010).
Regression Equation:
ROA = β0 + β1CAR + β2LDR + β3DER + β4SIZE + e
ROE = β0 + β1CAR + β2LDR + β3DER + β4SIZE + e
Where,
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